Foreign Exchange Market Overview Flashcards
(26 cards)
What is the foreign exchange market?
The foreign exchange market is a global dececentralised maerket where currencies and bank deposits are traded.
What are the two types of transactions in the Forex market?
Spot transactions and forward transactions.
What is a spot transaction?
An immediate exchange of one currency for another at the spot rate, usually settled within two business days.
Spot rate would be 1 euro for every 1.10 dollar
What is a forward transaction?
A contract to exchange currencies at a future date and at a pre-agreed forward rate.
What are Exchange Rates and Why do they Matter
Exchange rates determine the price of one currency in terms of another.
Importance:
Affect international trade by influencing export/import prices.
Influence domestic competitiveness: A strong currency can hurt exports; a weak one can boost them.
Impact consumers’ purchasing power, especially when buying imported goods or traveling abroad.
How are exchange rates determined?
By the interaction of supply and demand.
What are the Effects of Currency Appreciation
Reduced Export Competitiveness - Domestic goods are more expensive for buyers, so its harder to sell abroad, reducing competitiveness
Increased Demand for Imports - Imported goods are cheaper for domestic customers, so demand of foreign goods shifts
Central Bank Intervention - They may intervene in Forex to prevent too much appreciation due to the negative effects. (Swiss Bank Swiss Franc)
List some national currencies in the Forex market.
U.S. dollar (USD), Euro (EUR), Japanese yen (JPY), Chinese yuan (CNY), British pound (GBP), Canadian dollar (CAD).
Volatility of the Four Currencies against the US Dollar
Canadian Dollar (CAD) Least volatile Strong and integrated trade link with the US economy. Often moves in sync with US trends.
British Pound (GBP) More volatile Weaker link with the US economy, more susceptible to independent monetary/fiscal changes and geopolitical events (e.g. Brexit).
Japanese Yen (JPY) More volatile Impacted by domestic monetary policy (e.g. negative interest rates) and safe-haven flows.
Euro (EUR) More volatile Driven by eurozone-specific issues (e.g. sovereign debt crises, ECB policy), not always aligned with US dynamics.
What affects exchange rate volatility? (4)
Supply and demand - High demand for currency = Appreciation, Supply is depreciation
Interest Rates - High rates lead to high demand for domestic currency
Inflation - High reduces currency purchasing power leading to depreciation
Economic Stability - Stability leads to attractive investments and low volatility, turmoil leads to uncertain gov policies and depreciation
Which currency is likely the most volatile?
The Japanese yen (JPY) due to economic shifts and Bank of Japan’s monetary policies.
Which currency is possibly the least volatile?
The Euro (EUR) or British Pound (GBP), though both have had fluctuations.
How is Forex Traded
Its done through Over the Counter Trading
Meaning currency trades are done directly between two parties, decentralised exchanges,
This is done through forward and future contracts, allowing agreements on one date to be done later
(Company deciding to buy currency today at a fixed price but the exchange occurring months from now to avoid future lossess)
Why is the Forex market important?
It facilitates international business transactions and impacts inflation, interest rates, and purchasing power.
What is the estimated daily trading volume of the Forex market?
Over $7.5 trillion (as of 2022).
What influences long-term exchange rate movements?
Fundamental economic factors, primarily supply and demand.
What is the Law of One Price?
It states that an identical good should cost the same price worldwide, once exchange rates are adjusted.
LOOP implies that if a product costs £800 in the UK and $1,000 in the US, the exchange rate should be £0.80/$ to equalise prices.
What happens if price differences exist according to the Law of One Price?
Arbitrage will eventually equalize prices.
Will buy the lower 1.10 euro in NYSE and sell in LSE for 1.12 until price evens out
How does the Law of One Price Affect Exchange Rates in the Long Run
The Law of One Price is the underlying principle for the Purchasing Power Parity (PPP) theory, which specifically analyses currency markets. In the long run, the Law of One Price implies that exchange rates will adjust to ensure there is one international price for identical tradable goods, assuming free trade and negligible frictions.
What is Purchasing Power Parity (PPP)?
It states that exchange rates adjust so that the same basket of goods costs the same in different countries.
Absolute PPP: Domestic Country / Foreign Country = Exchange rate domestic per foreign
Relative PPP: Inflation change % A - B = %Change of Exchange Rate
What are the implications of PPP?
Higher inflation leads to currency depreciation, while high-quality competitive goods lead to currency appreciation.
What are the Limitations of PPP
Lack of Short-Run Predictive Power: PPP does not have significant predictive power in the short run. This is because it takes time for prices to adjust, and various frictions affect immediate exchange rate movements.
Non-tradable goods: Many services (e.g., haircuts) cannot be traded across borders, violating LOOP assumptions.
Product differentiation: Goods may not be perfectly identical across countries, even if similar in function (e.g., cars, clothing).
Core Principles of Law of One Price and PPP (Long Run)
In the long run, exchange rates adjust to equalise the purchasing power of different currencies.
Based on the Law of One Price, the Purchasing Power Parity (PPP) theory suggests that identical goods should cost the same across countries when expressed in a common currency.
If domestic prices rise faster than foreign prices, the domestic currency depreciates to maintain parity.
What factors affect exchange rates in the long run? (4)
Relative price levels:
Higher domestic inflation → reduced export competitiveness → lower demand for domestic goods → depreciation of domestic currency.
Lower inflation → more competitive exports → appreciation.
Tariffs and Quotas:
Higher trade barriers leads to lower imports, making domestic goods value go up, currency appreciation
Preferences for Domestic V Foreign - Preference for imports leads to higher demand for domestic currency so currency depreciation
Productivity - Higher productivity leads to lower costs and higher quality, boosts international demand so currency appreciation
