Topic 1 Flashcards
What does the international Monetary System refer too and what does it in turn have an effect on?
the institutions and policies that determine exchange rates. In turn has an effect on countries economies , companies need to know as determines how they do business
What are the two main different types of exchange rate systems and how are they classified?
Fixed and floating
classified by the extent of the intervention from either gov or central bank controlled or by the markets.
Explain fixed exchange rates
exchange rates are held constant or are allowed to fluctuate within very narrow boundaries
devaluation is when …
when the currency falls in value against another currency (fixed system)
revaluation is when …
when the currency rises in value against another currency (fixed system)
what are fixed rate exchange systems controlled by?
governments
what are pegged rate exchange systems controlled by?
central banks
what is an example of a pegged system
Hong Kong dollar (HK$) /US$
2016 Venezuelan Bolivar Example:
base rate is B10/US$
A) What happens when B9/US$?
B) What happens when B11/US$?
A) strengthening of B, gov/central bank sell B to bring rate back down
B) weakening of B, gov/central bank buy B to try and bring rate back down
Under pegged or fixed systems what would the gov or central banks do if the currency moved away from base level?
intervene to bring back to fixed rate by selling or buying currency determining if the currency had strengthened or weakened respectively.
Advantage of fixed rate exchange system
- reduces exchange rate risk for companies (little uncertainty about what it is worth)
BUT
there is still a risk of devaluation/revaluation, does not eliminate just reduce - fixed exchange rate systems can export economic problems
What happens when Argentinean goods become relatively more expensive than US products…. (Inflation)
- consumers will buy US products as cheaper
- move from Argentinean goods to US goods ( demand in argentina goes down and up in US. Production will have to go down in argentina and up in US.
- Move employment from argentina to US
- wage levels will fall in Argentina and rise in the US (wages in US will rise, so business costs rise in US, so prices in US rise = Inflation
Is inflation, wages and employment linked?
yes
What are floating exchange rates determined by?
market forces
what is the term used when there is an increase in currency value (floating system)
appreciation
what is the term used when there is an decrease in currency value (floating system)
depreciation
What is an advantage of floating rate system
- countries are insulated from economic problems of other countries, as the exchange rate will adjust to compensate for the change in price of goods
what is a disadvantage of floating exchange rate systems
companies are exposed to exchange rate risk, as rate changes all the times companies will not know what exchange rate will be when they make the transaction
what is hedging
getting rid of exchange rate risk
What are the 3 categories of of IMF’s classification of exchange rate systems 2009
hard pegs
soft pegs
floating arrangements
hard pegs is when….
example…
where countries have to give up the control over monetary policy, eg zimbabwe dollarisation
soft pegs is when
example…
covers countries with fixed exchange rate systems. subcategories differentiate between different types of fixed rate systems, e.g. extent to which variation is allowed , extent of government intervention.
eg HK$/US$ , former european exchange rate mechanism
(this category is more common)
floating arrangements is when …
examples …
covers countries whose exchange rates are mainly determined by market forces.
eg Managed/ dirty floats = £, $ ,¥
eg most floating currency = CA$ (ie least gov intervention)
What does de facto mean
actual behaviour / in practice
what does de jure mean
based on official policy statements / theory
Is the IMF 2009 system based on de facto or de jure
de facto
what is the purpose of the foreign exchange market?
to enable companies, individuals etc to trade one currency for another
Where do central banks agree to co-operate with one another
bank for international settlements
What are qualities of the foreign exchange market?
- over 90% of FX transactions are through the interbank market (where banks trade with one aother)
- an over-the-counter (OTC) market (not one physical location of trade - done via phone etc)
24hr market
where is 78% of trading concentrated (BIS, 2022)
UK
Singapore
Hong Kong
Japan
US
By what percentage does the US $ dominate the market (% of trades that involve the US$)
88%
What are the percentages of trade involving the dominant currencies and the % of the emerging market currencies in 2022 (BIS)
US$ - 88%
euro -30.5% (down from 2019)
japanese yen - 17%
brittish pound - 13%
emerging markets:
chinese renminbi - 7%
south korean won - 2.2%
mexican peso - 1.5%
What are the two types of FX transactions
spot market
forward market
describe what happens in a spot market transaction
currencies are traded for immediate delivery
t + 2 settlement delivery
transaction is conducted on todays price
describe the forward market
most popular
currencies are bought and sold at prices agreed now but for future delivery at an agreed date
“locking in a price” - hedging
forward rate is based on what they think the price/spot rate will be
regarding forward market transactions if the period is over 12 months what is this called
SWAP market
What are the different Market participants?
FX dealers (marketmakers)
brokers (matchmakers)
retail customers
speculators and arbitragers
what to FX dealers do
buy and sell currencies on a continuous basis
what is a bid price
bank buy price
what is a offer/ask price
bank sell price
bank needs to make a profit so what relationship must there be between bid and ask price
ask >bid
what does retail customers cover
governments/ central banks
companies eg exporting and importing
smaller domestic banks
what do speculators do
gamble on FX movements
what do arbitragers do
exploit riskless profit opportunities
if the companies aim is to maximize shareholder wealth what kind of market participant should they be and what should they not be
shouldnt be speculators, should be arbitragers as want to minimise currency risk rather than gamble
What is a direct quote
the number of units of home currency needed to buy one unit of foreign currency
e.g. £0.538/C$
What is an indirect quote
the number of units of foreign currency needed to buy one unit of home currency
e.g C$ 1.7129/£
How do you get from indirect to direct quote and vis versa
1/home(direct) = foreign (indirect)
1/foreign (indirect) = home (direct)
what is bid-ask spread
difference between buy and selling rate, shows how risky the currency is
what is the impact for us of
a) banks bid
b) banks sell price
a) our sell price
b) our buy price
what are the normal first 3 digits of the currency exchange dollor
1.60
difference between banks buy and sell ie buy-sell is called what
spread
what does pip stand for
Price Interest Point
Percentage In Point
%Spread =
(ask-bid)/ ask x100
what does spread reflect
risk
what does wide spread mean in terms of trade qualities
RISKY TO TRADE
Illiquid
Volatile
e.g. emerging markets
what does narrow spread mean in terms of trade qualities
LESS RISKY TO TRADE
Liquid
Stable
eg £,$, jap yen
what is a cross rate
an exchange rate that is calculated from 2 rates, e.g. if you don’t want to include dollar in rate
How would you calculate the value of 1 unit of A in units of B
Value of A in $(common currency) / Value of B in $(common currency)
where A = pricing currency ie RHS, expressed as one whole unit
b= LHS, base currency
what is capital flows
the movement of wealth across countrys
what is capital flows an indicator of
financial health of global economy
what can capital flows impact
countrys economic growth, development and financial stability
what does IMF stand for
International Monetary Fund
What is the impossible trinity
1 Exchange rate stability : value of currency is fixed in compassion to other major currencies
- Full Financial Integration : complete freedom of monetary flows between countries
- Monetary Independence: Domestic monetary and interest rate policies would be set by the individual countries
what one of the impossible trinity does
a) US
b) China
c) Europe
forgo
a) Exchange rate stability
b) Full Financial Integration
c) Monetary Independence
what are the benefits of the euro
cheaper transaction costs
risks associated with exchange rate reduced
price transparency and increased price competition
arguments against dollarisation
loss in authority over monetory policy
country losses the ability to profit from printing of its own money (seigniorage)
central bank can no longer have the role of lender as last resort
arguments for dollarisation
removes currency volatility againt the dollar
elminate the possibility of future crisis’s
greater economic integration with other dollar based economies
several countries that are highly economically integrated would benefit from dollarising together
what is the choice that emerging market nation currency’s must make
free-floating regime vs currency board or dollarisation
drawback of the euro
loss of monetary independance
what countries made up the euro in 1999 when it began and what country joined two years later
austria, belguim, finland, france, germany, ireland, italty, luxemburg, the Netherlands, Portugal, Spain
2 years later greece
euro vs the dollar
2002-2008 euro appreciated vs dollar
since then, it has depreciated slowly
though does show significant volatility
