Exchange Rates and Spot Rates in Foreign Exchange
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Questions and Answers

What is the exchange rate according to the definition?

  • The rate at which one country's currency can be traded in exchange for another country's security
  • The rate at which one country's currency can be traded in exchange for another country's service
  • The rate at which one country's currency can be traded in exchange for another country's commodity
  • The rate at which one country's currency can be traded in exchange for another country's currency (correct)

    • What is the spot rate in the context of foreign exchange?

  • The rate at which one country's currency can be traded in exchange for another country's commodity
  • The exchange rate set now for currencies to be exchanged at a future date
  • The exchange or interest rate currently offered on a particular currency or security (correct)
  • The rate at which one country's currency can be traded in exchange for another country's currency

    • What is the forward rate in the context of foreign exchange?

  • The rate at which one country's currency can be traded in exchange for another country's currency
  • The rate at which one country's currency can be traded in exchange for another country's commodity
  • The exchange or interest rate currently offered on a particular currency or security
  • The exchange rate set now for currencies to be exchanged at a future date (correct)

    • What is the theory of purchasing power parity?

    <p>A theory that states that exchange rates are determined by purchasing power</p> Signup and view all the answers

    What is the goal of buying the domestic currency by the central bank in direct intervention?

    <p>To increase the value of the currency</p> Signup and view all the answers

    What does the purchasing power parity theory use to predict future movements in exchange rates?

    <p>Inflation rates</p> Signup and view all the answers

    What is the main idea behind the purchasing power parity theory?

    <p>That indistinguishable goods should sell at the same price when converted into the same currency</p> Signup and view all the answers

    What is the purpose of coordinated intervention in the currency market?

    <p>To increase or decrease a currency value in coordination with other central banks</p> Signup and view all the answers

    What is the effect of increasing real rates on a currency?

    <p>It strengthens the currency</p> Signup and view all the answers

    What is the relationship between the current exchange rate and the forward rate, according to the interest rate parity?

    <p>The current exchange rate and the forward rate may differ, reflecting the interest rate</p> Signup and view all the answers

    What is the purpose of capital controls in the currency market?

    <p>To restrict access to foreign currency</p> Signup and view all the answers

    What is a challenge in estimating purchasing power parity?

    <p>Structural differences across countries</p> Signup and view all the answers

    What determines the methods of intervention in the currency market?

    <p>The magnitude of a country's economy, trading in its currency, and financial market development</p> Signup and view all the answers

    What is indirect intervention in the currency market?

    <p>The alteration of economic or financial fundamentals</p> Signup and view all the answers

    What is the primary basis for determining the exchange rate in the monetary approach?

    <p>Supply and demand for national monetary stocks</p> Signup and view all the answers

    What is the main criticism of the balance of payments approach?

    <p>It does not account for stocks of money or financial assets</p> Signup and view all the answers

    What is the primary goal of foreign currency intervention?

    <p>To manipulate the market's valuation of a country's currency</p> Signup and view all the answers

    What determines the exchange rate according to the asset market approach?

    <p>Supply and demand for a wide variety of financial assets</p> Signup and view all the answers

    What is the relationship between monetary and fiscal policy changes and exchange rates?

    <p>Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets</p> Signup and view all the answers

    What is the appeal of the balance of payments approach?

    <p>BOP transaction data is readily available and widely reported</p> Signup and view all the answers

    Why do critics argue that the balance of payments approach is limited?

    <p>It does not account for stocks of money or financial assets</p> Signup and view all the answers

    What is the primary focus of the asset market approach?

    <p>The supply and demand for a wide variety of financial assets</p> Signup and view all the answers

    Study Notes

    Exchange Rate Definitions

    • An exchange rate is the rate at which one country's currency can be traded for another country's currency.
    • The spot rate is the exchange or interest rate currently offered on a particular currency or security for immediate delivery.
    • The forward rate is an exchange rate set now for currencies to be exchanged at a future date.

    Exchange Rate Determination Theories

    Purchasing Power Parity (PPP)

    • PPP states that the exchange rate between two currencies is the same in equilibrium when the purchasing power of currency is the same in each country.
    • PPP uses inflation rates to predict future movements in exchange rates.
    • PPP emphasizes that indistinguishable goods should sell at the same price when converted into the same currency.
    • As local currency prices change with inflation, the exchange rates should change to keep the relative price the same.

    Interest Rate Parity

    • The current exchange rate (spot rate) and the forward rate may differ, and the difference reflects the interest rate.
    • Forward rate can be calculated using the formula: Forward Rate = Spot Rate x (1 + Interest Rate).

    Balance of Payments Approach

    • The balance of payments approach argues that the equilibrium exchange rate is found when currency flows match up vis-à-vis current and financial account activities.
    • This framework has wide appeal as BOP transaction data is readily available and widely reported.

    Monetary Approach

    • The monetary approach states that the exchange rate is determined by the supply and demand for national monetary stocks, as well as the expected future levels and rates of growth of monetary stocks.

    Asset Market Approach

    • The asset market approach argues that exchange rates are determined by the supply and demand for a wide variety of financial assets.
    • Shifts in the supply and demand for financial assets alter exchange rates.
    • Changes in monetary and fiscal policy alter expected returns and perceived relative risks of financial assets, which in turn alter exchange rates.

    Currency Market Intervention

    Why Intervene?

    • To fight inflation (strong currency)
    • To fight slow economic growth (weak currency)

    Currency Market Intervention Methods

    Direct Intervention

    • The active buying and selling of the domestic currency against foreign currencies.
    • If the goal is to increase the value, then the central bank buys its own currency.
    • If the goal is to decrease the value, then the central bank sells its own currency.

    Coordinated Intervention

    • Several central banks agree on a strategy to increase or decrease a currency value.

    Indirect Intervention

    • The alteration of economic or financial fundamentals thought to be drivers of capital to flow in and out of specific currencies.
    • Increase real rates to strengthen a currency.
    • Decrease real rates to weaken a currency.

    Capital Controls

    • Restrictions of access to foreign currency by the government by limiting the exchange of domestic currency for foreign currency.

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    Description

    This quiz covers the definitions and concepts of exchange rates and spot rates in the foreign exchange market.

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