Global Financial Environment - Foreign Exchange Market

These flashcards cover key concepts about the foreign exchange market, exchange rates, and related calculations for the upcoming exam.

What does the exchange rate denote?

The exchange rate represents the price of one currency in terms of another currency. For example, if the exchange rate between the U.S. dollar and the Euro is $1.10/€, it means that 1 Euro can be exchanged for $1.10. This price is crucial for international trade, investment, and tourism, as it determines how much foreign goods or assets cost in domestic currency (and vice versa).

What is required when trading currencies in the foreign exchange market?

When engaging in international transactions, direct currency conversion is required. For instance, if a U.S. company wants to buy goods from a European supplier who demands payment in Euros, the U.S. company must first convert U.S. dollars into Euros in the foreign exchange market. This applies to any pair of currencies involved in cross-border economic activity.

In the context of exchange rates, what does 'in US$' indicate?

When an exchange rate is quoted 'in US$', it signifies a direct quotation from the perspective of the United States. This means the quote expresses the value of one unit of foreign currency in terms of U.S. dollars (e.g., X/FC where FC is a foreign currency). For example, a quote of '$1.10/€' means that 1 Euro is worth $1.10, quoting the price of the Euro in US dollars.

If P$ is calculated as (e$/yuan)(Pyuan), what is the value of P$ if e$/yuan is 0.16/yuan and Pyuan is 6,250 yuan?

The value of P$ would be 1,000. The calculation is performed as follows:

P$ = (e$/yuan)(Pyuan)
P$ = ($0.16/yuan)(6,250 yuan)
P$ = $1,000

Here, P$ represents the price of a good in U.S. dollars, given its price in yuan (Pyuan) and the dollar-per-yuan exchange rate (e$/yuan).

What factors affect exchange rate values?

Exchange rate values are influenced by a complex interplay of various factors, including:

1. Economic Factors:
   • Interest Rate Differentials: Higher real interest rates in a country can attract foreign capital, increasing demand for its currency.
   • Inflation Differentials: Lower inflation rates generally strengthen a currency's purchasing power, leading to appreciation.
   • Economic Growth/Performance: Strong economic growth and positive economic outlooks often lead to currency appreciation as foreign investors seek opportunities.
   • Balance of Payments: A persistent current account surplus (exports > imports) tends to strengthen a currency, while a deficit can weaken it.
   • Government Debt and Fiscal Policy: High government debt or unsustainable fiscal policies can undermine investor confidence and devalue a currency.
2. Political Factors:
   • Political Stability: Countries with stable political environments tend to have more stable or appreciating currencies.
   • Government Policies and Interventions: Central bank interventions (buying/selling foreign currency) or changes in trade policies can directly impact exchange rates.
3. Behavioral/Psychological Factors:
   • Market Sentiment and Speculation: Traders' expectations about future economic events or currency movements can lead to large speculative flows.
   • Herd Mentality: Market participants often follow the actions of others, amplifying trends.
   • Safe-Haven Status: During global uncertainty, investors may flock to 'safe-haven' currencies (like the USD, JPY, CHF), increasing their value.

What is the model used to determine exchange rates based on?

The fundamental model used to determine exchange rates is based on the demand for and supply of foreign exchange in the spot market. Just like any other commodity, the interaction of buyers (demanders) and sellers (suppliers) of a foreign currency in the market will establish an equilibrium price, which is the exchange rate. The spot market refers to transactions for immediate delivery, typically within two business days.

What does triangular arbitrage involve?

Triangular arbitrage is a type of arbitrage that involves exploiting a discrepancy in currency exchange rates among three different currencies. The process typically involves three sequential currency transactions to profit from the imbalance:

1. Converting an initial currency into a second currency.
2. Converting the second currency into a third currency.
3. Converting the third currency back into the initial currency.

The goal is to end up with more of the initial currency than you started with, without taking any significant risk, by capitalizing on inconsistencies in the cross rates quoted by different financial institutions or market makers.

In the context of foreign exchange trading, what is the purpose of the balance of payments?

The Balance of Payments (BOP) is a comprehensive accounting record of all economic transactions between residents of a country and the rest of the world over a specific period (typically a quarter or a year). Its primary purpose in foreign exchange is multi-faceted:

1. Tracking International Reserves: It records changes in a country's official international reserves (holdings of foreign currencies, gold, and Special Drawing Rights), which are often used by central banks to intervene in the foreign exchange market.
2. Indicator of Currency Demand/Supply: The BOP helps track the net demand for and supply of a country's currency in the foreign exchange market. A current account deficit, for example, implies that a country is spending more foreign currency than it is earning, potentially putting downward pressure on its currency.
3. Policy Tool: It provides crucial information for governments and central banks to analyze international economic relationships and formulate appropriate monetary and fiscal policies related to trade, capital flows, and exchange rate management.
4. Components: The BOP is usually broken down into the current account (trade in goods, services, income, transfers) and the capital and financial account (international investments).

When given quotes of 1.15/€ and 1.35/£, what should be checked for triangular arbitrage opportunities?

To check for triangular arbitrage opportunities with quotes like 1.15/€ and 1.35/£, you would need a third quote, specifically the direct exchange rate between the Euro and the British Pound (/£). If this direct market quote for /£ deviates from the implied cross-rate calculated from the given quotes, an arbitrage opportunity exists.

For example:

1. Given:
   • e_{$/€} = $1.15/€
   • e_{$/£} = $1.35/£
2. Calculate the implied cross-rate for Euro per Pound (e€/£):
   • e{€/£} = e{$/£} / e_{$/€} (or equivalently, how many Euros you get for one Pound)
   • e_{€/£} = ($1.35/£) / ($1.15/€)
   • e_{€/£} \approx 1.1739€/£
3. Compare: You would then compare this calculated implied rate of 1.1739€/£ with the actual market quote for /£. If the market quote is, for instance, 1.18€/£, then you could exploit this difference by converting £ to , then $$ to €, and finally € back to £, or vice-versa, depending on which way the discrepancy favors profit.

What is the outcome if e0 is 1.60/£ and the supply and demand curves intersect at this point?

If e0 is 1.60/£ and this is the point where the supply and demand curves for British Pounds intersect in the foreign exchange market, then this indicates the market equilibrium exchange rate for pounds. At this equilibrium rate:

1. The quantity of pounds demanded by buyers (e.g., U.S. importers of British goods, U.S. investors