Finance Exam 1

Chapters 1, 2, 3, 5, 6

Calculating %∆ in the spot exchange rate

(End-Beg)/Beg * 100

(all rates quoted as PER this currency)

Gold Standard

• participating countries fixed the price of their currency in terms of a specified amount of gold

• countries maintained these prices be being willing to buy/sell their domestic currency in terms of gold

Dollar amount of gold during gold standard

$20.67/oz

Advantages to gold standard

1. monetary discipline

2. symmetric monetary adjustment (BOP automatically adjusts)

Disadvantages to gold standard

1. constrains on use of monetary policy to fight unemployment

2. reserve shortage

3. asymmetric distribution of gold production

Why did the gold standard fail?

1. outbreak of WW1

2. decreased confidence in the system

3. german hyper inflation

Bretton Woods System

post WW2 monetary strategy that pegged the USD to gold @ $35/oz and had foreign currencies pegged to the dollar

What percent band was established under the bretton woods system and what does it mean?

Participating countries had to keep their exchange rates within a 1% fluctuation margin (later expanded to 2.25%)

IMF

• created under Bretton woods system

• provides short-term aid to countries whose current accounts are in a deficit

SDR

• basket based on weighted average of 5 major currencies (dollar, euro, yen, chinese renminbi, GBP)

• intangible international reserve asset allotted by the IMF

• can be exchanged for hard currencies

• countries that receive must pay interest if they are in excess or shortfall

Fixed exchange rate

domestic currency pegged to anchoring foreign currency/commodity

Advantages of a fixed exchange rate

1. stability in prices

2. anti-inflammatory (monetary discipline = prices and interest rates in line w anchor currency)

3. fiscal discipline (government balances its budget)

Disadvantages of a fixed exchange rate

1. loss of monetary and fiscal autonomy

2. reserve requirements

3. may be under speculation attack (sudden selling of nation’s currency by investors who expect it to fail)

4. sudden collapse of system

Floating exchange rate

monetary system where a currency’s value rises and falls based on s & d in the forex market

Advantages of a floating exchange rate

1. BOP adjusts simultaneously through exchange rate fluctuations

2. no government intervention

3. determined by market forces

4. low international reserve requirement

5. monetary independence

Disadvantages of a floating exchange rate

1. lack of stability

2. frequent currency speculation

3. lost discipline

Explain the Impossible Trinity

a theory that states that countries cannot have exchange rate stability, monetary policy authority, and freedom of capital movement

• at most, countries can have 2/3

what is BOP?

a systematic statistical statement that shows a country’s international transactions for a specific time period, usually a year

• must equal 0

In BOP, the Current Account = _____ + _____+ _____ + _____

Capital Account + Financial Account + NEO + Reserves/Related

what is the current account in BOP?

all international transactions that generate income

Components of the Current Account

1. goods trade/goods import

2. services trade

3. income (dividends, interest, worker wages)

4. current transfer (one-sided transactions; gifts, foreign aid)

what is the capital account in BOP?

• Cap transfers (debt forgiveness)

• non-produced non-financial assets (acquisition/disposal of intangible or natural resources; land, minerals, water rights)

what is the financial account in BOP?

international monetary flows and changes in asset ownership

1. direct investment = A US automotive manufacturer spends $500 million to build a brand-new assembly plant in Mexico; German firm purchases a controlling 55% stake in an American robotics engineering company

2. portfolio investment = equity/debt securities (bonds, notes, money market instruments)

3. other investment (international loans, bank deposits)

functions of forex market

1. transfer purchasing power between countries through trade, DI, etc.

2. get/give credit for international trade transactions

3. mechanisms to hedge and transfer FX risk

What are the types of forex transactions?

1. Spot

2. Forward

3. Swap

what is a swap transaction?

simultaneous purchase and sale of a given amount of foreign currency for 2 different delivery dates (short leg and long leg)

Subcomponents of a swap transaction?

1. Spot against forward

2. non-deliverable forward

3. forward against forward

what is a non-deliverable forward?

short-term cash-settled financial contract used to hedge or speculate on exchange rates for currencies restricted by capital controls

• no physical delivery of underlying asset; net cash difference paid in USD

Which currency is the base/unit currency?

Eur/USD

Which currency is the price/quote currency?

Yen/Peso

What is a forward rate of < 1y called?

Cash rate

what is a forward rate of 1+ years called?

Swap rate

Spread Formula

(ask - bid) / (ask) * 100

If the forward rate > spot rate, it is a…?

forward premium for the dollar

If the spot rate > forward rate it is a…?

forward discount for the dollar

Forward Premium formula

Annualized FP/Discount Formula

hedging definition

locking in a price

• aims to reduce or eliminate the risk of financial loss

T/F: You can’t use a forward contract to hedge

False

• you can use a forward contract to hedge

Covered Interest Rate Parity Formula

F = S × (1 + i_dc × n/360) / (1 + i_fc × n/360)

Alternatives to IRP formula

IRP approximation

FP_fc ≈ i_dc - i_fc (measured in % terms)

• therefore, i_dc ≈ i_fc + FP_fc

Return of foreign currency has 2 components, what are they?

1. foreign currency interest rate

2. FC foreign premium

According to interest rate parity, what happens if domestic currency interest rate goes down?

According to interest rate parity, if the U.S. interest rate goes down relative to the foreign interest rate, the dollar's forward value decreases relative to its spot value.

Steps in money market hedging:

1. borrow currency you have in A/R

2. convert into currency you want @ spot

3. invest in desired currency for x amt of time

4. use A/R to pay off loan of A/R currency

• Same as synthetic forward

What are the 6 assumptions for IRP?

1. free capital mobility across countries

2. perfect capital market

3. no transaction costs

4. no taxes

5. complete certainty

6. 1 rate for all firms (equity)

what is the international fisher effect?

predicts exchange rate changes based on differences in nominal interest rates between two countries

• uncovered interest rate parity (UIA)

• expectations of future spot rates

International Fisher Effect formula

Hypothesis: S^e_{dc/fc, T} = F_{dc/fc, T}

How good is this predictor?

Not very good because predictions can be wrong

Speculating definition

attempting to make a profit by trading on expectations about future prices

Effective borrowing cost formula

what is the difference between depreciation and devaluation?

• depreciation = A decrease in the value of a domestic currency relative to other currencies that happens naturally due to market forces

• devaluation = official reduction of domestic currency by government (fixed/pegged exchange rate system)

Define PPP

purchasing power parity = exchange rates between currencies are in equilibrium when a fixed basket of identical goods and services costs the same in both countries

absolute vs relative PPP

absolute = compares price levels directly between countries at a single point in time

relative = looks at how exchange rates change over time based on inflation differences

PPP exchange rate formula

How to find percentage a currency is devalued?

(PPP exchange rate - Actual exchange rate) / Actual exchange rate * 100