Unit 2: Part 2- Exchange Rate & Interest Rate Fluctuations

Question 1

What determines the level of the spot exchange rate?

Answer 1

balance of payments, purchasing power parity, interest rate parity theory & international fisher effect

Question 2

What is balance of payments?

Answer 2

summary of transactions between domestic & foreign residents over a specified period of time (imports, exports etc.)

Question 3

What does balance of payments records & evaluate?

Answer 3

Balance of payments records detailed information concerning the demand & supply of a currency, and helps to evaluate the performance of a country in international economic competition

Question 4

What is balance of payments made up of?

Answer 4

Current account & financial account (capital account & reserve account)

Question 5

What is the UK’s current account made up of?

Answer 5

The UK’s current account is made up of: Balance of trade, Balance of services, Balance of income & Current transfers

Question 6

What is a current account deficit?

Answer 6

If you have an overvalued exchange rate this would make foreign goods & services a lot cheaper, and makes exports from your country abroad a lot more expensive. Therefore, less demand for your goods & services from foreign perspective, and greater demand to buy goods & services from another country

Question 7

How do you explain a current account deficit for the UK?

Answer 7

decline in oil industry, deficit in goods, financial account surplus (UK is a relatively high investment centre) & relatively low savings rate (high spending)

Question 8

What is a balance of payments equilibrium?

Answer 8

Balance of Payment Equilibrium: Supply = Demand & Balance Of Payments=0

Question 9

What is a balance of payments deficit?

Answer 9

supply of the home currency exceeds the demand in the foreign exchange market (Forex). Home currency would be under pressure to depreciate

Question 10

What is a balance of payments surplus?

Answer 10

BoP surplus: supply of home currency is less than the demand in the forex market. Home currency would be under pressure to appreciate (strengthen the home currency)

Question 11

What is the Purchasing Power Parity Theory?

Answer 11

Purchasing Power Parity Theory bases its predictions of exchange rate movement by changing patterns of trade due to different inflation rates between countries. 2 forms: absolute PPP & relative PPP

Question 12

What absolute PPP?

Answer 12

says commodities should cost the same regardless of what currency is used to purchase it or where it is selling

Question 13

What are the assumptions of absolute PPP?

Answer 13

no transaction costs (no shipping/delivery costs etc.), no barriers to trade (no tariffs, taxes or political barriers) & homogeneous products

Question 14

What is relative PPP?

Answer 14

accounts for the possibility of market imperfections e.g. transaction costs, tariffs, quotas &C. etc.

Question 15

What are limitations of relative PPP?

Answer 15

inflation is difficult to predict, 98% of the market is dominated by speculation-based transactions, rather than trade inflations (PPP breaks down) and government intervention (if this occurs, this approach does not work)

Question 16

What is the interest rate parity theory?

Answer 16

Interest rate parity theory: Covered interest arbitage no longer feasible, due to the equilibrium state, known as IRP

Question 17

What happens under IRP?

Answer 17

Under IRP, any interest rate in a foreign country will be offset by the prevailing interest rate in the future. Therefore, you can’t borrow at low rate in a foreign country & exchange it & invest in a higher interest rate country

Question 18

What does international fisher effect say?

Answer 18

high inflation= high interest rates, low inflation= low interest rates

Question 19

What are the 2 types of interest rate risks?

Answer 19

Gap exposure, basis risk

Question 20

What is gap exposure?

Answer 20

interest rate gap analysis- allocate assets, liabilities according to repricing/maturity buckets which are sensitive to interest rate changes

Question 21

What is basis risk?

Answer 21

Assets & liabilities set with reference to variable rates, but variable rates are set to different benchmarks

Question 22

What does an inverted & a hump yield curve indicate?

Answer 22

An inverted yield curve = recession as short term bonds give higher yield. A hump yield curve = economic transition period

Question 23

What is the expectations hypothesis?

Answer 23

The expectations hypothesis is a theory that states that in equilibrium, the investment in a series of short-term bond must offer the same expected return as investment in a single long maturity bond. Only if this is the case will investors be prepared to hold both short- & long- term bonds

Question 24

What are the implications of the pure expectations hypothesis?

Answer 24

implies that only reason for downward-sloping term structure is that investors expect the short-term rate to decline in the future, and implies that the only reason for upward-sloping term structure is investors expect the short-term rates to rise in the future

Question 25

What is the liquidity preference theory?

Answer 25

Liquidity preference theory (short-term): ability to sell an asset at the required price (liquidity risk: investor will have to sell the asset below its fair value).

Question 26

What are liquidity advocates?

Answer 26

market participants have preference for short-term, rather than long-term, therefore ST investors dominate the market. To induce ST investors to hold LT assets, a liquidity premium is needed as a form of compensation for bearing risk

Question 27

What is the market segmentation theory?

Answer 27

Market segmentation theory: main assumption is that the market for ST & LT investments are segmented. Market participants in each have different preferences, goals, other characteristics (interest rates, government policy, risk, wealth, liquidity)