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Money and Banking Exam 1

Chapters 1-5, 8
Explain the analogy relating irrigation flows to flows of funds in the finanial system. What happens to a farmer when irrigation water dries up? What happened to businesses in the U.S. when the flow of funds dried up in the financial crisis of 2007-2009?
If water dries up, farmers are not able to produce agricultural goods, such as fruits and vegetables because water is a critical resource in farming. When the flow of credit dried up during the financial crisis, it was difficult for businesses to keep producing goods and services because credit is a critical resource for this production.
Financial Asset
A financial claim, an asset that represents a claim on someone else for a payment
Briefly define money. (of 5 key financial assets)
Anything that is generally accepted in payment for goods and services or to pay off debts
Briefly define stocks. (of 5 key financial assets)
Equity, financial securities that represent partial ownership of a firm
Briefly define bonds. (of 5 key financial assets)
A financial security issues by a corporation or a government that represents a promise to repay a fixed amount of money
Briefly define foreign exchange. (of 5 key financial assets)
units of foreign currency. Banks are the most important b/s of foreign exchange.
Briefly define securitized loans. (of 5 key financial assets)
loans that banks can sell on financial markets
Is every financial asset also a financial security?
No, every financial asset is not a financial security. Only financial assets that can be bought and sold in a financial market are financial securities.
Is it possible that what a saver would consider a financial asset a borrower would consider a financial liability?
Yes, it is possible that a saver's assets could be a borrower's liability.
What is the difference between direct finance and indirect finance? Which involves financial intermediaries and which involves financial markets?
The flow of funds from savers to borrowers through financial intermediaries is indirect finance and flow through financial markets is direct finance.
In 2009, Dole Food Company, which markets fresh fruit and vegetables, moved from being a private company to becoming a public company by conducting a IPO. Were investors who bought stock in this IPO doing so in the primary or secondary market?
Primary market, as the IPO raises money directly for the company.
Briefly explain why the financial system is one of the most highly regulated sectors of the economy.
The financial system is perhaps the most complicated of all markets. Because of the amount of asymmetric information and the overwhelming complexity of financial markets, governments around the world impose restrictions in an attempt to create a more orderly market.
What is the Federal Reserve? How do the Fed's current responsibilities compare with its responsibilities when first created by Congress? Who appoints the members of the Federal Reserve's 's Board of Governors?
The Federal Reserve is the central bank of the United States and serves as lender of last resort to banks. The members of the Board of Governors are appointed by the president with consent of the senate. As the financial system and banking system have evolved, the Fed's role has expanded to include the conduct of monetary policy to manage inflation, unemployment, and the stability of the financial system.
Briefly describe the 3 key services that the financial system provides to savers.
1. Risk sharing, which allows investors to diversify their financial assets 2. Liquidity, which is the ease with which an asset can be exchanged for money 3.Collection and communication of information about borrowers and expectations of returns on financial assets
What do economists mean by a "bubble"? Why do many economists believe that there was a housing bubble in the U.S. between 2000 and 2005?
A bubble is an unsustainable increase in the price of a class of assets. Many economists believe that there was a housing bubble in the United States between 2000 and 2005 because, among other things, housing prices rose nearly 90% from 2000 to July 2005 and then fell more than 30% from 2006 to 2009.
By the 2000s, what significant changes had taken place in the mortgage market? What is a "subprime" borrower? What is an "Alt-A" borrower?
Mortgages were packaged together as mortgaged-back securities and sold to investors in the secondary mortgage market. Investment banks began buying mortgages and lenders greatly loosened their standards for obtaining a loan. A subprime borrower is a borrower with a flawed credit history. Alt-A borrowers are borrowers who simply state their income, but do not document or prove their income
What problems did the decline in housing prices that began in 2006 cause for the financial system?
The decline in housing prices led to rising defaults among subprime and Alt-A borrowers, borrowers with adjustable rate mortgages, and borrowers who had made only small down payments. This caused mortgage-backed securities to lose value, causing losses for the investment institutions that owned them.
What actions did the Fed and Treasury take in dealing with the financial crisis? What is the moral hazard problem? How is it related to the Fed's and Treasury's actions?
The Fed aggressively lowered interest rates and made loans to commercial banks and investment banks. Congress passed the Troubled Asset Relief Program (TARP) under which the Treasury provided funds to commercial banks in exchange for stock in those banks. The Fed and Treasury worked together to find a buyout partner for Bear Stearns, and the Fed provided a loan to AIG. Moral hazard is the possibility that managers of a financial firm will take on riskier investments because they believe that the federal government will save them from bankruptcy. The Fed's actions were controversial because many people believe that the actions would create moral hazard problems
What is specialization? How does it improve an economy's standard of living?
It is when economic agents engage in a small number of productive activities, but consume a larger number of goods and services. Specialization increases productivity.
What are the costs of a barter system?
transporting the form of payment and double coincidence of wants
What are the transaction costs? How does using money affect the level of transaction costs in an economy?
Transactions costs are the costs in time or other resources that parties incur in the process of agreeing and carrying out an exchange of goods and services. The use of money reduces transactions costs significantly from barter by eliminating the problem of the double coincidence of wants.
What makes a dollar bill money? What makes a personal check money? What factors, if changed, would affect your willingness to accept a dollar bill or a check as money?
To serve as money, dollar bills and checks must generally be accepted as means of payment. Your acceptance of dollar bills and checks as money is based on your confidence that others will accept them
Unit of Account (a function of money)
A way of measuring value in an economy in terms of money
Medium of Exchange (a function of money)
Something that is generally accepted as payment for goods and services
Store of Value (a function of money)
The accumulation of wealth by holding dollars or other assets that can be used to buy goods and services in the future
Standard of deferred payment (a function of money)
The characteristic of money by which it facilitates exchange over time.
What are the 4 main functions of money?
to serve as a medium of exchange, unit of account, store of value, and standard of deferred payment
Is the store of value function unique to money? If not, fiver some other examples of stores of value. Must money be a store of value to serve its function as a medium of exchange?
No, the store-of-value function is not unique to money. Houses, bonds, and stocks are also stores of value. Money must be a store of value to function as a medium of exchange. People will not accept the form of money unless it can be stored.
What is commodity money? How does it differ from fiat money?
Commodity money has value beyond its use as currency; fiat money has no intrinsic value
What is a payments system? If there were a decrease in the efficiency of the payments system, what would be the cost to the economy?
A payments system is a mechanism for conducting transactions in the economy. If the payments system became less efficient, the costs to the economy would be fewer and more costly transactions, causing the economy to achieve fewer gains from specialization
Why did the government begin issuing paper money?
It was expensive to transport gold and silver coins. Paper currency lowered the cost of transactions
Is the U.S. likely to become a cashless society?
It is likely that more transactions in the United States will be cashless in the future, but it is unlikely that cash will be eliminated. First, the infrastructure for an e-payments system is expensive to build, and second, many people want the option to use cash for privacy purposes
Are the assets in M1 more or less liquid than the assets included in M2? Briefly explain.
The assets in M1 are more liquid. M1 is the narrowest definition of money and includes currency, traveler's checks, and checking account deposits, all assets that are very liquid. M2 is a broader measure of money and includes M1, time deposits with a value of less than 100,000, savings accounts, money market accounts, and non-institutional money market mutual fund shares
Sine the 1960s, which measure of the money supply has grown more rapidly, M1 or M2? Why? Has the growth of M1 been more or less stable than the growth rate of M2?
M2 has grown more rapidly. CDs, money market mutual fund shares, and other assets have grown faster than currency or checking accounts. The growth of M2 has been more stable than the growth of M1.
Rank assets in terms of liquidity
dollar bill, checking account, money market mutual fund, savings account, corporate stock, gold bar, house
What is the equation of exchange? Is the equation of exchange a theory? Briefly explain.
MV = PY. The equation of exchange is an identity, not a theory. A theory is a statement about
the world that might possibly be false.
What is the quantity theory of money? What does the quantity theory indicate is the cause of inflation?
The quantity theory of money is a theory about the relationship between prices and the money supply. This theory is based on an identity known as the equation of exchange: MV = PY. Increases in the money supply that exceed increases in real GDP lead to inflation
What is purchasing power? How is it affected by inflation?
Purchasing power is the number of g/s that can be purchased with a unit of currency. Purchasing power decreases as inflation increases.
What is hyperinflation? What is the cause of hyperinflation?
Hyperinflation is triple digit inflation per year. Large increases in the M cause hyperinflation. As prices go up, the PP of the currency falls, increasing V, and further compounding the rapid increase in P. Ultimately caused by large government budget deficits.
Briefly discuss the pros and cons of a central bank being independent of the rest of the government
Pros: Independent from direct political action. Congress has no direct control over monetary policy. The trend is that inflation is lower under these circumstances. Cons: A central bank can have too much power without the checks and balances
What are the main reasons that lenders charge interest on loans?
Interest provides the profit incentive to supply loans, compensation for inflation, compensation for default risk, and compensation for the opportunity cost of spending your money
Give an example of a financial transaction that requires a payment in the future.
A corporate bond promises payments in the future
If you deposit 1,000 in a bank CD that pays interest of 3% per year, how much will you have after 2 years?
$1,000 x (1 + 1.03)^2 = $1,060.90 FV
What is the present value of 1,200 to be received in one year if the interest rate is 10%?
PV = $1,200/(1 + 0.10) = $1,090.91
Time Value of Money
the way that the value of a payment changes depending on when the payment is received
present value
value today of funds that will be received in the future
the process of finding the present value of funds that will be received in the future; opposite of the compounding
How is the price of a financial asset related to the payments to be received from owning it?
the price of a financial asset is related to the payments to be received through the present value formula
What is the difference between a debt instrument and equity?
Debt instruments include loans granted by banks or bonds issued by government. Equities imply the ownership of a firm.
face value
the amount to be repaid by the bond issuer at maturity
the annual (or semiannual) fixed dollar amount of interest paid by the issuer of the bond to the buyer
coupon rate
the value of the coupon expressed as a percentage of the face value
current yield
the value of the coupon expressed as a percentage of the current price of the bond
the length of time before the bond expires
Explain which category of debt instrument the following belongs: car loan
Fixed payment loan
Explain which category of debt instrument the following belongs: Treasury Bond
Coupon bond
Explain which category of debt instrument the following belongs: 3 month treasury bill
Discount bond
Explain which category of debt instrument the following belongs: mortgage loan
Fixed payment loan
What is the yield to maturity? Why is the yield to maturity a better measure of the interest rate on a bond than is the coupon rate?
It's the interest rate that equates the PV of future payments of a debt instrument with its current value. It's a better measure of the interest rate than the coupon rate because value of a bond may differ from the face value of the bond
Write an expression showing the relationship among the price of a coupon bond, the coupon payments, face value, and the yield to maturity
P= C/(1 + i) + C/(1 + i)^2 + C/(1 + i)^3 +...FV/(1 + i)^n
Write an expression showing the relationship among the amount borrowed on a simple loan, the required loan payment, and the yield to maturity
i = (required loan payment - principle)/principle
Write an expression showing the relationship among the price of a discount bond, the bond's face value, and the yield to maturity
i = (FV - P)/P
Write an expression showing the relationship among the amount borrowed on a fixed payment loan, the payments on the loan and the yield to maturity.
loan value = Fixed payments/ (1 + i) + Fixed payments/ (1 + i)^2 + ...Fixed payments/ (1 + i)^n
What is the difference between the primary market a bond and the secondary market?
If a bond is purchased directly from the company issuing the bond, it was purchased in the primary market. If the bondholder decides to sell the bond to another investor, that transaction would take place on the secondary market
What is a capital gain on a financial security? If you own a bond and market interest rates increase, will you experience a capital gain or a capital loss?
Capital gain is an increase in the price of an asset. If market interest rates increase, bond prices fall, so you will experience a capital loss
Briefly explain why yields to maturity and bond prices move in opposite directions,
The equation for bond prices shows that the higher the purchase price of the bond, the lower the rate of return. Buying a bond at a high price means that the difference made between the purchase price and face value can be small and even negative. The higher the price, the lower the overall rate of return.
What is the difference between an investor and a trader?
Investors hold a stock/bond for a long period of time and collect the dividend from a corporation or the coupon payment from the bond. A trader buys and sells securities and bonds hoping to take advantage of price arbitrage in a short time horizon
What is financial arbitrage?
Financial arbitrage is the process of buying and selling securities to profit from price changes over a brief period of time
What is the difference between the yield to maturity on a coupon bond and the rate of return?
Yield to maturity is the return on a bond assuming the bondholder holds the bond for the full maturity. Rate of return is the return over a specific holding period that takes into account not just the coupon rate but the price change
What is interest-rate risk? Why does a bond with a longer maturity have greater interest rate risk than a bond with a shorter maturity?
it's the risk of IR changes affecting the bond value. A given change in interest rates has a larger effect on the present value, and therefore the price, of a long-term bond than a short-term bond.
What is the difference between the nominal
interest rate on a loan and the real interest rate?
Nominal interest rates do not adjust for inflation. Real interest rates adjust for inflation
What is the difference between the actual real
interest rate and the expected real interest rate?
expected real interest rate = the nominal interest rate minus expected inflation. actual real interest rate = the nominal interest rate minus actual inflation
What is deflation? If borrowers and lenders
expect deflation, will the nominal interest rate be
higher or lower than the expected real interest
rate? Briefly explain.
it's a sustained decline in the price level. If borrowers and lenders expect deflation, the nominal interest rate will be lower than the real interest rate because the nominal interest
rate = the real interest rate + expected inflation, which will be negative with borrowers and lenders expecting deflation
What are TIPS?
TIPS are Treasury Inflation Protection Securities, where the interest rate increases with inflation
What is a portfolio?
A portfolio is a collection of investments held by an institution or private individual.
What are the determinants of asset demand?
There are five determinants: 1) The amount of wealth a saver has, 2) the expected rate of return compared to alternative investments, 3) the comparative degree of risk, 4) the comparative degree of liquidity, and 5) the comparative degree of the cost of acquiring information about the investment
How do economists define expected return and
Expected return is the return expected on an asset during a future period. Risk is the degree of uncertainty in the return on an asset.
Define risk averse. Are investors typically risk
averse or risk loving?
Risk averse refers to investors who have an aversion to risk, meaning that when choosing between two assets with the same expected returns risk-averse investors would choose the asset with the lower risk. Most investors are risk averse.
In what sense do investors face a trade-off
between risk and return?
The higher the risk that an asset has, the lower the demand for the asset, which raises the yield or return.
What is the difference between market risk and
idiosyncratic risk?
Market risk is the risk that is common to all assets of a certain type because of shared economic conditions. Idiosyncratic risk is the risk that pertains to a particular asset, such as an individual stock, rather than to the market as a whole.
What is diversification? How does it reduce the
risk of a financial portfolio?
Diversification is the process by which individuals or firms allocate savings among many different assets. Diversification reduces risk because individuals and firms have a variety of different asset classes, so if one class (say bonds) performs poorly the rest of the portfolio may perform well.
Explain why each of the following change
might occur: demand curve for bonds shifts to the
1. wealth decreases 2. expected returns on bonds relative to other assets decreases 3. expected inflation increases 4. risk on bonds relative to other assets increases 5. liquidity decreases 6. costs of information increases
Explain why each of the following change
might occur: supply curve for bonds shifts to the
1. expected profitability increases,
2. corporate tax rates decrease,
3. subsidies to business increase,
4. expected inflation rises, or
5. government borrowing increases
Why does the supply curve for bonds slope up? Why does the demand curve for bonds slope
The bond demand curve slopes down because as the price of bonds decreases, the interest rates on the bonds will rise, and the bonds will become more desirable to investors, so the quantity demanded will rise. The bond supply curve slopes up because as the price of bonds decreases, their interest rates will rise, and holders of existing bonds will be less willing to sell them. Also, firms will find it more expensive to borrow at the higher interest rate and will issue fewer bonds. For both of these reasons, the quantity of bonds supplied will decrease.
If the current price in the bond market is above
the equilibrium price, explain how the bond
market adjusts to equilibrium.
The excess supply of bonds causes the price of bonds to fall, increasing quantity demanded and reducing quantity supplied. There is no shift in the supply or demand curve
T/F: The higher the price of bonds, the greater the
quantity of bonds demanded.
False: the quantity demanded of bonds falls.
T/F: The lower the price of bonds, the smaller the
quantity of bonds supplied.
True: The lower the price, the higher the yield, which increases the cost of borrowing.
T/F:As the wealth of investors increases, all else
held constant, the interest rate on bonds
should fall.
True: A shift to the right in the demand curve will push bond prices up and yields down.
T/F: If investors start to believe that the U.S. government
might default on its bonds, the
interest rate on those bonds will fall.
False: This would cause a shift to the left of the demand for U.S. government bonds, pushing price down and yield up.
Briefly explain what typically happens to interest
rates during a recession. Use a demand and supply
graph for bonds to illustrate your answer.
Interest rates fall during recessions. As the graph below shows, the demand for bonds decreases since households experience declining wealth, and the supply of bonds decreases since businesses have fewer profitable opportunities during a recession. For interest rates to fall, the price of bonds must rise, so the decrease in the supply for bonds must exceed in magnitude the decrease in the demand for bonds.
What is the Fisher effect? Use a demand and
supply graph for bonds to illustrate the Fisher
According to the Fisher effect, the nominal interest rate rises or falls point for point with changes in the expected inflation rate. As the graph below shows, an increase in expected inflation decreases bond demand and increases bond supply, decreasing bond prices and increasing bond yields (interest rates).
Compare the bond market approach to the
loanable funds approach by explaining the following
for each approach. a. What the good is
Bond Market: The good is the bond. Loanable Funds: The good is the use of funds.
Compare the bond market approach to the
loanable funds approach by explaining the following
for each approach. b. Who the buyer is
Bond Market: The buyer is the bond holder (the saver/investor). Loanable Funds: The buyer is the borrower.
Compare the bond market approach to the
loanable funds approach by explaining the following
for each approach. c. Who the seller is
Bond Market: The seller is the borrower (a government or a corporation). Loanable Funds: The seller (supply curve) is the saver.
Compare the bond market approach to the
loanable funds approach by explaining the following
for each approach. d. What the price is
Bond Market: The price is the price of the bond. Loanable Funds: The price is the interest rate.
In the loanable funds model, why is the demand
curve downward sloping? Why is the supply
curve upward sloping?
The demand curve is downward sloping because the higher the interest rate, the less demand for borrowing because the cost is higher. The supply curve is upward sloping because the higher the interest rate the more willing suppliers of loanable funds will be to lend money.
When are economists most likely to use the
bond market approach to analyze changes in
interest rates? When are economists most likely
to use the loanable funds approach?
The bond market approach is most useful when considering how the factors affecting the demand and supply for bonds affect the interest rate. The loanable fund approach is most useful when looking at the flow of funds between the U.S. and foreign financial markets.
Closed economy
A closed economy is an economy where households, firms, and governments do not borrow or lend internationally.
Small open economy
An economy where the quantity of loanable funds supplied or demanded is too small to affect the world real interest rate. It is also assumed that financial capital moves internationally.
Large open economy
A large open economy is an economy that is large enough to affect the world interest rate and assumes that capital moves internationally.
World real interest rate
The world real interest rate is the interest rate that is determined in the international capital market that equates the world quantity demanded of loanable funds to the world quantity supplied of loanable funds.
What is the risk structure of interest rates? Briefly
explain why bonds that have the same maturities
often do not have the same interest rates.
The risk structure of interest rates is the relationship among the interest rates on bonds that have different characteristics but the same maturity. The differences between interest rates among bonds with the same maturities exists because of different default risk, liquidity, information costs, and taxation.
What is default risk? How is default risk measured?
Default risk is the risk that the bond issuer will fail to make payments of interest and principal. The default risk is measured as the difference between the interest rate on the bond and the interest rate on a U.S. Treasury bond with the same maturity.
What is meant by a bond issuer's creditworthiness? What is a bond rating? Who are the major credit rating agencies?
A bond issuer's creditworthiness is the projected rating of a company's or a government's ability to pay off the bond. A bond rating is a rating assigned to a company or a government that rates its creditworthiness. The major credit rating agencies are Moody's Investors Service, Standard and Poor's Corporation, and Fitch Ratings.
How does the interest rate on an illiquid bond
compare with the interest rate on a liquid bond?
How does the interest rate on a bond with high
information costs compare with the interest rate
on a bond with low information costs?
Investors favor liquidity, so a bond that is not liquid would have less demand compared to an equivalent bond with more liquidity. This would mean a lower price for the illiquid bond and a higher yield. A bond with high information costs would have lower demand than an equivalent bond that has lower information costs. Investors favor full information, so this would push the price of the high information cost bond down and the yield up.
What are the two types of income an investor
can earn on a bond? How is each taxed?
Interest income from coupons and capital gains/losses from price changes. Capital gains are taxed at the income tax rate (within one year) and at a lower rate (capital gains tax) if held for more than one year. Coupon payments are taxed at the income tax rate.
Compare the tax treatment of the coupons on
the following bonds: a bond issued by the city
of Houston, a bond issued by GE, and a bond
issued by the U.S. Treasury.
The bond issued by Houston is a municipal bond and its coupons are not subject to federal, state, or local taxes. The bond issued by GE is a corporate bond and its coupons are subject to federal taxes, and typically to state and local taxes. The coupons of the U.S. Treasury bond are subject to federal tax, but not state or local taxes.
What is the term structure of interest rates?
What is the Treasury yield curve?
The term structure of interest rates is the relationship among the interest rates on bonds that are otherwise similar, but differ in maturity. The Treasury yield curve graphically illustrates the term structure of interest rates by illustrating for a particular day the interest rates on treasury bonds of different maturities
What are three key facts about the term
1) interest rates on long-term bonds are usually higher than interest rates on short-term bonds; 2) interest rates on short-term bonds are occasionally higher than interest rates on long-term bonds; and 3) interest rates on bonds of all maturities tend to rise and fall together.
Briefly describe the three theories of the term
1) Segmented market theory: Holds that the market for bonds of different maturities are completely separated from each other. 2) Liquidity premium theory: Holds that interest rates on long-term bonds are averages of the expected interest rates on short-term bonds plus a term premium. 3) Expectations theory: Holds that interest rates on long-term bonds are an average of the interest rates investors expect on short-term bonds over the lifetime of the long-term bond.
What is the difference between the nominal exchange rate and the real exchange rate? When a
newspaper article uses the term "the exchange
rate," is it typically referring to the nominal exchange rate or the real exchange rate?
The nominal exchange rate is the price of one country's currency in terms of another country's currency. That is, nominal exchange rates tell you how many yen or euros or Canadian dollars you will receive in exchange for a U.S. dollar, but they do not tell you how much of another country's goods and services you can buy with a U.S. dollar. When we are interested in the relative purchasing power of two countries' currencies, we use the real exchange rate, which measures the rate at which goods and services of one country can be exchanged for goods and services of another country. The newspapers are generally referring to the nominal exchange rate.
If the exchange rate between the yen and the
dollar changes from ¥80 = $1 to ¥90 = $1, has
the yen appreciated or depreciated against the
dollar? Has the dollar appreciated or depreciated
against the yen?
The yen has depreciated against the dollar. The dollar has appreciated against the yen.
What is the difference between a direct
quotation of an exchange rate and an indirect
Direct quotations are exchange rates as units of domestic currency per unit of foreign currency. Indirect quotations express exchange rates as units of foreign currency per unit of domestic currency.
Suppose that the euro falls in value relative to
the dollar.What is the likely effect on European exports to the United States? What is the likely
effect on U.S. exports to Europe?
European exports will increase, while U.S exports to Europe will decrease.
What does it mean to describe the foreign exchange
market as an "over-the-counter market"?
Over-the-counter is a market consisting of dealers linked together by computers, rather than a physical place.
What is the difference between a spot transaction
and a forward transaction in the foreign exchange
The difference is trade today (spot transaction) versus trade in future (forward transaction).
What are the key differences between foreign exchange forward contracts and foreign exchange
futures contracts? Why are forward contracts more widely used in the foreign exchange
market than are futures contracts?
Forward contracts are private agreements among traders to exchange any amount of currency on any future date. Futures contracts are traded on exchanges and are standardized, including a stated settlement date. With forward contracts, the exchange rate is fixed at the time the contract is agreed to, while with futures contracts the exchange rate changes continually as contracts are bought and sold on the exchange. Forward contracts are used 10 times more than futures contracts because the counter party risk between big banks is relatively low, and these banks value the flexibility of the forward contract.
What is exchange-rate risk? How can exchange rate risk be hedged using forward, futures, and
options contracts?
Exchange-rate risk is the risk that a firm will suffer losses because of fluctuations in exchange rates. To hedge against a fall in the exchange rate, firms can sell forward or futures contracts, or buy a put option. To hedge against a rise in the exchange rate, firms can buy forward or futures contracts, or buy a call option
How might an investor use forward, futures, and
options contracts to speculate on the future
value of a currency?
For forward or futures contracts, if an investor becomes convinced that the future value of the euro will be lower than other people in the foreign-exchange market currently believe, the investor can sell euros in the forward or futures market. If the value of the euro falls, then the spot price of the euro in the future will be lower, which will allow the investor to fulfill the forward or futures contract at a profit. Alternatively, the investor could buy a put option on euros. If the euro falls below the strike price, the firm could exercise the option and sell at the (above-market) strike price. If an investor expects the euro to be higher than other people in the market believe, the investor can buy euros in the forward or futures market, or buy a call option on euros.
What is the law of one price? How is it
related to the theory of purchasing power parity
The law of one price is the fundamental economic idea that identical products should sell for the same price everywhere. The law of one price is the basis for the theory of purchasing power parity. PPP is the theory that the exchange rates move to equalize the purchasing power of different currencies.
Is PPP a theory of exchange rate determination
in the long run or in the short run?
PPP is a theory of exchange rate determination in the long run.
According to the theory of purchasing power
parity, if the price level in Great Britain rises
more slowly than the price level in Canada, what
should happen to the exchange rate between the
British pound and the Canadian dollar in the
long run?
The British pound will appreciate compared to the Canadian dollar because of the lower inflation in Great Britian than in Canada.
What is a tariff? What is a quota? What are the
implications of tariffs and quotas for the theory
of PPP?
A tariff is a tax imposed on imports. A quota is a limit a government imposes on the quantity of a good that can be imported. Tariffs and quotas prevent exchange rates from following the law of one price and, therefore, purchasing power parity.