CH10

Question 1

Foreign Exchange Market

Answer 1

Market for converting currency of one country into that of another country.

Question 2

Exchange Rate

Answer 2

The rate at which one currency is converted into another.
- Future exchange rates cannot be accurately predicted.

Question 3

Functions of Foreign Market Exchange

Answer 3

• Convert the currency of one country into the currency of another.
• Provide some insurance against foreign exchange risk.

Question 4

Bussinesses use the Foreign Exchange Market to:

Answer 4

• Convert the payments received for its exports, the income received from foreign investments, or the income received from licensing agreements with foreign firms
• Make payment to a foreign company for its products or services in its country’s currency
• To invest cash for short terms in foreign money markets.

Question 5

Currency Speculation

Answer 5

Typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Question 6

Carry Trade

Answer 6

A kind of speculation that involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another country where interests are high.

Question 7

Insuring Against Foreign Exchange Risk

Answer 7

1. Spot exchange rates
2. Forward exchange rates
3. Currency Swaps

Question 8

Exchange Rate

Answer 8

Rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

Question 9

Forward Exchange

Answer 9

Occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.

Question 10

Currency Swap

Answer 10

The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
- Transaction between international businesses and their banks, between banks, and between governments

Question 11

Foreign Exchange Market

Answer 11

• Global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems
• Rapidly growing
• Most important trading centers are London (largest), New York, Zurich, Tokyo, and Singapore.
• A market is open 24 hours a day
• High-speed computer linkages among trading centers around the globe have effectively created a single market.
• Arbitrage
• Most transactions involve the DOLLAR.

Question 12

Arbitrage

Answer 12

Refers to the purchase of securities in one market for immediate resale in another to profit from a price discrepancy.

Question 13

Law of One Price

Answer 13

States that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

Question 14

Purchasing Power Parity (PPP)

Answer 14

• Comparison of prices of identical products determine the real or PPP exchange rate
• The price of a “basket of goods” should be roughly equivalent in each country
• Big Mac Index

Question 15

Efficient Market

Answer 15

Has no impediments to the free flow of goods and services, such as trade barriers. It is a market where prices reflect all available information.

Question 16

Money Supply and Price Inflation

Answer 16

• The growth rate of a country’s money supply determines its likely future inflation rate.
  Inflation – money supply increases faster than output increases.
  .- An increase in the money supply makes it easier to borrow, which increases demand for goods and services.
• A country with a high inflation rate will see depreciation in its currency exchange rate.
• Government policy determines growth rates.

Question 17

Bandwagon Effect

Answer 17

Movement of traders like a herd, all in the same direction and at the same time, in response to each other’s perceived actions.

Question 18

Summary of Exchange Rate Theories

Answer 18

• Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates.
• But they are poor predictors of short-run changes.

Question 19

Approaches to Forecasting

Answer 19

• Fundamental Analysis
• Technical Anlysis

Question 20

Fundamental Analysis

Answer 20

• Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements
• Includes relative money supply growth rates, inflation rates, and interest rates, and possibly balance-of-payments positions

Question 21

Techincal Analysis

Answer 21

• Uses price and volume data to determine past trends, which are expected to continue into the future.
• There are analyzable market trends and waves that can be used to predict future trends and waves.

Question 21

Currecnies can be:

Answer 21

• Freely Convertible
• Externally Convertible
• Nonconvertible

Question 22

Freely Convertible

Answer 22

A country’s currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency.

Question 23

Externally Convertible

Answer 23

Limitations on the ability of residents to convert domestic currency, though nonresidents can convert their holdings of domestic currency into foreign currency.

Question 24

Nonconvertible

Answer 24

A currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency. - Not desirable for international bussiness.

Question 25

Capital Flight

Answer 25

Converting domestic currency into a foreign currency.

Question 26

Countertrade

Answer 26

The trade of goods and services for other goods and services.

Question 27

Foreign Exchange Rate Risk

Answer 27

- Transaction exposure - Translation exposure - Economic exposure

Question 28

Transaction Exposure

Answer 28

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

Question 29

Translation Exposure

Answer 29

The impact of currency exchange rate changes on the reported financial statements of a company.

Question 30

Economic Exposure

Answer 30

The extent to which a firm’s future international earning power is affected by changes in exchange rates.

Question 31

Reducing Translation and Transaction Exposure

Answer 31

- Forward exchange rate contracts - Buying swaps - Lead strategy - Lag strategy

Question 32

Lead Strategy

Answer 32

Collecting foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.

Question 33

Lag Strategy

Answer 33

Delaying the collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if that currency is expected to depreciate.