(Topic 5) Foreign Exchange Markets Flashcards
What is the foreign exchange market?
A global marketplace where various national currencies are bought and sold.
Who are the main participants of the foreign exchange market?
- Retail clients
- Commercial banks
- Foreign exchange brokers
- Central banks
What is the exchange rate?
The price of one currency in terms of another.
What is the difference between a bid and offer rate (in terms of exchange rates)?
Bid rate:
The rate at which bank will buy a currency.
Offer rate:
The rate at which bank will sell a currency.
What is the spot exchange rate?
The exchange rate between two currencies for immediate delivery.
What is the forward exchange rate?
The exchange rate between two currencies quotes for a given date in the future.
As the pound appreciates against the dollar, the price of UK exports to US importers increases. This leads to a lower quantity of exports with a reduced demand for pounds. What causes a rightward shift in the demand curve?
- A rise in US income
- A change in US tastes in favour of UK goods
- A rise in the price of US goods
As the pound appreciates against the dollar, the costs of US exports becomes cheaper for UK residents. They demand more US exports, increasing demand for dollars which are purchased bu increasing the amounts of pounds supplied in the foreign exchange market.
What causes a right shift in the in supply?
- An increase in UK income
- A change in British tastes in favour of US goods
- A rise of UK prices
What main exchange rate regimes were aided by the collapse of the the Bretton Woods system in 1973?
- Floating exchange rates
- The authorities do not intervene to buy or sell their currency in the foreign exchange market (only fluctuations in s/d) - Fixed exchange rates
- A system whereby the exchange rate is fixed against another currency at a given target exchange rate
What happens in the forward exchange rate market?
Market buyers and sellers agree to exchange currencies at some specific date in the future.
There are 3 groups of economic agents within the forward exchange rate market, what are they?
- Hedgers (protect themselves against exchange rate fluctuations)
- Arbitrageurs (aim to make a riskless profit out of any discrepancy between interest-rate differentials and the forward discount/premium)
- Speculators (aim to make a profit by accepting exchange rate risk, taking open position in the foreign currency market)
What is the forward discount/premium?
A measure expressed as a percentage per annum of the spot rate by which a currency is weaker/stronger in the forward market than in the spot market.
F-S/S * 100
F = forward
S = spot
What is the covered interest parity (CIP)?
A formula used by banks to calculate a forward exchange rate quotation.
The presence of arbitrageurs ensures that the CIP holds continuously.
F = (r-r)S/(1+r) + S
r = domestic interest rate
r foreign interest rate
What is the nominal exchange rate?
The price of one currency in terms of another, with no reference made to what this means in terms of purchasing power of goods and services.
What is the real exchange rate?
The nominal exchange rate adjusted for relative prices between the countries under consideration and is expressed in an index form so that a rise represents a loss competitiveness, while a fall represents a gain in competitiveness of the indexed currency.
