FIN 410 Chapter 4 Review

When investors capitalize on currency crisis by borrowing the local currency that is expected to weaken and exchanging it for other currencies will make the local currency's value....

decline substantially. They buy back that currency at a much lower price and repay their loan. Such speculation can add to the downward pressure of the currency's value.

The following equation summarizes the factors that can influence a currency spot rate =

e = f(ChangeINF, ChangeINT, ChangeINC, ChangeGC, ChangeEXP) e = percentage change in the spot rate INF = change in the differential between U.S inflation and the foreign currency's inflation INT = Change in the differential between the U.S interest rate and the foreign country's interest rate INC = Change in the differential between U.S income level and the foreign country's income level GC = change in government controls EXP = change in expectations of future exchange rates

Financial flow transactions are _______ responsive to news.

extremely because decisions to hold securities denominated in a particular currency often depend on anticipated changes in currency values. Sometimes trade related factors and financial factors interact and simultaneously affect exchange rate movements. Chart on pg. 114

The country's government might even attempt to impose....

foreign exchange restrictions in order to stabilize the currency situation, but this may create more panic as local investors rush to move their money out of the country before restrictions are imposed.

If the two countries engage in a large volume of capital flows then....

interest rate fluctuations may be more influential.

Changes in relative inflation rates can affect...

international trade activity, which influences the demand for and supply of currencies and therefore affects exchange rates.

The real interest rate is appropriate for international comparisons of exchange rate movements because....

it incorporates both the nominal interest rate and inflation, each of which influences exchange rates. Other things held constant, a high U.S real rate of interest (relative to other countries) tends to boost the dollar's value.

When a country experiences political problems, its appeal to foreign and local investors disappears. Foreign investors liquidate their investments and move their money out of the country. Local investors may follow the lead of the foreign investors by....

liquidating their investments and selling their local currency in exchange for currencies of other countries so that they can move their money to a safer (more politically stable) environment.

A fifth factor affecting exchange rates is market expectations of future rates. News of a potential surge in U.S inflation may cause currency traders to.....

sell dollars because they anticipate a future decline in the dollar's value. This response places immediate downward pressure on the dollar.

A review of daily exchange rate movements is important to an MNC:

that will need to obtain a foreign currency in a few days and wants to assess the possible degree of movement over that period.

A third factor affecting exchange rates is relative income levels. Because income can affect.....

the amount of imports demanded, it can also affect exchange rates.

The price of a currency is determined by:

the demand for that currency relative to its supply. Thus, for each possible price of a British pound, there is a corresponding demand for pounds and a corresponding supply of pounds for sale (to be exchanged for dollars).

Positive percent change indicates:

the foreign currency has appreciated over the period

Negative percent change indicates:

the foreign currency has depreciated over the period

An exchange rate (at a given time) represents:

the price of the currency or the rate at which one currency can be exchanged for another.

If two countries engage in large volume of international trade but a small volume of international capital flows, then.....

the relative inflation rates will likely more influential.

When the pounds valuation in low....

the supply for sale (to be exchanged for dollars) is smaller, reflecting less British desire to obtain U.S goods.

Many MNCs review exchange rates based on both short and long term horizons because....

they expect to engage in international transactions in both the neat and distant future.

Why do managers of MNCs closely monitor the volatility of currencies they are exposed to?

Because a more volatile currency has more potential to deviate far from what is expected and could have a major impact on their cash flows.

When the pounds valuation is high....

British consumers and firms are more willing to exchange their pounds for dollars to purchase U.S products or securities; hence they supply a greater number of pounds to the market to be exchanged for dollars.

Assume that the U.S inflation rate becomes high relative to Canadian Inflation. Other things being equal, how should this affect the (a) U.S demand for Canadian dollars, (b) supply for Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease and the Canadian dollar's value should increase.

Assume U.S interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound?

Demand for pounds should increase, supply of pounds for sale should decrease, and the pound's value should increase.

U.S interest rates rose relative to the British interest rates. The expected reaction was an increase in the British supply for pounds for sale to obtain more U.S dollars (in order to capitalize on high U.S money market yields). However, if the British government placed a heavy tax on interest income earned from foreign investments.....

Such taxation would likely discourage the exchange of pounds for dollars.

A review of annual rate movements would be more appropriate for a MNC:

That conducts foreign trade every year and wants to assess the possible degree of movements on a yearly basis.

Changes in relative interest rates affect investment in foreign securities, which influences....

The demand for and supply of currencies and thus affects the equilibrium exchange rate.

What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies?

The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal.

Look at graph on pg. 107 (exhibit 4.4). the equilibrium exchange rate is $1.55 because this rate equates:

The quantity of pounds demanded with the supply of pounds for sale.

Consider how the demand and supply schedules displayed on pg. 109 would be affected if U.S inflation suddenly increased substantially while British inflation remained the same. (Assume that both British and U.S goods can serve as substitutes for each other).

The sudden jump in U.S inflation should cause some U.S consumers to buy more British products instead of U.S products. There would be an increase in the U.S demand for British goods, which represents an increase in the U.S demand for British pounds. The increased U.S demand for pounds and the reduced supply of pounds for sale together place upward pressure on the value of the pound.

The exchange rate varies because....

banks that serve as intermediaries in the foreign exchange market adjust the price at which they are willing to buy or sell a particular currency in the face of a sudden shortage or excess of that currency.

Why is the demand schedule facing downward on pg. 105?

because corporations and individuals in the united states would purchase more British pounds when the pound is worth less (because it takes fewer dollars to obtain the desired amount of pounds)

Assume the spot rate of the British Pound is $1.73. The Expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect?

($1.66 - $1.73)/$1.73 = -4.05% Expected depreciation of 4.05% percent

Assume there is a sudden and substantial increase in British inflation while U.S inflation remains low. (1) How is the demand schedule for pounds affected? (2) How is the supply schedule of pounds for sale affected? (3) Will the new equilibrium value of the pound increase, decrease, or remain unchanged?

(1) The demand schedule for pounds should shift inward. (2) The supply schedule for pounds should shift outward. (3) The new equilibrium value of the pound should decrease.

A fourth factor affecting exchange rates is government controls. The government of foreign countries can influence the equilibrium exchange rate in the following ways:

(1) imposing foreign exchange barriers (2) imposing foreign trade barriers (3) intervening (buying and selling currencies) in foreign exchange markets (4) affecting macro variables such as inflation, interest rates and income levels

Real Interest rates

Although a relatively high interest rate may attract foreign inflows (to invest in securities offering high yields), that rate may reflect expectations of relatively high inflation. Because high inflation can place downward pressure on the local currency, some foreign investors may discourage from investing in securities denominated in that currency. In such cases, it is useful to consider the real interest rate, which adjusts the nominal interest rate for inflation: Real interest rate = Nominal interest rate - inflation rate

Decrease in supply schedule: Now assume that conditions cause British firms, consumers, and government agencies to need fewer U.S dollars. Hence there is a decrease in the supply of the British pound. (inward shift on the supply schedule)

Although the demand schedule for British pounds has not changed. In this case, the amount of pounds supplied will be less than the amount demanded in the foreign exchange markets resulting in a shortage of pounds. Banks that serve as intermediaries in the foreign exchange market will respond by increasing the price of the pound. As they increase the rate, there will be a reduction in the amount of British pounds demanded and an increase in the amount of British pounds supplied. The banks will increase the exchange rate to the level at which the amount of British pounds demanded is equal to the amount of British pounds sold in the foreign exchange market.

Appreciation

An increase in currency value

Assume that the U.S income level rises at a much higher rate than does the Canadian income level. how should this affect (a) U.S demand for Canadian dollars (b) supply of Canadian dollar (c) equilibrium value of the Canadian dollar.

Assuming no effect on U.S interest rates, demand for Canadian dollars should increase, supply of Canadian dollars for sale may not be affected, and the Canadian dollar's value should increase. (income Levels are only a direct impact on that country experiencing the change. So when US income rises we buy more goods from everywhere, including Canada, therefore we would be demanding more Canadian Dollars which would raise the value due to increased demand, their supply though would not necessarily change directly because nothing has happened in their economy.)

equilibrium exchange rate

At any given moment, a currency should exhibit the price at which the demand for that currency is equal to the supply. Of course, conditions can change over time. These changes induce adjustments in the supply of or demand for any currency of interest, which in turn creates movement in the currency's price.

Assume that U.S and British Interest rates are initially equal but the British interest rates rise while U.S rates remain constant.

British interest rates may become more attractive to U.S investors with excess cash, which would cause the demand for British pounds to increase. At the same time, U.S interest rates should look less attractive to British investors., so the British supply of pounds for sale would decrease. Given the outward shift in demand for pounds and inward shift in supply of pounds for sale, the pounds equilibrium exchange rate should increase.

Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect (a) U.S demand for Japanese yen (b) supply of yen for sale (c) equilibrium value of the yen?

Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease. (Japan will now buy more US goods, importing more, therefore they are spending more Yen than previously which will supply more Yen out there to the market, which drops the value. Demand for yet should not change though, just because Japan can buy more goods from the US does not mean that the US would also buy more from Japan, this is another situation where the change only has a direct impact on one economy)

Assume that the U.S income level rises substantially while the British income level remains unchanged. Consider the impact of this scenario on (1) the demand schedule for pounds (2) the supply schedule of pounds for sale (3) the equilibrium exchange rate.

First, the demand schedule for pounds will shift outward. Reflecting the increase in U.S income and attendant increased demand for British goods. Second, the supply schedule for pounds for sale is not expected to change Third, the equilibrium exchange rate of the pound should rise. Furthermore, an increase in U.S income levels (and in U.S economic growth) could also have an indirect effect on the pound's exchange rate by influencing interest rates. Under conditions of economic growth, the business demand for loans increase and thus cause a rise in interest rates. Higher interest rates in the United States could attract more U.K based investors; this is another reason why the supply schedule of British pounds may increase enough to offset any effect of increased U.S income levels on the demand schedule. See pg. 111-112 for more info

If the movements in the euro are typically larger than movements in the Canada dollar, this means:

From a U.S perspective, the euro is a more volatile currency. The standard deviation of the exchange rate movements for each currency confirms this point. The standard deviation should be applied to percentage movements (not to the actual exchange rate values) when comparing volatility among currencies. From the U.S perspective, come currencies (such as, Australian dollar, Brazilian real, Mexican peso, New Zealand Dollar) tend to exhibit higher volatility than does the euro. (Chart example on page 104)

Many investors realize that ______interest rates in a country could attract more funds and cause an ________in demand for the local currency.

Higher / Increase

Increase in Supply Schedule: Assume that conditions cause the British demand for U.S dollars increase. Then there is an increase in the amount of British pounds to be supplied in the foreign exchange market (depicted graphically as an outward shift in the supply schedule) even though the demand schedule for British pounds has not changed.

In this case, the amount of the currency supplied in the foreign exchange market will exceed the amount of British pounds demanded in the market, resulting in a surplus of British pounds. The banks that serve as intermediaries in the foreign exchange market will respond by reducing the price of the pound. As they reduce the exchange rate, there will be an increase in the amount of British pounds demanded. The banks will reduce the level at which the amount of British pounds demanded is equal to the amount of British pounds supplied in the foreign exchange market.

Explain why a public forecast by a respected economist about future interest rates could affect the value of the dollar today. Why do some forecasts by well-respected economist have no impact on today's dollar value?

Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because their expectations about currency movements, since their yield will be affected by changes in currency value. These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected economist was already anticipated by market participant or is not different from investors original expectations, an announced forecast does not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected.

If daily exchange rate movements were accessed, the movements would be ______ volatile.

Less

Trade related foreign exchange transactions are generally ______ responsive to news.

Less

If the pound's exchange rate is high then corporations and individuals in the United States are....

Less willing to purchase British goods because the products or securities could be acquired at a lower price in the united states or other countries.

Foreign Exchange movements tend to be larger for ________ time horizons.

Longer

Increase in Demand Schedule: Assume that the demand for British pounds in the foreign exchange market increases but that the supply schedule of British pounds has not changed....

Then the amount of pounds demanded in the foreign exchange market will be more than the amount for sale in the foreign exchange market at the prevailing price (exchange rate). Resulting in a shortage of British pounds. The Banks that serve as intermediaries in the foreign exchange market will not have enough pounds to accommodate demand for ponds at the prevailing exchange rate. The banks will respond by raising the price of they pound. As they raise the exchange rate, there will be a decline in the amount of British pounds demanded as well as an increase in the amount of British pounds sold in the foreign exchange markets. The banks will increase the exchange rate to the level at which the amount of British pounds demanded is equal to the amount of British pounds supplied in the foreign exchange market.

Assume that U.S and British interest rates are initially equal but then U.S interest rates rise while British rates remain constant.

U.S investors will likely reduce their demand for pounds, because U.S rates are now more attractive than British rates. Because U.S rates now look more attractive for British investors with excess cash, the supply of pounds for sale by British investors should increase as they establish more bank deposits in the United states. In response to this inward shift in demand for pounds and out ward shift in the supply for pounds for sale, the equilibrium rate should decrease.

Decrease in demand schedule: Now suppose the conditions cause the demand for the British pounds to decrease (depicted graphically as an inward shift in the demand schedule) but that the supply schedule of British pounds has not changed.

Under these conditions, the amount of pounds demanded in the foreign exchange market will be less than the amount for sale in the foreign exchange market at the prevailing exchange rate. The banks that serve as intermediaries in this market will have an excess of British pounds and they will respond by lowering the price of the pound. As they reduce the price there will be an increase in the amount of pounds demanded in the foreign exchange market and a decrease in the amount of British pounds supplied. The Banks will reduce the exchange rate to the level at which the amount of the British pound demanded is equal to the amount supplied in the foreign exchange market.

Impact of favorable expectations: investors may temporarily invest funds in Canada if they expect Canadian interest rates to increase, because this may cause further capital inflows into Canada, which would place.....

Upward pressure on the Canadian dollars value. By investing in securities denominated in Canadian dollars based on expectations, investors can fully benefit from the rise in the Canadian dollars value because they will have purchased Canadian dollars before the change occurred. Although, these investors face the obvious risk that their expectations may be wrong, the point is that expectations can influence exchange rates because they commonly motivate institutional investors to take foreign currency positions.

Percent change in foreign currency value

When a foreign currency's spot rate at two different times are compared, the spot rate at the more recent date is denoted as S and the spot rate at the earlier date is denoted as S t-1. The percentage change is the value of the foreign currency over a specified period is then computed as follows: S - S t-1/S t-1 or New - Old / Old

Depreciation

When the British Pound depreciates against the U.S dollar, this means that the U.S dollar is strengthening relative to the pound.

Change in the demand and supply schedules of a currency force:

a change in the equilibrium exchange rate in the foreign market.

Impact of unfavorable expectations: During 2010-2015 period, Greece experienced a major debt crisis because of concerns that it could not repay its existing debt. Some institutional investors expected that Greece crisis might spread throughout the eurozone, which could cause....

a flow of funds out of the eurozone. There were also concerns that Greece would abandon the euro as its currency, which causes additional concerns to investors who had investments in euro denominated currencies Consequently, many institutional investors liquidated their investments in the eurozone, exchanging their euros for other currencies in the foreign market. Investors who owned euro denominated securities attempted to liquidate their positions before the euro's value declined. These conditions played a large part in the euro's substantial depreciation during this period.

Look at graph on pg. 107 (exhibit 4.4). At an exchange rate of $1.50, the quantity of pounds demanded would exceed the supply of pounds for sale. Consequently, the banks that provide foreign exchange services would experience:

a shortage of pounds at that exchange rate.

Look at graph on pg. 107 (exhibit 4.4) At an exchange rate of $1.60, the quantity of pounds demanded would be less that the supply of pounds for sale; in this case , banks providing foreign exchange services would experience:

a surplus of pounds at that exchange rate.