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Financial Markets 2014 > Topic 3 - Foreign exchange > Flashcards

Topic 3 - Foreign exchange Flashcards

1
Q

3.01 - What are the four major exchange rate regimes?

A
  • Floating exchange rate
  • Managed float
  • Crawling peg
  • Lined exchange rate
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2
Q

3.02 - What is the floating exchange rate?

A

An exchange rate is determined by supply and demand factors in FX markets (AUD, USD).

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3
Q

3.03 - What is the Managed float exchange rate regime?

A

An exchange rate is held within a defined band relative to another currency and only limited fluctuations are allowed (IDR, SGD).

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4
Q

3.04 - What is the crawling peg exchange rate regime?

A

It is a managed float where an exchange rate is allowed to appreciate in controlled steps over time.

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5
Q

3.05 - What is the linked exchange rate regime?

A

It is the value of the pegged currency tied into the value of another currency or basket of currencies (HKD)

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6
Q

3.06 - Who are the FX market participants?

A
  • FX Dealers
  • FX Brokers
  • Central banks
  • Firms conducting international trade transactions
  • Investors and borrowers
  • Speculators
  • ARbitrage transactions
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7
Q

3.07 - What is the role of the FX dealer in the FX market?

A

They are institutions that quote buy (bid) and sell (offer) - ie two way prices - and act as principals in the FX market. They include investment and commercial banks

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8
Q

3.08 - What is the role of the FX broker?

A

To obtain the best prices in the global FX markets and match FX dealers buy and sell orders for a fee.

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9
Q

3.09 - What is the role of the central banks in the FX market?

A
  • to purchase FX to pay for govt imports or interest on govt debt
  • change the composition of holdings in FX
  • influence the exchange rate
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10
Q

3.10 - What is the role of the firms conducting the international trade transactions in the FX market?

A
  • Exporters - receive foreign currency for sale of their G&S
  • Exporters - sell foreign currency to buy AUD
  • Importers - buy foreign currency to purchase imports
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11
Q

3.11 - Who are the investors and borrowers in the international money markets and capital markets? and what is their role?

A
  • Commercial banks - need FX to repay loan and interest in FX
  • Corporations & investors - need FX to make investments and to convert interest or dividends received.
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12
Q

3.12 - What is the role of speculators in the FX market?

A

They anticipate future exchange rate movements to make a profit.

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13
Q

3.13 - What are arbitrage transactions?

A

Profit is made through FX transactions that involve no FX risk exposure. This is because transactions occur simultaneously in two or more currencies to take advantages of pricing differences.

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14
Q

3.14 - What are the two ways that an arbitrage transaction could come about?

A
  • Geographic - dealers in different locations quote at different rates on a currency
  • Triangular - where three or more currencies are out of alignment.
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15
Q

3.15 - Describe the operation of the FX market?

A

It is global, operating 24 hours a day according to business hours across the time zones. It is vast and highly sophisticated and includes large FX dealers who operate through their treasury operations.

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16
Q

3.16 - FX market instruments are typically what?

A
  • Spot transactions - maturity date two business days after the FX contract is entered into
  • Forward transactions - maturity date is more than two days after an FX contract was entered into.
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17
Q

3.17 - Dealers also use ‘Tod’ and ‘Tom’ transactions, what are these?

A

They are transactions that have a maturity date of ‘Today’ for Tod and ‘Tomorrow’ for Tom.

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18
Q

3.18 - How are spot market quotations expressed?

A

First currency is base currency (unit of quote) and second is the terms currency which is used to express the value of the base currency.

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19
Q

3.19 - Explain the spot quote AUD/USD 1.24

A

This means that one AUD is equal to $1.24 USD.

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20
Q

3.20 - What is a two-way quotation?

A

A two way quotation is where a dealer indicates a buy (bid) price and sell (offer) price. The dealer buys low and sells high and is known as a price maker.

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21
Q

3.21 - What is the spread?

A

The spread is the difference between the buy and sell prices.

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22
Q

3.22 - How would you transpose a spot quotation? eg. EUR / AUD 1.3755-65

A

1) transpose bid and offer price to offer and bid 1.3765 and 1.3755 (Swap)
2) divide both numbers into 1 eg 1/1.3765 = 0.7265 and 1/1.3755 = 0.7270 (Div by 1)
3) reword to AUD/EUR 0.7265-70 (Reword)

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23
Q

3.23 - When does the cross rate need to be calculated?

A

When an FX transaction is to occur between two currencies where neither currency is the USD (as most currencies are quoted in USD).

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24
Q

3.24 - The method for calculating the cross rate depends on whether the quote is a direct or indirect quote with the USD. What does this mean?

A
  • A direct quote has the USD as the base currency

* An indirect quote has the USD as the term currency and the other currency as the base.

25
Q

3.25 - What is the process for calculating the crossing of two direct FX quotations?

A

1) Place currency that is to become the unit of quotation first (swap)
2) Divide opposite bid and offer rates
3) Divide base currency offer into the terms currency bid (gives bid rate)
4) Divide base currency bid into the terms currency offer.

26
Q

3.26 - What is the process for calculating the crossing of a direct and indirect FX quotation?

A

1) Multiply the two bid rates (gives the new bid rate)

2) Multiply the two offer rates (gives the new offer rate)

27
Q

3.27 - What is the difference between the forward exchange rate and the spot rate?

A

They vary because of interest rate parity. This is because interest rates vary from country to country and the differential is therefore taken into account when calculating forward exchange rates.

28
Q

3.28 - A forward market quote of AUD/USD 0.9630-40,32,27. The last two numbers are the forward points. How would this quote be interpreted?

A

The forward points are decreasing, going from larger to smaller, so they are subtracted from the spot rate, so this would give a spot rate of AUD/USD 0.9598-0.9613.

29
Q

3.29 - What is a forward exchange contract?

A

It is a contract that locks in the exchange rate on a currency pair that will apply at a future nominated date. The FX dealer will trade today and then invest the funds.

30
Q

3.30 - What are the complications with the FX quotations?

A
  • Two-way - care is needed in selecting appropriate bid and offer rates in calculating forward points.
  • Different interest rate year conventions - 360 vs 365 day years
  • variations in compounding periods - consider the effective rate of interest on borrowed funds and the value of deposits
  • borrowing and lending interest rates.
31
Q

3.31 - What are the factors that influence exchange rate movements?

A
  • Relative inflation rates
  • Relative national income growth rates
  • Relative interest rates
  • Exchange rate expectations
  • Central bank or government intervention
32
Q

3.32 - What way is demand drawn and why? What is the impact of a fall in AUD?

A

Downward sloping because people will want more as the dollar decreases. A fall of AUD effectively reduces the price of everything in Australia.

33
Q

3.33 - What way is the supply line drawn and why?

A

Upward sloping as the quantity of AUD supplied to the FX market increases as the price of AUD increases. As AUD appreciates the price of foreign currency falls making foreign goods cheaper for Australians.

34
Q

3.34 - Where is equilibrium for exchange rates?

A

It occurs where the supply of AUD is equal to the demand for AUD.

35
Q

3.35 - What is the Purchasing Power Parity?

A

It is where exchange rates adjust to ensure prices of the same goods are equal between countries

36
Q

3.36 - What law is the Purchasing Power Parity based on and what does this predict?

A

The law of one price - which predicts that identical commodities will sell at the same price in different currencies after adjustment for exchange rates.

37
Q

3.37 - Does Purchasing Power Parity hold true over the short or long run and why?

A

It holds true over the long run, but not short, as not all goods are traded.

38
Q

3.38 - What could cause the Purchasing Power Parity (PPP) to fail?

A
  • Theory may be wrong
  • Statistical problems between countries
  • Goods are not homogenous
  • Transport costs and trade barriers
  • Element of monopoly or monopsony (single buyer)
  • Sticky prices
  • Uncertainty and bias for home.
39
Q

3.39 - How do inflation rates impact foreign exchange rates? eg if there was an increase in inflation in the US?

A

Increase in US inflation would make goods more expensive so Australian demand would decline, so there would be less demand in Australia for USD so the amount of AUD on the market would decline.

40
Q

3.40 - How do relative national income growth rates impact foreign exchange rates? eg if Australian income rises relative to the US?

A

The Australian demand for imports will increase, increasing the supply of AUD in the FX market which in turn will cause the AUD value to decrease. A secondary effect could be increased investment in Australia, increasing the demand for AUD, which may cause the AUD to recover some value.

41
Q

3.41 - How do relative interest rates impact foreign exchange rates? eg if Australian rates rise relative to the US?

A

US residents and companies may redirect some of their cash into Australian interest bearing instruments, increasing demand for AUD. Australians are likely to keep surplus funds invested in Australia reducing the supply of AUD, causing AUD to appreciate.

42
Q

3.42 - What is the other important factor to consider in comparing interest rates across countries?

A

That the value of the currency may also change during the investment period and this may reduce or completely wipe out interest rate gains.

43
Q

3.43 - What are the two types of change in the nominal interest rate?

A

Change due to the:

  • real rate of return
  • inflation expectations premium
44
Q

3.44 - What is the formula for determining the nominal rate of interest?

A 
inom = r + Pe where:
r= real rate of return
Pe = inflationary expectations premium
45
Q

3.45 - Why is it important to determine whether it is the real rate of return or inflation expectations that have caused the nominal rate of interest to change?

A

Because depending on which is the cause, the currency may depreciate if rates rise due to inflationary expectations, but appreciate if rates rise due to a real rate of return.

46
Q

3.46 - Why could the currency depreciate if rates rise because of inflationary expectations premium?

A

Because of:

  • The effect of inflationary expectations (PPP) theory
  • People seeking to invest in overseas holdings to avoid loss of value.
47
Q

3.47 - Why could the currency appreciate if rates rise due to an increase in the real rate of return?

A
  • Because of an inflow of funds from the rest of the world.
48
Q

3.48 - What are the causes of turnover in the FX market?

A
  • transactions associated with exports & imports
  • transactions associated with financial assets
  • exchange rate expectations (speculation)
49
Q

3.49 - Exchange rate expectations are based on future changes of what?

A
  • relative inflation
  • relative income growth
  • relative interest rates
50
Q

3.50 - How can policies and government intervention affect the expectations of speculators in the FX markets?

A

Policies can influence the rate of inflation, income growth and interest rates.

51
Q

3.51 - How may the Central Bank influence currency?

A
  • By intervening in international trade flows
  • Intervening in foreign investment flows
  • Directly intervening in the FX market
52
Q

3.52 - What are international trade flows aimed at doing? and how are these achieved?

A

Increase exports and/or reduce imports by using:

  • subsidies to exporters (more competitive)
  • intervention on the import side
53
Q

3.53 - What are the types of intervention on the import side that a government can achieve to improve international trade flow?

A
  • Tariffs - charge levied on imports increasing price
  • Quotas - restrict the amount imported
  • Embargo - prohibition on the import of specified goods and services
54
Q

3.54 - What are foreign investment flows aimed at doing? and how are these achieved?

A

Alter the exchange rate by imposing:

  • prohibitions on the outflow of funds from a country
  • penalty taxes on residents who earn income off shore
  • penalty taxes on non-residents interest income earned in the home country.
55
Q

3.55 - Direct FX market intervention involves the purchases of currency. What are the two motivations?

A
  • Smoothing - RBA tries to remove volatility caused by speculators
  • Exchange rate targeting - push the equilibrium to some level
56
Q

3.56 - What is the net exchange position?

A

Total foreign currency bought minus the total sold.

57
Q

3.57 - What is a long position?

A

Where the net exchange position shows more foreign currency bought than sold.

58
Q

3.58 - What is a short position?

A

Where the net exchange position shows more foreign currency sold than bought.

59
Q

3.59 - What is a square position?

A

Where the total bought equals the total sold

Financial Markets 2014 (8 decks)

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