Chapter 13.2 Flashcards
Foreign Exchange Markets (96 cards)
1
Q
What are the foreign exchange markets?
A
International markets where currencies are bought and sold in wholesale amounts
2
Q
What is the first basic economic benefit of foreign exchange markets?
A
They transfer purchasing power between individuals dealing in different currencies, facilitating the import/export of g&s
3
Q
What is the second economic benefit of foreign exchange markets?
A
They allow corporations to hedge against foreign exchange risk by passing it to professional risk-takers.
4
Q
Why is the hedging function of foreign exchange markets especially important today?
A
Because we are in an era of floating (variable) exchange rates.
5
Q
What is the third economic benefit of foreign exchange markets?
A
A channel for importers and exporters to acquire credit for international business transactions. The time span between the shipment of goods by exporters and their receipt by importers can be considerable
6
Q
How do foreign exchange markets help during the transit of goods in international trade?
A
While the goods are in transit, they must be financed. They offer financing and currency conversion efficiently and at low cost.
7
Q
What was the average daily trading volume of the foreign exchange market in 2016?
A
About $5 trillion.
8
Q
How does this trading volume compare to real goods traded in the economy?
A
More than the value of all the cars, wheat, oil, and other products sold daily in the real economy
9
Q
Which city is the largest center for foreign exchange trading?
A
London
10
Q
What are other major foreign exchange trading centers besides London?
A
New York City, Hong Kong, and Singapore.
11
Q
Is there a single formal foreign exchange market?
A
No, there are a group of informal markets closely interlocked through international banking relationships
12
Q
How are participants in the foreign exchange markets connected?
A
By telephone and electronic networks
13
Q
When does trading occur in the foreign exchange markets?
A
Any time of day or night, and every day of the year.
14
Q
Does every country have a foreign exchange market?
A
Virtually every country has some type of active foreign exchange market.
15
Q
Who are the major participants in the foreign exchange markets?
A
- Multinational commercial banks
- Large investment banking firms
- Currency boutiques that specialize in foreign exchange transactions
16
Q
Which institutions dominate the U.S. foreign exchange market?
A
Money center banks including Citigroup, JP Morgan, and Bank of America
17
Q
What role do central banks play in the foreign exchange markets?
A
Intervene in the markets primarily to smooth out fluctuations in the exchange rates for their countries’ currencies
18
Q
Why is comparing purchase alternatives easier when suppliers are located in the U.S.?
A
Because both parties use the same currency (U.S. dollars) for bookkeeping and payments.
19
Q
Why are comparisons more difficult when suppliers are located outside the U.S.?
A
Because different currencies are involved, introducing foreign exchange rate risk.
20
Q
Why do foreign suppliers prefer to be paid in their domestic currency?
A
To cover local expenses like employee wages and other operating costs.
21
Q
What happens when only one party in a transaction uses its preferred currency?
A
The other party must deal in a foreign currency and face exchange rate risk.
22
Q
What causes foreign exchange rate risk?
A
Uncertainty associated with future exchange rate movements
23
Q
How can buyers compare prices in different currencies?
A
By checking foreign exchange rate quotes in newspapers or online.
24
Q
What is a foreign exchange rate?
A
The price of one monetary unit (e.g., British pound) stated in terms of another (e.g., U.S. dollar).
25
If American steel costs $660 per ton, what price makes a British supplier less attractive at an exchange rate of $1.25/£?
A price of £536 × $1.25/£ = $670.00, which is $10 more than the American supplier.
26
At an exchange rate of ¥111/$, what is the cost in U.S. dollars for Japanese steel priced at ¥71,500 per ton?
$644.14 per ton (¥71,500 ÷ ¥111/$).
27
Given a price of ¥71,500 per ton and an exchange rate of ¥111/$, how does the cost of Japanese steel compare to American steel priced at $660 per ton?
$644.14 per ton. This price is $15.86 per ton ($660.00 − $644.14 = $15.86) less than the American supplier's price of $660.00 per ton
28
In the example where Japanese steel is priced at ¥71,500 per ton and converts to $644.14, under what condition would a U.S. manufacturer choose the Japanese supplier over the American supplier charging $660?
f the ¥71,500 price includes transportation and tariffs, or if those additional costs are less than $15.86 per ton, making the total cost lower than $660.
29
What happens to the U.S. dollar cost of British steel priced at £536 when the exchange rate falls from $1.25/£ to $1.15/£?
It drops to $616.40 (£536 × $1.15/£), making it cheaper than American steel at $660.
30
In the example where British steel is priced at £536 per ton, how does a change in the exchange rate from $1.25/£ to $1.15/£ make the British firm the low-cost supplier?
The lower exchange rate reduces the cost of British steel to $616.40, undercutting the U.S. price of $660, even though the British firm hasn’t changed its local price.
31
In the scenario where the exchange rate between the dollar and pound falls from $1.25/£ to $1.15/£, what does the resulting change in British steel pricing illustrate about floating exchange rates?
It shows that freely floating exchange rates can shift cost advantages between suppliers without any change in local currency pricing.
32
In the example where the exchange rate changes from $1.25/£ to $1.15/£, what does it mean when fewer dollars are needed to buy one pound?
It means the value of the pound has fallen against the dollar, or the dollar has risen against the pound.
33
What is the effect of a weaker pound on the cost of British goods for U.S. buyers?
British goods become cheaper for those holding dollars.
34
What happens to the cost of U.S. goods for British buyers when the pound weakens against the dollar?
U.S. goods become more expensive for those holding pounds.
35
How does a decline in a country’s currency value affect global demand for its products, assuming other factors remain constant?
It increases demand for the country’s products because they become cheaper in foreign currency terms.
36
In the example where British steel is priced at £536 per ton, how did the change in the exchange rate from $1.25/£ to $1.15/£ affect the U.S. manufacturer's supplier decision?
At $1.25/£, British steel cost $670.00 per ton, making it the most expensive option. After the rate changed to $1.15/£, the cost dropped to $616.40, making it the cheapest option and reversing the manufacturer’s original decision.
37
While in a clothing store on Savile Row in London, you find the blue cashmere sweater of your dreams. The sweater is on sale at 50 percent off, priced at £250. “In the states, a sweater like that costs about $300.” If the current exchange rate is $1.38/£, is the sweater a bargain?
The price of the sweater in dollars is £250 × $1.38/£ = $345, which is higher than the $300 price in the United States. It is not such a good deal.
38
You are the purchasing agent for the U.S.-based firm buying steel in the example just discussed in the text. Your assistant, Omar, who is a British subject, runs into the office and breathlessly says, “The pound is stronger against the dollar! The new exchange rate is $1.32/£!” Is Omar's report good news or bad news?
The fact that the pound has risen in value against the dollar is good news for Omar, because the British pounds he owns will now buy more U.S. goods. But for your firm, the news is bad. It now takes more U.S. dollars to purchase one British pound. At the new exchange rate, the British steel costs $707.52 per ton (£536 × $1.32/£ = $707.52).
39
In the equilibrium exchange rate graph, what does the downward-sloping demand curve for pounds represent?
As the dollar price of pounds decreases, Americans demand more pounds to buy cheaper British goods, increasing U.S. imports.
40
In the equilibrium exchange rate graph, what happens to the demand for pounds when the U.S. dollar appreciates relative to the British pound?
The demand for pounds increases, because British goods become cheaper in dollar terms, leading Americans to import more.
41
What is the equilibrium exchange rate in the equilibrium exchange rate graph?
It’s the dollar price per pound at which the quantity of pounds demanded equals the quantity supplied, shown where the supply and demand curves intersect.
42
Why does the supply of pounds increase as the dollar price of pounds rises, according to the equilibrium exchange graph?
Because British sellers receive more dollars per pound, making it more attractive to exchange pounds for dollars, which increases the supply of pounds.
43
When does the demand for pounds in exchange for dollars decrease?
As the dollar price of pounds decreases
44
When does the supply of pounds in exchange for dollars increase?
As the dollar price of pounds increases
45
The supply of and demand for pounds move in what direction relative to the exchange rate changes?
Opposite
46
As pounds become less expensive in relation to dollars, British products become ______ expensive for Americans to buy.
Less
47
When the pound becomes less expensive, do we import more or less British goods? What slope is this exhibited by?
Import more British goods; demand more British pounds to pay for those goods. Shown by the downward sloping curve
48
Why does the supply of British pounds to the foreign exchange market decrease when the dollar price of pounds declines?
Because British residents receive fewer dollars per pound, making U.S. goods more expensive, so they import less and supply fewer pounds to buy foreign goods.
49
How does a lower dollar price for pounds affect British consumer behavior in the foreign exchange market?
It encourages substitution toward domestic goods over imports, reducing the supply of pounds available for currency exchange.
50
In the equilibrium exchange graph, what does the upward-sloping supply curve for pounds represent?
When purchases are diverted to domestic goods, British residents will supply fewer pounds to the foreign exchange markets because they no longer want to buy as many imports
51
What happens at the equilibrium exchange rate ($/£) in the equilibrium exchange graph?
The quantity of pounds demanded equals the quantity supplied, and no net accumulation or divestment of currency occurs in the market.
52
What causes the demand curve for a foreign currency (e.g., British pounds) to shift in the U.S. foreign exchange market?
Any factor that causes U.S. residents to buy more or fewer foreign goods, such as changes in income, preferences, or relative prices.
53
What causes the supply curve for a foreign currency to shift in the U.S. foreign exchange market?
Any factor that causes foreign residents to buy more or fewer U.S. goods, affecting how many units of their own currency they supply to exchange for dollars.
54
Why are major currencies such as the British pound and U.S. dollar referred to as "floating" currencies"?
Their exchange rates are allowed to freely fluctuate with supply and demand on the foreign exchange markets
55
What does it mean for a country to “peg” its currency?
It means the country fixes its exchange rate to another major currency, such as the U.S. dollar or the euro, rather than allowing it to float.
56
Why might a country choose to peg its currency to another, like the U.S. dollar?
To maintain exchange rate stability and keep its exports competitively priced in global markets.
57
What are examples of countries that have opted to peg their currency exchange rate?
Denmark, Togo, and Bulgaria
Bahrain maintains a fixed exchange rate between its dinar and the U.S. dollar of 0.376 dinar per U.S. dollar
58
What is the spot rate?
The exchange rate for immediate delivery of a currency, cost of buying a foreign currency today "on the spot"
59
In foreign exchange quoting, what is the USD Equivalent or American quote?
It shows how many U.S. dollars it takes to buy one unit of foreign currency. Example: $1.2154/£ means it costs $1.2154 to buy 1 British pound.
60
What is the Currency per USD or European quote?
It shows how much foreign currency one U.S. dollar will buy. Example: $1 = £0.8228 means one U.S. dollar can be exchanged for 0.8228 British pounds.
61
How are the American quote and European quote related?
They are reciprocals of each other. For instance, if the USD Equivalent is $1.2154/£, then the Currency per USD is 1 ÷ 1.2154 = 0.8228 £/$.
62
Using the March 14, 2017 data, how many U.S. dollars does it take to buy one Indian rupee?
$0.01520 per rupee.
63
According to the same data, how many Indian rupees can you get for one U.S. dollar?
65.7705 rupees.
64
How is the second exchange rate a reciprocal of the first?
1/x of the first
Ex: American quote for the British pound is $1.2154/£; the European exchange rate, which is the reciprocal, is 1/1.2154 = 0.8228, or £0.8228/$; that is, $1 equals £0.8228.
65
Where do the foreign exchange rate quotes in the Wall Street Journal come from?
They are provided by foreign exchange dealers, most of whom operate in large money center banks.
66
What two prices do foreign exchange dealers typically quote?
They quote a bid rate (buying price) and an ask rate (selling price).
67
In foreign exchange markets, what does the bid quote represent?
The bid quote is the rate at which a foreign exchange dealer is willing to buy foreign currency.
68
What does the ask quote represent in foreign exchange transactions?
The ask quote is the rate at which a dealer is willing to sell foreign currency.
69
What does the bid-ask spread measure in foreign exchange markets?
The bid-ask spread represents the dealer’s profit margin and is calculated as the percentage difference between the ask and bid rates.
70
What is the formula for calculating the bid-ask spread as a percentage?
Bid-ask spread= Ask rate−Bid rate/Ask rate
71
If a dealer quotes a bid of $1.0595/€ and an ask of $1.0681/€, what is the bid-ask spread?
1.0681-1.0595/1.0681 = 0.00805 or 0.805%
72
If ABC Corporation buys €1,000,000 at the ask rate of $1.0681/€, how much do they pay in total?
$1,068,100 (€1,000,000 × $1.0681/€)
73
If ABC Corporation first purchases €1,000,000 at an ask rate of $1.0681/€, but later no longer needs the euros and sells them back at the bid rate of $1.0595/€, how much will the company receive in return?
$1,059,500 (€1,000,000 × $1.0595/€)
74
In the example where ABC Corporation buys €1,000,000 at an ask rate of $1.0681/€ and later sells it back at a bid rate of $1.0595/€, what is the total dollar loss, and how does it reflect the bid-ask spread?
The company loses $8,600 ($1,068,100 − $1,059,500), which matches the 0.805% bid-ask spread calculated as
(1.0681−1.0595)/1.0681
75
What do people dealing with multiple foreign currencies often use?
They often use a table of spot exchange rates called cross rates.
76
What are cross rates in foreign exchange?
Simply exchange rates between two currencies
77
Where can cross rate tables be found?
Cross rate tables can be found in the Wall Street Journal and on many financial websites.
78
How can you calculate the cross rate between the Canadian dollar and the euro if given their exchange rates with the U.S. dollar?
You divide the Canadian dollar to U.S. dollar rate by the euro to U.S. dollar rate:
C$/€ = (C$/U.S.$) ÷ (€/U.S.$) = 1.3480 ÷ 0.9430 = C$1.4294/€
79
An American executive is going on a business trip to Japan and England. Before she departs, the executive purchases $10,000 worth of Japanese yen at the prevailing rate of ¥114.74/$. After finishing her business in Japan, she departs for London, where she converts her remaining yen to British pounds. She sells ¥512,375 at a rate of ¥139.4586/£. She finally returns to the United States with £567.35, which she would like to convert to U.S. dollars. Based only on the rates given, how many dollars will she receive if she sells the pounds?
¥139.4586/£ ÷ ¥114.74/$ = $1.2154/£
Amount of dollars received = £567.35 × $1.2154/£ = $689.55
80
What is the forward rate?
A rate agreed on today for an exchange to take place on a specified date in the future
81
For which major world currencies does the Wall Street Journal typically list forward rates, and for what time periods?
The Wall Street Journal lists forward rates for major currencies like the U.S. dollar, British pound, and Japanese yen, typically for one month, three months, and six months.
82
Why are forward contracts important in international business transactions?
Because transactions often extend over long periods, forward contracts let managers lock in exchange rates in advance and avoid risk from unfavorable currency movements.
83
What advantage does a forward contract offer to financial managers?
It eliminates uncertainty about the future exchange rate by fixing the currency cost at the beginning of the transaction.
84
What is the difference between the forward rate and the spot rate called?
It is called the forward premium or forward discount, depending on whether the forward rate is higher or lower than the spot rate.
85
: What does it mean if the three-month forward rate for the British pound is lower than the current spot rate?
It means the pound is at a forward discount relative to the U.S. dollar, or the U.S. dollar is at a forward premium against the pound.
86
What is the formula (measured as a % on an annualized basis) for forward premium (discount)?
Forward premium (discount) = Forward rate- Spot rate/Spot rate x 360/n x 100
87
Suppose the spot rate today on the British pound is $1.2179/£, while the three-month forward rate is $1.2105/£. According to the forward quote, the market expects the British pound to cost $1.2105 three months in the future, a value that is less than today's spot rate of $1.2179.
What is the Forward discount?
Forward discount = 1.2105-1.2179/1.2179 x360/90 x 100 = -2.43%
88
Ian Chappell is planning a trip from Sydney, Australia, to visit his brother, who works in India. He plans to make the trip in six months. In preparing his budget for the trip, he finds that the spot rate for Indian rupees is Rs54.4811 per Australian dollar (A$). He also finds the six-month forward rate to be Rs50.9001/A$. What is the forward premium or discount on the Indian rupees against the Australian dollar?
Forward Discount = (50.9001−54.4811/54.4811) x 360/180 x 100 = −13.15%
89
What is a hedge?
A financial transaction intended to reduce risk
90
In the example of the American exporter selling farm equipment for £100,000, what is the value of the transaction at the spot rate of $1.30/£?
$130,000 (£100,000 × $1.30/£)
91
In the example where an American exporter sells farm equipment to a British firm for £100,000 to be paid in 90 days, how can the American firm hedge against foreign exchange risk?
The American firm can hedge by entering into a forward contract to sell the £100,000 in 90 days at a locked-in forward rate.
92
If the American exporter hedges by locking in a 90-day forward rate of $1.28/£ for the £100,000 sale, how many U.S. dollars will the firm receive?
$128,000 (£100,000 × $1.28/£)
93
In an international transaction where an American exporter sells farm equipment to a British firm for £100,000, with payment due in 90 days, and the exporter hedges by locking in a forward rate of $1.28/£, how much does the exporter effectively save if the spot rate after 90 days turns out to be $1.22/£?
The exporter saves $6,000, because the forward contract guarantees $128,000 (£100,000 × $1.28/£), whereas selling at the spot rate of $1.22/£ would yield only $122,000.
94
What is a limitation of forward contracts in hedging foreign exchange risk?
Forward contracts protect against unexpected changes in exchange rates, not against expected changes already reflected in forward rates.
95
In the case where an American exporter sells farm equipment to a British firm for £100,000 with payment in 90 days, and the exporter hedges by locking in a forward rate of $1.28/£, how does the outcome compare if the spot rate unexpectedly rises to $1.40/£ at the time of payment?
The unhedged transaction would yield $140,000 (£100,000 × $1.40/£), while the hedged transaction yields only $128,000 (£100,000 × $1.28/£), meaning the exporter receives $12,000 less by hedging.
96
Why might firms still choose to hedge, even if they risk missing out on favorable currency movements?
Because leaving the receivable unhedged is considered speculation, which is not viewed as a logical or legitimate role for nonfinancial businesses that import/export goods or services
