Foreign Exchange Market Basics
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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?

  • 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?

  • 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?

    <p>Banks that trade solely for their own accounts.</p> Signup and view all the answers

    What is a primary disadvantage of using foreign exchange brokers?

    <p>They impose a brokerage fee on transactions.</p> Signup and view all the answers

    Which role primarily influences the exchange rates through currency and securities transactions?

    <p>Central banks.</p> Signup and view all the answers

    Why might a dealer use the USD over the Euro when purchasing other currencies?

    <p>The USD is more widely traded and cheaper to use.</p> Signup and view all the answers

    What distinguishes 'other commercial banks' from dealers in foreign exchange?

    <p>Other commercial banks only act as intermediaries.</p> Signup and view all the answers

    What is the nominal exchange rate primarily concerned with?

    <p>Current market value of the currency</p> Signup and view all the answers

    Which equation correctly represents the real exchange rate (RER)?

    <p>RER = S × (P / P*)</p> Signup and view all the answers

    What does a real appreciation of the pound signify for US residents?

    <p>US residents need to spend more to buy UK goods</p> Signup and view all the answers

    What does an effective exchange rate measure?

    <p>Currency value against a basket of foreign goods</p> Signup and view all the answers

    What happens to domestic goods when the euro appreciates against the dollar?

    <p>The price of exports increases for foreign buyers</p> Signup and view all the answers

    Why is the demand for currencies described as a derived demand?

    <p>It arises from the need to purchase goods and services</p> Signup and view all the answers

    When evaluating effective exchange rates, what weights are assigned based on trade relationships?

    <p>Weights determined by the volume of trade with partner countries</p> Signup and view all the answers

    In the context of exchange rates, what does a downward slope in the demand curve indicate?

    <p>More of one currency is needed when the other currency appreciates.</p> Signup and view all the answers

    What is the primary goal of a sterilized intervention?

    <p>To impact market participants psychologically while maintaining monetary targets</p> Signup and view all the answers

    What characterizes the current exchange rate regime referred to in the content?

    <p>It allows central banks to influence exchange rates in a managed manner</p> Signup and view all the answers

    How does an increase in aggregate income (y) affect money demand?

    <p>It increases money demand due to a higher need for transactions</p> Signup and view all the answers

    In response to a supply shock, what initial impact occurs according to the graph concept discussed?

    <p>Exchange rate (E) initially reaches where S2 and D1 intersect</p> Signup and view all the answers

    What is the effect of raising interest rates in a sterilized intervention?

    <p>It increases the demand for the currency due to higher yields</p> Signup and view all the answers

    What is a potential risk of sterilized interventions?

    <p>They may cause overshooting of inflation targets</p> Signup and view all the answers

    Which factor is NOT directly controlled by the central bank in managing the money supply?

    <p>Aggregate income (y)</p> Signup and view all the answers

    What happens to money supply during a demand shock?

    <p>It is initially raised and then adjusted back down</p> Signup and view all the answers

    What is the primary goal of arbitrage in the foreign exchange market?

    <p>To exploit price differentials for riskless guaranteed profits</p> Signup and view all the answers

    Which option correctly describes financial centre arbitrage?

    <p>It ensures the same exchange rate for the same currency across different financial centres.</p> Signup and view all the answers

    What distinguishes forward contracts from future contracts?

    <p>Future contracts are listed in markets, whereas forward contracts are tailor-made.</p> Signup and view all the answers

    What is a disadvantage of future contracts compared to forward contracts?

    <p>They can be too volatile.</p> Signup and view all the answers

    In a scenario where $/£ = 1.35 and $/€ = 1.21, what should the €/£ rate be to avoid illegal actions?

    <p>1.108</p> Signup and view all the answers

    What is a key advantage of using forward contracts?

    <p>They provide more flexibility in contract size and maturity.</p> Signup and view all the answers

    What role do clearing houses play in future contracts?

    <p>They act as agents ensuring contract execution between parties.</p> Signup and view all the answers

    Which of the following describes spot exchange rates?

    <p>They are quotations for immediate delivery of currency.</p> Signup and view all the answers

    What occurs when the demand for domestic currency increases?

    <p>Appreciation of the currency</p> Signup and view all the answers

    Which of the following factors would likely lead to an increase in demand for foreign currency?

    <p>Change in domestic taste for foreign goods favoring foreign options</p> Signup and view all the answers

    In a flexible exchange rate system, what triggers the appreciation of a currency?

    <p>Increase in foreign demand for exports</p> Signup and view all the answers

    How is the spot exchange rate determined?

    <p>By the intersection of supply and demand for the currency</p> Signup and view all the answers

    What happens if the currency depreciates?

    <p>Imports from foreign countries become more expensive</p> Signup and view all the answers

    What characterizes a pegged exchange rate system?

    <p>It is fixed against another currency</p> Signup and view all the answers

    What effect does an increase in domestic income have on currency supply?

    <p>It increases the supply of domestic currency</p> Signup and view all the answers

    What describes non-sterilized intervention in currency markets?

    <p>It directly affects both money supply and interest rates</p> Signup and view all the answers

    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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    Description

    This quiz covers key concepts of the foreign exchange market, including the definitions of exchange rates, bid and offer rates, and the characteristics of market participants. Test your understanding of how national currencies are traded and the terminology associated with Forex trading.

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