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International Finance Test #2
Terms in this set (31)
Why do we need foreign currency?
-Import/export demand and supply
-Foreign direct investment: controlling ownership in a business enterprise in another country
-Portfolio investments: investments in foreign financial assets such as stocks and bonds
FX Market Participants
International commercial banks: "market makers"
Bank customers: MNCs, money managers, private speculators
Nonbank dealers: Investment banks, mutual funds, pension funds, hedge funds
FX brokers: match dealer orders to buy/sell
Central banks: market intervention
Correspondent Banking Relationships
Correspondent banking accounts: demand deposit accounts that large commercial banks maintain with one another → facilitates the efficient functioning of the FX market.
SWIFT: The Society for Worldwide Interbank Financial Telecommunications (private)
provides a network that enables financial institutions worldwide to send and receive information about financial transactions in a secure, standardized and reliable environment.
CHIPS: Clearing House Interbank Payments System (works in cooperation with Federal Reserve Bank System)
it was settling well over US$1.5 trillion a day in around 250,000 interbank payments in cross border and domestic transactions.
Settles over 95% of U.S. dollar payments btw international banks.
ECHO: Exchange Clearing House Limited
the first global clearinghouse for settling interbank FX transactions
transaction involving (almost) immediate purchase/sale of FX.
price of one unit of foreign currency in domestic currency
-From US perspective: $0.00899/1 JPY
-E.g., "1 Japanese yen is worth almost a penny."
direct quote from US perspective
-$ price of 1 unit of foreign currency
$/€ = 1.1321 (1€ costs $1.1321)
$/£ = 1.4402 (1£ costs $1.4402)
price of one unit of domestic currency in foreign currency
-From US perspective: 111.26 JPY/$1.00
-E.g., "You get about 111 yen to the dollar."
indirect quote from US perspective
-Foreign currency price of $1
€/$ = .8825 ($1 costs €0.8825)
£/$ = .6944 ($1 costs £0.6944)
Exchange rates can be equivalently quoted two different ways, which can create confusion:
-S(€/$) = 1/S($/€)
-Euro value of one dollar = 1 / dollar value of one euro
is the price a dealer is willing to pay you for something; dealer is buying the asset.
is the amount the dealer wants you to pay for the thing; dealer is selling the asset.
Currency against currency" trade: an FX trade between two currencies, neither of which is the US dollar
The process of trading Currency A for Currency B, and then trading Currency B for Currency C. Currency C is then traded for Currency A, yielding a profit.
Currency Forward Contract
an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.
Non-Deliverable Forward Contracts
-Due to government-initiated capital controls, the currencies of some emerging market countries are not freely traded.
-For many of these currencies, trading in non-deliverable forward contracts exists.
-A non-deliverable forward contract is settled in cash, usually U.S. dollars.
an agreement to provide a counterparty with something he wants in exchange for something that you want.
Exchange-Traded Currency Funds or Currency ETFs
-Currency is now recognized as a distinct asset class, like stocks and bonds.
-Currency ETFs facilitate investing in the euro, the British pound, the Chinese yuan, the Japanese yen, and other currencies.
-the purchase of securities in one market for immediate resale in another to profit from a price discrepancy
-a zero risk, zero investment strategy that yields a guaranteed profit.
Interest Rate Parity (IRP)
the condition stating that the interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate
Covered Interest Arbitrage
the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract
Purchasing Power Parity (PPP)
The amount of money needed in one country to purchase the same goods and services in another country; PPP adjusts income figures to account for differences among countries in the cost of goods
Absolute Purchasing Power Parity
the idea that the exchange rate should equal the ratio of the price indexes of two countries
Relative Purchasing Power Parity
-relates the change in two countries' expected inflation rates to the change in their exchange rates.
-Relative purchasing power parity examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials.
a financial instrument whose value depends on the value of some other, more basic underlying variable(s)
an agreement to buy (long position) or sell (short position) foreign exchange at a certain future time for a specified delivery price.
the number of contracts outstanding for a particular delivery month
gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future at prices agreed upon today.
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