WEEK 3

Question 1

What are real bilateral exchange rates?

Answer 1

How much goods are worth in one country in comparison to another country.

Example:

Eur: USD example = 1

Eurozone Big Mac = 3
USD Big Mac = 4

E = p* x e / P
E
p* is base currency price
P is quote currency price

3x1 / 4 is 0.75

Question 2

What are nominal exchange rates?

Answer 2

A nominal bilateral exchange rate is the price you would pay at the train station. You give me x I give you y back.

Xxx:yyy
Xxx is base currency
Yyy is Quote currency

Question 3

What are effective change rates?

Answer 3

Effective exchange rates are: weighted averages of bilateral exchange rates.

This is when you are taking all currency.
Only way you can use it is to compare changes over time. Stronger over time or weaker over time.

effective exchange rates refer to a measure of the value of a country’s currency compared to a basket of other currencies. It takes into account the exchange rates between the country’s currency and the currencies of its trading partners.

Question 4

What is appreciation?

Answer 4

Appreciation refers to an increase in the value of a currency relative to other currencies. It means that the currency can buy more of another currency or goods and services in international markets.

currency becomes stronger against other currencies

Question 5

When does appreciation happen?

Answer 5

Appreciation often occurs when there is high demand for a currency due to factors such as strong economic performance, high interest rates, stable political environment, or positive investor sentiment. When a currency appreciates, it becomes stronger against other currencies.

Question 6

What is depreciation?

Answer 6

Depreciation refers to a decrease in the value of a currency relative to other currencies. It means that the currency can buy less of another currency or goods and services in international markets.

Currency becomes weaker against other currencies

Question 7

When does depreciation happen?

Answer 7

Depreciation often occurs when there is less demand for a currency due to factors such as weak economic performance, low interest rates, political instability, or negative market sentiment. When a currency depreciates, it becomes weaker against other currencies.

Question 8

What are the benefits of fixed exchange rates?

Answer 8

Stability: Fixed exchange rates provide stability and predictability for businesses engaged in international trade and investment. They create a more stable environment for planning and conducting economic activities.

Reduced Currency Risk: Fixed exchange rates can reduce currency risk for businesses as they eliminate or minimize the uncertainty associated with exchange rate fluctuations.

Lower Transaction Costs: Fixed exchange rates can lower transaction costs for international trade since there is no need for frequent currency conversions.

Question 9

What are the negatives of fixed exchange rates?

Answer 9

Limited Monetary Policy Flexibility: Under a fixed exchange rate regime, countries have limited flexibility to pursue independent monetary policies. They may need to adjust their domestic policies to maintain the pegged exchange rate, which can restrict their ability to address domestic economic challenges.

Vulnerability to External Shocks: Fixed exchange rates make economies more vulnerable to external shocks, such as changes in global economic conditions or capital flows. If the fixed rate becomes overvalued or undervalued, it can lead to imbalances and economic difficulties.

Speculative Attacks: Fixed exchange rates can be vulnerable to speculative attacks by traders and investors who believe that the exchange rate is misaligned. Such attacks can put pressure on the central bank’s reserves and undermine the stability of the fixed rate.

Question 10

What are the benefits of floating exchange rates?

Answer 10

Flexibility: Floating exchange rates provide countries with greater flexibility to pursue independent monetary policies to address domestic economic challenges. They can adjust interest rates and exchange rates based on their specific economic conditions.

Automatic Adjustments: Floating exchange rates allow for automatic adjustments in response to changes in market forces. If a country’s currency is overvalued, it tends to depreciate, making its exports more competitive and helping to correct trade imbalances.

Absence of Speculative Attacks: Floating exchange rates are less susceptible to speculative attacks since the market determines the exchange rate. It reduces the pressure on central banks to defend a specific rate.

Question 11

What are the negatives of floating exchange rates?

Answer 11

Exchange Rate Volatility: Floating exchange rates can be volatile, leading to uncertainty for businesses engaged in international trade and investment. Sudden and large fluctuations in exchange rates can affect import/export costs and profitability.

Currency Risk: Floating exchange rates expose businesses to currency risk, as the value of their foreign transactions can change due to exchange rate fluctuations.

Reduced Price Transparency: Floating exchange rates make it challenging to compare prices across countries accurately, as the exchange rate can affect the relative cost of goods and services.

Question 12

What are spot transactions?

Answer 12

The ones happening „right now“ aka airport exchanges for holidays

Question 13

What are outright forwards?

Answer 13

Outright forwards are contracts that specify, in the future, you will either buy or sell a currency, at a rate that is named in the contract for a date set in the future. This Locks in exchange rate now. Example of jet fuel given (air India. You have to execute contract.)

when you know you need to change currency in the future.

Question 14

What are the benefits of outright forward contracts?

Answer 14

• useful for managing fuel costs
• useful for managing budget efficiently as expenditure is predictable and set
• can be a risk as the jet fuel could get cheaper in the future but you are stuck with the contract and a specified price, thus loosing money.

Question 15

What are foreign exchange swaps?

Answer 15

(forex) swap is a financial transaction that involves the exchange of one currency for another at a predetermined exchange rate, with an agreement to reverse the transaction at a future date

The key feature of a forex swap is the agreement to reverse the initial exchange at a future date. The specific date and terms for reversing the transaction are predetermined. For example, Party A and Party B agree to reverse the transaction after six months.

benefit: the parties also agree on the interest rates applicable to each currency.

buying the right to buy or sell currency at a rate in the future, but you do not have to.

Question 16

What are currency swaps?

Answer 16

Swaps especially foreign swaps are extremely important because they manage currency swaps. Swaps are where partner 1 borrows in 1 currency, partner 2 in another currency, and they then swap to pay off loans?
Mechanisms to manage currency that you receive and you owe. Very often used to illuminate currency risk. Swap currency slows
FX options

Question 17

What is a currency risk?

Answer 17

income in one currency, expenditure in another. Risk of your original currency depreciating and your expenditure getting more expensive etc.

Example: Income in kenyan shillings, but expenditure in euros. or holiday travel and exchange rate changes while you are on holiday. Thus you have less money when you arrive or fly back etc.

Question 18

When would you use which type of exchange rate?

Answer 18

In summary, nominal exchange rates are used for day-to-day transactions and basic currency conversions.

Example: When you are planning a vacation and need to exchange your currency for the local currency of the destination country to pay for expenses like accommodation, meals, and shopping.

Real bilateral exchange rates are useful for analyzing purchasing power and competitiveness between two specific countries.

Example:

When a government wants to assess the impact of exchange rate changes on the cost of living for its citizens by considering inflation differentials between countries.

or

When analyzing the purchasing power of your currency when traveling abroad to determine how much goods and services you can afford in another country after adjusting for differences in price levels.

Effective exchange rates provide a broader measure of currency value, taking into account multiple currencies and trade weights, and are useful for assessing overall competitiveness and the impact of currency movements on an economy.

Example: When a central bank monitors the overall competitiveness of its country’s exports by tracking the effective exchange rate, which reflects the average value of its currency against a basket of currencies of its major trading partners.

Question 19

What is PPP

Answer 19

Purchasing Power Parity

It is a concept used to compare the cost of living and the prices of goods and services between different countries. PPP takes into account the fact that the value of money can vary across countries due to differences in prices.

Question 20

What is the difference between absolute PPP and relative PPP?

Answer 20

Absolute PPP = is an extreme way of understanding long term currency movements. Only thing that should work is exchange rate = 1
Exchange rates will move, either appreciate or depreciate, in order to make theory of 1 work. This does not work. Keeping same price everywhere

Absolute PPP assumes that there are no barriers to trade, transportation costs, or other factors influencing price differences.

Absolute PPP says that in the long run, the prices of the same goods in different countries should be the same when measured in the same currency.

Vs.

Relative PPP = high inflation currencies depreciate relative to low inflation currencies. You put your money where inflation is lower, and you expect appreciation over time.

It suggests that the exchange rate should adjust to reflect the difference in inflation rates between the two countries. If one country has a higher inflation rate than another, the currency of the country with higher inflation should depreciate relative to the other currency. Relative PPP accounts for the changing purchasing power of currencies due to differences in inflation rates.

Question 21

” Contrast the operation of fixed vs floating exchange rate regime”

Answer 21

Exchange Rate Determination: Under a fixed exchange rate regime, the exchange rate is set and maintained at a fixed level by the central bank or monetary authority. It does not fluctuate freely in response to market forces.

Intervention by Central Bank: To maintain the fixed exchange rate, the central bank intervenes in the foreign exchange market by buying or selling its currency. It uses its foreign reserves to stabilize the exchange rate.
Monetary Policy Adjustments: In a fixed exchange rate regime, the central bank’s monetary policy is often geared towards maintaining the exchange rate target. Interest rates and money supply may be adjusted to support the fixed rate.

Exchange Rate Stability: Fixed exchange rates provide stability and predictability for businesses and investors as they eliminate or minimize the uncertainty of exchange rate fluctuations.

Trade and Capital Controls: Fixed exchange rate regimes may require trade and capital controls to prevent speculative activities and maintain the stability of the exchange rate.
Floating Exchange Rate Regime:

Market Determination: Under a floating exchange rate regime, the exchange rate is determined by market forces of supply and demand in the foreign exchange market. It fluctuates freely based on factors such as economic conditions, interest rates, capital flows, and market expectations.

Minimal Intervention by Central Bank: In a floating exchange rate regime, the central bank may intervene occasionally to smooth out extreme exchange rate fluctuations or address disorderly market conditions but generally allows the market to determine the exchange rate.

Monetary Policy Autonomy: With a floating exchange rate, the central bank has more freedom to conduct independent monetary policy based on domestic economic objectives, such as controlling inflation or promoting economic growth.

Exchange Rate Flexibility: Floating exchange rates allow for automatic adjustments in response to changing economic conditions. If a currency becomes overvalued or undervalued, the exchange rate will adjust, helping to correct trade imbalances.

Market Efficiency: Floating exchange rates tend to reflect market fundamentals and provide signals about the relative strength or weakness of a currency, facilitating international trade and investment decisions.

In summary, fixed exchange rate regimes involve a fixed exchange rate set by the central bank, with intervention to maintain the rate, while floating exchange rate regimes allow the market to determine the exchange rate, with minimal central bank intervention. Fixed rates offer stability but restrict monetary policy flexibility, while floating rates offer flexibility but can be more volatile.