IB chapter 10

forward market transactions

- in the form of contracts - forward contracts allow firms to lock in a rate of exchange on funds required in the future

interest rate parity

- real interest rates become equal through arbitrate - if the nominal interest rate in one country is lower than that in another, the first country's inflation rate is expected to be lower so that real interest rates are equal.

spot exchange rates

- when two parties agree to exchange currency and execute the deal immediately. - exchange rates governing such "on the spot" trades - define: the rate at which a foreign exchange dealer converts one currency into another currency on a particular day - reported on a real time basis - change continually, often a min-by-min basis

international trade involves two transactions:

1) the transfer of merchandise, services and portfolio products, and 2) the exchange of currencies

foreign exchange markers serves two main functions:

1- convert the currency of one country into the currency of another 2 - provide some insurance against foreign exchange risk (adverse consequences of unpredictable changes in exchange rates)

4 main uses of foreign exchange markets by international businesses

1. the payments a company receives for its exports, the income from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign countries. to use those funds in its home country, the company must convert them to its home country's currency 2. international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country's currency 3. use foreign exchange markets when they spare cash that they wish to invest for short terms in money markets. 4. currency speculation

The foreign exchange market never sleeps. Tokyo, London, and new york are all shut for only ______ hours, but trading continues in a number of minor centers (san fran and sydney). the various trading centers are very integrated.

3

More demand leads to a strengthening of a currency against others

Less demand leads to a weakening of that currency against others

foreign exchange market

a market for converting the currency of one country into that of another - provides some insurance against the risks that arise from such volatile changes in exchange rates (foreign exchange risk). does not provide complete insurance. there are unpredicted changed in exchange rates. - not located in any one place, it is a global network of banks, brokers, and foreign exchange dealers connected by electronic communication - when companies wish to convert currencies, they usually go through their own banks rather than entering into the market directly - it has grown rapidly, from $200 billion per day (1986) to $5.3 trillion a day (2013)

Cross Rate

an exchange rate computed from two other exchange rates EXAMPLE: exchange rate of argentina peso/ brazil real: Arg.Peso 9.3940 US $ Arg. Peso 9.3940 ___________________ X ________________ = ________________ US $ Braz.Real 4.1767 BR 4.1767

interbank market

banks dealing with other banks in large volume, usually involving transactions exceeding $1M

the spread in the spot market is the difference between the _____ and _____ rates

bid and offer

the pound is ?

british currency

value of currency is determined by the interaction between the ________ and _________ of that currency relative to the ________ and ________ of other currencies

demand and supply

big mac index

economists look at real exchange rates

Foreign exchange risk is the adverse consequences of unpredictable changes in _________

exchange rates

the euro is?

france, germany, and 17 other members of euro zone

secondary trading centers are:

frankfurt, paris, hong kong, and sydney

The foreign exchange market enables an international business to __________

pay for foreign products

A forward exchange rate gives the holder the right to exchange currency for a point in the future at a(n)

predetermined exchange rate

brokers

professionals who assist in the transfer of funds between banks and find most favorable currency prices

forward rate

rate quoted for transactions that call for delivery at some future date

short-range vs long-range predictors

short range: - psychological effects (don't need to know for exam) - bandwagon effects (don't need to know for exam) - investor expectations long-range: -relative monetary growth (the money supply should be increased as same rate as demand for goods & services) -relative inflation rates (when a countries money supply grows faster than demand for goods & services, inflation increases) - nominal interest rate differentials (nominal interest rate in the sum of the required "real" rate of interest and the expected rate of inflation during a loan period. a strong relationship exists between nominal interest rates and exchange rates.)

spot exchange rate vs. forward exchange rate

spot: real time (price of currency now), based on supply & demand changes, conversion happens within a day or two forward: majority use (2/3 of all transactions), future time, guarantees (insurance, reduces uncertainty)

forward premium

the foreign exchange dealers expectations that the dollar will appreciate against the yen over the next 30/90/180..days *** when the forward rate is more than the spot rate

arbitrage

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy. aka * buying a currency low and selling it high *

exchange rate

the rate at which one currency is converted into another an exchange rate of 1euro = $1.30. means that 1 euro buys 1.30 US dollars - allows us to compare the relative prices of goods and services in different countries

bandwagon effect

traders moving as a herd in the same direction at the same time in response to each others actions.

hard (vehicle) currency

usually fully convertible, strong and/or stable in value in comparison with other currencies

the dollar is a _________ currency. It has a central role in so many foreign exchange deals. **** 89% of all foreign exchange transactions involved the dollar on one side of the transactions. next was euro (33%) next was yen (23%) next was pound (12%)

vehicle

hedging

when a firm insures itself against foreign exchange risk by buying forward exchanges that guarantee that at some point in the future the company can use a current exchange rate in future trades as if it were predetermined. risky bc expensive and also uncertainty. may lose or gain money but you never know what exchange rates will do.

forward discount

when foreign exchange dealers expected the dollar to depreciate against another currency in the 30/90/180/future days than with a spot exchange *** when forward rate is worth less than on the spot market

nonconvertible

when neither residents nor nonresidents are allowed to convert it into a foreign currency.

externally convertible

when only nonresidents may convert it into a foreign currency without any limitations

freely convertible

when the country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it.

forward exchange

when two parties agree to exchange currency and execute the deal at some specific date in the future - future transactions - most major currencies, forward exchange rates are quoted for 30, 90, and 180 days into the future

central banks

national banks that implement government policies regarding currency values

direct quote/rate

number of units of the domestic currency needed to acquire one unit of the foreign currency - matters where foreign trader is & thats how direct quota is found --> ex: if we are in the US, a direct quote would be $/foreign currency if we are in Japan, a direct quote would be yen/foreign currency

indirect quote

number of units of the foreign currency needed to acquire one unit of the domestic currency ex: if we are in the US --> foreign currency/US $ if we are in Japan ---> foreign currency/ yen

soft currency

mostly not convertible comparatively weak and unstable un value looses its value over time

Inflation is a monetary phenomenon....

It occurs when the quantity of money in circulation rises faster than the stock of goods and services—that is, when the money supply increases faster than output increases.

carry trade

a common type of speculation involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another country where interest rates are high.

the PPP theory tells us that...

a country with a high inflation rate will see depreciation in its currency exchange rate 1980s- bolivia - hyperinflation

currency speculation

involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. - very risky business - example: Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 = ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million!

the Yen is?

japan currency

purchasing power parity (PPP)

links changes in the exchange rate between two countries currencies to changes in the countries price levels. - brings in the issue of exchange rates/ inflation (that law of one price does not) **** it is a theory that brings in the issue of inflation./ exchange rates to explain the law of one price currencies across countries that is reflected in the exchange rate **** An economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power. S= p1$/p2foreign "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1US DOLLAR "P2" represents the cost of good "x" in currency 2FOREIGN

most important foreign exchange trading centers

london, New York, zurich, tokyo, and singapore.

fisher effect

states that a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). More formally, states that a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). i = r + I For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. a strong relationship exists between inflation rates and interest rates. in USA r= 5% in JAPAN r= 2% borrow at 2% in japan, invest at 5% in USA and make a 3% profit. - causes interest rate in japan to go UP because the high demand for currency - causes interest rates in usa to go DOWN because of the large supple of currency

international fisher effect

states that 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 the two countries. - real interest becomes equal through arbitrage - real interest rate + inflation = nominal interest rate - combines interest rates, inflation, and exchange rates - the currency of the country with the lower nominal interest rate is expected to strengthen in the future.

the law of one price

states that 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 terms of the same currency. - acts as if there are no exchange rates in the world - its about the issue of arbitrage - buy at low price, sell at high price to make a profit -- continue this process until the prices in the separate countries are the same - taking advantage of price discrepancies to make money because of exchange rates among currencies - handbag is $100 in USA and 24,000yen in Japan and after currency conversion with exchange rates 120yen/$ = $200 in japan. actually less in USA - under completely free trade, prices of comparable goods should be equivalent across countries - in an EFFICIENT MARKET, the price of goods should only be ONE PRICE

When buying a good from one country, you have to pay for it in _________________

that country's currency

two quotes that are given by the foreign exchange trader are?

the bid (buy) and the offer (sell) rates

At the most basic level, exchange rates are determined by .....

the demand and supply of one currency relative to the demand and supply of another.