Exchange Rates and International Capital Flows

Foreign exchange market

the market in which people or firms use one currency to purchase another currency

Foreign direct investment (FDI)

refers to purchasing a firm (at least 10%) in another country or starting up a new enterprise in a foreign country

portfolio investment

involves a purely financial investment that does not entail any management responsibility; often linked to expectations about how exchange rates will shift

hedge

using a financial transaction as protection against risk

interbank market

Most banks provide foreign exchange as a service to its customers

appreciating

When the exchange rate for a currency RISES, so that the currency exchanges for MORE of other currencies, it is “strengthening”

depreciating

When the exchange rate for a currency FALLS, so that a currency trades for LESS of other currencies, it is “weakening.”

arbitrage

the process of buying and selling goods or currencies across international borders at a profit

Purchasing power parity (PPP) exchange rate

the exchange rate that equalizes the prices of internationally traded goods across countries

floating exchange rate

a policy which allows the foreign exchange market to set exchange rates

peg

When a government intervenes in the foreign exchange market so that the exchange rate of its currency is different from what the market would have produced, it is said to have established a “peg” for its currency

soft peg

an exchange rate policy where the government usually allows the exchange rate to be set by the market, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market

hard peg

exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate

merged currency

when a nation chooses to use the currency of another nation

d

1. Which exchange rate policy eliminates foreign exchange risk entirely?
   a) Floating exchange rate.
   b) Soft peg.
   c) Hard peg.
   d) Merged currency.

b

1. A weaker U.S. dollar typically leads to:
   a) Fewer U.S. exports and more imports.
   b) More U.S. exports and fewer imports.
   c) No change in trade balances.
   d) Higher inflation in all countries.

b

1. If investors expect the euro to appreciate against the U.S. dollar, they will likely:
   a) Sell euros and buy U.S. dollars.
   b) Buy euros and sell U.S. dollars.
   c) Demand fewer euros in the foreign exchange market.
   d) Avoid trading currencies altogether.

b

1. A hard peg exchange rate policy involves:
   a) Allowing the market to set the exchange rate with occasional interventions.
   b) Fixing the exchange rate at a constant value through central bank actions.
   c) Eliminating the national currency and adopting another country’s currency.
   d) Letting the exchange rate fluctuate wildly to attract foreign investment.

a

1. Purchasing Power Parity (PPP) refers to:
   a) The exchange rate that equalizes the prices of identical goods across countries.
   b) The total value of a nation’s exports minus imports.
   c) The interest rate difference between two currencies.
   d) The amount of foreign reserves held by a central bank.

b

1. A currency depreciates when:
   a) Its exchange rate rises relative to another currency.
   b) Its exchange rate falls relative to another currency.
   c) Its central bank prints more money.
   d) Its country’s GDP increases.

b

1. If the U.S. dollar appreciates against the Mexican peso, it means:
   a) One dollar buys fewer pesos than before.
   b) One dollar buys more pesos than before.
   c) The peso’s value has not changed.
   d) The U.S. inflation rate has decreased.

b

1. Which of the following is a participant in the foreign exchange market?
   a) Only governments and central banks.
   b) Firms engaged in international trade, tourists, and investors.
   c) Domestic retailers with no overseas operations.
   d) Local grocery stores.

b

1. An exchange rate is best defined as:
   a) The price of gold in a country’s currency.
   b) The price of one currency in terms of another currency.
   c) The total value of imports and exports in an economy.
   d) The interest rate set by a central bank.