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Financial > Wk6 > Flashcards

Wk6 Flashcards

1
Q

Foreign exchange market definition

A

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

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2
Q

What are the functions of the foreign exchange market

A
  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
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3
Q

When does the demand for currency arise

A
  • when tourists visit another currency
  • when a domestic firm wants to import from other countries
  • when an individual wants to invest abroad
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4
Q

When does the supply of currency arise

A
  • export earnings
  • receiving forgiven investments
  • foreign tourists expenditures
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5
Q

Why is credit needed for foreign transactions

A

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

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6
Q

Why does the FEM provide facilities for hedging and speculation

A

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

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7
Q

Who are the participants of thr FEM

A
  • 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 )
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8
Q

What is open economy macroeconomic

A

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

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9
Q

What agrégative prices are highly significant

A
  • 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*
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10
Q

How is S determined

A
  • 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
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11
Q

What is depreciation

A

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.

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12
Q

What happens when currency appreciates

A

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

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13
Q

How can exchange rate systems be classified

A
  • fixed
  • freely floating
  • managed float
  • pegged
  • currency board
  • dollarisation
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14
Q

What are a fixed exchange rate system

A

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

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15
Q

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

A

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

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16
Q

What is a freely floating exchange rate

A

Rates are determined by market forces without governmental
intervention.

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17
Q

Pros of floating exchange rate

A
  • 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
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18
Q

Cons of freely floating exchange rate

A
  • 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.
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19
Q

What is a managed floating exchange rate

A

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.

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20
Q

What are the cons of a managed float exchange rate

A

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

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21
Q

What is a pegged exchange rate

A

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

22
Q

What is an example of a pegged exchange rate system

A

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

23
Q

What is a currency board

A
  • 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
24
Q

Pros and cons of currency board

A
  • 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
25
Q

What is dollarisation

A

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

26
Q

Pros and cons of dollarisation

A
  • 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
27
Q

What is a direct quotation

A

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

28
Q

What is an indirect quotation

A

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

29
Q

What is a bid ask spread

A

Ask rate - bid rate / ask rate

30
Q

What is the cross exchange rate

A

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 €

31
Q

What is an effective exchange rate

A

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

32
Q

What is arbitrage

A
  • 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.
33
Q

What are the balance of payments

A

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

34
Q

What is the spot rate

A

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.

35
Q

What is the forward rate

A

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.

36
Q

What is the forward discount

A

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

37
Q

What is the forward premium

A

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

38
Q

What is currency swaps

A
  • 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.
39
Q

What are currency futures

A

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

40
Q

What are forgiven exchange futures

A

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

41
Q

What’s the difference between forward and future markets

A
  • 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
42
Q

What are forgiven exchange options

A

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.

43
Q

What is a foreign exchange risk

A

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

44
Q

Why does foreign exchange risk arise

A
  • 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
45
Q

What is hedging

A
  • The avoidance of foreign exchange risk - removing risk but no guaranteeing the best possible outcome
  • no money changes hands until maturity
46
Q

What is speculation

A

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.

47
Q

What is stabilising speculation

A
  • 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.
48
Q

Why is stabilising speculation useful

A

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

49
Q

What is a destabilising speculation

A

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.

50
Q

Why can destabilising speculation be disruptive

A

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

Financial (17 decks)

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