Chapter 9: The Foreign Exchange Market

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What are the two ways to quote currency?

spot rates and forward rates

What is a spot rate?

the exchange rate between 2 currencies; delivery within two days (conversion on a particular day)

What is a forward rate?

the exchange rate between 2 currencies;future delievery in 30/60/90/180 days

What are the three ways of insuring against a Forex risk?

spot rates, forward rates, and swaps

What is hedging?

the process of insuring one's business against foreign exchange risk by using forward exchanges or currency swaps

What is a currency swamp?

simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

What are some characteristics of swaps?

- these transactions are used when need to move out of one currency into another
- they are for a limited period
- there is no foreign exchange rate risk

No single theory can explain explain the causes the value of currencies to change. True or False?


What are some factors that influence exchange rates?

-Supply & demand of the currency
-Interest rates
-Investor expectations

What are the types of Exchange Rate Fluctuations?

- monetary and fiscal policies

What do monetary policies do?

-control the amount of money in circulation
-enforced by government policies
- focus on growth rate

What are the purposes of fiscal policies?

collecting & spending of money by the government

What is the law of one price?

in competitive markets free of transportation costs and barriers to trade identical products sold in different countries must sell for the same price is expressed in terms of the same currency

What is arbitrage?

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy (no risk)

What is the nature of the forex market?

high-speed computer linkages between trading centers around the globe
-have created 1 market
-resulted in no significant difference between exchange rate quotes
-different exchange quoted result in arbitrage opportunities

True or False. Most Transaction inovolve u.s. dollar


What are the important trading centers?

London, New York, Tokyo, and Singapore

Ture or false. Marekts are open 24/7


According to economic theories of exchage rate determination?

exchange rates are determined by the demand and supply for different currencies

What are three factors that impact a country's future exchange rate movements?

inflation, interest rate, and market psychology

What is the nominal exchange rate?

currency of one country can be exchanged for the currency of another country

What is the real exchange rate?

goods and services of one country can be exchanged for the goods and services of another country

What holds true to Purchase Power Parity Theory?

-there is absence of trade barriers
-each country price in commodity basket are at an equal ration
- not accurate in predicting exchange rates in the short run

In the long run empirical testing has of the PPP Theory has proven to be accurate in the long run. True or False


Burger economics!!! Why do we use it?

It is used to measure how far the nominal exchange rate deviate from the one that would create PPP

What causes big mac prices to vary?

transportation costs, trade barriers, and not trade inputs such as rents or wages

When do countries use the foreign exchange market?

1. receive payments for exports
2. receive income from FDI
3. Receive income from licensing agreements with foreign firms are in foreign currencies.

When do countries use foreign exchange market?

1. pay a foreign co for its products or services in a countries currency
2. spare cash for short term money market investments
3. involved in currency speculation

What is free convertible currency?

government allows both residents and non residents to purchase unlimited amounts of foreign currency with domestic currency

What is non convertible currency?

both residents and on residents are prohibited from converting their holdings of domestic currency into a foreign currency

What is externally convertible currency

1. non residents can convert their holdings of domestic currency
2. residents are limited in some way to convert currency

What are the first two things that determine Forex rates?

relative price differences and ppp

What is the second thing that determines the Forex rates?

interest rates and money supply

What is the third thing that determines the forex rates?

productivity and balance payments

What is the fourth thing that determines the forex rates?

exchange rate policies

What is the fifth thing that determines the forex rates?

investor psychology

What is the first roels of the U.S. dollar outside the U.S.?

a common reference

What is the second role of the U.S. dollar outside the U.S. ?

intervention currency (peg country currency)

What is the third role of the U.S. dollar outside the U.S.?

reserve currency

What is the fourth roles of the U.S. dollar outside the U.S.?

vehicle currency(transaction between 2 less commonly used currencies)

What is the bandwagon effect when looking at form investor psychology ?

group of investors movement in the same direction and same time
or government intervention

What is capital fight when looking at it form investor psychology?

large number of individuals and cos exchange of domestic currencies for a foreign currency

What implications does understanding foreign exchange rates have on managers?

it helps them understand the influence of exchange rates on profitability of trade investment deals

What are the three different types of foreign exchange rate risks?

transaction, translation and economic exposure

How can transaction exposure be described?

the income form individual transacations

What is the first characteristic of transaction exposure ?

affected by fluctuation in foreign exchange values

what is the second characteristic of transaction exposure?

obligations for the purchase or sale of goods and services at previously agreed prices

what is the third characteristic of transaction exposure?

borrowing of funds in foreign currency

what is the fourth characteristic of transaction exposure?

lending of funds in foreign currencies

How can translation exposure be described?

impact of currency exchange rate changes on reported financial statements

What is the characteristic of translation expose?

measurement of past events

What is economic exposure?

firms future international earning power

what are the characteristics of economic exposure?

affected by changes in exchange rates aslo long term effect of changes in exchange rates on future prices, sales, and costs

What are two methods of reducing translation and transaction exposure?

lead and lag strategies

What is the first characteristic of lead strategy?

an attempt to collect currency receivables early as result of expected depreciation

What is the second characteristic of lead strategy?

paying foreign currency payable before dues as a result expected currency appreciation

What is the first characteristic of lag strategy?

delay collection of foreign currency receivables if currency is exception to appreciate

What is the second characteristic of lag strategy?

delay payables if currency is expected to depreciate

What are the two ways to reduce economic exposure?

1. distribute productive assets
2. ensure assets are not concentrated in countries

How and what is the purpose of distributing assets?

distribute to various locatoij so firms long term financial well being is not severly affected by changes in exchange rates

What is the purpose of not concentrating assets in countries?

increase currency values and protect against increases in foreign prices of goods and services

How do you insure or hedge against a Forex risk?

forward exchange or spot exchange

What are some strategies for managing forex risk?

establish central control and attempts to forecast future exchange rates

HOw do you establish central control?

1. protect resources efficiently
2. ensure correct mix of tactics and strategies

What are other strategies for managing forex risk?

estb. good reporting systems, check monthly foreign exchange reports and distinguish between transaction , economic and translation exposure

True or False. It is important to stay up to date with yo current events


The euro faces risks fo recapitalization?

banks stability was measure at a 5% capital adequacy ratio

Currently margins require more cash reserves, what is the best method of doing this **** in the Euro Zone?

Issue mo good loans so that profits from new business can eat away the losses form the bad

Because of the recessionary environment euro banks have failed to do what?

increase their exposure to banking europe's banking center

Because many banks (2/3) are below the capital adequacy ratio of 9% many can not recapitalize on their own as a result

state driven recapitalization are now needed

Bailout Fund of EFSF, What is this shiz nitz?

manages the Greeks, the Irish, and Portuguese bailouts and has passed recent amendments to legally assit euro banks and govs

What is the first issue with EFSF?

1. no process
2. no agreement as to who should hold the process
3. Germans want eco reforms following bailout
4. remediation and supervisory structures must be built

What is the second issue with EFSF?

1. not that many staffing
2. months away form being implemented
3. esfs new power to restructured banks goes against EU treaties that guarantee all banking authority to the member state level

Greece has not defaulted because it has not been able to fully implement it agreed upon austerity. True or False


Defaulting on debt has a domino effect that intertwines all countries in Europe.


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