2.8 Currency Exchange Rates Flashcards
(33 cards)
Purchasing power parity (PPP)
asserts nominal exchange rates will adjust, so identical baskets of goods have the same real price in different countries
–> In practice, PPP rarely holds because baskets are not identical across countries and trade barriers exist.
While FX markets facilitate international trade in goods and services, the dominant transactions in FX markets are from what?
capital transactions
Spot transactions
used to exchange currencies immediately
Forward transactions
agreements to exchange currencies further in the future
Most FX transactions are done through what?
forward contracts, FX swaps, and FX options
forward contract
the specific date, amount, and exchange rate are set on the trade date
difference between futures contract and forward contract
futures contract has the following:
- Trade on exchanges rather than in the over-the-counter (OTC) market
- Have standardized terms, such as amounts and settlement dates
- Require collateral to be posted and are marked-to-market at the end of each trading day
An FX swap
a simultaneous spot and forward transaction
The swap transactions can extend existing forward positions to later dates
Rolling the position forward leads to cash flow on the settlement date
FX swaps are also used to convert funding from one currency into another.
FX options
give the right (not obligation) to make an FX transaction in the future
A fee must be paid upfront to purchase this option.
The buy-side of FX Markets can be broken down into several categories:
- Corporate accounts – purchases and sales of goods and services; investment flows
- Real money accounts – investment funds managed by entities like insurance companies and mutual funds; restricted in the use of leverage
- Leveraged accounts – entities like hedge funds and commodity trading advisers that engage in active trading for profit
- Retail accounts – includes exchanging currency at the airport kiosk and small electronic trading accounts
- Governments – could be transactional or following policy goals
-= Central banks – sometimes intervene to protect the domestic exchange rate
- Sovereign wealth funds (SWFs) – used by countries with large current account surpluses to hold capital flows rather than reserves managed by central banks
The sell-side of FX Markets can be broken down into several categories:
composed of major multinational banks (e.g., Deutsche Bank, Citigroup)
With their economies of scale, IT expertise, and global client bases, these tier-one banks are able to offer the most competitive FX quotes
Regional and local banks act as sell-side participants as well, but to a much lesser degree than larger banks.
the world’s three largest FX trading market
London
New-York
Tokyo
A Japanese company seeking to hedge the exchange rate risk attributable to a large USD-denominated payment expected from an American customer in six months would most likely:
A
sell USD in the spot market.
B
buy JPY in the forward market.
C
buy USD in the forward market.
B
buy JPY in the forward market.
Because the Japanese company is expecting a payment denominated in USD, it has long USD exposure. If the company does not hedge this exposure, it will suffer in the event that the USD depreciates relative to the JPY over the next six months. This exposure can be hedged by entering a forward contract to sell USD and buy JPY.
A direct quote
uses the domestic country for the price currency and the foreign country for the base currency
Investor in the Eurozone:
Direct quote: EUR/GBP = 1.25 (1 GBP costs 1.25 Euro).
An indirect quote
the reciprocal of the direct quote
Investor in the Eurozone:
Indirect quote: GBP/EUR = 1/1.25 = 0.80 (1 Euro costs 0.80 GBP).
The bid
represents the price at which the bank will buy the base currency
Banks profit by buying at the bid price and selling at the offer price
the offer
represents the price at which the bank will sell
Banks profit by buying at the bid price and selling at the offer price
points (or “pips”)
present the difference between the forward rate quote and the spot rate quote
forward premium for the base currency
when the forward rate is greater than the spot rate
the points are positive
a forward discount for the base currency
If the points are negative
A forward premium indicates:
A
an expected increase in demand for the base currency.
B
the interest rate is higher in the base currency than in the price currency.
C
the interest rate is higher in the price currency than in the base currency.
A country’s exchange rate regime
s the policy framework adopted by its central bank.
The ideal currency regime would have the following properties:
how are these unrealistic
- Exchange rates between currency pairs are credibly fixed.
- All currencies would be fully convertible (i.e., unrestricted capital flows).
- Each country undertakes an independent monetary policy for domestic objectives.
these three properties are inconsistent with each other. If the first two were true, different currencies would be interchangeable like coins and bills of the same currency. Under such conditions, the impact of using lower interest rates as part of an independent monetary policy would be offset by capital outflows. Similarly, attempts to raise interest rates would be rendered ineffective by capital inflows. Therefore, it is not possible to achieve the ideal currency regime.
the Smithsonian Agreements
In 1973, the Smithsonian Agreements put an end to the Bretton Woods system, and the world moved to a system of flexible exchange rates
