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Y3 International money and finance > The parities > Flashcards

The parities Flashcards

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1
Q

Who does the exchange rate expose to potential risks?

A

The exchange rate exposes all households, firms and others who engage in international transactions to risk.

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2
Q

What is foreign exchange risk?

A

Foreign exchange risk is the risk that the value of a future receipt or obligation will change due to a change in the foreign exchange rate.

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3
Q

What is transaction exposure?

A

Transaction exposure is the risk that the cost of a transaction or the proceeds from that transaction may change in terms of the domestic currency due to a change in exchange rates

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4
Q

What is translation exposure?

A

Translation exposure is the foreign exchange risk that results from converting the value of a firm’s foreign-currency denominated assets and liabilities into a common currency value.

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5
Q

What is economic exposure?

A

Economic exposure is the risk that a firm’s future cash flows may be impacted by a change in exchange rates.

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6
Q

Hedging is the act of … or … risk …

A

Hedging is the act of offsetting or eliminating risk exposure.

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7
Q

What does covered exposure mean?

A

A covered exposure means a foreign exchange risk that has been completely eliminated using a hedging instrument.

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8
Q

What is the forward exchange market and what is it’s use?

A

The forward exchange market is a market for contracts that specify the future delivery of a foreign currency at a specified exchange rate.

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9
Q

What is a long position? (Forward market)

A

A long position is an obligation to purchase a financial instrument at a given price at a specific time

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10
Q

What is a short position? (Forward market)

A

A short position is the obligation to sell a financial instrument at a given price at a specific time

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11
Q

What kind of position does a firm expecting future payment have?

A

A firm expecting future payment would therefore have a long position in the market, because they’ll be receiving their payment at the future exchange rate

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12
Q

What is the forward exchange rate?

A

The forward exchange rate specifies the supply and demand for a currency for future delivery

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13
Q

Describe a forward premium

A

A forward premium is when the forward exchange rate is higher than the current spot exchange rate

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14
Q

Describe a forward discount

A

A forward discount is when the forward exchange rate is lower than the current spot exchange rate

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15
Q

What is the formula for a forward premium?

A

The formula for forward premium/discount is (F-E)/E where F is the forward rate and E is the spot rate.

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16
Q

What formula holds if traders share the same expectation?

A

If traders share the same expectation, then the forward discount will equal the expected forward discount.

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17
Q

Under what condition might investors move funds between nations?

A

Investors might move funds between nations if the exchange-rate adjusted return on a similar instrument is different

18
Q

What is a minimum $ related reason why someone may not choose to use a forward rate to hedge risk?

A

Some people may choose not to use a forward rate to hedge risk is because forward transactions usually involve a minimum size of $1 million.

19
Q

What is interest parity?

A

Interest parity is when exchange-rate adjusted domestic and foreign interest rates on similar investments are the same.

20
Q

Individual financial instruments may have characteristics that affect their degree of…

A

Individual financial instruments may have characteristics that affect their degree of risk

21
Q

What is Country risk?

A

Country risk is the possibility of losses on holdings of financial instruments issued in another nation due to political uncertainty in that country.

22
Q

What is the process for a carry trade?

A

A carry trade is when an investor borrows money from a low interest rate country, then after converting the currency, they lend that money in the country with a higher interest rate.

23
Q

An efficient market is one in which market prices…

A

An efficient market is one in which market prices adjust quickly to new and relevant information.

24
Q

What are the two types of foreign investment?

A
  • Portfolio investment

- Foreign direct investment

25
Q

What is portfolio investment?

A

Portfolio investment is the process of investing in a foreign country by purchasing stocks or bonds issued in foreign currencies

26
Q

What is Foreign direct investment?

A

Foreign direct investment is the process of investing in a country by purchasing a new plant, equipment or other physical asset in the country, or taking an ownership stake in a firm in that country.

27
Q

What is the law of one price?

A

The law of one price states that in the absence of transaction costs and official trade barriers, identical goods will have the same price in different countries when expressed using the same currency.

28
Q

Purchasing power parity explains the relationship between…

A

Purchasing power parity explains the relationship between the prices of goods and services, and exchange rates.

29
Q

Absolute PPP is when the exchange rate between two … is equal to the ratio of their … …

A

Absolute purchasing power parity is when the exchange rate between two currencies is equal to the ratio of their price indexes.

30
Q

What are some reasons we see deviations from PPP?

A
  • Differentiated products
  • Transaction costs
  • Trade barriers
  • Goods being untradeable across borders
  • Local regulations and taxes
  • Different consumer preferences in different countries
31
Q

What is relative PPP?

A

Relative purchasing power parity is when the percentage change in the exchange rate is equal to the difference between the inflation rates

32
Q

What is interest parity?

A

Interest parity is the theory that hedged returns from investing in different currencies should be the same, regardless of their interest rate.

33
Q

What are the two options for a domestic investor?

A

A domestic investor can either invest in a domestic instrument or buy a foreign instrument.

34
Q

How can an individual cover their risk?

A

An individual can cover their risk by purchasing a forward contract.

35
Q

What does purchasing a forward contract achieve?

A

By purchasing a forward contract, the investor “locks in” a guaranteed exchange rate at the time of maturity of the investment, which eliminates all foreign exchange uncertainty

36
Q

What are the two steps to cover the foreign exchange rate risk?

A
  • Buy the foreign currency needed to purchase the foreign treasury bill/security
  • Sell the foreign currency on the forward market.
37
Q

Why will CIRP always hold?

A

Covered interest rate parity will always hold because it is an arbitrage condition. When arbitrageurs see the opportunity, they will react to benefit from it, which will close the gap that creates the opportunity itself.

38
Q

What are 2 ways to measure price levels?

A
  • CPI (Tradeable and non-traded goods)

- PPI (Mostly traded goods)

39
Q

If one country’s price level rises faster than the other, what will happen to the lower increasing rate?

A

If one country’s price level rises faster than the other, the currency of the country with the lower increasing price level will appreciate against the currency of the country with the faster-rising price level.

40
Q

Under what condition do we say the dollar is undervalued?

A

We say the dollar is undervalued if it does not fall by the amount suggested by the PPP.

41
Q

What are some fixed factors in the PPP condition?

A
  • Tariffs
  • Quotas
  • Government restrictions
42
Q

What is the difference between absolute and relative PPP?

A

If absolute PPP holds, then relative PPP will also hold. If Absolute PPP does not hold, then relative PPP may still hold.

Y3 International money and finance (9 decks)

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