200591 Lecture Notes - Lecture 6: Foreign Exchange Market, Foreign Exchange Risk, Floating Exchange Rate

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nellyxo20

20 Jun 2018

School

UWS

Department

University of Western Sydney

Course

200591

Professor

All

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Week 6-Foreign exchange-and the international and monetary system

ARBITRAGE The purchase of securities in one market for immediate resale in another market to

profit from a price discrepancy

CARRY TRADE Involves borrowing in one currency where the interest rates are low and then

using the proceeds to invest in another currency where the interest rates are high

CROSS RATE The exchange rate between two currencies calculated by reference to their

respective rates quoted in a common third currency

PURCHASING POWER PARITY (PPP) The exchange value of currencies based on the comparison

of prices between nations— that is, a comparison of what currencies can buy in real terms

FISHER EFFECT The theory that nominal interest rates ( i ) in each country equal the required real

rate of interest (r) and expected rate of inflation (I) over the time period for which the funds are to be

lent. That is, i = r + I

Fixed exchange rate system-rate pegged ,don’t not vary with market forces

PEGGED EXCHANGE RATE The exchange rate is fixed relative to a reference currency or

basket of currencies, and this exchange rate is defended by government intervention in the

foreign exchange market

MANAGED OR ‘DIRTY’ FLOAT SYSTEM A system under which a country’s currency is nominally

allowed to float freely against other currencies, but in which the government will intervene if it

believes the currency has deviated too far from its fair value

Internal balance-economy operating at full capacity-employment,price stability

External balance-international balance payments into future-sustainable

SURVEILLANCE The IMF monitors and consults members with regard to the national and

international consequences of their domestic macroeconomic

Functions of iMF:

Ajustment-pricing of restorign external balance

Liquidity-international money supply to finance trade and investment to achieve exchange

rate balance

Confidence-belief that relo of countries help sust. stability

Foreign exchange market-

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

exchange rate-rate at which one currency is converted into another

bitcoin (digital currency)-alternative –fast and secure means for transactions online

Edequor

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Foreign exchange market-

global network of banks, brokers and forex dealers

connected by electronic communications systems

never sleeps

a single market

exchange rates quoted worldwide tend to be same due arbitrage

most transactions involve US dollars on one side.

other vehicles: Euro, Japanese, yen,british pound.

Functions of Foreign exchange market-CI

1)currency conversion-PPIC

payments received for exports, income from foreign investments and foreign lisencing

agreements

products or services procured in foreign countries currency

investments in overseas markets

currency speculation

2)Insurance/hedging against foreign exchange risk-ff

a)Forward exchange-when 2 parties agree to exchange currency and execute the deal at

some specific date in the future

b)Foreign exchange swaps-

simultaneous purchase and sale of a given amount of foreign exchange for 2 different

value dates

Foreign exchange contract-

-contract bw 2 parties (bank and the customer)

one party contract to sell,other to buy, one currency for another

,at agreed future date,at a rate of exchange which is fixed at the time the contract is entered to

features/benefits:

contract can be arranged to either buy or sell foreign currency

against your domestic currency,or your foreign currency

avail. in all major currencies for any purpose such a trade, investment or other commitments

changes in spot rates can be problematic-

exchange risk arises when buyer and seller use different currencies and time elapses

between sale and payment

avoid risk-quote price in aus dollars (exchange risk known by buyer)

Determinants of exchange rate-demand and supply for diff currencies

3 factors impact on future exchange rates movements:PIM

1)countries price inflation

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Document Summary

Week 6-foreign exchange-and the international and monetary system. Arbitrage the purchase of securities in one market for immediate resale in another market to profit from a price discrepancy. Carry trade involves borrowing in one currency where the interest rates are low and then using the proceeds to invest in another currency where the interest rates are high. Cross rate the exchange rate between two currencies calculated by reference to their respective rates quoted in a common third currency. Purchasing power parity (ppp) the exchange value of currencies based on the comparison of prices between nations that is, a comparison of what currencies can buy in real terms. Fixed exchange rate system-rate pegged ,don"t not vary with market forces. Pegged exchange rate the exchange rate is fixed relative to a reference currency or basket of currencies, and this exchange rate is defended by government intervention in the foreign exchange market.

Related Questions

Where can you find currency exchange rates and cross rates? At OANDA.com, the currency website. At this site's main page, click on the Currency Converter tab found at the top of the page and then below that, choose "Converter" to convert one currency into another.

Question 1: Several years ago the Wall Street Journal reported that the âindirectâ exchange rate between the Canadian and US dollars was $0.9507 CAN per $1.00 US (or $0.9507 Canadian dollars per one US dollar). Using the OANDA website, identify the current âindirectâ exchange rate between these two currencies in terms of $CAN per one $US?

Question 2: Has the U.S. dollar appreciated or depreciated relative to the Canadian dollar over this two-year time period? Explain your answer.

Question 3: Suppose the exchange rate between the U.S. dollar and the Swedish krona is 6.55 kronas per one U.S. dollar and the exchange rate between the British pound and the dollar is 0.641 pounds per U.S. dollar. Determine the cross rate between kronas and pounds. Your answer should be expressed as Swedish kronas per one British pound.

(B) Calculate the premium or discount of the British pound in the forward market where the spot rate is $1.982 US per one pound and the 90 day forward rate is $1.967 US per one pound. Be sure that you calculate the percent amount of the premium or discount AND also identify the amount as either a premium or discount.

(C) The spot rate of the Brazilian Real (BRL) is $0.44 US. The one-year U.S. interest rate is 5.75% and the one-year Brazilian interest rate is 9.52%.

Question 1: Assuming the existence of interest rate parity, determine the forward premium or discount of the Brazilian Real (be sure to identify whether it is a premium or a discount).

Question 2: Given the forward discount for the Real in question 1, now estimate the forward exchange rate of the Brazilian Real.

Question 3: Given interest rate parity, assume that the forward rate of the Brazilian Real is the same as the spot rate, one BRL = $0.44 US. Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 5.75%.

bronzeelk514

1.Purchasing power parity implies that

a. the real exchange rate is equal to 1.

b. the law of one price does not hold.

c. inflation rates are equal across countries.

d. the real exchange rate is equal to 0.

e. if the domestic country has low prices, then the domestic currency will depreciate until foreign citizens can buy the same amount of goods as domestic citizens.

2.Which of the following is a prediction from the PPP model of exchange rates?

A. An increase in the US money supply leads to an appreciation of the dollar in the long run.

B. An increase in US production leads to a depreciation of the dollar.

C. An increase in US production will lead to a proportional increase in the inflation rate.

D, An increase in the US money supply leads to a depreciation of the dollar in the long run.

E.An increase in the US interest rates leads to a fall in prices.

3.Relative purchasing power parity predicts that

A.the difference between the inflation rates in the two countries should equal the ratio of the interest rates in the two countries.

B. the difference between the inflation rates in two countries should equal the per cent change in the exchange rate.

C.inflation rates should be equal across countries.

D.the real exchange rate should equal one.

E.relative price levels in the two countries should be equal when expressed in the same currency.

4.Which of the following is NOT a valid explanation for the failure of purchasing power parity?

a. Differences in monetary policies across countries

b. Lack of competition

c. Transportation costs

d. Trade barriers

5.If P represents (the level of) domestic prices, P* represents (the level of) foreign prices and E represents the exchange rate as units of domestic currency per units of foreign currency, then the real exchange rate equals

a. EP/P*	b. P*/EP
C. E/PP*	d. EP*/P
e. P/P*

6.The difference between nominal and real interest rates is that

A.Nominal interest rates are measured in terms of a country's output, while real interest rates are measured in monetary terms

B.Nominal interest rates are measured in monetary terms, while real interest rates are measured in terms of a country's output

C.Nominal interest rates can fluctuate, while real interest rates always remain fixed

D.Real interest rates can fluctuate, while nominal interest rates always remain fixed

E.Real interest rates are the same in every country, while nominal interest rates are different for every country

7.Which of the following is predicted to cause the value (or price or cost) of U.S. goods to appreciate relative to the value (or price or cost) of foreign goods in the long run?

a. An increase in the growth rate of U.S. GNP. b. A decrease in the growth rate of U.S. GNP.

c. A decline in the growth rate of the U.S. money supply.

d. An increase in the price of petroleum that reduces world demand for American cars. e. An appreciation of the dollar.

jadewallaby469

You, a foreign exchange trader for Green Valley Capital, are exploring covered interest arbitrage opportunities between Euros (C) and US Dollar ($) for the next 60 days.

You have â¬ 1 million or $ 1.1 million at the current spot rate for the covered interest arbitrage and face the following quotes:

Arbitrage fund available	â¬1,000,000 or $1,100,000
Spot exchange rate	$1.1000/C
60-day forward rate	$1.1040/C
US Dollar annual interest rate	1.8%
Euro annual interest rate	0.90%

1(A) What is the annual effective US Dollar interest rate from Euro investment?

1(B) Show the steps and calculate the amount of the covered interest arbitrage profit

1(C) Determine a theoretical 6o-day forward rate (round to 4 decimal places) that will result in a zero covered interest arbitrage profit.

1(D) The following appeared in the Feb. 4, 2016 Wall Street Journal article "Dollar Continues to Fall Ahead of Friday's Jobs Report":

Investors have been fleeing the dollar in recent days, amid expectation that the Federal Reserve won't be able to raise interest rates as much as expected this year due to soft growth in the U.S. and turbulent global markets. Such persistently low interest rates weigh on the U.S. currency, as they make the dollar less attractive to yield-seeking investors. The dollar has now fallen 2.6% against a basket of currencies in February.

Explain (not more than half of a page) the above narrative with the interest rate parity relationship

200591 Lecture Notes - Lecture 6: Foreign Exchange Market, Foreign Exchange Risk, Floating Exchange Rate

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