Wk6

Question 1

Foreign exchange market definition

Answer 1

Where individuals and firms and banks buy and sell forgiven currencies or forgiven exchange

Question 2

What are the functions of the foreign exchange market

Answer 2

1. Transfer purchasing power from one nation and currency to another
2. Provide credit for forgiven transactions
3. Provide the facilities for hedging and speculation

Question 3

When does the demand for currency arise

Answer 3

• when tourists visit another currency
• when a domestic firm wants to import from other countries
• when an individual wants to invest abroad

Question 4

When does the supply of currency arise

Answer 4

• export earnings
• receiving forgiven investments
• foreign tourists expenditures

Question 5

Why is credit needed for foreign transactions

Answer 5

Credit is needed when goods are in transit, and to allow
the buyer time to resell the goods to make the payment.

Question 6

Why does the FEM provide facilities for hedging and speculation

Answer 6

◼ About 90% of foreign exchange trading reflects purely
financial transactions, and only about 10% trade
financing

Question 7

Who are the participants of thr FEM

Answer 7

• those needing currency to fund transactions (tourists, exporters, investors )
• commercial banks ( act as clearinghouses for currency exchange )
• Foreign exchange brokers (Clearinghouse for surpluses and shortages between the
  commercial banks)
• central banks ( buyer and seller of last resort in the FEM )

Question 8

What is open economy macroeconomic

Answer 8

It deals with the home country trading in aggregate with the rest of the world - comparing home country currency with another currency

Question 9

What agrégative prices are highly significant

Answer 9

• Home price measured as P
• foreign or ROW price measured as P*
• relative price of forgiven exchange denoted as S which converts P into P*

Question 10

How is S determined

Answer 10

• By the intersection of market demand and supply for a given currency (euros)
• S = $/€
• If S = $/€ = 1, then one dollar is required to purchase one euro

Question 11

What is depreciation

Answer 11

When the currency declines in value
e.g. If the dollar price of the euro increases from $1 to $1.50, the
dollar has depreciated.

Question 12

What happens when currency appreciates

Answer 12

When the currency’s increases in value
- If the dollar price of the euro decreases from $1 to $0.50, the dollar has appreciated.

Question 13

How can exchange rate systems be classified

Answer 13

• fixed
• freely floating
• managed float
• pegged
• currency board
• dollarisation

Question 14

What are a fixed exchange rate system

Answer 14

Rates are held constant or allowed to fluctuate within very
narrow bands only.

Question 15

What are the pros ans cons of a fixed exchange rate system

Answer 15

The future exchange rates are known
Cons
- governments can revalure their currencies
- Each country is also vulnerable to the economic
conditions in other countries.

Question 16

What is a freely floating exchange rate

Answer 16

Rates are determined by market forces without governmental
intervention.

Question 17

Pros of floating exchange rate

Answer 17

• each country is more insulated from economic problems of other countries
• central bank to control exchange rates is not needed
• Governments are not constrained by the need to maintain
  exchange rates when setting new policies

Question 18

Cons of freely floating exchange rate

Answer 18

• You may need to devote substantial resources to managing their exposure to exchange rate fluctuations
• The country that initially experienced economic problems (such as
  high inflation, increased unemployment) may have its problems
  compounded.

Question 19

What is a managed floating exchange rate

Answer 19

Exchange rates can move freely daily, and no official
boundaries exist. However, governments may
intervene to prevent the rates from moving too much
in a certain direction.

Question 20

What are the cons of a managed float exchange rate

Answer 20

A government may manipulate its exchange rates
such that its own country benefits at the expense of
other countries

Question 21

What is a pegged exchange rate

Answer 21

The currency’s value is pegged to a foreign currency
or to some unit of account, and therefore moves in
line with that currency or unit against other
currencies

Question 22

What is an example of a pegged exchange rate system

Answer 22

European Economic Community’s snake
arrangement (1972), European Monetary System’s
exchange rate mechanism (1979), Mexican peso’s
peg to the US dollar (1994).

Question 23

What is a currency board

Answer 23

• A system for pegging the value of the local currency to some other specified currency.
• domestic currency is backed 100% by a foreign currency
• Money supply can expand only when foreign currency is exchanged for domestic currency

Question 24

Pros and cons of currency board

Answer 24

• stronger commitment by central Bank
• loss of independent monetary policy and increased exposure to shock from anchor country x
• loss of ability to create money and act as a lender of last resort

Question 25

What is dollarisation

Answer 25

Dollarization refers to the replacement of a country’s currency with US dollars and the country no longer has a local currency

Question 26

Pros and cons of dollarisation

Answer 26

• Avoids possibility of speculative attack on domestic currency
• loss of independent monetary policy and increased exposure to shocks from anchor country
• inability to create money and act as lender of last resort

Question 27

What is a direct quotation

Answer 27

Direct quotations represent the value of a foreign currency in terms of the home currency

Question 28

What is an indirect quotation

Answer 28

represent the number of units of a foreign currency per unit of home currency.

Question 29

What is a bid ask spread

Answer 29

Ask rate - bid rate / ask rate

Question 30

What is the cross exchange rate

Answer 30

An implied exchange rate
E.g. the right hand side of the quote ( the base ) must be the same currency for both rates and the denominator ( lower half ) of the ration becomes the base of the new quote

S = €= $ value of £ / $ value of €

Question 31

What is an effective exchange rate

Answer 31

A weighted average of the exchange rates between the domestic currency and the nation’s most important trading partners.

Question 32

What is arbitrage

Answer 32

• The purchase of currency in one market for immediate re sell in another market
• it keeps the exchange rate between any two currencies the same across different markets
• The purchase/re-selling closes differences in exchange rates by reducing currency available in the low price market and increasing availability in the high price market.

Question 33

What are the balance of payments

Answer 33

summary statement of international transactions for a nation for a specified period of time.
Help government in formulation monetary, fiscal and trade policies

Question 34

What is the spot rate

Answer 34

The exchange rate that calls for payment and receipt of the foreign exchange within two business days from the date when the transaction was made.

Question 35

What is the forward rate

Answer 35

The exchange rate that calls for delivery of the foreign exchange one, three, six, twelve or twenty-four months after the date the contract is signed.

Question 36

What is the forward discount

Answer 36

The percentage per year by which the forward rate is below the spot rate.

Question 37

What is the forward premium

Answer 37

The percentage per year by which the forward rate is above the spot rate.
- FD or FP = FR-SR / SR x 4 x100
4 to annualise

Question 38

What is currency swaps

Answer 38

• A spot sale of a currency combined with a forward repurchase of the same currency – as part of a single transaction.
• Combined transactions are treated as one which saves transactions costs
• Most interbank trading involving the purchase or sale of currencies for future delivery are done as currency swaps.

Question 39

What are currency futures

Answer 39

Individual firms or banks can sell forex futures and option on international monetary market (IMM)

Question 40

What are forgiven exchange futures

Answer 40

Forward currency contracts for standardized currency amounts and select dates trade on an organized market.

Question 41

What’s the difference between forward and future markets

Answer 41

• In futures market only a few currencies are traded and only operates in standardise contracts only with a few specific delivery dates and only trading in a few locations
• whereas future contracts are for smaller amounts more useful for small firms

Question 42

What are forgiven exchange options

Answer 42

Contracts giving the purchaser the right, but not the obligation, to buy (call option) or to sell (put option) a standard amount of a traded currency on a stated date (European option) or any time before the stated date (American option) at a stated price (strike or exercise price).
- they are standard sizes that are half those of future IMM contracts
- Buyer of options can forgo the purchase if it turns out to be unprofitable
- Seller however, must fulfill the contract if the buyer so desires.

Question 43

What is a foreign exchange risk

Answer 43

Whenever a future payment must be made or received in foreign currency, a foreign exchange risk is involved because spot rates vary over time.
- usually businesses are risk averse and avoid this

Question 44

Why does foreign exchange risk arise

Answer 44

• Transactions involving future payments and receipts in a foreign currency (transaction exposure)
• Value inventories and assets held abroad in terms of domestic currencies (translation exposure)
• contracted future foreign currency payments may become more expensive if the domestic currency falls in value

Question 45

What is hedging

Answer 45

• The avoidance of foreign exchange risk - removing risk but no guaranteeing the best possible outcome
• no money changes hands until maturity

Question 46

What is speculation

Answer 46

the opposite of hedging, is the acceptance of foreign exchange risk in the hope of making a profit.

E.g. If the speculator expects the spot rate in three months time to be $1/€1, she may sell euros at a current three-month forward rate of $1.10/€1 with the expectation that she will be able to buy euros to cover her sale at the lower spot rate.

Question 47

What is stabilising speculation

Answer 47

• The purchase of a foreign currency when the domestic price falls or is
  low, in the expectation that it will soon rise, leading to a profit, OR
• The sale of a foreign currency when the domestic price rises, in the expectation that it will fall.

Question 48

Why is stabilising speculation useful

Answer 48

Stabilizing speculation moderates fluctuations in exchange rates over time, serving a useful function.

Question 49

What is a destabilising speculation

Answer 49

The sale of a foreign currency when the domestic price falls or is low, in
the expectation that it will fall even lower, OR
The purchase of a foreign currency when the domestic price rises, in the expectation that it will rise even higher.

Question 50

Why can destabilising speculation be disruptive

Answer 50

It magnifies fluctuation in exchange rates overtime and can be disruptive to international flow of trade and investments