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?

USD 2 Million Signup and view all the answers

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

Capital Account Signup and view all the answers

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

Short-term transactions Signup and view all the answers

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

Dividend payments to overseas investors Signup and view all the answers

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

To classify transactions consistently across countries Signup and view all the answers

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

Using the quotes for each currency with respect to a widely traded currency. 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?

4 Signup and view all the answers

What do forward foreign exchange rates represent?

Rates for transactions that will be settled at a future date. Signup and view all the answers

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

They should be added to the spot rate. Signup and view all the answers

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

The Spot Bid rate. Signup and view all the answers

When should forward points be subtracted from the spot rate?

When the forward points are low. Signup and view all the answers

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

They provide a benchmark for unvaluated currencies. Signup and view all the answers

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

Points are added or subtracted from the spot rates. Signup and view all the answers

What does the Interest Rate Parity Theorem mathematically express?

The difference between spot and forward exchange rates is explained by interest rate differences. 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?

$1,005,000 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?

1.5075 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?

2% Signup and view all the answers

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

1.5 Signup and view all the answers

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

Investing in the Swiss money market Signup and view all the answers

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

The investor earns the same effective return using either market. Signup and view all the answers

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

The difference between the domestic and foreign interest rates. Signup and view all the answers

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

To act as a buffer during potential bad economic times Signup and view all the answers

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

Depletion of the foreign exchange reserves in the host country Signup and view all the answers

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

A summary of foreign currency inflows and outflows over a year Signup and view all the answers

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

Heightened risk of a currency crisis Signup and view all the answers

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

By offering funding or loans to stabilize economies Signup and view all the answers

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

When its foreign exchange reserves are insufficient Signup and view all the answers

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

Cross-border transactions of all types Signup and view all the answers

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

Unstable foreign exchange reserves Signup and view all the answers

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

To exploit price imperfections for riskless profit 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?

The USD appreciates in New York and depreciates in Tokyo Signup and view all the answers

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

They provide two-way quotes from multiple counterparties Signup and view all the answers

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

They facilitate more efficient exchange rate discovery Signup and view all the answers

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

By eliminating price discrepancies across markets Signup and view all the answers

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

It involves private transactions between parties Signup and view all the answers

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

They maintain anonymity until the transaction is completed Signup and view all the answers

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

They implement monetary policies impacting currency values Signup and view all the answers

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

Identical goods should cost the same in both countries if costs are low. Signup and view all the answers

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

High inflation can lead to a depreciating currency over time. Signup and view all the answers

What does exchange rate pass through measure?

The degree to which exchange rate fluctuations affect import and export prices. Signup and view all the answers

Which of the following describes nominal exchange rates?

They reflect the current price of one currency in terms of another without adjustment for inflation. Signup and view all the answers

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

Interest rate parity theorem. Signup and view all the answers

What are real effective exchange rates used for?

To measure the value of a currency adjusted for price levels across multiple countries. Signup and view all the answers

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

Consistent high inflation rates. Signup and view all the answers

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

By indicating if a currency is overvalued or undervalued based on price adjustments. Signup and view all the answers

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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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.