Chapter 5 - FX (2/3) Flashcards
What is a FX market?
Where converting currencies takes place
What is a SPOT XR?
AN XR which is quoted for immediate delivery of currency
What is a FORWARD XR
agreed on now for delivery of currency on a future date
What is a DIRECT quote?
How many of the home currency can be obtained from a single unit of the foreign currency
£/$
What is a INDIRECT quote
how many of the foreign currency can be obtained from a single unit of the foreign currency
$/£
What is the mathematical relationship between Direct and Indirect?
Direct = 1/Indirect
How are XR’s reported
As a bid - offer range
$/£ N1 - N2
the bank buys high and sells low
In a free market, how is XR established?
In a free market, XR is set by interaction by demand-supply
XR ($/£) vs Q
FOr UK, If £ is converted to other S is shifted out
If other converted to £, D is shifted out
What does £ strengthening mean?
INCREASE in $/£
cheaper for UK to buy US goods
more expensive for US to buy UK
What does £ weakening mean?
DECREASE in $/£
More expensive for UK to buy US goods
Cheaper for US to buy UK
What influences XR?
1) Interest Rates - UP UP
2) Inflation Rates UP DOWN
3) Balance of Payments M>X DOWN
4) Speculation
How does Interest Rate influence XR?
If interest rates INCREASE in UK more than US
Increase in demand for UK, increase in spot rate
Forward rate $/£ adjusted
Forward rate ($/£) = spot rate ($/£) * (1+Interest rate $/1+Interest rate £)
How does inflation rate influence XR?
Inflation erodes purchasing power
One country has Higher inflaction to another
weakens currency of Higher Inflation
LI/HI DECREASE
Future spot rate(a/b) = spot rate (a/b)* (1 + inf rate a/1+inf rate b)
How does balance of payments influence XR?
If imports > exports
-weakens the currency = DECREASE F/H
How does Speculation influence XR?
People try to make gains by trading in currencies
If this happens in large quantities, this can influence the whole market
How can XR be controlled by government?
1) Directly - Buring and selling currency using foreign currenct reserves
(shifts supply and demand)
2) Indirectly via the ability to change the level of domestic interest rates
What are the 4 management levels of XR?
1) Floating rate
2) Managed floating rate
3) Fixed rate
4) Moving peg
What is a floating rate system?
No intervention from government at all - only market dictates
What is a managed floating rate system?
To keep the XR within an acceptable range, gov may intervene by using currency reserves
What is a fixed rate system?
XR is fixed, gov use currency reserves to maintain
XR will be benchmarked against something e.g. gold/another stable currency
What is a moveable peg system?
Fixed rate but with periodic revaluation/devaluation
ADVANTAGES: Floating rate system?
No gov intervention required
DISADVANTAGE: Floating rate system?
Increased potential volatility Increased risj
Increased swings -> increased movement in Balance of Payments
= instability
ADVANTAGE: Fixed rate system?
Certainty for international trade
