Week 1 - Intro and Overview of Exchange Rates Flashcards
What is the definition of an exchange rate?
An exchange rate is the relative price of two currencies, indicating how much one currency is worth in terms of another.
What determines the exchange rate in the foreign exchange (FX) market?
The supply and demand of the currencies in the FX market
What is the difference between an exchange rate and the price of goods? (2)
- Exchange Rate - represents the price of one currency in terms of another
- Price of Goods - the cost of a specific product in a given currency
What happens if the supply of a currency increases or decreases in the FX market? (2)
- increase in the supply of a currency => value typically decreasing => currency depreciates
- decrease in the supply of a currency => value typically increases => currency appreciates
What is the nominal exchange rate? (2)
- St
- the actual exchange rate of a currency at a given point in time
What is the real exchange rate? (2)
- Rt
- Measures competitiveness by adjusting the nominal exchange rate for price differences between countries
What is the Real Exchange Rate formula? (2)
Rt = St * (Pf/Pd)
Real Exchange Rate = Nominal exchange rate x (Price of Foreign Goods / Price of Domestic Goods)
What are the two main tiers in the foreign exchange market? (2)
- The retail tier - small agents buy and sell FX
- The wholesale tier - informal network of banks and brokerage firms
What is the bid/ask spread in the foreign exchange market and what is it used for? (2)
- The difference between the price at which a bank buys a currency (bid) and the price at which it sells the currency (ask)
- used to cover the costs of conducting foreign exchange transactions
Which currencies are the most actively traded in the foreign exchange market? (3)
- USD
- EUR
- JPY
How does the foreign exchange market compare in size to other financial markets? (2)
- Largest financial market in the world
- Turnover of 7.5trillion per day as of April 2022
What is the spot market in foreign exchange? (2)
- Where currencies are traded for immediate delivery at the current exchange rate
- Usually delivered within 2 business days
What is a cross-rate in foreign exchange?
The exchange rate between two currencies derived from their individual exchange rates with a third currency.
How do you calculate a cross rate?
Divide the quote of currency X in terms of Z by the quote of currency Y in terms of Z
What is CHF/EUR at time t when CHF/USD = 0.8 and EUR/USD = 0.9?
CHF/EUR, t = 0.8 / 0.9 = 0.89
What is the forward market in the foreign exchange?
Contracts to buy or sell a set amount of currency at a predetermined price on a specific future date
What is the main use of forward contracts in foreign exchange?
Used for hedging to protect against fluctuations in currency exchange rates
What is the structure of an FX swap?
Combines a spot transaction with a forward transaction to roll forward the value date of an open FX position
How do outright forwards and FX swaps differ? (2)
- Outright forwards involve a single transaction at a future date
- FX swaps combine a spot transaction to manage liquidity needs
How does an FX swap manage currency exposure and liquidity?
FX swaps help manage short-term liquidity needs without altering currency exposure
What role do governments play in the foreign exchange market?
They influence the value of their currency through monetary policies or foreign exchange reserves
What is the significance of exchange rate fluctuations for multinational corporations? (2)
- Exchange rate fluctuations impact the profitabilityof MNCs
- They affect the value of foreign income, expenses and investments
What is the practical use of real exchange rate in international finance? (2)
- Measures the competitveness of a country’s goods and services
- adjusts the nominal exchange rate for relative price levels between countries
Give 5 main factors that influence exchange rates?
- Inflation Rates
- Economic Growth
- Interest Rates
- Political Stability
- Overall Market Speculation
