Foreign Exchange Market Basics

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Questions and Answers

What does PPP theory suggest about predicting long-term and short-term exchange rates?

PPP theory predicts exchange rates accurately in the long run but is not a strong predictor for short-term movements.

What are the primary reasons international businesses use foreign exchange markets?

International businesses use foreign exchange markets for facilitating payments to foreign companies and for investing spare cash in short-term money markets.

How does currency speculation operate in foreign exchange markets?

Currency speculation involves the short-term movement of funds between currencies to profit from shifts in exchange rates.

What is foreign currency risk, and why is it significant for businesses?

Foreign currency risk refers to unpredictable changes in exchange rates that can adversely affect a firm's financial position. Signup and view all the answers

Describe the term 'hedging' in the context of foreign exchange risk.

Hedging is a risk management strategy that involves buying or selling investments to reduce potential losses from existing positions. Signup and view all the answers

What role do interest rates play in relation to expected future inflation rates?

Interest rates reflect expectations about future inflation; higher expected inflation leads to higher interest rates. Signup and view all the answers

What is the Fischer effect and how does it relate to interest rates and inflation?

The Fischer effect states that a country's nominal interest rate equals the required real rate of interest plus the expected inflation rate. Signup and view all the answers

Define spot exchange rates and their significance in foreign exchange transactions.

Spot exchange rates are the rates at which foreign exchange dealers convert one currency into another for immediate delivery. Signup and view all the answers

What is inflation in terms of money supply and output?

Inflation occurs when the quantity of money in circulation rises faster than the stock of goods and services. Signup and view all the answers

How do banks benefit from an increase in the money supply?

An increase in the money supply makes it easier for banks to borrow from the government. Signup and view all the answers

What is the function of the foreign exchange market?

The foreign exchange market facilitates the conversion of one currency into another. Signup and view all the answers

What is the exchange rate?

The exchange rate is the rate at which one currency is converted into another. Signup and view all the answers

What is a potential outcome if a country's money supply grows faster than its output?

The result will be inflation due to increased demand for goods and services. Signup and view all the answers

List one main use of the foreign exchange market by international businesses.

One main use is the payment a company receives for its exports. Signup and view all the answers

What does an increase in credit resulting from a larger money supply lead to?

It leads to increases in demand for goods and services. Signup and view all the answers

How is the growth of a country's money supply related to exchange rate movements?

Faster money supply growth than output can fuel price inflation, affecting exchange rates. Signup and view all the answers

What is the formula that relates nominal interest rate, real interest rate, and expected inflation rate?

$i = r + I$ Signup and view all the answers

Given a real interest rate of 5% and an expected inflation rate of 10%, what is the nominal interest rate?

15% Signup and view all the answers

In the provided example, what is the spot exchange rate for converting dollars into yen?

$1 = ¥120$ Signup and view all the answers

What is the forward exchange rate for converting dollars into yen in the given scenario?

$1 = ¥110$ Signup and view all the answers

How much will the importer pay per computer if they lock in the 30-day forward rate?

$1,818$ Signup and view all the answers

What does the International Fischer Effect (IFE) state about spot exchange rates?

They should change in the opposite direction to the difference in nominal interest rates between two countries. Signup and view all the answers

What is a currency swap?

It is the simultaneous purchase and sale of a currency for two different value dates. Signup and view all the answers

What role do investor psychology and bandwagon effects play in exchange rate movements?

They significantly influence short-run exchange rate movements and can be hard to predict. Signup and view all the answers

What are forward exchange rates expected to be in an efficient market?

Unbiased predictors of future spot rates. Signup and view all the answers

Define the law of one price.

Identical products sold in different countries must sell for the same price when expressed in the same currency. Signup and view all the answers

How does purchasing power parity (PPP) relate to the conversion of currencies?

PPP expresses the purchasing power of different currencies in common units. Signup and view all the answers

What characterizes a freely convertible currency?

Both residents and non-residents can purchase unlimited amounts of foreign currency. Signup and view all the answers

What is capital flight and what typically causes it?

Capital flight occurs when domestic currency depreciates due to hyperinflation or poor economic prospects. Signup and view all the answers

Differentiate between fundamental and technical analysis in forecasting exchange rates.

Fundamental analysis uses economic theory for sophisticated models, while technical analysis relies on past price and volume data. Signup and view all the answers

What is the meaning of countertrade?

Countertrade is a range of barter-like agreements for trading goods and services. Signup and view all the answers

Explain the carry trade strategy.

The carry trade involves borrowing at low-interest rates to invest in higher-yielding assets. Signup and view all the answers

What is transaction exposure and how does it affect a company's income?

Transaction exposure is the extent to which fluctuations in foreign exchange values affect the income from individual transactions. Signup and view all the answers

Explain translation exposure and its impact on financial statements.

Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Signup and view all the answers

How does economic exposure differ from transaction and translation exposure?

Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Signup and view all the answers

Describe the lead strategy in minimizing foreign exchange exposure.

The lead strategy involves collecting foreign currency receivables early and paying foreign currency payables before they are due when favorable exchange changes are expected. Signup and view all the answers

What is the lag strategy and when is it used?

The lag strategy involves delaying the collection of foreign currency receivables and payables when expecting favorable changes in exchange rates. Signup and view all the answers

What strategic choices are necessary to reduce economic exposure?

To reduce economic exposure, firms should distribute their productive assets to various locations to mitigate risks from adverse currency changes. Signup and view all the answers

Why is central control exposure important for managing foreign exchange risk?

Central control exposure is important to protect resources efficiently and ensure subsidiaries adopt the correct mix of tactics and strategies. Signup and view all the answers

List two key steps that firms should take to manage foreign exchange risk.

Firms should forecast future exchange rate movements and establish good reporting systems for monitoring exposure positions. Signup and view all the answers

Study Notes

The Foreign Exchange Market

Foreign currency market is a market for converting one country's currency into another.
Exchange rate is the rate at which one currency is converted into another.
Functions of the foreign exchange market:
- Currency conversion: Each country uses its own currency for pricing goods and services.
- Insuring against foreign exchange risk: Firms can hedge against potential adverse effects of exchange rate fluctuations.

Types of Exchange Rates

Spot exchange rate: Current rate for exchanging one currency for another.
Forward exchange rate: Agreed-upon rate for a future exchange at a specific date.
Currency swap: Simultaneous purchase and sale of a specific amount of foreign exchange for two different dates.

International Trade and Currency

International businesses use the foreign exchange market heavily for a variety of reasons:
- Receiving payments for exports.
- Paying for imports.
- Investing excess cash globally.
- Speculating on currency rate changes.

Types of Exchange Rate Risk

Transaction exposure: The impact of exchange rate fluctuations on the income from individual transactions.
Translation exposure: The impact of currency exchange rate changes on a company's financial statements.
Economic exposure: The impact of exchange rate changes on a firm's long-term earning power.

Managing Exchange Rate Risk

Strategies for minimizing transaction and translation exposure:
- Lead strategy: Collecting foreign currency receivables early if currency depreciation is expected.
- Lag strategy: Delaying collection of foreign currency receivables if currency appreciation is expected.
Reducing economic exposure:
- Strategic asset allocation: Distribute assets to various locations to buffer against adverse exchange rate changes.
- Centralized control: Monitor and manage exchange rate exposure across different subsidiaries.
- Forecasting: Regularly predict future exchange rate movements for informed decision-making.

Purchasing Power Parity (PPP)

PPP theory: In competitive markets, identical products should sell for the same price when expressed in a common currency.
PPP puzzle: No strong correlation between relative inflation rates and exchange rate movements in the short term.

Interest Rates and Exchange Rates

Fischer effect: A country's nominal interest rate equals the real rate of interest plus the expected inflation rate.
International Fisher Effect (IFE): The spot exchange rate should change proportionally to differences in nominal interest rates between two countries.

Approaches to Forecasting Exchange Rates

Fundamental analysis: Uses economic theory and econometric models to predict exchange rate movements.
Technical analysis: Examines past price and volume data to identify trends that might continue into the future.

Currency Convertibility

Freely convertible: Residents and non-residents can freely exchange domestic currency for foreign currency.
Externally convertible: Only non-residents can convert the currency.
Nonconvertible: Neither residents nor non-residents are allowed to convert the currency.

Capital Flight

Capital flight: Occurs when people rapidly convert a currency into a perceived safer one due to economic instability or hyperinflation.

Countertrade

Countertrade: Barter-like agreements where goods and services are exchanged for other goods and services, used as a trade alternative when currency convertibility is limited.

Carry Trade

Carry trade: Borrowing at a low interest rate and investing in an asset yielding a higher return. This strategy carries significant risk due to potential exchange rate fluctuations.

Investor Psychology

Bandwagon effects: Investor sentiment and market trends can strongly impact short-term exchange rate moves.
Efficient market school: Prices reflect all available information.
Inefficient market school: Prices don't reflect all available information. Forward exchange rates are not always good predictors in inefficient markets.

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Description

This quiz covers essential concepts of the foreign exchange market, including currency conversion, exchange rates, and the functions of this market in international trade. Test your understanding of spot and forward exchange rates, as well as currency swaps and their importance in global finance.