week 3 currency markets and exchange rates

Question 1

What are the different kind of transactions? (4)

Answer 1

1. spot transaction
2. outright forwards
3. fx option
4. forex swaps & currency swaps

Question 2

define spot transactions

Answer 2

transaction with the exchange right at that moment (spot).
- e.g. at airports, transtations

Question 3

define outright forwards

Answer 3

transaction when you know you need to exchange in the future. The exchange rate is ‘set’ in a contract for a specific date.
- however there is currency risk: income in one currency, expenditure in another (depending on depreciation/appreciation of both currencies)

Question 4

define fx option

Answer 4

buying the right to sell or buy currency at a certain rate in the future. You don’t have to stick with it (different from outright forwards).

Question 5

define forex & currency swaps

Answer 5

2 partners borrow in different currencies and swap currency flows –> income or expenditure
- way of managing currency risk
- strictly financial actor to actor that have state backup

Question 6

what is nominal bilateral exchange rate?

Answer 6

how many units of the ‘quote’ you can get for one unit of the ‘base’
- yyy (quote)/ xxx (base)

Question 7

what is effective exchange rate?

Answer 7

= weighted averages of bilateral exchange rates
- some components are more important than others
- measures overall currency rate, which is only useful over time

Question 8

what is real exchange rate?

Answer 8

e (als in epsilon) = (p* x e)/p , where p* = price currency base and p = price currency quote

Question 9

what are long-term currency movements of exchange rates?

Answer 9

Purchasing Power Parity PPP
1. absolute = overtime all prices for the same goods should equal through trade, where e (epsilon) becomes 1. this is unrealistic
2. relative = high inflation currencies depreciate, relative to low inflation currencies. Relative PPP predicts that exchange and inflation rates equal over time in two trading countries.
- also ceteris paribus –> you put your funds into low inflation currencies, resulting in appreciation of those currencies