essay q's

What is the difference between a central bank carrying out a foreign exchange market intervention and carrying out a domestic open market operation?

A foreign exchange intervention involves the sale or purchasing of foreign currency assets. Domestic open market operations involve the purchase or sale of US government securities.

Explain the difference between the nominal exchange rate and the real exchange rate.

A nominal exchange rate is the price of one currency in the terms of another currency. Real exchange rate is the rate at which goods and services in one country can be exchanged for goods and services in another country.

Explain the difference between a stock exchange and an over-the-counter market.

A stock exchange is a physical place where stocks are bought and sold face to face on a trading floor (NYSE). An over the counter market is a stock exchange in which financial securities are bought and sold by dealers linked to computers (NASDAQ).

What is the difference between adaptive expectations and rational expectations?

Adaptive - people make forecasts of future values of a variable using only the past values of the variable. Rational - People make optimal forecasts of future values of a variable using all the information available to them.

Use T-accounts to show the effect on the Fed's balance sheet of the Fed selling $5 billion in Japanese government bonds, denominated in yen. Is this a sterilized or an unsterilized foreign exchange intervention?

Assets decreases by 5 billion foreign bonds, Liabilities decreases by 5 billion bank reserves. This is unsterilized due to not being accompanied by an open market operation to offset the change in monetary base.

Briefly explain why bonds that have the same maturities often do not have the same interest rates.

Because risk, liquidity, information costs, and taxation can all have an effect on interest rates.

Explain the advantages that open market operations have over other policy tools.

Benefits of open market operations include control, flexibility, and ease of implementation. Discount loans depend in part on the willingness of banks to take loans and so are not completely under the fed's control. The Fed can also make both large and small open market operations. Where as dynamic operations require large purchases/sales and defensive can be small. Also reversing open market operations is much simpler for the Fed. The Fed can also implement its open market operations with no administration delays, changing the discount rate or reseve requirements would take lengthy deliberation.

Suppose the Fed reduces interest rates while interest rates in Europe do not change. Briefly explain and make use of a graph of the foreign exchange market to show how this will affect the value of the dollar.

Demand curve shifts left, lowering the interest rates. Lower interest rates in the US will reduce the demand for Dollars as foreign investors will buy fewer US financial securities.

Rights and obligations of Futures buyer and seller

Futures Buyer: Has obligation to buy the underlying asset on settlement date. Can use futures contract to hedge if the buyer intends to buy the underlying asset. Futures Seller: Has the obligation to deliver underlying asset on settlement date. May use selling a futures contract to hedge if the seller wants to insure against falling price

Explain the difference between hedging and speculating.

Hedging is taking action to reduce risk on an investment. Speculating is to place financial bets in an attempt to profit from the movements in asset prices.

What are the economic implications of an inverted yield curve?

Historically, an inverted yield curve occurs as investors anticipate a recession is likely to cause future short term rates to be lower than long term rates. During a recession, short-term rates tend to fall lower than long term rates as the Fed lowers rates to stimulate the economy. Liquidity premium theory of term structure predicts that long-term rates should be lower than short term rates, inverting the yield curve.

How can investors use options to manage risk?

Investors can use options and futures to hedge the risk from fluctuations in asset prices. Options are more expensive than futures but they have an advantage in the fact that the max loss a buyer will receive in the options premium. Many hedgers buy options not on the underlying asset, but on a futures contact derived from the asset.

Rights and obligations of options buyer and seller

Options Buyer: • Call: Right to purchase the underlying option at the strike price on or before expiration date. • Put: Right to sell the underlying asset at strike price on or before expiration Options Seller: • Call: Obligation to sell the underlying asset at strike price if the buyer exercises that option. • Put: Obligation to buy the underlying asset at strike price if the buyer exercises that option.

What is pegging? What are the advantages and disadvantages of pegging?

Pegging is the decision by a country to keep the exchange rate fixed between its currency and another country's. Advantages are that of a fixed exchange rate, being reduced exchange rate risk, a check against inflation, a protection for firms that have taken out loans in the foreign currencies. Disadvantages include that problems that may arise if the equilibrium exchange rate is significantly different from the pegged rate.

What trade-offs does the Fed face, particularly in the short run, in attempting to reach its goals?

The Fed can choose a reserve aggregate for it's policy instrument or it can choose the federal funds rate, it cannot choose both. This causes trade-offs between the two. For example, using reserves as the policy instrument will cause federal funds rate to fluctuate in response to changing demand for reserves. While using the FFR will cause the levels of reserves to also fluctuate in response to changes in demand for reserves.

What is the fundamental value of a share of stock?

The fundamental value of a share of stock equals the present value of all dividend payments expected to be received in the indefinite future.

Briefly explain what determines the supply curve for reserves. Why does the supply curve have a horizontal segment?

The reserve level and the discount rate that the fed sets determines the supply curve for reserves. There is a horizontal portion of the curve representing when the federal funds rate is below the discount rate. At this point, borrowing from the fed is at zero because banks can borrow from each other with ease.

How does the Treasury yield curve illustrate the term structure of interest rates?

The treasury yield curve shows the relationship among the interest rates on treasury bonds with different maturities. • If the yield curve is upward sloping, than short term rates are lower than long-term rates. • If the yield curve is downward sloping, than short term rates are higher than long-term rates.

Briefly explain how a U.S. company that exports to Europe can hedge against exchange rate risk.

To hedge against decrease (rise) in the value of currency, a firm sells (buys) that currency in the forward market.