Exchange Rate and the Firm
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Questions and Answers

What does currency risk primarily relate to?

  • Operational inefficiencies in a firm
  • The credit quality of borrowers
  • Changes in government regulations
  • Variability in the value of an exposure due to exchange rate fluctuations (correct)
  • Which of the following is NOT a type of risk associated with exchange rates?

  • Market Risk
  • Emotional Risk (correct)
  • Liquidity Risk
  • Credit Risk
  • What factor is NOT considered to determine the degree of currency risk?

  • Amount of exposure
  • Type of production
  • Volatility of exchange rates
  • Interest rates in the home country (correct)
  • How is credit risk described?

    <p>Loss from the default or fall in credit quality of a borrower</p> Signup and view all the answers

    What is an example of market risk?

    <p>Changes in currency or interest rates</p> Signup and view all the answers

    If the exchange rate were to drop by 1%, how much could Airbus potentially lose on the sale mentioned in the content?

    <p>$7.8 million</p> Signup and view all the answers

    What type of risk includes uncertainties regarding demand for products?

    <p>Business Risk</p> Signup and view all the answers

    Which situation is characterized by low currency risk?

    <p>Low volatility and low exposure</p> Signup and view all the answers

    What does a long position in the market indicate?

    <p>A bet on an increase in value</p> Signup and view all the answers

    Which of the following is NOT a type of financial derivative used in hedging?

    <p>Equities</p> Signup and view all the answers

    Who participates in the spot market?

    <p>Individuals and businesses engaging in foreign transactions</p> Signup and view all the answers

    What is the bid price?

    <p>The price a dealer is willing to pay</p> Signup and view all the answers

    What happens to the bid-ask spread as uncertainty increases?

    <p>It increases.</p> Signup and view all the answers

    Which category does NOT belong to the main market participants?

    <p>Private equity firms</p> Signup and view all the answers

    What happens if all market participants have the same forecast?

    <p>There will be no buying or selling</p> Signup and view all the answers

    Which economic principle indicates that supply increases with price?

    <p>Law of supply.</p> Signup and view all the answers

    What is triangular arbitrage used for in currency markets?

    <p>To exploit discrepancies in currency values.</p> Signup and view all the answers

    What does the ask price represent?

    <p>The price at which a buyer can purchase an asset</p> Signup and view all the answers

    Given the exchange rates S($/€) = 1.50 and S(¥/€) = 50, what is the implied $/¥ cross rate?

    <p>$1.00 = ¥33.33</p> Signup and view all the answers

    Which of the following best describes the bid-ask spread?

    <p>The difference between the bid price and ask price</p> Signup and view all the answers

    What might indicate that an auction is necessary according to Arrow-Debreu?

    <p>A market does not reach equilibrium.</p> Signup and view all the answers

    What is one of the first steps in executing triangular arbitrage?

    <p>Sell $ for £.</p> Signup and view all the answers

    Which mechanism is presumed to help achieve market equilibrium according to auction systems?

    <p>Auctions.</p> Signup and view all the answers

    What does an increased bid-ask spread likely indicate about market conditions?

    <p>High uncertainty.</p> Signup and view all the answers

    What is a key difference between futures and forward contracts?

    <p>Futures contracts are traded on an exchange.</p> Signup and view all the answers

    What mechanism is primarily used in futures contracts to avoid default risk?

    <p>Mark to market with margin requirements</p> Signup and view all the answers

    In futures contracts, what is the term for the minimum amount required to maintain a market position?

    <p>Maintenance margin</p> Signup and view all the answers

    Which statement is true regarding the trading of futures contracts?

    <p>Futures can be traded electronically or via open-outcry.</p> Signup and view all the answers

    What happens during daily settlements in a futures contract?

    <p>Cash adjustments are made based on price fluctuations.</p> Signup and view all the answers

    What type of position does a buyer of a futures contract hold?

    <p>Long position</p> Signup and view all the answers

    Which of the following is NOT a characteristic of futures contracts?

    <p>They are exclusively traded on the over-the-counter market.</p> Signup and view all the answers

    What is required to enter the futures market based on the margin system?

    <p>A performance bond of 10% to 15% of the transaction</p> Signup and view all the answers

    What is the initial margin required for trading a CME S&P 500 contract?

    <p>$19,688</p> Signup and view all the answers

    How much does a 1/32 price movement in the 10-year T-note lead to in mark to market per contract?

    <p>$15.625</p> Signup and view all the answers

    If the dollar depreciates, what is the impact on Airbus's futures account based on the example given?

    <p>The futures account generates profits that offset some of the losses.</p> Signup and view all the answers

    What is the tick size for contracts involving gold priced per troy ounce?

    <p>$0.10</p> Signup and view all the answers

    What does it mean if a firm is long on the dollar in a futures market?

    <p>They expect the dollar to appreciate.</p> Signup and view all the answers

    What is the relationship between Airbus and Delta Airlines in the context of futures trading?

    <p>Airbus gains while Delta Airlines incurs losses since they are in a zero-sum game.</p> Signup and view all the answers

    In the given example, what is the loss calculated on the underlying position if the spot rate opens at 1.35 and the P future at 1.34?

    <p>-$5 million</p> Signup and view all the answers

    What does the term 'zero-sum game' imply in the context of futures trading?

    <p>The total profit and loss among participants equals zero.</p> Signup and view all the answers

    What is the primary benefit of a currency swap for firms?

    <p>It enables firms to take advantage of comparative borrowing advantages.</p> Signup and view all the answers

    In a currency swap, how is the domestic currency loan typically converted?

    <p>By purchasing forward contracts to convert payments.</p> Signup and view all the answers

    Which of the following statements about implied forward rates in currency swaps is true?

    <p>Implied forward rates may vary but should resemble an average forward rate in total over the loan term.</p> Signup and view all the answers

    What market condition allows currency swaps to be useful?

    <p>When there are market imperfections affecting debt access.</p> Signup and view all the answers

    What is one of the approaches to analyze exchange rate cycles mentioned?

    <p>Using moving averages to decompose trends.</p> Signup and view all the answers

    How many different moving averages should be calculated according to the exercise?

    <p>Three different moving averages.</p> Signup and view all the answers

    What is the purpose of the Hodrick-Prescott filter in analyzing exchange rates?

    <p>To remove irregularities in the exchange rate data.</p> Signup and view all the answers

    Which value of lambda is considered in one of the HP filter scenarios?

    <p>1,440</p> Signup and view all the answers

    Study Notes

    Exchange Rate and the Firm

    • Exchange rates affect financial sectors and non-financial firms. A crisis in one sector can impact others.
    • Banking sector risks are linked to exchange rate expectations. Macroeconomic risks can affect firms' and government's financial stability.
    • Risks include:
      • Credit risk: Loss due to borrower default (banks, government, firms).
      • Market risk: Changes in financial prices (currency, interest rate, equity, commodity).
      • Liquidity risk: Inability to liquidate assets or roll over debt.
      • Operational risk: System failures, management errors, fraud, human error.
      • Legal and regulatory risk: Changes to laws, regulations, and codes.
      • Business risk: Uncertain demand for products.
    • Currency risk is the variability in an exposure's value due to exchange rate uncertainty.
    • Currency risk depends on:
      • Exchange rate volatility.
      • Amount of exposure.
    • Exposure:
      • Long exposure: Assets exceeding liabilities in a particular currency.
      • Short exposure: Liabilities exceeding assets in a particular currency.
    • Example: Airbus selling planes in US dollars; A change in the exchange rate impacts the profit as liabilities and assets are denominated in different currencies.

    Exposure

    • Companies or individuals with assets or liabilities denominated in different currencies are exposed to exchange rate risk.
    • A 'Brexit announcement' can be an example of an event that significantly impacts the exchange rate and business operations.
    • Currency exposures depend on the volatility of exchange rates and the quantity of the exposure.

    Foreign Exchange Rates and Hedging Strategies

    • Hedging: Taking an opposite position to reduce macroeconomic risk, potentially involving costs or gains.
    • Companies may have long or short positions in foreign currencies based on future expectations.
    • Hedging can be done through futures, options, and swaps.

    Spot Markets and Participants

    • Foreign exchange markets have various participants (banks, individuals, etc.).
    • There are wholesale and retail markets for large and small currency transactions.

    Spot Rate Quotations

    • Bid price: Price a dealer pays for an asset (e.g., currency).
    • Ask price: Price a dealer expects from the buyer for an asset.
    • Bid-ask spread: Difference between bid and ask prices. Bid-Ask Spread reflects the uncertainty.

    Cross Rates

    • Triangular arbitrage profits can be made if there are discrepancies between different currency exchange rates
    • The risk-adjusted value determines the profit from cross rate analysis.

    Hedging

    • A future or forward contract is a promise to buy or sell an asset at a fixed price on a future date.
    • A forward contract is customized, while a future contract is standardized.
    • Margin calls can occur on futures contracts, guaranteeing contract performance.
    • Options give the right, not the obligation, to buy or sell an asset at a certain price (strike price) on or before a date (expiration date).
      • Call option: Right to buy.
      • Put option: Right to sell.
    • American options can be exercised any time before expiration, while European options only on the expiration date.

    Currency Swaps

    • A currency swap is an exchange of debt obligations denominated in different currencies.
    • Firms use swaps to benefit from their respective borrowing advantages in different currencies.
    • Investment banks facilitate currency swaps between parties, mitigating borrowing uncertainties.

    Evolution of FX Markets

    • Global FX market turnover increased over time.
    • US dollar dominance persists in exchange rate transactions.

    Exercises

    • Several exercises involve analyzing exchange rates using different methods (moving averages, Hodrick-Prescott filter, etc.) to understand trends, interpret data, and apply trading strategies.
    • Currency hedging strategies are considered in the exercises.

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    Description

    This quiz explores the critical impact of exchange rates on both financial and non-financial sectors. It examines various types of risks associated with currency fluctuations, including credit, market, liquidity, operational, legal, and business risks. Additionally, the quiz delves into how these risks affect the stability of firms and government financials.

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