The parities

Question 1

Who does the exchange rate expose to potential risks?

Answer 1

The exchange rate exposes all households, firms and others who engage in international transactions to risk.

Question 2

What is foreign exchange risk?

Answer 2

Foreign exchange risk is the risk that the value of a future receipt or obligation will change due to a change in the foreign exchange rate.

Question 3

What is transaction exposure?

Answer 3

Transaction exposure is the risk that the cost of a transaction or the proceeds from that transaction may change in terms of the domestic currency due to a change in exchange rates

Question 4

What is translation exposure?

Answer 4

Translation exposure is the foreign exchange risk that results from converting the value of a firm’s foreign-currency denominated assets and liabilities into a common currency value.

Question 5

What is economic exposure?

Answer 5

Economic exposure is the risk that a firm’s future cash flows may be impacted by a change in exchange rates.

Question 6

Hedging is the act of … or … risk …

Answer 6

Hedging is the act of offsetting or eliminating risk exposure.

Question 7

What does covered exposure mean?

Answer 7

A covered exposure means a foreign exchange risk that has been completely eliminated using a hedging instrument.

Question 8

What is the forward exchange market and what is it’s use?

Answer 8

The forward exchange market is a market for contracts that specify the future delivery of a foreign currency at a specified exchange rate.

Question 9

What is a long position? (Forward market)

Answer 9

A long position is an obligation to purchase a financial instrument at a given price at a specific time

Question 10

What is a short position? (Forward market)

Answer 10

A short position is the obligation to sell a financial instrument at a given price at a specific time

Question 11

What kind of position does a firm expecting future payment have?

Answer 11

A firm expecting future payment would therefore have a long position in the market, because they’ll be receiving their payment at the future exchange rate

Question 12

What is the forward exchange rate?

Answer 12

The forward exchange rate specifies the supply and demand for a currency for future delivery

Question 13

Describe a forward premium

Answer 13

A forward premium is when the forward exchange rate is higher than the current spot exchange rate

Question 14

Describe a forward discount

Answer 14

A forward discount is when the forward exchange rate is lower than the current spot exchange rate

Question 15

What is the formula for a forward premium?

Answer 15

The formula for forward premium/discount is (F-E)/E where F is the forward rate and E is the spot rate.

Question 16

What formula holds if traders share the same expectation?

Answer 16

If traders share the same expectation, then the forward discount will equal the expected forward discount.

Question 17

Under what condition might investors move funds between nations?

Answer 17

Investors might move funds between nations if the exchange-rate adjusted return on a similar instrument is different

Question 18

What is a minimum $ related reason why someone may not choose to use a forward rate to hedge risk?

Answer 18

Some people may choose not to use a forward rate to hedge risk is because forward transactions usually involve a minimum size of $1 million.

Question 19

What is interest parity?

Answer 19

Interest parity is when exchange-rate adjusted domestic and foreign interest rates on similar investments are the same.

Question 20

Individual financial instruments may have characteristics that affect their degree of…

Answer 20

Individual financial instruments may have characteristics that affect their degree of risk

Question 21

What is Country risk?

Answer 21

Country risk is the possibility of losses on holdings of financial instruments issued in another nation due to political uncertainty in that country.

Question 22

What is the process for a carry trade?

Answer 22

A carry trade is when an investor borrows money from a low interest rate country, then after converting the currency, they lend that money in the country with a higher interest rate.

Question 23

An efficient market is one in which market prices…

Answer 23

An efficient market is one in which market prices adjust quickly to new and relevant information.

Question 24

What are the two types of foreign investment?

Answer 24

• Portfolio investment

- Foreign direct investment

Question 25

What is portfolio investment?

Answer 25

Portfolio investment is the process of investing in a foreign country by purchasing stocks or bonds issued in foreign currencies

Question 26

What is Foreign direct investment?

Answer 26

Foreign direct investment is the process of investing in a country by purchasing a new plant, equipment or other physical asset in the country, or taking an ownership stake in a firm in that country.

Question 27

What is the law of one price?

Answer 27

The law of one price states that in the absence of transaction costs and official trade barriers, identical goods will have the same price in different countries when expressed using the same currency.

Question 28

Purchasing power parity explains the relationship between…

Answer 28

Purchasing power parity explains the relationship between the prices of goods and services, and exchange rates.

Question 29

Absolute PPP is when the exchange rate between two … is equal to the ratio of their … …

Answer 29

Absolute purchasing power parity is when the exchange rate between two currencies is equal to the ratio of their price indexes.

Question 30

What are some reasons we see deviations from PPP?

Answer 30

- Differentiated products - Transaction costs - Trade barriers - Goods being untradeable across borders - Local regulations and taxes - Different consumer preferences in different countries

Question 31

What is relative PPP?

Answer 31

Relative purchasing power parity is when the percentage change in the exchange rate is equal to the difference between the inflation rates

Question 32

What is interest parity?

Answer 32

Interest parity is the theory that hedged returns from investing in different currencies should be the same, regardless of their interest rate.

Question 33

What are the two options for a domestic investor?

Answer 33

A domestic investor can either invest in a domestic instrument or buy a foreign instrument.

Question 34

How can an individual cover their risk?

Answer 34

An individual can cover their risk by purchasing a forward contract.

Question 35

What does purchasing a forward contract achieve?

Answer 35

By purchasing a forward contract, the investor “locks in” a guaranteed exchange rate at the time of maturity of the investment, which eliminates all foreign exchange uncertainty

Question 36

What are the two steps to cover the foreign exchange rate risk?

Answer 36

- Buy the foreign currency needed to purchase the foreign treasury bill/security - Sell the foreign currency on the forward market.

Question 37

Why will CIRP always hold?

Answer 37

Covered interest rate parity will always hold because it is an arbitrage condition. When arbitrageurs see the opportunity, they will react to benefit from it, which will close the gap that creates the opportunity itself.

Question 38

What are 2 ways to measure price levels?

Answer 38

- CPI (Tradeable and non-traded goods) | - PPI (Mostly traded goods)

Question 39

If one country’s price level rises faster than the other, what will happen to the lower increasing rate?

Answer 39

If one country’s price level rises faster than the other, the currency of the country with the lower increasing price level will appreciate against the currency of the country with the faster-rising price level.

Question 40

Under what condition do we say the dollar is undervalued?

Answer 40

We say the dollar is undervalued if it does not fall by the amount suggested by the PPP.

Question 41

What are some fixed factors in the PPP condition?

Answer 41

- Tariffs - Quotas - Government restrictions

Question 42

What is the difference between absolute and relative PPP?

Answer 42

If absolute PPP holds, then relative PPP will also hold. If Absolute PPP does not hold, then relative PPP may still hold.