Week 5

Question 1

What does the USD being the global reserve currency mean?

Answer 1

Most financial contracts are denominated in USD.

Question 2

What should we do if we want to speculate on a currency going up in value, why is using a forward contract potentially extra useful?

Answer 2

If we want to speculate on a currency going up we should either buy it at the spot rate or buy a forward contract for our time period. The forward contract can be particularly lucrative if the forward market is moving opposite to our speculation.

Question 3

What is the profit of a call option? What is our loss?

Answer 3

The spot rate - (Strike price + premium). The maximum loss is only the premium if the spot price is less than the strike price. Having an option means we have limited loss and unlimited profit.

Question 4

When should we write a call option?

Answer 4

We could write a call option when we believe the currency will go down or stay the same, we are selling the right ot buy, as such our profit will be the premium - (spot rate - strike rate), and our maximum profit is the premium.

If we write a naked call option (we don’t currently own the asset), then we have unlimited loss and limited profit.

Question 5

What is the profit of a put option, what about our loss?

Answer 5

Strike price - (spot rate + premium). Our maximum loss is the premium if the strike price is less than the spot price. This means we have a limited loss and unlimited profit.

Question 6

What is the profit on writing a put?

Answer 6

premium - (strike rate - spot price), it has limited profit and unlimited loss.

Question 7

What is a long straddle?

Answer 7

In a long straddle we buy a put and a call with the same expiration date and strike price. We will have to pay two premiums, but will get money as long as the currency moves in a large way from the strike rate (enough to cover both premiums).

Question 8

What is a short straddle?

Answer 8

We sell a put and call with the same expiration date and strike price. We can do this if we believe a currency will not move much from the strike rate.

Question 9

What is a long currency strangle?

Answer 9

Buy a put and a call with the same expiration date and different strike prices. We do this if expect that the price will move above or below the strike prices so we realise profit.

Question 10

What is a short currency strangle?

Answer 10

Sell a put and call with the same expiration date and different strike prices, we do this if we expect the price not to differ much from the middle of the strike prices.

Question 11

What is a fixed exchange rate? What are some pros and cons?

Answer 11

A fixed exchange rate has fixed rates and can only move in very narrow boundaries if at all, it requires central bank intervention to devaluate and revaluate if required.

Advantages: no Forex risk for foreign direct investments
-The home currency central bank can revalue (increase) or devaluw own currency if needed.

Disadvantages:

• Multi national corporation is more vulnerable to economic conditions in other countries
• Countries with low interest rates must impost capital flow restrictions to stop investors flowing out of the country.

Question 12

What happens in a country with a fixed exchange rate if there is excess demand?

Answer 12

If there is excess demand for a currency the foreign country will have to sell it’s forein exchange reserve holdings to meet it, if this continues a contractionary monetary and fiscal policy will be required to keep the rate fixed.

Question 13

What is a freely floating exchange rate system? What are some pros and cons?

Answer 13

A freely floating exchange rate system adjusts based on demand and supply

pros:

• country is more insulated from inflation of other countries
• Country is more insulated from unemployment of other countries
• does not require central bank to maintain exchange rate within boundaries

Cons:
-Can adversely affect a country with high unemployment, or high inflation.

Question 14

What was the Smithsonian agreement?

Answer 14

A fixed rate regime, with the USD being the central dollar.

Question 15

How can inflation in one country spread to others under a fixed rate system? How does a floating rate help?

Answer 15

They increase demand for goods in lower inflation countries.

Under a floating rate this will increase the value of the lower inflation currency, hence decreasing demand.

Question 16

What is a dirty float?

Answer 16

A dirty float allows the currency to fluctuate daily but the governments can intervene to prevent the currencies from fluctuating too far.

Question 17

What is a pegged exchange rate? Why can they be useful? What can be a problem?

Answer 17

The home currency is pegged to either one foreign currency, or an index of currencies.
These can be useful because they can attract foreign investment by making the exchange rate relatively stable.
Weak economic or political conditions can cause firms and investors to question whether the peg will be broken, causing more instability for the country’s economy.

Question 18

How did the European monetary system work?

Answer 18

Exchange rates tied to the European country unit, this was known as the exchange rate mechanism. Countries that participated were forced to have comparable interest rates, with Germany wanting high rates but others wanting low rates.

Question 19

How did the Argentine pesos crisis occur?

Answer 19

The ARS was pegged to the USD and had low inflation, causing lots of foreign investment and hence appreciation of the psop. This hurt the exports and caused economic downturn, forcing abandonment of the dollar parity with the USD.
Essentially, the system collapsed because of low fiscal discipline, an inflexbile labour market, and contagion from the Russian and Brazilian crisis, as well as Argentinian government defaulting on debt.

Question 20

What is a currency board?

Answer 20

The system in charge of pegging value of the local currency to some other currency, the interest rates will move in tandem and will typically be pegged to currency with low exchange rate risk (euro or USD).

Question 21

What is dollarization?

Answer 21

The replacement of a foreign currency with USD.

Question 22

What are open market operations?

Answer 22

An open market operation is when central banks buy or sell government securities in the open market to expand (or contract) the amount of money in the system, buying bonds expands the money supply and selling contracts. Increasing the money supply lowers interest rates, stimulating growth, while less money increases interest rates, protecting against inflation.

Question 23

Why are government exchange interventions done?

What does it rely on?

Answer 23

These are done to smooth exchange rate movements, establish implicit exchange rate boundaries, and respond to temporary disturbances.
This is most commonly direct intervention, such as selling home currency to make it depreciate, or buying home currency to strengthen it.
This relies on reserves, how often governments intervene, and the coordination between other banks.

Question 24

What is a nonsterilized intervention?

Answer 24

A nonsterilized intervention involves no change in money supply after the intervention.
If some action is taken to interfere with the money supply after the intervention occurs it is sterilized (commonly done through government securities, selling them to strengthen currency, or buying if weakening).