Currency Exchange Rates Flashcards
(13 cards)
Define an exchange rate, and distinguish between nominal and real exchange rates and spot and forward exchange rates
Exchange rate: The price or cost of units of one currency in terms of another
$Price currency / EUR Base Currency
Nominal Exchange Rates: At some point in time, it costs Price Currency to purchase one Base countries basket of goods.
Real Exchange Rate: The dollar cost of purchasing that same unit of goods and services based on the new current dollar / euro exchange rate and the relative changes in the Plevels of both countries.
Real Exchange Rate formula: D/F (CPI foreign/CPI domestic) = Change in D1 and D2 to indicate a fall in real exchange rate, where D1>D2, or an increase.
Spot exchange Rate: The currency exchange rate for immediate delivery, which for most currencies means the exchange of currencies takes place two days after the trade.
Forward Exchange Rate: A currency exchange rate for an exchange to be done in the future.
Describe functions of and particiapnts in the the foreign exchange market
To serve companies and individuals that purchase or sell foreign goods and services denominated in foreign currencies
To hedge via forward currency contracts
Participants in the foreign exchange markets
Corporations:
Investment accounts: Real Money; mutual funds, pension funds, insurance companies, non-deriv using institutions. Leveraged accounts; hedge funds, deriv users
Governments and government entities: Sovereign Wealth Funds:
Retail Market: FX trans. by households and relatively small institutions for tourism, cross-border investment, speculative trading.
Cal, interpret the percentage change in a currency relative to another currency
Calc the % change of the BASE CURRENCY in a FX quote
%change $$/EUR is actually as Abase/Bbase - 1, then denote the %change in the OTHER currency
Calc, interpret currency cross-rates
Cross Rate: The exchange rate between two currencies implied by their exchange rates with a common third currency (necessary when there is no active FX market in the currency pair)
Key to calc cross rates: Note that the basis of the quotes must be such that we get the desired result algebraically.
[(Base/Price) / New BASE NEW] / [CURRENCY/ ORIGINAL PRICE]
Convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation
Forward Quotation: The difference between the spot exchange rate and the forward exchange rate.
Spot exchange + points, expressed in terms of 0.0001, or 1/10,000th; 4 decimal place
so, +3.5 points is .00035
If spot is given as -0.062%, calc that as (1-.00062)
Explain the arbitrage relationship between spot rates, forward rates, and interest rates
% diff. between forward and spot rates is approximately equal to the diff. between the two countries interest rates. (that is because of an arbitrage trade w/ a riskless profit to be made when this relation does not hold);(no arbitrage condition); opp. to make profit w/o risk.
Interest rate parity; no-arbitrage relation
forward/spot = (1+Rdomestic)/(1+R foreign)
Calc, interpret a forward discount or premium
Forward discount or forward premium for a currency is calc. relative to the spot exchange rate.
The ‘t’ forward prem. or disc. on the US $$ = Fwd/Spot - 1
= + ; Fwd discount rate of ‘n’%
When forward quote > spot quote , it will take more dollars to buy one other currency ‘t’ time from now, so the other currency is expected to appreciate versus the $, and the $ is expected to depreciate v. the other currency.
If Spot>Fwd; = - ; Forward premium for $$ relative foreign
Calc, interpret the forward rate consistent with the spot rate and the interest rate in each currency; Calculating the arbitrage-free FWD exchange rate, +with 90-day interest
Forward = Spot rate (regular form)*(1+%rbase/1+%rprice)
Fwd rate > Spot rate by A/B - 1 = %n, which is approximately = to the interest rate differential of Baserr% - Pricer%
*The currency w/ the higher interest rate should depreciate over time by approximately the amount of the % rate differential.
If 90 day or 180 day, use those %rates rather than annual
Just R/M = period rate
*something about earning a riskless profit
Describe exchange rate regimes
Countries that dont issue their own currencies can use another countries currency(eliminates their opp. to have their own monetary policy);formal dollarization Monetary Union (euro): All countries participate in determining the monetary policy of the ECB
Countrys that do issues their own currencies
Currency Board Arrangement: An explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, EX: Hong Kong currency may only be issued when backed by equivalent US dollars
Conventional Fixed Peg Arrangement: Peg currency within +-1 versus another, or a basket that includes the currencies of its major trading or financial partners.
Target Zone; horizontal bands; in a system of pegged exchange rates - wider bands, +- 2 %, and monetary authority has more policy discretion
Crawling Peg: Exchange rate is adjusted periodically,to adjust for higher inflation versus the currency used in the peg. Active crawl - A series of rate adjustments over time is announced and implemented.
Management of exchange rates within crawling bands: Increase exchange rate bands over time. Use to transition from fixed to floating.
Managed floating exchange rates: Fed responds BoP, inflation rates, or employment indirectly or directly - may induce partners to respond in way which reduce stability.
Independently Floating: Exchange rate is market determined, and foreign exchange market intervention is used only to slow the rate of change and reduce short-term fluctuations, not to keep exchange rates at a certain target level.
Explain the effects of exchange rates on countries international trade and capital flows
Address the question of how a change in exchange rates affects a countries balance of trade using two approaches (elasticities approach, absorption approach)
The relationship between the balance of trade and capital flows = X - M ==(S-I) + (T-G)
INtuition: a trade deficit (X - M < 0) means the right side must be - so that total savings (Priv + Gov) is less than domestic investment in physical capital. So theres a surplus in the capital acct to offset the deficit in the trade acct. Another thing: Gov deficit is not funded by an excess of fomestic saving over domestic investment which is consistent with a trade deficit (imports > exports) which is offset by an inflow of foreign capital (a surplus in the capital acct)
Elasticities Approach: Focus - how exchange rates affect total expenditures (not quantity of NX) on imports and exports.
Condition under which a depreciation of the domestic currency will -trade deficit; Marshall-Lerner condition
Elasticities approach tells us that currency depreciation will result in a great improvement in the trade deficit when either imp or exp demand is elastic
Currency depreciation will have a greater effect on the balance of trade when import or export goods are primarily luxury goods, goods with close substitutes, and goods that represent a large proportion of overall spending.
Absorption Approach: (Elas shortcoming: only considers the microecon relationship between exchange rates and trade balances. Ignores capital flows) :Abs. Approach focus’ on the Capital Account as BT(balance of trade) = Y - E(domestic absorption of goods and services, aka total expenditure)
Inc relative to Expenditure must ++ (domestric absorp must fall) for the BT to + in response to currency depr. BT improves when domestic saving increases relative to domestic investment in physical capital (a component of E) aka for the depreciation of the domestic currency to improve the balance of trade towards surplus, it must increase national income relative to expenditure. aka requirement: Nat. saving must increase relative to domestic investment in physical capital.
Currency depreciation and capacity utilization: Capacity util is low, econ operating at less than full emp, depreciation makes domestic goods and services relatively more attractive than foreign. Thus expenditures AND income increases. Nat Inc will inc. more than total expend. because part of income incr. will be saved, which improves BT
Operation at full emp: +Domestic expenditures (spending) = higher P = BT deficit
Currency depr. At full op = decline in the value of domestic assets, thus declining savers real wealth, which induces savings, and a return to previous state and balance of trade.
A currency exchange rate that is set today for an exchange to be made 90 days in the future is best described as a:
A) real exchange rate.
B) forward exchange rate.
C) spot exchange rate.
Your answer: C was incorrect. The correct answer was B) forward exchange rate.
A forward exchange rate is a currency exchange rate for an exchange to be made in the future. Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or one year).
A currency exchange rate that is set today for an exchange to be made 90 days in the future is best described as a:
A) real exchange rate.
B) forward exchange rate.
C) spot exchange rate.
Your answer: C was incorrect. The correct answer was B) forward exchange rate.
A forward exchange rate is a currency exchange rate for an exchange to be made in the future. Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or one year).
In the foreign exchange markets, transactions by households and small institutions for tourism, cross-border investment, or speculative trading comprise the:
A) retail market.
B) real money market.
C) sovereign wealth market.
Your answer: A was correct!
The retail foreign exchange market refers to transactions by households and relatively small institutions and may be for tourism, cross-border investment, or speculative trading.
In the foreign exchange markets, transactions by households and small institutions for tourism, cross-border investment, or speculative trading comprise the:
A) retail market.
B) real money market.
C) sovereign wealth market.
Your answer: A was correct!
The retail foreign exchange market refers to transactions by households and relatively small institutions and may be for tourism, cross-border investment, or speculative trading.
If we compare the prices of goods in two countries through time, we can use the price information in concert with the quoted foreign exchange rate to calculate the:
A) real exchange rate.
B) interest rate spread.
C) nominal exchange rate.
Your answer: B was incorrect. The correct answer was A) real exchange rate.
A comparison of consumption costs between two markets can, in concert with the foreign exchange rate (also called the nominal exchange rate), be used to calculate the real exchange rate.
If we compare the prices of goods in two countries through time, we can use the price information in concert with the quoted foreign exchange rate to calculate the:
A) real exchange rate.
B) interest rate spread.
C) nominal exchange rate.
Your answer: B was incorrect. The correct answer was A) real exchange rate.
A comparison of consumption costs between two markets can, in concert with the foreign exchange rate (also called the nominal exchange rate), be used to calculate the real exchange rate.
