Chapter 2: Introduction to Exchange Rates and the Foreign Exchange Market

Question 1

Exchange Rate

Answer 1

The price of some foreign currency expressed in terms of a home (domestic) currency

Question 2

Appreciation

Answer 2

When one currency buys more of another currency

Happens when the exchange rate falls

Question 3

Depreciation

Answer 3

When one currency buys less of another currency

Happens when the exchange rate rises

Question 4

Effective Exchange Rate

Answer 4

The calculated multilateral exchange rate changes for baskets of currencies using trade weights to construct an average of all the bilateral exchanges for each currency in the basket

Question 5

Exchange Rate Regime

Answer 5

A pattern of exchange rate behavior

Question 6

Fixed (Pegged) Exchange Rate Regime

Answer 6

An exchange rate regime in which a country’s exchange rate either does not fluctuate or fluctuates in a narrow range against some base currency over a sustained period, usually a year or longer. A country’s exchange rate can remain rigidly fixed for long periods only if the government intervenes in the foreign exchange market in one or both countries

Question 7

Floating (Flexible) Exchange Rate Regime

Answer 7

An exchange rate regime in which a country’s exchange rate is allowed to do whatever it wants. Appreciations and depreciations may occur whenever.

Question 8

Band

Answer 8

A very small area for fluctuation about an exchange rate peg

Question 9

Dirty Float (aka Managed Float)

Answer 9

A middle-ground, in which an exchange rate is allowed to float until the government doesn’t want it to, and then fixes it.

Question 10

Exchange Rate Crisis

Answer 10

Dramatic depreciations

Question 11

Crawl

Answer 11

A fixed arrangement in which one currency is allowed to slowly depreciate against another one. If the exchange rate follows a simple trend, it is a crawling peg. If the exchange rate allows for some variation about the trend, it is a crawling band

Question 12

Dollarization

Answer 12

When one country unilaterally adopts the currency of another country

Question 13

Currency (Monetary) Union

Answer 13

An agreement under which there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member nations, who all use the same currency

Question 14

Foreign Exchange (FX or forex) Market

Answer 14

A collection of private individuals, corporations, and some public institutions, that buy and sell currencies.

Question 15

Spot Contract

Answer 15

The simplest FX Market transaction, in which an immediate exchange of one currency for another occurs
Essentially riskless
These account for the majority of the activity in the forex market

Question 16

Spot Exchange Rate

Answer 16

Exchange rate for a spot contract

Question 17

Forward Contract

Answer 17

Two parties make the contract today, but the settlement date for the delivery of the currencies is in the future. The maturity (time to deliver) varies, and the contract carries no risk

Question 18

Swap Contract

Answer 18

Combines a spot sale of foreign currency with a forward repurchase of the same currency. This is common for parties who trade often, because it lowers transaction costs

Question 19

Futures Contract

Answer 19

A promise that the two parties holding the contract will deliver currencies to each other at some future date at a prespecified exchange rate, just like a forward contract. Unlike a forward contract, however, futures contracts are standardized, mature at certain regular dates, and can be traded on an organized futures exchange

Question 20

Options

Answer 20

An option provides the buyer with the right to buy or sell a currency in exchange for another at a prespecified exchange rate at a future date. The other party, the seller, must perform the trade if asked to do so, but the buyer is under not obligation to trade, and will generally not exercise the option of the spot price on the expiration date turns out to be more favorable.

Question 21

Commercial Banks

Answer 21

The majority of forex traders work for these. They trade for themselves and also serve clients who want to import or export goods, services, or assets.

Question 22

Interbank Trading

Answer 22

Approximately 3/4 of all fx market transactions are handled by 10 banks.
The vast majority of forex transactions are profit-driven interbank trades and it is the exchange rates for these trades that underlie quoted market exchange rates

Question 23

Corporations in the FX Market

Answer 23

Some corporations may trade in the fx market if they are engaged in extensive transactions either to buy inputs or sell products in the foreign markets. This is expensive, but they can bypass having to pay the bank to do it for them, and it might be worth it, depending on various factors

Question 24

Capital Controls

Answer 24

Restrictions on cross=border financial transactions

Question 25

Black (Parallel) Markets

Answer 25

Illegal market where individuals may trade at exchange rates determined by market forces and not set by the government

Question 26

Arbitrage

Answer 26

A trading strategy that exploits any profit opportunities arising from price differences

Question 27

Vehicle Currency

Answer 27

The vast majority of currency pairs are exchanged for one another through a third currency, called the vehicle currency

Question 28

Forward Exchange Rate

Answer 28

Exchange rate used in forward contracts

Question 29

Covered interest Parity (CIP)

Answer 29

Dolalr return on dollar deposits equals the dollar return on euro deposits

(1+i(h)) = (1 + i(f))(F/E)

Question 30

Expected Exchange Rate (Ee)

Answer 30

Forecasted exchange rate

Question 31

Uncovered Interest Parity

Answer 31

Dollar return on dollar deposits equals the expected dollar return on euro deposits
(1+i(h)) = (1 + i(f))(Ee/E)