26 Questions
What is the purpose of the foreign exchange market?
To convert the currency of one country into the currency of another
What does the term 'exchange rate' refer to?
The rate at which one currency is converted into another
How does the foreign exchange market provide insurance?
By mitigating foreign exchange risk
What is the primary reason for businesses to use the foreign exchange market?
To convert payments received for exports and foreign investments
What is currency speculation in the context of the foreign exchange market?
Short-term movement of funds to profit from shifts in exchange rates
What is carry trade in the context of the foreign exchange market?
Borrowing in a low-interest currency to invest in a high-interest currency
What is the risk associated with changes in exchange rates for businesses?
Changes in exchange rates may hurt the profitability of business deals
In general, where must one use the national currency within a particular country?
Within the borders of that country
What does 'future exchange rates cannot be accurately predicted' imply?
It is challenging to forecast future exchange rates with precision
What does 'converting payments received for exports' refer to?
Converting money received from selling goods or services to other countries into national currency
What is the definition of a freely convertible currency?
Residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency
What is the impact of non-convertible currency on international business?
It is not desirable for international business
What is the purpose of limiting convertibility of a currency?
To preserve foreign market reserves and prevent capital flight
What is the definition of capital flight?
Converting domestic currency into a foreign currency
What is the purpose of countertrade in international trade?
To trade goods and services for other goods and services when a country’s currency is nonconvertible
What is the purpose of lead strategy in managing foreign exchange risk?
Collecting foreign currency receivables early
Which theory involves the simultaneous purchase and sale of foreign exchange for different value dates?
Currency swap
Where are the most important trading centers in the foreign exchange market located?
London, New York, Zurich, Tokyo, and Singapore
What percentage of all foreign exchange transactions involve the U.S. dollar?
85%
Which economic theory suggests that money supply growth determines a country's likely future inflation, influencing exchange rates?
$i = r + I$ equation
According to empirical tests, which theory is not a strong predictor of short-run movements in exchange rates for countries with high inflation and underdeveloped capital markets?
Purchasing power parity (PPP)
'Neither PPP theory nor the international Fisher effect is particularly good at explaining short-term movements in exchange rates' - What other factors are mentioned as playing a role in short-term movements in exchange rates?
$F = ma$ principle and investor psychology
What do relative monetary growth, inflation rates, and nominal interest rate differentials predict?
Long-run changes in exchange rates
What does the efficient market school suggest about prices in the foreign exchange market?
Prices reflect all available public information
What do approaches to forecasting in the foreign exchange market include?
Fundamental analysis and technical analysis
What reflects expectations about likely future inflation rates according to the text?
Interest rates
Study Notes
Foreign Exchange and Exchange Rate Theories
- Spot exchange rates are the rates at which a foreign exchange dealer converts one currency into another on a specific day, reported in real-time and subject to continual changes.
- Forward exchange rates involve agreements between two parties to exchange currency at a future date, usually quoted for 30, 90, or 180 days.
- Currency swaps involve the simultaneous purchase and sale of foreign exchange for different value dates, commonly used to mitigate foreign exchange rate risk.
- The foreign exchange market is a global network of banks, brokers, and dealers, with the most important trading centers in London, New York, Zurich, Tokyo, and Singapore, operating 24 hours a day.
- About 85% of all foreign exchange transactions involve the U.S. dollar, making it a vehicle currency.
- Economic theories of exchange rate determination include the law of one price, purchasing power parity (PPP), and the Big Mac Index for informal PPP measurement.
- Money supply growth determines a country's likely future inflation, influencing exchange rates.
- Empirical tests of PPP theory suggest that it is not a strong predictor of short-run movements in exchange rates, particularly for countries with high inflation and underdeveloped capital markets.
- Interest rates reflect expectations about likely future inflation rates, and the Fisher Effect equation (i = r + I) explains the relationship between interest rates and inflation.
- Neither PPP theory nor the international Fisher effect is particularly good at explaining short-term movements in exchange rates, with investor psychology and bandwagon effects also playing a role.
- Relative monetary growth, inflation rates, and nominal interest rate differentials are moderately good predictors of long-run changes in exchange rates, but poor predictors of short-run changes.
- The efficient market school suggests that prices reflect all available public information, while the inefficient market school argues that prices do not reflect all available information. Approaches to forecasting include fundamental analysis and technical analysis.
Test your knowledge of foreign exchange and exchange rate theories with this quiz covering spot exchange rates, forward exchange rates, currency swaps, exchange market structure, economic theories of exchange rate determination, inflation influence, interest rates, and forecasting approaches.
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