The Foreign Exchange Market

Question 1

What is the Foreign Exchange Market?

Answer 1

The Foreign Exchange Market is the market in which individuals, firms, and banks buy and sell foreign currencies or foreign exchange.

Question 2

What is the principal function of foreign exchange markets?

Answer 2

The principal function of foreign exchange markets is the transfer of funds or purchasing power from one nation to another.

Question 3

How is the transfer of funds accomplished in foreign exchange markets?

Answer 3

The transfer of funds is accomplished by an electronic transfer where a domestic bank instructs its correspondent bank in a foreign monetary center to pay a specified amount of local currency to a person, firm, or account.

Question 4

What role do commercial banks play in the foreign exchange markets?

Answer 4

Commercial banks operate as clearinghouses for foreign exchange demanded and supplied in the course of foreign transactions by the nation’s residents, serving as intermediaries for the transfer of funds.

Question 5

What is another function of the foreign exchange markets?

Answer 5

Another function of the foreign exchange markets is the credit function

Question 6

How is the exchange rate between the Egyptian pound and the dollar defined?

Answer 6

The exchange rate between the Egyptian pound and the dollar (R) is equal to the number of Egyptian pounds needed to purchase one dollar (R=LE/$).

Question 7

How can the exchange rate be defined alternatively?

Answer 7

The exchange rate can also be defined as the foreign currency price of a unit of the domestic currency.

Question 8

If the Egyptian pound price of the dollar is R=4, what would be the dollar price of the Egyptian pound?

Answer 8

If the Egyptian pound price of the dollar is R=4, the dollar price of the Egyptian pound would be 1/R=1/4, or it would take a quarter of a dollar to purchase one Egyptian pound.

Question 9

How does the demand curve for dollars behave in relation to the exchange rate?

Answer 9

The demand curve for dollars is negatively sloped, indicating that as the exchange rate decreases (lower LE required to purchase a $), the quantities of dollars demanded by Egyptians increase because it means imports become cheaper.

Question 10

How does the supply curve for dollars behave in relation to the exchange rate?

Answer 10

The supply curve for dollars is positively sloped, indicating that as the exchange rate increases (more LE required to purchase a $), the quantity of dollars supplied by US residents and earned by Egypt increases because it means exports become cheaper.

Question 11

Why does a higher exchange rate lead to a greater quantity of dollars supplied by US residents and earned by Egypt?

Answer 11

At a higher exchange rate, US residents receive more Egyptian pounds for each of their dollars, making Egyptian goods and investment cheaper and more attractive. As a result, they spend more in Egypt, thus supplying more dollars to Egypt.

Question 12

How is the equilibrium Egyptian pound price of the dollar (R) determined under a flexible exchange rate system?

Answer 12

The equilibrium Egyptian pound price of the dollar (R) is determined by the intersection of the market demand and supply curves for dollars, similar to the price of any commodity.

Question 13

Where does the equilibrium occur in the market for dollars under a flexible exchange rate system?

Answer 13

The equilibrium occurs at the point (E), where the quantity demanded and the quantity supplied of dollars are equal, as determined by the intersection of the Egyptian demand and supply curves for dollars.

Question 14

What happens when the exchange rate is higher than the equilibrium rate in a flexible exchange rate system?

Answer 14

When the exchange rate is higher than the equilibrium rate, a surplus of dollars would result, which would tend to lower the exchange rate toward the equilibrium rate.

Question 15

What happens when the exchange rate is lower than the equilibrium rate in a flexible exchange rate system?

Answer 15

When the exchange rate is lower than the equilibrium rate, a shortage of dollars would result, which would drive the exchange rate up toward the equilibrium level.

Question 16

What does depreciation refer to in the context of foreign currency?

Answer 16

Depreciation refers to an increase in the domestic price of the foreign currency.

Question 17

What causes depreciation of the domestic currency?

Answer 17

An upward shift in Egypt’s demand curve for dollars, indicating an increase in Egypt’s taste for US goods, intersects the supply curve at a higher exchange rate, resulting in the depreciation of the domestic currency.

Question 18

If the exchange rate increased from 1 LE to 1.50 LE, what does it indicate about the Egyptian pound?

Answer 18

If the exchange rate increased from 1 LE to 1.50 LE, it means that the Egyptian pound has depreciated because it now requires 1.50 LE to purchase 1 dollar instead of 1 LE.

Question 19

What does appreciation refer to in the context of foreign currency?

Answer 19

Appreciation refers to a decline in the domestic price of the foreign currency.

Question 20

What causes appreciation of the domestic currency?

Answer 20

A downward shift in Egypt’s demand curve for dollars, indicating a decrease in Egypt’s demand for US goods, intersects the supply curve at a lower exchange rate, resulting in the appreciation of the domestic currency.

Question 21

If the exchange rate decreased to 0.50 LE instead of 1 LE, what does it indicate about the Egyptian pound?

Answer 21

If the exchange rate decreased to 0.50 LE instead of 1 LE, it means that the Egyptian pound has appreciated because it now requires 0.50 LE to purchase 1 dollar instead of 1 LE.

Question 22

What is the relationship between the appreciation of the domestic currency and the depreciation of the foreign currency?

Answer 22

An appreciation of the domestic currency implies a depreciation of the foreign currency, and vice versa.

Question 23

What is a cross exchange rate?

Answer 23

A cross exchange rate refers to the exchange rate between two currencies that are not the domestic currency.

Question 24

Define cross exchange rates

Answer 24

A cross exchange rate refers to the exchange rate between two currencies that are not the domestic currency.

Question 25

How are cross exchange rates determined?

Answer 25

Once the exchange rate between each of a pair of currencies with respect to the dollar is established, the exchange rate between the two currencies themselves, or cross exchange rate, can be easily determined.

Question 26

Give an example of a cross exchange rate.

Answer 26

An example of a cross exchange rate would be the exchange rate between the Egyptian pound (LE) and the British pound, or between the Egyptian pound and the Swiss Franc.

Question 27

How are cross exchange rates related to the exchange rate between the domestic currency and the dollar?

Answer 27

Cross exchange rates are derived from the exchange rates between the domestic currency and the dollar, as well as the exchange rates between other currencies and the dollar.

Question 28

What is arbitrage in the context of exchange rates?

Answer 28

Arbitrage refers to the purchase of a currency in a monetary center where it is cheaper, for immediate resale in a monetary center where it is more expensive, in order to make a profit.

Question 29

How does arbitrage help in keeping the exchange rate between two currencies the same in different monetary centers?

Answer 29

Arbitrage ensures that the exchange rate between two currencies remains the same in different monetary centers because traders take advantage of price discrepancies to buy low and sell high, effectively equalizing the exchange rates.

Question 30

How does arbitrage work in practice?

Answer 30

In practice, an arbitrageur would purchase a currency at a lower price in one monetary center and immediately resell it in another monetary center where it is priced higher, thereby making a profit from the price difference.

Question 31

Can you provide an example of arbitrage in action?

Answer 31

An example of arbitrage would be if the dollar price of the euro was $0.99 in New York and $1.01 in Frankfurt. An arbitrageur could buy euros in New York at $0.99 and sell them in Frankfurt for $1.01, making a profit of $0.02 per euro.

Question 32

How can arbitrage lead to significant profits even with small price differences?

Answer 32

Although the profit per currency transferred may seem small, on larger transactions, such as €1 million, the profit can amount to a significant sum, such as $20,000, making arbitrage a lucrative opportunity.

Question 33

What is the effect of arbitrage on the exchange rate between two currencies in different monetary centers?

Answer 33

Arbitrage equalizes the exchange rate between two currencies in different monetary centers. It increases demand for the currency in the cheaper monetary center, putting upward pressure on its price, while the sale of the currency in the more expensive monetary center increases its supply, putting downward pressure on its price. This process continues until the exchange rate becomes equalized in both centers.

Question 34

What is meant by two-point arbitrage?

Answer 34

Two-point arbitrage refers to the situation where only two currencies and two monetary centers are involved in the arbitrage process, such as in the example provided.

Question 35

What is triangular or three-point arbitrage?

Answer 35

Triangular or three-point arbitrage occurs when three currencies and three monetary centers are involved. The arbitrage operates in a similar manner to two-point arbitrage, aiming to equalize exchange rates among the three currencies.

Question 36

How do changes in exchange rates impact the prices of internationally traded goods and services?

Answer 36

Changes in exchange rates affect the prices of goods and services traded internationally, including imports and exports. When the exchange rate fluctuates, it directly influences the cost of foreign goods and can impact the competitiveness of domestic products in foreign markets.

Question 37

Why is official intervention in the foreign exchange markets necessary?

Answer 37

Official intervention in foreign exchange markets is often carried out by central banks to influence the value of their domestic currency. This intervention is motivated by the desire to achieve exchange rate levels different from the values determined by free market forces. It is done to manage the impact on imports, exports, and the balance of payments.

Question 38

What is one major reason for central banks to engage in buying and selling currencies?

Answer 38

Central banks engage in buying and selling currencies to control and influence the value of their domestic currency. By buying or selling currencies, they can intervene in the foreign exchange markets to manage the exchange rate and its impact on trade and the overall economy.

Question 39

What role does the nation’s central bank play when there is an imbalance between foreign exchange supply and demand?

Answer 39

The nation’s central bank acts as the seller and buyer of last resort in the foreign exchange market when there is an imbalance between foreign exchange supply and demand. It manages this by drawing down or adding to the foreign exchange reserves.

Question 40

How does the central bank address a balance of payment deficit?

Answer 40

In the case of a balance of payment deficit, where the total demand for foreign exchange exceeds the total foreign exchange earnings, the central bank allows for adjustments in exchange rates to equilibrate the quantities demanded and supplied. If this adjustment is not sufficient, the central bank becomes the “lender of last resort” and provides foreign currency by drawing down its reserves.

Question 41

What happens when there is a balance of payment surplus?

Answer 41

When there is a balance of payment surplus and an excess supply of foreign exchange, the central bank allows for adjustments in exchange rates. If these adjustments are not sufficient, the central bank exchanges the excess supply of foreign exchange for the national currency, thus increasing the nation’s foreign currency reserves.

Question 42

What happens to the exchange rate if there is an increase in Egyptian imports from the US?

Answer 42

If there is an increase in Egyptian imports from the US, the demand for dollars (D$) shifts up to D’$, leading to the depreciation of the Egyptian pound against the dollar. The exchange rate remains at R=1, but the central bank of Egypt satisfies the excess demand for $250 million per day by selling dollars from its official reserves, shifting the supply curve to S’

Question 43

What is the new equilibrium point after the increase in Egyptian imports?

Answer 43

The new equilibrium point is B, where the exchange rate remains at R=1, but at a higher quantity of dollars being traded. At this new equilibrium, the central bank’s intervention maintains the exchange rate stability.

Question 44

What would happen under a freely flexible exchange rate system?

Answer 44

Under a freely flexible exchange rate system, the Egyptian pound would continue to depreciate until the exchange rate reaches R=1.50 at the new equilibrium point (E’). This depreciation reflects the market forces adjusting the exchange rate to balance the supply and demand of dollars.