Section 4 - Exchange rates

Question 1

how does the foreign exchange rate market behave?

Answer 1

Like other markets with downward-sloping demand curves and upward-sloping supply curves

Question 2

what is the balance of payments in terms of exchange rates?

Answer 2

a formal and systematic record of transactions between the residents of one country and the rest of the world

Question 3

what are the different versions of the balance of payments? and explain these

Answer 3

• current account refers to the cross-border flow of goods, services and other net income from abroad
• capital account involves the flows of transactions in financial assets
• visible trade is trade in goods
• invisible trade refers to flows of services

Question 4

what must the overall balance of payments sum to and when?

Answer 4

sum to zero once government intervention is included

Question 5

if domestic residents are exporting more than they are importing then….

Answer 5

they must be increasing their holdings of foreign assets

Question 6

what is a floating exchange rate?

Answer 6

the value of a county’s currency fluctuates with market forces

the market sets the exchange rate

Question 7

what is a fixed exchange rate

Answer 7

the government manipulates the value of the countries currency

try to keep exchange rate fixed or in some form of range

Question 8

what is an optimal currency area OCA

Answer 8

a geographic region created to maximise a region’s economic efficiency through use of a single currency.

Question 9

what is the intention of an OCA

Answer 9

intended to allow for closer integration of capital markets and facilitate trade between countries within it.

Question 10

what may countries with close economic ties benefit from?

Answer 10

• a common currency area
• reduced transaction costs for inter-country trade within the OCA
• enhanced sale of production leading to scale economies with larger ‘domestic market’

Question 11

what does a common currency result in in terms of loss

Answer 11

loss of each country’s ability to direct fiscal and monetary policy interventions to stabilise its own economy

Question 12

what are the conditions generally considered to be essential for a successful currency union

Answer 12

• labour should be fully mobile between countries, with few meaningful barriers. Different languages and pension schemes for example would be considered barriers
• capital should be able to move between countries with no restrictions
• if labour and capital are not fully mobile; then a risk-sharing mechanism (such as an automatic fiscal transfer scheme) should be available to redistribute income to less well off regions
• countries should have similar business cycles so that the central bank can set a single interest rate appropriate to all countries. This could happen if some countries were experiencing a boom whilst others were in a slump

Question 13

what is exchange rate risk?

Answer 13

uncertainty in the return on a foreign investment due to the uncertainty in the rate that domestic currency can be exchanged for foreign currency.

Question 14

does the FOREX market have a physical presence?

Answer 14

no

Question 15

what is the FOREX market

Answer 15

market for foreign exchange

Question 16

who are final customers of the FOREX market?

Answer 16

• corporations requiring foreign currency, for example, to purchase foreign inputs to their production process, or which wish to exchange foreign currency earned through the export of their goods for domestic currency
• financial institutions wishing to buy foreign financial assets
• private individuals who may wish to purchase foreign currency, such as for a holiday abroad

Question 17

how are participants of forex linked and who are the 300 participants

Answer 17

linked via computers

The market makers are the major international banks who also trade on their own behalf. Some participants act only as brokers dealing on behalf of their clients

Question 18

what type of market is FOREX?

Answer 18

continuous dealers marker

Question 19

where do foreign exchange transactions on the FOREX market that are for immediate delivery of foreign currency take place?

Answer 19

on the spot market

Question 20

when are transactions on the spot market usually settled?

Answer 20

T+2 days - but this may be extended for example when one of the foreign currency markets has a bank holiday

Question 21

in the spot market what will currency market makers quote?

Answer 21

two spot prices

• the lower rate is the bid price - price they are willing to buy sterling
• the higher rate is the rate at which they are willing to sell sterling - ask price

the difference between these two rates is the market makers spread, which is how they generate their profit.

Question 22

when is the forward rate said to be trading at a premium?

Answer 22

if the forward price of the currency is higher than the spot price

Question 23

what is a forward market transaction?

Answer 23

an agreement to buy currency at a future date and at. fixed price agreed now

Question 24

when is the forward rate said to be trading at a discount?

Answer 24

when the currency’s spot price is higher than its forward rate

Question 25

an increase in domestic interest rates will tend to cause that country’s currency to…………

Answer 25

appreciate

Question 26

a decrease in domestic interest rates will tend to cause that country’s currency to…………

Answer 26

depreciate

Question 27

if the UK raises interest rates how will this affect demand for sterling?

and what would this cause?

Answer 27

will increase demand for sterling

meaning investors can take advantage

Question 28

what is Covered interest rate parity

Answer 28

Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. The covered interest rate parity situation means there is no opportunity for arbitrage using forward contracts, which often exists between countries with different interest rates.

Question 29

what is uncovered interest rate parity

Answer 29

Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.