Foreign Exchange Market

This set of flashcards covers key concepts, definitions, and important theories related to the Foreign Exchange Market as outlined in the lecture notes.

What is the role of the foreign exchange market?

The foreign exchange market is used for converting currency of one country into that of another, facilitating international trade and investments.

What are spot exchange rates?

Spot exchange rates are the rates at which a foreign exchange dealer converts one currency into another currency on a particular day.

What is a forward exchange rate?

A forward exchange rate is the rate agreed upon by two parties to exchange currency at a specific date in the future.

What is a currency swap?

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

What does the law of one price state?

In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when expressed in the same currency.

What is purchasing power parity (PPP)?

Purchasing power parity is the theory that compares the prices of identical products to determine the real exchange rate.

What is hyperinflation?

Hyperinflation is an explosive and uncontrollable price inflation where money loses value rapidly.

What factors do empirical tests of PPP theory consider?

Empirical tests of PPP theory consider relative prices; changes in relative prices can affect exchange rates.

What is the international Fisher effect?

The international Fisher effect states that any difference in interest rates between countries reflects differing expectations about future inflation rates.

What is transaction exposure?

Transaction exposure is the extent to which income from individual transactions is affected by fluctuations in foreign exchange values.

What strategies can firms use to reduce translation and transaction exposure?

Firms can use forward exchange rate contracts, buying swaps, lead strategy, and lag strategy to manage exposure.

How can economic exposure be managed?

Economic exposure can be managed by distributing the firm’s productive assets to various locations to mitigate the impact of adverse exchange rate changes.

What is the efficient market hypothesis in relation to exchange rate forecasting?

The efficient market hypothesis posits that prices reflect all available public information, and therefore, forward exchange rates should be unbiased predictors of future spot rates.

What is the 'Big Mac Index'?

The 'Big Mac Index' is a method used to compare the purchasing power parity between different currencies based on the price of a Big Mac sandwich.

What is capital flight?

Capital flight occurs when residents rush to convert domestic currency into foreign currency, often during a depreciation of domestic currency.

What are the three forms of currency convertibility?

The three forms of currency convertibility are freely convertible, externally convertible, and nonconvertible.