Los 18.a Flashcards
(10 cards)
What is the role of foreign currency markets?
Foreign currency markets facilitate the exchange of currencies for purchasing foreign goods, services, physical assets, and financial securities. This market supports capital flows and is crucial for businesses and individuals involved in cross-border transactions or investments.
What is foreign exchange risk, and how do companies manage it?
Foreign exchange risk arises from fluctuations in currency values when companies engage in cross-border transactions. To manage this risk, firms use hedging strategies like entering into forward currency contracts, which lock in exchange rates for future transactions, thus reducing or eliminating potential currency losses.
What is a direct quote and an indirect quote in foreign exchange?
Direct quote is the price of the base currency in terms of the price currency (e.g., 1.25 USD/EUR).
Indirect quote is the price of the price currency in terms of the base currency (e.g., 0.80 EUR/USD).
For USD/EUR, 1.25 USD/EUR is a direct quote for USD-based investors and an indirect quote for EUR-based investors.
How does the nominal exchange rate impact purchasing power?
If the nominal exchange rate increases (e.g., USD/EUR rises from 1.10 to 1.15), the purchasing power of the base currency (USD) decreases relative to the price currency (EUR), meaning goods priced in EUR become more expensive for USD-based consumers.
A decrease in the nominal exchange rate (e.g., USD/EUR falls) increases the purchasing power of the base currency (USD) relative to the price currency (EUR).
Q: What is the real exchange rate?
The real exchange rate adjusts the nominal exchange rate for changes in the price levels between two countries. It reflects the actual purchasing power of one currency in terms of goods priced in another currency, relative to an earlier base period.
How is the real exchange rate calculated?
Real change rate = nominal exchange x (CPI of base / CPI of price)
What happens to the real exchange rate if the nominal exchange rate changes?
Increase in nominal exchange rate (e.g., USD/EUR rises): The real exchange rate increases, meaning the purchasing power of the price currency (EUR) in the base currency country (USD) increases.
Decrease in nominal exchange rate (e.g., USD/EUR falls): The real exchange rate decreases, increasing the purchasing power of the base currency (USD) relative to the price currency (EUR).
How do price levels affect the real exchange rate?
Increase in price level in the price currency country (e.g., Eurozone prices rise) relative to the base currency country (e.g., U.S.): The real exchange rate decreases, decreasing the purchasing power of the price currency in terms of the base currency.
Decrease in price level in the price currency country increases the real exchange rate, enhancing the purchasing power of the price currency in terms of base country goods.
What is the difference between a spot exchange rate and a forward exchange rate?
Spot exchange rate is the exchange rate for immediate delivery, usually settled within two business days.
Forward exchange rate is the agreed-upon exchange rate for a future date (e.g., 30, 60, 90 days). A forward contract allows the exchange of currencies at a set rate in the future, thus reducing the risk of currency fluctuations.
