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Financial Markets & Institutions > Part B: Foreign Exchange Market > Flashcards

Part B: Foreign Exchange Market Flashcards

1
Q

Functions of foreign exchange markets (3)

A

Transfer PP from one nation and currency to another.

Provide credit for foreign transactions

Provide facilities for hedging and speculation

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2
Q

When does demand for currency arise (when we need foreign currency)

A

Tourists visit another country

Import

Invest abroad

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3
Q

Where does supply of currency arise from (3)

A

Foreign tourist expenditures

Export earnings

Foreign investments coming here

(Since we supply currency for the foreigners)

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4
Q

Who participates in the FEM (6)

A

Tourists

Exporters/importers

Investors

Commercial banks

Foreign exchange brokers

Central banks

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5
Q

Commercial banks function

A

Serve as clearinghouses for currency exchange

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6
Q

Foreign exchange brokers

A

Clearinghouse for surpluses and shortages between the commercial banks

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7
Q

Central banks function

A

Buyer or seller of the last resort in the FEM

(Buy domestic currency to appreciate, sell domestic currency to depreciate)

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8
Q

3 aggregative prices in open economy model

A

Domestic prices P
Foreign prices P*
Relative price of foreign exchange S (converting P into P*)

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9
Q

Assume only two economies, the United States and
the European Monetary Union.
Domestic currency = dollar ($)
Foreign currency = euro (€)

What is S (exchange rate)

A

S = $/€

The number of dollars needed to purchase one euro

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10
Q

What is S determined by in a flexible exchange system

A

Supply and demand for the currency.

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11
Q

Pros/cons of fixed exchange rate system (1,2)

A

Pros: Future rates are known.

Cons:
Government can just revalue their currencies

Countries are also vulnerable to economic conditions in other countries

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12
Q

Freely floating exchange rate pros cons (2, 2)

A

Insulation - from problems of other countries (unlike
Government not constrained by the need to maintain a fixed rate when considering new policies.

Less capital flow restrictions, improved market efficiency.

Cons:
May need substantial resources to manage exchange rate fluctuations.

The country that experiences problems may have its problems compounded.

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13
Q

Managed float

A

Exchange rates can move freely daily, however government can intervene to prevent rates moving too much to stabilise.

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14
Q

Con of managed float

A

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

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15
Q

Pegged exchange rate and example

A

Fixed to another currency. (Usually US as most stable)

Pesos to USD

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16
Q

Currency board, and example

A

Pegging value of local currency to some other specified currency.

E.g HKD $7.80:$1 USD ALWAYS

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17
Q

Difference between currency board and pegged (4)

A

Currency board - domestic currency is 100% backed by foreing currency. (Basically eliminating independent monetary policy.

A peg requires active management - currency board is automatic.

Currency board loses independent M.P so increased exposure to shocks from anchor.

Loss of money creation and lender of last resort

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18
Q

Dollarization

A

Replacement of a country’s currency with US dollars

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19
Q

Why may they do this?

A

If hyperinflation, so abandon local currency.

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20
Q

Pros and cons of dollarization (1,3)

A

Avoids possibility of speculative attack on domestic currency

Loss of independent monetary policy

Increased exposure to shocks from anchor country

Inability to create money and act as a lender of last resort

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21
Q

Direct vs indirect quotations

A

Direct quotations - value of a foreign currency in terms of the home currency (basically where the home currency
≉1)

Indirect quotations represent the number of units of a foreign currency per unit of home currency

22
Q

Example: With the £ as the home currency
£0.625:$1 is called a ‘direct quote’ i.e. like the price of
any other ‘product’.

This is the same as
$1.6 to the £1’ or $1.6:£1 which is called an ‘indirect quote’

A
23
Q

Banks provide foreign exchange services for a fee: how is this expressed

A

Bid ask spread = ask rate - bid rate / ask rate

Their ask (sell) price will be greater than bid (buy) price to make profit

24
Q

What is the cross exchange rate?

Formula? Assume dollar is the home currency

A

When exchange rate for 2 currencies against the dollars exist, we can then find the exchange rate between them.
(NOTE IT IS IMPLIED EXCHANGE RATE)

S = $ value of currency 1 / $ value of currency 2

25
Q
  1. Suppose $/€ exchange rate is $1.25 and the $/£
    exchange rate is $2.

2.
Canadian dollar was worth £0.43. You still have C$200 from your trip and could exchange them for pounds at the airport, but the airport foreign exchange desk will only buy
them for £0.40. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for £0.055 per peso. You met a tourist who is willing to buy your C$200 for 1,500 pesos.
Should you accept the offer or cash the Canadian
dollars in at the airport? Explain.

A

S = euro/£ = 2 / 1.25 = 1.6

26
Q

Effective exchange rate

A

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

27
Q

Arbitrage

A

Purchase one currency for immediate resell in another market.

(Similar to derivatives where buy in low price to sell in high price market)

28
Q

Balance of payments

A

Records transactions between one country and the rest of the world

29
Q

Main purpose of balance of payments

A

Help government in their monetary, fiscal and trade policies

30
Q

Spot and forward exchange rate

A

Spot - current exchange rate that calls for payment and receipt within 2 business days from the transaction date

Forward - exchange rate that calls for delivery of the foreign exchange in future, after contract is signed.

31
Q

Forward discount

A

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

32
Q

Forward premium

A

The percentage per year by which the forward rate is above the spot rate

33
Q

Forward discount or Forward premium formula

A

FR - SR
/ SR x 100

34
Q

If the spot rate is $2 = £1 , 3-month forward is $1.98 = £1

Is the pound at a 3-month premium or
discount? And by how much?

A

1.98 - 2 / 2 x 100 = -1% so forward discount.

If want to annualise x 4 to (since forward is 3 month)

35
Q

Currency swap

A

A spot sale of a currency combined with a forward repurchase of the same currency – as part of a single transaction. (LOOK PG41)

(Opposite of covered interest arbitrage where we buy spot and sell forward to remove FER)

36
Q

Why engage in currency swaps

A

Combined transactions treated as one saves transaction costs. Good if don’t need to hold money for that period so sell and then buy as a future

37
Q

Currency futures: how the futures market differ from the forward market (3)

A

Futures - only few currencies traded (FORWARD ANY)

Futures are in standardised contracts

Futures are for smaller amounts

38
Q

Currency 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 date
(American option) at a stated price

39
Q

Foreign exchange risks - how do they arise (3)

A

Because spot rates vary overtime

Transactions exposure

Translation exposure

40
Q

Business’s risk attitude and what do they do in response to foreign exchange risk?

A

Risk adverse - so they insure against foreign exchange risk

41
Q

Transaction exposure vs translation exposure

A

Transaction exposure is from transactions involving future payments and receipts in a foreign currency.

Translation exposure is inventory/assets held abroad in terms of domestic currencies.

42
Q

When do contracted future foreign currency payments may become more expensive? (pay money to overseas)

A

If domestic currency depreciates

Since costs more domestic currency to pay for the payment which is to be paid in foreign currency.
A contract requires £100,000 payment in 3 months.
Assume US to be home currency, so as dollar depreciates (needs more dollar for pound), cost would now be
E.g used to be $1:£1 so dollar cost is $100,000 for £100,000, now $1.20:£1 so costs $120,000 for £100,000

43
Q

When do contracted future foreign currency receipts fall? (receive money from overseas)

A

If domestic currency appreciates.

If US producer expects to receive £10000 payment
if currently $1:£1, expected receipt is $10000
If changes to $0.90:£1, expected receipt is $90000.

Sounds obvious - we dont want our domestic currency to appreciate since we will receive less since the foreign currency we get is now worth less. We want foreign currency to appreciate since whatever amount that is made (in foreign currency) will buy more home currency than before

44
Q

Hedging aim

A

Avoid exchange rate risk

45
Q

3 ways to hedge, and evaluations for 2nd and 3rd

A
  1. Buy at current spot , let funds earn interest until needed.
  2. Buy a forward contract
    Eval: May pay forward premium, increasing cost of transaction.
  3. Buy a call option
    Eval: If not exercised, the premium is lost.
46
Q

Speculation

A

Acceptance of foreign exchange risk in the hope of making a profit

(Sell while strong expecting it to fall and repurchase)

47
Q

2 types of speculation

A

Stabilising speculation - purchase foreign currency, when price falls, expecting to rise. Or sale of currency when price is high, expecting it to fall. (Like last example)

Destabilising speculation - sale when low, expecting it will fall even lower. Or purchase currency when high, expecting it to rise even higher.

48
Q

Where are currency futures sold on?

A

International monetary market (IMM)

49
Q

Stabilising vs destabilising speculation

A

Stabilising moderates fluctuations in E.R

Destabilising magnifies fluctuations in E.R, which can disrupt international trade & investment

50
Q

Assume that SR = $2/£1 and the three-month FR =
$1.96/£1.
a. how can importer who will have to pay £10,000 in
three months hedge the foreign exchange risk?
b. Indicate how an exporter who expects to receive a
payment of £1 million in three months hedges the
foreign exchange risk.

A

American importer would purchase forward of £10000 (costs 19600 in dollars using the forward rate), so after 3 months he will pay the $19600 and receive £10000 to make the payment

Exporter would sell forward, so receives £10000 as $19600 after 3 months

51
Q

Assume that SR = $2/£1 and the three-month FR =
$1.96/£1.
a. how can importer who will have to pay £10,000 in
three months hedge the foreign exchange risk?

b. Indicate how an exporter who expects to receive a
payment of £1 million in three months hedges the
foreign exchange risk.

A

A) buy forward at $1.96:£1 - they have to pay £10,000 , so at SR costs £20,000, but FR costs 19600 so cheaper so buy.

B) sell forward

52
Q

FR = $2.00/£1 and speculator believes in 3 months SR = $2.05/£1.

a. How can a person speculate in the forward market?

Speculator believes in 3 monthsSR = $1.95/£1
b. How can he speculate in the forward market?
c. What will the result be if in three months SR = $2.05/£1
instead?

A

A) buy forward at $2:1 , and if belief is true, makes $0.05 per dollar.

B) sell forward as believes spot rate falls. Makes $0.05 per dollar

C) They sold forward at $2, but it has gone up to $2.05 so lose $0.05 per dollar

Financial Markets & Institutions (18 decks)

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