Podcast
Questions and Answers
What is the bid rate in the foreign exchange market?
What is the bid rate in the foreign exchange market?
- The average market rate for foreign currency.
- The rate for buying securities with currency.
- The rate at which a bank will sell a currency.
- The rate at which a bank will buy a currency. (correct)
Which definition of exchange rate is the most commonly used?
Which definition of exchange rate is the most commonly used?
- Average rate of all currencies traded.
- Unit of foreign currency per unit of domestic currency.
- Unit of domestic currency per unit of foreign currency. (correct)
- The rate defined by central banks.
What is the bid-offer spread in the context of foreign exchange?
What is the bid-offer spread in the context of foreign exchange?
- The difference between the interest rates of two currencies.
- The difference between the bid rate and the offer rate. (correct)
- The rate of exchange for quick transactions.
- The total amount of currency bought or sold in a day.
Who are considered dealers in the foreign exchange market?
Who are considered dealers in the foreign exchange market?
What is a primary disadvantage of using foreign exchange brokers?
What is a primary disadvantage of using foreign exchange brokers?
Which role primarily influences the exchange rates through currency and securities transactions?
Which role primarily influences the exchange rates through currency and securities transactions?
Why might a dealer use the USD over the Euro when purchasing other currencies?
Why might a dealer use the USD over the Euro when purchasing other currencies?
What distinguishes 'other commercial banks' from dealers in foreign exchange?
What distinguishes 'other commercial banks' from dealers in foreign exchange?
What is the nominal exchange rate primarily concerned with?
What is the nominal exchange rate primarily concerned with?
Which equation correctly represents the real exchange rate (RER)?
Which equation correctly represents the real exchange rate (RER)?
What does a real appreciation of the pound signify for US residents?
What does a real appreciation of the pound signify for US residents?
What does an effective exchange rate measure?
What does an effective exchange rate measure?
What happens to domestic goods when the euro appreciates against the dollar?
What happens to domestic goods when the euro appreciates against the dollar?
Why is the demand for currencies described as a derived demand?
Why is the demand for currencies described as a derived demand?
When evaluating effective exchange rates, what weights are assigned based on trade relationships?
When evaluating effective exchange rates, what weights are assigned based on trade relationships?
In the context of exchange rates, what does a downward slope in the demand curve indicate?
In the context of exchange rates, what does a downward slope in the demand curve indicate?
What is the primary goal of a sterilized intervention?
What is the primary goal of a sterilized intervention?
What characterizes the current exchange rate regime referred to in the content?
What characterizes the current exchange rate regime referred to in the content?
How does an increase in aggregate income (y) affect money demand?
How does an increase in aggregate income (y) affect money demand?
In response to a supply shock, what initial impact occurs according to the graph concept discussed?
In response to a supply shock, what initial impact occurs according to the graph concept discussed?
What is the effect of raising interest rates in a sterilized intervention?
What is the effect of raising interest rates in a sterilized intervention?
What is a potential risk of sterilized interventions?
What is a potential risk of sterilized interventions?
Which factor is NOT directly controlled by the central bank in managing the money supply?
Which factor is NOT directly controlled by the central bank in managing the money supply?
What happens to money supply during a demand shock?
What happens to money supply during a demand shock?
What is the primary goal of arbitrage in the foreign exchange market?
What is the primary goal of arbitrage in the foreign exchange market?
Which option correctly describes financial centre arbitrage?
Which option correctly describes financial centre arbitrage?
What distinguishes forward contracts from future contracts?
What distinguishes forward contracts from future contracts?
What is a disadvantage of future contracts compared to forward contracts?
What is a disadvantage of future contracts compared to forward contracts?
In a scenario where $/£ = 1.35 and $/€ = 1.21, what should the €/£ rate be to avoid illegal actions?
In a scenario where $/£ = 1.35 and $/€ = 1.21, what should the €/£ rate be to avoid illegal actions?
What is a key advantage of using forward contracts?
What is a key advantage of using forward contracts?
What role do clearing houses play in future contracts?
What role do clearing houses play in future contracts?
Which of the following describes spot exchange rates?
Which of the following describes spot exchange rates?
What occurs when the demand for domestic currency increases?
What occurs when the demand for domestic currency increases?
Which of the following factors would likely lead to an increase in demand for foreign currency?
Which of the following factors would likely lead to an increase in demand for foreign currency?
In a flexible exchange rate system, what triggers the appreciation of a currency?
In a flexible exchange rate system, what triggers the appreciation of a currency?
How is the spot exchange rate determined?
How is the spot exchange rate determined?
What happens if the currency depreciates?
What happens if the currency depreciates?
What characterizes a pegged exchange rate system?
What characterizes a pegged exchange rate system?
What effect does an increase in domestic income have on currency supply?
What effect does an increase in domestic income have on currency supply?
What describes non-sterilized intervention in currency markets?
What describes non-sterilized intervention in currency markets?
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Study Notes
Foreign Exchange Market
- The foreign exchange market involves the buying and selling of national currencies.
- Exchange rates define the price of one currency in terms of another.
- Two common exchange rate definitions are:
- Unit of foreign currency per unit of domestic currency.
- Unit of domestic currency per unit of foreign currency (most widely used).
Bid and Offer Rates
- Bid rate: the rate at which banks buy currency.
- Offer rate: the rate at which banks sell currency.
- The difference between bid and offer rates is called the bid-offer spread, representing the bank's profit margin.
Market Characteristics and Participants
- Exchange rates are treated similarly to financial securities.
- Major market participants include:
- Retail clients: businesses, investors, multi-national corporations (MNCs).
- Commercial banks: act as dealers or mere intermediaries.
- Dealers trade for themselves and facilitate market liquidity; only 20-22 banks have significant dealer power.
- Other commercial banks focus on intermediate transactions.
- Forex brokers: find the best quotations and execute buy/sell orders for clients, earning a brokerage fee.
- Central banks: exchange currency and securities to influence exchange rates.
Arbitrage
- Arbitrage exploits price differentials for riskless profit.
- Two types of arbitrage:
- Financial center arbitrage: ensures uniform exchange rates in different locations.
- Cross currency arbitrage: ensures that cross exchange rates reflect consistent ratios.
Spot and Forward Exchange Rates
- Spot exchange rate: price for immediate currency delivery.
- Forward exchange rate: price for future currency delivery (custom agreements).
- Forward contracts are tailor-made without standardized terms.
- Future contracts are standardized and listed on markets.
Forward vs Future Contracts
- Forward contracts:
- Advantages: flexibility and stability.
- Disadvantages: risk if one party fails to deliver.
- Future contracts:
- Advantages: market warranties and protection against default.
- Disadvantages: potential volatility.
Nominal, Real, and Effective Exchange Rates
- Nominal exchange rate: market price at a point in time, ignoring purchasing power.
- Real exchange rate: considers price level differences across countries.
- Real appreciation leads to higher costs for foreign buyers.
- Effective exchange rate: measures currency value relative to a basket of currencies.
- Nominal effective exchange rate compares against a basket.
- Real effective exchange rate adjusts for domestic price levels.
Supply and Demand in Exchange Rates
- Demand for foreign currency is derived from purchasing needs.
- An appreciating currency increases export prices, making goods less competitive.
- Demand shifts are driven by income changes and foreign preferences.
- Supply of currency is influenced by domestic demand for foreign goods and overall economic factors.
Exchange Rate Regimes
- Types of exchange rate regimes:
- Pegged exchange rate: fixed to USD established post-Bretton Woods.
- Flexible (floating) exchange rate: fluctuates freely based on supply and demand.
- Fixed exchange rate: maintained by central bank interventions.
- Central banks intervene via:
- Non-sterilized interventions: impact money supply and interest rates.
- Sterilized interventions: do not affect money supply or rates but aim for market stability.
Current Exchange Rate Regime
- Managed float (dirty float) regime allows central banks to correct exchange rate fluctuations while targeting monetary goals.
- Demand shocks increase supply leading to initial appreciation; central banks adjust money supply accordingly.
- Supply shocks decrease supply, prompting banks to raise rates in response.
Money Demand and Supply
- Money demand is influenced by income levels and interest rates:
- Increased income raises money demand for transactions.
- Higher interest rates generally decrease money demand.
- Money supply, manipulated by the central bank, is composed of asset holdings and liabilities.
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