Reading 18: Capital Flows and FX Market

Book 1: Economics

Forward Currency Contracts

agreement to exchange currencies at some point in the future at a predetermined rate today

Hedging

taking a position in the FX market to reduce existing risk

Speculating

taking a position in the FX market to increase existing risk

Sell-Side

primary dealers and originators of FX contracts

multinational banks

Buy-Side

buyers of reign currency contracts

Corporations, investment accounts, governments, retail investors

Real Money Account

institutional accounts that don’t use derivatives

Leveraged Accounts

accounts that use derivatives

Base Currency

the currency being priced in the terms of another currency

Price Currency

the currency that you are exchanging

How would you say this:

“1.416 USD/EUR“

The price of 1£ is $1.416

Direct Quote

amount of domestic currency needed to buy a foreign currency

exchange rate expressed as price/base

Indirect Quote

amount of foreign currency needed to buy a domestic currency

exchange rate expressed as base/price

Nominal Exchange Rate

the exchange rate at a point in time

Real Exchange Rate

the purchasing power of one currency (price) in terms of goods in another currency (base)

An increase in the nominal USD/EUR rate ___________ the purchasing power of the USD in the Eurozone.

decreases

An decrease in the nominal USD/EUR rate ___________ the purchasing power of the USD in the Eurozone.

increase

What condition needs to be met to find the % change in a currency against another?

The exchange rate needs to be in terms of whatever the base currency is.

If USD/EUR goes from 1.42 to 1.39, you can say the Euro has depreciated against the Dollar, but you can’t say the Dollar has appreciated against the Euro. You need to but the exchange rate in terms of EUR/USD, then see how much the Dollar has appreciated

Exchange Rate Regime

the type of system a country uses to manage its currency value relative to another

Formal Dollarization

a country uses the currency of another country

What are the exchange rate regimes for countries that don’t have their own currency?

Formal Dollarization

Monetary Union

Currency Board

explicit commitment to exchange domestic currency for a region currency at a fixed rate

• Hong Kong

Conventional Fixed Peg

a country pegs its currency within margins of ± 1% to another currency or basket

How does a country maintain a fixed peg?

Direct and Indirect interventionDi

Direct Intervention

buying or selling of securities to maintain the peg

Indirect Intervention

using interest rate policy ore regulating FX transactions to maintain the peg

Target Zone

a wider band to allow a currency to fluctuate against the fixed peg; ± 2%

Passive Crawling Peg

exchange rate is adjusted periodically; typically for inflation

Active Crawling Peg

series of adjustments is announced

Management of Exchange Rates within Crawling Bands

the relative band to another is expanded over time; used when transitioning from peg to floating rate

Managed Floating Rate System

monetary authority attempts to influence the exchange rate along a predetermined path

Independently Floating Exchange Rate

market determines the exchange rate

If the USD/EUR decreases, what happens to imports?

Eurozone imports from US decreases

US imports from Eurozone increases

The effects of imports/exports will occur (faster/slower) than the effects on capital flows.

slower

Balance of Payments

capital flows must offset any imbalance between a country’s exports and imports

Why does a government impose capital restrictions?

Reduce the volatility of asset prices

Maintain fixed exchange rates

Keep domestic interest rates low

Protect strategic industries