Chapter 10: The Foreign Exchange Market

True

(True-or-False) Higher interest rates usually reflect high levels of inflation

True

(True-or-False) Monetary growth, inflation rates, and interest rates are moderately good predictors of long-run changes in FX rates but not short-term changes because of psychological factors

True

(True-or-False) Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones

True

(True-or-False) When a domestic currency appreciates against other foreign currencies it can have a negative impact on the profits and sales of companies

Freely convertible currency

A country's currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency

Nonconvertible currency

A currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency.

Carry trade

A kind of speculation that involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high

Foreign exchange market

A market for converting the currency of one country into that of another country

Efficient market

A market where prices reflect all available information

Lead strategy

Collecting foreign currency receivables early when a foreign currency is expected to depreciate, and paying foreign currency payables before they are due when a currency is expected to appreciate

Capital flight

Converting domestic currency into a foreign currency

Lag strategy

Delaying the collection of foreign currency receivables if that currency is expected to appreciate, and delaying payables if that currency is expected to depreciate

International Fisher Effect

For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries

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 when their price is expressed in the same currency

Currency speculation

Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates

Externally convertible currency

Limitations on the ability of residents to convert domestic currency, though nonresidents can convert their holdings of domestic currency into foreign currency

Bandwagon Effect

Movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceived actions

Fisher Effect

Nominal interest rates (i) in each country equal the required real rate of interest (r) and the expected rate of inflation over the period of time for which the funds are to be lent (I). That is, i = r + I Relationship between interest rates and inflation

Inefficient market

One in which prices do not reflect all available information

Currency swap

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

Spot exchange rate

The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day

Forward exchange rate

The exchange rates governing forward exchange transactions

Economic exposure

The extent to which a firm's future international earning power is affected by changes in exchange rates

Transaction exposure

The extent to which the income from individual transactions is affected by fluctuations in FX values

Translation exposure

The extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuations in FX values

Arbitrage

The purchase of securities in one market for immediate resale in another to profit from a price discrepancy

1. To convert the currency of one country into the currency of another 2. To provide some insurance against foreign exchange risk or the adverse consequences of unpredictable changes in exchange rates

What are the 2 main purposes of the FX market serves?

1. Transaction exposure 2. Translation exposure 3. Economic exposure

What are the 3 FX risk exposures?

1. Inflation 2. Interest rates 3. Market psychology

What are the 3 major factors affecting FX rates?

Hedging

What is it called when one engages in currency insurance?

Forward exchange

When two parties agree to exchange currency and execute a deal at some specific date in the future