Foreign Exchange Markets Overview
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Questions and Answers

What was the amount lent by Utopian banks to companies overseas?

  • USD 6 Million
  • USD 22 Million (correct)
  • USD 10 Million
  • USD 31 Million

What is the net increase in foreign exchange reserves for the year under consideration?

  • USD 25 Million
  • USD 22 Million
  • USD 31 Million (correct)
  • USD 28 Million

Which of the following does NOT classify as a Current Account item?

  • Long-term foreign investments (correct)
  • Dividends paid to foreign investors
  • Equity shares purchased overseas
  • Foreign aid provided

How much did the Utopian government provide as aid to the South Asian country?

<p>USD 2 Million (D)</p> Signup and view all the answers

What category do equity shares purchased by Utopian investors fit into?

<p>Capital Account (A)</p> Signup and view all the answers

What type of foreign currency items does the Current Account primarily comprise of?

<p>Short-term transactions (D)</p> Signup and view all the answers

Which of the following transactions is considered an inflow of foreign currency?

<p>Dividend payments to overseas investors (D)</p> Signup and view all the answers

What is the purpose of the International Monetary Fund's classification guidelines for Balance of Payments?

<p>To classify transactions consistently across countries (D)</p> Signup and view all the answers

How is the exchange rate between two currencies not actively traded determined?

<p>Using the quotes for each currency with respect to a widely traded currency. (D)</p> Signup and view all the answers

If the USD MXN rate is 15 and USD INR is 60, what is the exchange rate from Mexican Pesos to Indian Rupees?

<p>4 (D)</p> Signup and view all the answers

What do forward foreign exchange rates represent?

<p>Rates for transactions that will be settled at a future date. (A)</p> Signup and view all the answers

What do high forward points indicate about the forward rate adjustment?

<p>They should be added to the spot rate. (B)</p> Signup and view all the answers

In the quote USD/JPY provided as 110.50/60, what does 110.50 represent?

<p>The Spot Bid rate. (B)</p> Signup and view all the answers

When should forward points be subtracted from the spot rate?

<p>When the forward points are low. (A)</p> Signup and view all the answers

What is the role of widely traded currencies in determining the exchange rates of less traded currencies?

<p>They provide a benchmark for unvaluated currencies. (B)</p> Signup and view all the answers

What method is used to quote forward rates in relation to spot rates?

<p>Points are added or subtracted from the spot rates. (B)</p> Signup and view all the answers

What does the Interest Rate Parity Theorem mathematically express?

<p>The difference between spot and forward exchange rates is explained by interest rate differences. (B)</p> Signup and view all the answers

If an American investor has $1,000,000 to invest in the US money market at 2% per annum for 90 days, how much will he have at the end of this period?

<p>$1,005,000 (C)</p> Signup and view all the answers

What should be the 90-day forward exchange rate according to the Interest Rate Parity theorem if the investor could earn 1,515,000 Swiss Francs after investing in Switzerland?

<p>1.5075 (C)</p> Signup and view all the answers

If the interest rate for Swiss Francs is 4% per annum, what is the effective rate for 90 days?

<p>2% (D)</p> Signup and view all the answers

In the example provided, what was the initial exchange rate between the US Dollar and Swiss Franc?

<p>1.5 (B)</p> Signup and view all the answers

Which investment route provided the American investor with 1,515,000 Swiss Francs?

<p>Investing in the Swiss money market (B)</p> Signup and view all the answers

What happens if the Interest Rate Parity holds perfectly in this example?

<p>The investor earns the same effective return using either market. (D)</p> Signup and view all the answers

What is the difference represented by in the formula for Interest Rate Parity?

<p>The difference between the domestic and foreign interest rates. (A)</p> Signup and view all the answers

What is the primary purpose of building up Foreign Exchange Reserves during good economic times?

<p>To act as a buffer during potential bad economic times (B)</p> Signup and view all the answers

What consequence may result from a country repatriating cash in the host country’s currency?

<p>Depletion of the foreign exchange reserves in the host country (C)</p> Signup and view all the answers

Which of the following best defines the Balance of Payments (BoP)?

<p>A summary of foreign currency inflows and outflows over a year (B)</p> Signup and view all the answers

What might be a result of having low or unstable foreign exchange reserves?

<p>Heightened risk of a currency crisis (C)</p> Signup and view all the answers

How can multilateral institutions like the International Monetary Fund assist countries facing balance of payment crises?

<p>By offering funding or loans to stabilize economies (D)</p> Signup and view all the answers

In what scenario might a country require a bailout from institutions like the IMF?

<p>When its foreign exchange reserves are insufficient (D)</p> Signup and view all the answers

What does a country’s Balance of Payments reflect regarding its economic interactions?

<p>Cross-border transactions of all types (D)</p> Signup and view all the answers

Which outcome can destabilize a country's economy according to historical data?

<p>Unstable foreign exchange reserves (C)</p> Signup and view all the answers

What is the primary goal of arbitrageurs in the foreign exchange markets?

<p>To exploit price imperfections for riskless profit (A)</p> Signup and view all the answers

In the scenario described, what happens to the USD/JPY exchange rates when arbitrageurs buy USD in New York and sell in Tokyo?

<p>The USD appreciates in New York and depreciates in Tokyo (B)</p> Signup and view all the answers

What role do foreign exchange brokers play in the foreign exchange market?

<p>They provide two-way quotes from multiple counterparties (C)</p> Signup and view all the answers

What is the effect of the presence of speculators in the foreign exchange markets?

<p>They facilitate more efficient exchange rate discovery (B)</p> Signup and view all the answers

How do arbitrageurs contribute to the overall stability of foreign exchange markets?

<p>By eliminating price discrepancies across markets (C)</p> Signup and view all the answers

What characterizes the foreign exchange market as predominantly an OTC market?

<p>It involves private transactions between parties (B)</p> Signup and view all the answers

Which statement accurately describes the anonymity maintained by foreign exchange brokers?

<p>They maintain anonymity until the transaction is completed (B)</p> Signup and view all the answers

What unique role do central banks play in the foreign exchange market?

<p>They implement monetary policies impacting currency values (D)</p> Signup and view all the answers

What does the law of one price suggest regarding the pricing of identical goods in different countries?

<p>Identical goods should cost the same in both countries if costs are low. (C)</p> Signup and view all the answers

How does purchasing power parity (PPP) relate to inflation and currency value?

<p>High inflation can lead to a depreciating currency over time. (C)</p> Signup and view all the answers

What does exchange rate pass through measure?

<p>The degree to which exchange rate fluctuations affect import and export prices. (B)</p> Signup and view all the answers

Which of the following describes nominal exchange rates?

<p>They reflect the current price of one currency in terms of another without adjustment for inflation. (A)</p> Signup and view all the answers

Which theory complements purchasing power parity by addressing short-term currency movements?

<p>Interest rate parity theorem. (A)</p> Signup and view all the answers

What are real effective exchange rates used for?

<p>To measure the value of a currency adjusted for price levels across multiple countries. (D)</p> Signup and view all the answers

What is the primary factor that can lead to a country's currency becoming less competitive?

<p>Consistent high inflation rates. (C)</p> Signup and view all the answers

How can nominal and real exchange rates help evaluate a country's currency status?

<p>By indicating if a currency is overvalued or undervalued based on price adjustments. (A)</p> Signup and view all the answers

Flashcards

Cross Exchange Rate

The exchange rate between two currencies that are not directly traded in the market. It is calculated using a third, widely traded currency as a reference.

Reference Currency

A widely traded currency used to determine the exchange rate between two currencies that are not actively traded.

Forward Exchange Rate

The exchange rate for a currency transaction that will be settled at a future date.

Forward Points

The difference between the forward exchange rate and the spot exchange rate, expressed in points.

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High Forward Points

Indicates that the forward rate is higher than the spot rate, suggesting a currency is expected to appreciate.

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Low Forward Points

Indicates that the forward rate is lower than the spot rate, suggesting a currency is expected to depreciate.

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Bid Rate

The price at which a dealer is willing to buy a currency.

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Ask Rate

The price at which a dealer is willing to sell a currency.

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Law of One Price

If two countries produce an identical good with low production costs, the good should have the same price in both countries.

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Purchasing Power Parity (PPP)

Exchange rates between currencies should adjust to reflect differences in price levels between countries.

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PPP and Long-Term Currency Trends

PPP helps predict long-term currency movements, but it doesn't account for short-term fluctuations.

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Exchange Rate Pass Through

The degree to which changes in exchange rates affect the prices of imported and exported goods.

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Nominal Exchange Rate

The current market price of one currency compared to another.

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Real Exchange Rate

The relative purchasing power of a currency, considering price differences between two countries.

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Nominal Effective Exchange Rate (NEER)

Measures the value of a currency against a trade-weighted basket of other currencies.

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Real Effective Exchange Rate (REER)

Measures the value of a currency adjusted for inflation and price differences with a weighted basket of other currencies.

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Arbitrageur

A trader who seeks to profit from price discrepancies across different markets by buying low and selling high simultaneously. They aim for risk-free profits.

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Speculator

A trader who takes on risk by buying or selling assets in anticipation of price changes, hoping to profit from these fluctuations. They are willing to gamble on the direction of the market.

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Arbitrage vs. Speculation

Arbitrageurs focus on exploiting temporary price differences across markets for risk-free profits, while speculators aim to profit from their predictions on future price movements, accepting potential losses.

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Foreign Exchange Broker

An intermediary who facilitates transactions in the foreign exchange market by connecting buyers and sellers without themselves becoming counterparties to the trade.

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Over-the-Counter (OTC) Market

A financial market where transactions happen directly between two parties without the involvement of a central exchange.

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Central Bank's Role in Foreign Exchange Market

Central banks play a crucial role in maintaining exchange rate stability and managing their national currencies.

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Balance of Payments (BoP)

A summary statement of a country's inflows and outflows of foreign currency over a specific period, typically one year.

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Foreign Exchange Reserves

A country's holdings of foreign currencies, typically held by a central bank, used to manage exchange rates and pay for imports.

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Depletion of Foreign Exchange Reserves

When a country uses more foreign currency than it receives, reducing its reserves.

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Currency Depreciation

A decrease in the value of a currency relative to other currencies.

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Balance of Payments Crisis

A situation where a country struggles to maintain its exchange rate due to insufficient foreign exchange reserves.

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International Monetary Fund (IMF)

A global financial institution that provides loans and financial assistance to countries experiencing financial difficulties.

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Cross-border Transactions

Financial transactions between individuals, businesses, or governments located in different countries.

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Foreign Currency Inflows

Money flowing into a country from outside sources, such as foreign investments or exports.

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Interest Rate Parity Theorem

The difference in interest rates between two currencies should be reflected in the difference between the spot exchange rate and the forward exchange rate for the same time period.

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Spot Exchange Rate

The current exchange rate at which one currency can be exchanged for another.

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Domestic Currency Interest Rate (Id)

The interest rate offered on investments in the investor's own currency.

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Foreign Currency Interest Rate (Ie)

The interest rate offered on investments in a currency other than the investor's own.

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Interest Rate Parity Formula

Id = Ie - (F - S) / S, where Id is the domestic interest rate, Ie is the foreign interest rate, F is the forward exchange rate, and S is the spot exchange rate.

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How does Interest Rate Parity affect investment decisions?

If Interest Rate Parity holds, an investor should get the same return on an investment regardless of whether they invest in their own currency or a foreign currency, after taking into account exchange rate movements.

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Example of Interest Rate Parity

An investor has a choice to invest in US Dollars at 2% or Swiss Francs at 4%. If the spot exchange rate is 1.5 and the forward exchange rate is 1.5075, Interest Rate Parity holds because the investor gets a 2% return in either case.

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Current Account

A part of the BoP that tracks the flow of goods, services, income, and transfers.

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Capital Account

A part of the BoP that tracks long-term capital flows, including investments and debt.

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Visible Items

Goods that are physically traded, like exports and imports.

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Invisible Items

Services and income flows, like tourism, transportation, and profits.

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Foreign Direct Investment (FDI)

Investment made by a company in a foreign country, where the investor has significant control over the investment.

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Balance of Payments Surplus

A situation where a country's total inflows exceed its total outflows in the BoP.

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Study Notes

Foreign Exchange Markets: An Overview

  • A foreign exchange transaction is an agreement between two parties where one party agrees to pay a fixed amount of one currency in exchange for another currency at an agreed rate.
  • The price of one currency in terms of another currency is called the exchange rate.
  • Currencies are bought and sold in foreign exchange markets.
  • This market provides the institutional, physical, and technological infrastructure for foreign exchange transactions.

Nature, Size, and Distribution of Foreign Exchange Markets

  • Foreign exchange markets exist globally.
  • Virtually all currencies are traded in some foreign exchange market.
  • Dominant currencies traded include the US dollar, Japanese yen, Euro, and Pound Sterling.
  • Foreign exchange markets operate 24/7, constantly moving in sync with the rotation of the earth.
  • Markets open and close in different time zones, so one market might be open while another is closed.

Participants in the Foreign Exchange Markets

  • Individuals and firms (tourists, international business travelers, importers, exporters, investors) participate to meet personal, commercial, or investment needs.
  • Banks (and non-banks like money changers) participate to meet the demands of individuals and firms, often profiting from exchange rate differences.
  • Foreign exchange brokers connect counterparties in the market while maintaining anonymity.
  • Central banks participate not for profit but to stabilize their domestic currency exchange rate.
  • Speculators and arbitrageurs seek to profit from fluctuations in exchange rates, while arbitrageurs seek risk-free profits (taking advantage of price differences in different markets).

Types of Transactions Traded in the Foreign Exchange Market

  • Trading activity: Agreement between counterparties on the quantum of currencies and exchange rate.

  • Settlement activity: Execution of the trade, debiting/crediting accounts.

  • Cash transactions: Date of trade is also the settlement date.

  • TOM (Tomorrow): Settlement one day after the trade.

  • Spot transactions: Settlement two days after the trade.

  • Outright forward contracts: Settlement date later than two days after the trade.

  • Swap transactions: Two simultaneous foreign exchange transactions that are contractually binding on both counterparties. There are Spot and Forward Swap and Forward-Forward Swap.

Exchange Rates: Importance and Quotation

  • Exchange rates are crucial as they influence the price of domestic goods in foreign countries (and vice-versa), affecting exports and imports.
  • Exchange rate volatility is crucial for countries and central banks to manage.
  • Currencies have unique codes (e.g., USD for US Dollar, GBP for British Pound).
  • Exchange rates are quoted as currency pairs (e.g., USD/JPY). The base currency is on the left, and the quote currency is on the right. For example, USD/JPY 100 means 1 USD equals 100 JPY.
  • Direct quotes show the price of one unit of foreign currency in terms of domestic currency units. Indirect quotes show the price of one unit of domestic currency in terms of foreign currency unit.

How and Why do Exchange Rates Fluctuate

  • Law of one price: Identical goods should cost the same in different countries, assuming transportation costs are low.
  • Purchasing Power Parity (PPP): Exchange rate adjustments should reflect relative price levels of goods in different countries.
  • High inflation causes domestic currency depreciation.

Interest Rate Parity

  • Interest Rate Parity (IRP) states that the difference between the spot exchange rate and forward exchange rate between any two currencies should be explained by the difference in their respective interest rates over the same period.
  • IRP Theorem captures the movement in exchange rates in the short term, whereas PPP captures the long-term direction of currency value.

Foreign Exchange Reserves

  • Foreign Exchange Reserves (FXR) are critical for any country's financial stability.
  • Ideally, FXR should be enough to cover imports and ensure the currency doesn't fluctuate too rapidly.

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Foreign Exchange Markets:Instruments, Risks and Derivatives PDF

Description

Explore the fundamentals of foreign exchange markets, including the mechanics of currency transactions and the significance of exchange rates. Understand the global nature, size, and distribution of these markets, as well as the key currencies involved. This quiz will test your knowledge of how foreign exchange operates around the clock.

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