MKT 310 - Chapter 10 Review
According to lecture, what is the impact of a Strong U.S. Dollar on Consumer Purchases? How is it affected by a Weak U.S. Dollar?
- *When the Dollar is Strong:* A dollar can buy more foreign products, Imports become cheaper, Inflation stays low - *When the Dollar is Weak:* Imports become more expensive, the price of everyday goods increase, Inflation could increase
According to lecture, what is the impact of a Strong U.S. Dollar on Domestic Companies? How is it affected by a Weak U.S. Dollar?
- *When the Dollar is Strong:* Domestic Companies have difficulty competing with imports, supplies and commodities are cheaper - *When the Dollar is Weak:* Imports cost more, so Domestic Companies find it easier to compete. However, imported supplies and commodities now cost more
According to lecture, what is the impact of a Strong U.S. Dollar on Foreign Travel? How is it affected by a Weak U.S. Dollar?
- *When the Dollar is Strong:* Foreign prices feel cheaper, consumers may start to think that travel abroad is affordable - *When the Dollar is Weak:* Foreign prices are expensive, customers find it more difficult to travel abroad
If the value of the U.S. Dollar were to depreciate relative to the Euro (that is, it is less valuable than the Euro), how would it influence the price of Imports and Exports between these countries?
- American goods would become cheaper in Europe, boosting Export sales - European goods would become more expensive in the U.S., which would hurt the sales and profits of European companies that sell goods to the U.S.
What are the two ways in which an Exchange Rate can be quoted?
- As the amount of foreign currency one U.S. dollar will buy - As the value of a dollar for one unit of foreign currency
What is a Lead Strategy?
- Collecting Foreign Currency Receivables (payments from customers) early when a foreign currency is expected to Depreciate - Paying Foreign Currency Payables (to suppliers) before they are due when a foreign currency is expected to Appreciate
Many economists believe the Foreign Exchange Market is efficient at setting Forward Exchange Rates. According to the perspective of the Efficient Market School, what are the implications of this?
If Forward Rates reflect all available information about likely future changes in Exchange Rates, a company cannot beat the market by investing in forecasting services - An Efficient Market is one in which prices reflect all available public information - If the Foreign Exchange Market is Efficient, Forward Exchange Rates should be unbiased predictors of future Spot Rates
What is a Lag Strategy?
- Delaying the Collection of Foreign Currency Receivables (payments from customers) if the foreign currency is expected to Appreciate - Delaying Payables (to suppliers) if the foreign currency is expected to Depreciate
What are the 4 main methods of Managing Translation and Transaction Exposure?
- Forward Contracts - Swaps - Lead Strategy - Lag Strategy
What are the two main approaches to Forecasting?
- Fundamental Analysis - Technical Analysis
What is Technical Analysis?
A method of Forecasting that uses price and volume data to determine past trends, which are expected to continue into the future - Technical Analysis does NOT rely on a consideration of economic fundamentals - Instead, Technical Analysis is based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves
What is the Purchasing Power Parity (PPP) Theory?
A theory stating that Exchange Rates are determined by relative prices. That is, changes in relative prices will result in a change in Exchange Rates - The theory argues that in a relatively efficient market, the price of a "basket of goods" should be roughly equivalent in each country - EX: If a basket of goods costs $200 in the U.S. and ¥20,000 in Japan, the PPP Theory predicts that the Dollar/Yen exchange rate should be $1 = ¥100
True or False: Without the Foreign Exchange Market, the degree of international trade and investment we see today would still be possible
False - Without the Foreign Exchange Market, International Trade and International Investment on the scale we see today would be impossible - Without it, companies would have to resort to barter
True or False: The currencies of every country are freely convertible into other currencies
False - Due to government restrictions, a significant number of currencies are not freely convertible into other currencies
True or False: The PPP Theory seems to best predict short-term Exchange Rate movements between the currencies of advanced industrialized nations that have relatively small differentials in Inflation Rates
False - The PPP Theory seems to best predict exchange rates for countries with high rates of Inflation and underdeveloped capital markets - The PPP theory is less useful for predicting short-term Exchange Rate movements between the currencies of advanced industrialized nations that have relatively small differentials in Inflation Rates
True or False: Forms of Currency Speculation, such as Carry Trade, will almost always be profitable
False - The success of Carry Trade, for instance, is based on the belief that there will be no adverse movements in exchange rates (or interest rates) that will make the trade unprofitable
True or False: To finance public expenditure projects such as building roads and paying government workers, Governments typically raise taxes
False - While raising taxes to finance public expenditure projects would be a perfectly reasonable course of action, Governments typically decide against doing it - Instead, Governments typically increase the Money Supply. Keep in mind that Government policy determines whether the rate of growth in a country's Money Supply is greater than the rate of Growth in Output.
How does the increase in a country's Money Supply influence the status of its currency in the Foreign Exchange Market?
If a country's Money Supply is growing more rapidly than its output of goods and services, its currency will be relatively more plentiful than the currencies of countries where monetary growth is on par with output growth - As a result of the relative increase in the supply of this currency, its value will depreciate on the Foreign Exchange Market relative to the currencies of countries with slower monetary growth
Other economists believe that the Foreign Exchange Market is Inefficient. According to the perspective of the Inefficient Market School, what are the implications of this?
In an Inefficient Market, Forward Exchange Rates would NOT be the best possible predictors of Future Spot Exchange Rates - Thus, it would be worthwhile for International Businesses to invest in Forecasting Services - The belief is that professional Exchange Rate Forecasts might provide better predictions of Future Spot Rates than Forward Exchange Rates do
What is an Inefficient Market?
One in which prices do NOT reflect all available information - In such a market, Forward Exchange Rates would NOT be the best possible predictors of Future Spot Exchange Rates
What ultimately determines the value of a currency?
The value of a currency is determined by the interaction between the Demand and Supply of that currency relative to the Demand and Supply of other currencies - EX: If Demand for the U.S. Dollar is High and in short Supply, and Demand for the Euro is Low and in plentiful supply, the U.S. Dollar is likely to appreciate relative to the Euro
In what way does Economic Exposure differ from Transaction Exposure?
Unlike Economic Exposure, Transaction Exposure is concerned with the effect of exchange rate changes on individual transactions. Most of these are short-term affairs that will be executed within a few weeks or months - Economic Exposure is concerned with the long-run effect of changes in Exchange Rates on Future Prices, Sales, and Costs
Ultimately, what is the purpose of a firm entering a Forward Exchange Contract?
When a firm enters into a Forward Exchange Contract, it is taking out insurance against the possibility that future Exchange Rate Movements will make a transaction unprofitable by the time that the transaction has been executed
True or False: Although foreign exchange transactions can involve any two currencies, most transactions involve dollars on one side. In fact, this is true even when a dealer wants to sell a non-dollar currency to buy another non-dollar currency
True - A dealer wishing to sell Mexican pesos for Japanese yen, for example, will usually sell the pesos for dollars and then use the dollars to buy yen
True or False: PPP Theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations
True - Dominant enterprises may engage in Price Discrimination - They might also be able to control distribution channels, which would limit the unauthorized resale (arbitrage) of products purchased in another national market
True or False: External Convertibility Restrictions can limit domestic companies' ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country
True - EX: Even if the Japanese government tightly controlled the ability of its residents to convert the Yen into U.S. dollars, all U.S. businesses with deposits in Japanese banks may convert their yen into dollars and take them out of the country
True or False: In the long-run, there appears to be a relationship between Interest Rate differentials and subsequent changes in Spot Exchange Rates
True - However, the IFE is not an excellent predictor of short-run changes in Spot Exchange Rates
True or False: A rise in Import prices may lead to further increases in Inflation
True - This provides another rationale for limiting Convertibility
True or False: When the growth in a country's money supply is faster than the growth of its output, the result is typically Price Inflation
True - Note that the PPP Theory states that a country with a high Inflation Rate will see depreciation in its Currency Exchange Rate
What is Hedging?
Hedging refers to when a firm insures itself against foreign exchange risk
If an International Business is attempting to predict future movements in the value of a country's currency on the Foreign Exchange Market, why should it examine that country's policy toward Monetary Growth?
- If the government seems committed to controlling the rate of growth in the national Money Supply, the country's future Inflation Rate may be Low and its Currency should not Depreciate as much on the Foreign Exchange Market - If the government seems to lack the political will to control the rate of growth in the national Money Supply, the country's future Inflation Rates may be High, which would cause its currency to Depreciate
In the Short-Run, what supposedly provides the best predictors of Exchange Rate Movements? What about in the Long-Run?
- In the Short-Run, Forward Exchange Rates provide the best predictors of Exchange Rate Movements - In the Long-Run, Fundamental Economic Factors (particularly Relative Inflation Rates) should be watched because they influence exchange rate movements
Why would a National Government want to avoid a run on its Foreign Exchange Reserves?
- It would limit the country's ability to service its International Debts - It would limit the country's ability to pay for Imports - As Residents and Nonresidents unload their holdings of domestic currency on the foreign exchange markets and increase the market supply of the country's currency, the exchange rate for the country's currency will Depreciate
According to the text, what factors can influence Investor Psychology?
- Political Factors - Microeconomic Events (investment decisions of individual firms, etc) - Bandwagon Effects
According to most economic theories of Exchange Rate Movements, what three factors have an important impact on Future Exchange Rate movements in a country's currency?
- The Country's Price Inflation - The Country's Interest Rate - Market Psychology
A company's need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid decision making. What two schools of thought address this issue?
- The Efficient Market School - The Inefficient Market School
According to the text, two features of the Foreign Exchange Market are of particular note. What are they?
- The Foreign Exchange Market is constantly operational (it "never sleeps") - The Foreign Exchange Market's integration of various trading centers has effectively created a single market
What factors explain the failure of the PPP Theory to predict Exchange Rates more accurately?
- The PPP Theory assumes away Transportation Costs, which can be significant for many goods - The PPP Theory also assumes away barriers to trade. Because governments can and do intervene in cross-border trade, the link between relative price changes and changes in Exchange Rates is weakened
Why are Lead and Lag Strategies difficult to implement?
- The firm must be in a position to exercise some control over payment terms - Because lead and lag strategies can put pressure on a weak currency, many governments limit Leads and Lags
What are the two main functions of the Foreign Exchange Market?
- To convert the currency of one country into the currency of another - To provide insurance against Foreign Exchange Risk
International Businesses have four main uses of Foreign Exchange Markets. What are they?
- To convert the payments it receives for its exports and the income it receives from foreign investments/licensing agreements into its home currency - To pay a foreign company for its products or services in its country's currency - When the business has extra cash that it wishes to invest for short terms in money markets - Currency Speculation
What are the three main categories of Foreign Exchange Rate Risk?
- Transaction Exposure - Translation Exposure - Economic Exposure
What is a Currency Swap? When do Currency Swaps typically take place?
A Currency Swap refers to the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates - Currency Swaps are transacted between International Businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring Foreign Exchange Risk
What is a Forward Exchange? What are Forward Exchange Rates?
A Forward Exchange is a transaction in which two parties agree to exchange currency and execute a deal at some specific date in the future - The Forward Exchange Rate is the Exchange Rate governing a Forward Exchange transaction
When do Governments typically impose Convertibility Restrictions?
A Government will typically impose Convertibility Restrictions on their currency when they fear that free Convertibility will lead to a run on their foreign exchange reserves - This often occurs as a result of Capital Flight
What is a Spot Exchange? What is the Spot Exchange Rate?
A Spot Exchange refers to a transaction in which two parties agree to exchange currency and execute a deal immediately - The Spot Exchange Rate is the Exchange Rate at which a Foreign Exchange dealer will convert one currency into another that particular day
What is a Vehicle Currency? What are the 4 most important Vehicle Currencies?
A Vehicle Currency is a currency that plays a central role in many foreign exchange deals - The U.S. Dollar, the Euro, the Japanese Yen, and the British pound are the most important Vehicle Currencies
What does it mean for a country's currency to be Externally Convertible?
A country's currency is Externally Convertible when only Nonresidents may convert it into a Foreign Currency without any limitations - That is, a country places restrictions on their Residents' ability to convert the Domestic Currency into a Foreign Currency
What does it mean for a country's currency to be Freely Convertible?
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
What does it mean for a country's currency to be Nonconvertible?
A country's currency is Nonconvertible when neither Residents nor Nonresidents are allowed to convert it into a Foreign Currency
What is 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 rates are high - EX: If the interest rate on borrowings in Japan is 1% but the interest rate on deposits in American banks is 6%, it can make sense to borrow in Japanese Yen, convert the money into U.S. dollars, and deposit it into an American bank. This would yield a 5% margin
What is the Foreign Exchange Market?
A market for converting the currency of one country into that of another country
What is an Efficient Market?
A market in which prices reflect all available information - In a perfectly Efficient Market, there are no impediments to the free flow of goods and services
What is Fundamental Analysis?
A method of Forecasting that draws on economic theory to construct sophisticated econometric models for predicting Exchange Rate movements
What is a Forward Contract?
An agreement to buy a currency for a fixed price at a future date - EX: In a transaction between a U.S. Firm and a Japanese Firm, the U.S. firm will provide payment at the exchange rate in place at the time of the deal. Even if the value of the Yen appreciates relative to the Dollar prior to the actual payment period, the U.S Firm will only be required to provide payment at the agreed-upon exchange rate.
What is the "Big Mac Index"? What is the Big Mac PPP?
An index comparing a country's actual Exchange Rate with the one predicted by the PPP theorem based on relative prices of Big Macs in order to determine whether a currency is Overvalued/Undervalued relative to the Dollar - The Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country
What is Arbitrage? How often do opportunities for Arbitrage arise?
Arbitrage refers to the purchase of securities in one market for immediate resale in another market in order to profit from a price discrepancy - Because Foreign Exchange Dealers are always watching their computer screens for Arbitrage Opportunities, the few that arise tend to be small and fleeting
Why is the movement of Foreign Exchange Rates in the future valuable information for International Businesses?
Because Future Exchange Rate Movements influence: - Export Opportunities - The Profitability of International Trade and Investment Deals - The Price Competitiveness of Foreign Imports
Why is it so difficult to forecast Exchange Rate Movements in the Short-Term?
Both Investor Psychology and Bandwagon effects play an important role in determining Short-Run Exchange Rate Movements - Thus, it is very difficult to forecast Short-Term changes in Exchange Rates
What is Capital Flight? When is it most likely to occur?
Converting domestic currency into foreign currency - Capital Flight is most likely to occur when the value of the domestic currency is Depreciating rapidly because of hyperinflation or when a country's economic prospects are shaky in other respects - In this case, both Residents and Nonresidents tend to believe that their money is more likely to hold its value if its is converted into a foreign currency and invested abroad
True or False: Countertrade is more significant today than it was 20 years ago
False - 20 years ago, a large number of nonconvertible currencies existed in the world and Countertrade was quite significant - In recent years, many governments have made their currencies Freely Convertible, and the percentage of world trade that involves Countertrade is quite low
True or False: Empirical evidence suggests that both PPP and the IFE are excellent tools to use for explaining Short-Term movements in Exchange Rates
False - Empirical evidence suggests that neither PPP theory nor the IFE is particularly good at explaining Short-Term movements in Exchange Rates - However, Investor Psychology has a profound effect on Short-Term movements in Exchange Rates
True or False: Consider a U.S. company that has $10 million that it wants to invest for 4 months. Given that the interest rate in South Korea's money market account is much higher than that of the U.S., the firm decides to change its $10 million into won and invest it in a South Korean bank. Thus, the rate of return that the U.S. company earns depends solely on the South Korean interest rate
False - The rate of return the U.S. company earns on this investment depends not only on the South Korean interest rate, but also on the changes in the value of the Korean won against the U.S. dollar during the 4-month period
What problems can arise for International Businesses when they are operating in a country under a policy of Non-Convertibility?
For instance, consider a U.S. multinational operating in Russia shortly after the collapse of the Soviet Union. - When strictly applied, Non-Convertibility means that although a U.S. company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert these rubles into dollars and take them out of the country
What do Forward Exchange Rates represent?
Forward Exchange Rates represent Market Participants' collective predictions of likely Spot Exchange Rates at specified future dates
Why do Governments limit the Convertibility of their currency?
Governments limit Convertibility to preserve their Foreign Exchange reserves - A country needs an adequate supply of these reserves to service its international debt commitments and to purchase imports
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 when their price is expressed in the same currency - EX: Assume that the exchange rate between the British pound and the dollar is £1 = $2. A jacket in London retails for £40 and in the U.S. for $80. - EX: At the same exchange rate, assume the jacket now costs £30 in London (which is $60 in America) and $80 in the U.S.. If someone were to buy the jacket in London and sell it in the U.S. (Arbitrage), they could earn a $20 margin. However, prices between the two countries would eventually equalize as the Demand for the jacket increases in London (Price Increase) and Supply for the Jacket increases in the U.S. (Price Decrease)
Describe the relationship between Inflation Rates and Interest Rates
In countries where Inflation is expected to be high, Interest Rates will also be high because investors want compensation for the decline in the value of their money - This is known as the Fisher Effect
What is Inflation? What causes Inflation to occur?
Inflation is a monetary phenomenon in which the quantity of money in circulation rises faster than the stock of goods and services - An increase in a nation's Money Supply makes it easier for banks to borrow from the government and for individuals and companies to borrow from banks. This resulting increase in credit causes increases in the demand for goods and services. - Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be inflation
How can International Businesses deal with the Non-Convertibility issue?
International Businesses can engage in Countertrade
What is Currency Speculation?
Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in Exchange Rates - EX: Assume that the current Dollar/Yen Exchange Rate is $1 = ¥120. Expecting the value of the U.S. dollar to depreciate relative to the Japanese yen, a U.S. company exchanges $10 million for ¥1.2 billion. 4 months later, the Dollar/Yen Exchange Rate is $1 = ¥100. When the U.S. company exchanges its ¥1.2 billion for U.S. dollars, it finds that it has made a $2 million profit ($12 million is received)
According to the text, London has largely dominated the Foreign Exchange Market. What are the two main reasons for this?
London's dominance in the foreign exchange market is due to both history and geography - As the capital of the world's first major industrial trading nation, London had become the world's largest center for international banking by the end of the 19th century, a position it has retained to this day
What can be used to forecast Long-Term Exchange Rate Movements?
Relative Monetary Growth, Relative Inflation Rates, and Nominal Interest Rate Differentials are all moderately good predictors of Long-Run changes in Exchange Rates - They are poor predictors of Short-Run changes in Exchange Rates. This may be due to the impact of Psychological Factors, Investor Expectations, and Bandwagon Effects on short-term currency movements
What is the main risk associated with Spot Exchanges?
Spot Exchange Rates change continually, often on a minute-by-minute basis - Although the magnitude of these changes are usually small, they are still changing on a frequent basis
What is the main argument made by the Efficient Market School?
The Efficient Market School argues that Forward Exchange Rates do the best possible job of forecasting Future Spot Exchange Rates - Thus, investing in Forecasting Services would be a waste of money
What is the main argument made by the Inefficient Market School?
The Inefficient Market School argues that companies can improve the Foreign Exchange Market's estimate of Future Exchange Rates by investing in Forecasting Services - That is, the Inefficient Market School does NOT believe that Forward Exchange Rates are the best possible predictors of Future Spot Exchange Rates
Assume that the yen/dollar Exchange Rate quoted in London is ¥120 = $1. At the exact same time, the yen/dollar Exchange Rate in New York is ¥125 = $1. Explain how a U.S. Foreign Exchange Dealer could take advantage of this Arbitrage Opportunity with the $1 million that they have on hand. For how long would this Arbitrage Opportunity last?
The U.S. dealer could use the $1 million buy ¥125 million in the New York market (where the Yen is relatively less valuable) and then immediately sell the ¥125 million to the London market (where the Yen is relatively more valuable) in exchange for U.S. Dollars. This would result in a profit of $41,666. - If all dealers attempted to cash in on this opportunity, the demand for Yen in New York would rise. This would result in an appreciation of the Yen relative to the dollar such that the price differential between New York and London would disappear
According to the textbook, running a deficit on a Balance-of-Payments Current Account can create pressures that may result in the depreciation of the country's currency on the Foreign Exchange Market. Using the U.S. Current Account Deficit as an example, how this may occur?
The U.S. has been running a persistent Current Account Balance-of-Payments Deficit for many years - Because the U.S. is importing more than it is exporting, people in other countries would be increasing their holdings of U.S. dollars - If people converted their U.S. dollars into other currencies, the supply of dollars in the foreign exchange market would increase - This shift in Demand and Supply would create pressures that could potentially lead to the depreciation of the dollar against other currencies
What is Economic Exposure?
The extent to which a firm's future international earning power is affected by changes in Exchange Rates - Economic Exposure is concerned with the long-run effect of changes in Exchange Rates on Future Prices, Sales, and Costs - EX: Medical equipment exporters becoming less competitive when the U.S. dollar strengthens
What is Transaction Exposure?
The extent to which income from individual transactions is affected by fluctuation in foreign exchange value - Transaction Exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies - EX: You sign a contract to pay for goods in a foreign currency 6 months from now
How can information about the growth in a nation's money supply be used to forecast Exchange Rate Movements?
The growth of a country's Money Supply determines its likely future Inflation Rate - If a country's future Inflation Rate can be predicted, we can also predict how the value of its currency relative to other currencies (its Exchange Rate) is likely to change - EX: A country in which Price Inflation is rampant should expect to see its currency depreciate against that of countries in which Inflation Rates are lower
What is Translation Exposure?
The impact of Currency Exchange rate changes on the reported financial statements of a company - Translation Exposure is concerned with the present measurement of past events - The Resulting accounting Gains or Losses are said to be Unrealized - EX: If an American firm has a subsidiary in the European Union and the value of the Euro Depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary, resulting in negative Translation Exposure
What is Countertrade?
The trade of goods and services for other goods and services - EX: A Venezuelan government negotiated a contract with Caterpillar under which Venezuela would trade 350,000 tons of iron ore for Caterpillar heavy construction equipment. The Iron ore was sold to Romania in exchange for farm products, which were then sold on International Markets for dollars
According to the text, what is the key to reducing Economic Exposure?
The key to reducing Economic Exposure is to distribute the firm's productive assets to various locations so the firm's long-term financial well-being is not severely affected by adverse changes in exchange rates - EX: Fearing that the euro would continue to strengthen against the U.S. dollar, some European firms that did significant business in the U.S. established local production facilities in that market to ensure that a rising euro did not put them at a competitive disadvantage relative to their local rivals
What is the Bandwagon Effect?
The movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceived actions
What is a Currency Swap?
The practice of buying a currency now and agreeing to sell it for a fixed price at a future date
What is an Exchange Rate?
The rate at which one currency is converted into another
What is Foreign Exchange Risk?
The risk that changes in Exchange Rates will hurt the profitability of a business deal
What is Price Discrimination?
The setting of different prices in different markets to reflect varying demand conditions
What is the International Fisher Effect (IFE)?
The theory that describes the link between Interest Rates and Exchange Rates - In simple terms, High Inflation --> High Interest Rates --> Weaker Currency - EX: If the U.S. nominal interest rate is higher than Japan's, this would reflect greater expected Inflation Rates in the U.S.. Thus, the value of the dollar against the yen should fall by that Interest Rate differential in the future - EX: If the Interest Rate is 10% in the U.S. and 6% in Japan, we would expect the value of the dollar to depreciate by 4% relative to the yen
What is Short Selling?
This occurs when one borrows and sells money of one currency type in exchange for currency of another type with the intention of buying back the currency that was initially sold at a more favorable exchange rate
If the interest rate on borrowings in Japan is 1% but the interest rate on deposits in American banks is 6%, it can make sense to borrow in Japanese Yen, convert the money into U.S. dollars, and deposit it into an American bank. However, what would happen if the value of the Japanese Yen appreciated relative to the U.S. Dollar during this period?
This trade might become unprofitable if the yen were to appreciate relative to the dollar - That is, it would take a greater number of U.S. dollars to repay the original loan that was borrowed from the Japanese bank
How is the Big Mac Index calculated? According to the PPP Theory, what is the interpretation of this calculation?
To calculate the Big Mac Index, the price of a Big Mac in a country is converted into dollars at the current exchange rate and is then divided by the average price of a Big Mac in America - According to the PPP Theorem, the prices should be the same. If they are not, it implies that the currency is either Overvalued or Undervalued relative to the dollar
True or False: Both Currency Swaps and Forward Exchange Contracts enable a firm to insure itself against Foreign Exchange Risk
True
True or False: While the PPP Theory seems to yield relatively accurate predictions in the long-term, it does not appear to be a strong predictor of short-term movements in exchange rates covering time spans of five years or less
True
True or False: If the Law of One Price were true for all goods and services, the Purchasing Power Parity (PPP) Exchange Rate could be found from any individual set of prices
True - By comparing the prices of identical products in different currencies, it would be possible to determine the "real" exchange rate that would exist if markets were efficient
True or False: The Foreign Exchange Market is not located in any one place
True - The Foreign Exchange Market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems - The foreign exchange market has been growing at a rapid pace, which reflects a general growth in the volume of cross-border trade and investment
True or False: Many companies seem to focus on reducing their Transaction and Translation Exposure and pay little attention to Economic Exposure
True - While Transaction and Translation Exposure have Short-Term Implications, Economic Exposure may have more profound Long-Term Implications - For instance, failing to hedge against Economic Exposure may put firms at a disadvantage relative to their competitors
When investors are free to transfer capital between countries, what can be said of the Interest Rates in every country?
When investors are free to transfer capital between countries, real Interest Rates will be the same in every country - If differences in real interest rates did emerge between countries, Arbitrage would soon equalize them - EX: If the real interest rate in Japan was 10% and only 6% in the U.S., investors would borrow money from the U.S. and invest it in Japan. This would increase the demand for money in the U.S., raising its real interest rate. It would also increase the supply of foreign money in Japan, which would lower the real interest rate there.
Imagine that the current Pound/Euro Exchange Rate is €1.00 = $1.25. An American tourist who is visiting Europe wants to purchase a bottle of French wine that costs €30. How much would this same bottle of wine cost in terms of American Dollars?
€30 x $1.25 = $37.50
