Chapter 18

Question 1

How to read 1.416 USD/EURO

Answer 1

1 Euro will cost 1.416 USD

Question 2

Nominal

Answer 2

Exchange rate is quoted rate at any given time

Question 3

Real

Answer 3

Exchange rate is nominal exchange rate adjusted for inflation in each country compared to the base.

Question 4

Quote in Direct Terms

Answer 4

Price/ Base
Domestic / Foreign

Question 5

Real Exchange Rate Formula

Answer 5

Question 6

What does it mean when there is a fall in base?

Answer 6

US is our home
We invest in euroland
Exposure to currency is euro

Any fall in euro means we get less when we convert back to USD.

Say its 2 USD/EUR .. so 1 euro is 2 dollars.

If euro falls to .50, you get less dollars.

Question 7

What does it mean when there is a fall in Price?

Answer 7

If USD rises, its the same as fall in euro

When we convert from euro to USD, we get less …

Say its 2 USD/EUR .. so 1 euro is 2 dollars

If USD rises, you still loose in euros

Question 8

Direct vs indirect terms

Answer 8

Direct:
Price/Base
Domestic/Foreign

Indirect:
Base/Price
Foreign/Domestic’s

If its 1.416 USD/EUR(Direct)

For indirect its 1/quote given so:
1/1.416

Question 9

Sell Side and Buy Side for FX

Answer 9

Sell: Large Multinational Banks
Buy:
- Corp

• Real Money accounts (own money); don’t use derivatives (mutual funds)
• Leveraged Accounts; don’t use derivatives (Hedge Funds)
• Govt., Sovereign wealth funds, pension plans, CENTRAL BANKS

-Retail Market: Households (tourism)

Question 10

Example Question:

CAD exchange rate with JPY changes from
JPY/CAD 75 to JAP CAD 78.

What happened to CAD?

Answer 10

(78-75)/75 = 4%
CAD appreciated 4%

Its inverted so:

1/75 = 0.0133
1/78 = 0.0128

(0.0128-0.0133)/0.0133 = -3.8%

JYP deprecated -3.8%

Question 11

Relation between balance of trade and cap flows Formula

Answer 11

Question 12

4 objectives of cap restrictions

Answer 12

1. Reduce volatility of DOMESTIC prices as cap outflows may drive down asset prices.

• With no restrictions of foreign investment capital, asset markets of small countries can be volatile over the econ cycle.

2. Maintain fixed exchange rates.

• with fixed rates, limiting inflows of foreign investment capital makes it easier to meet the exchange rate target. Lets them use monetary and fiscal policy to pursue econ goals for domestic econ.

3. Keep Domestic interest rates low by restricting outflow of inv capital.

• If you restrict outflow of inv capital, countries can keep their domestic interest rates low and manage domestic econ with monetary policy bc investors cannot pursue higher rates in foreign countries.

4. Protect strategic industry for national security.

• Gov can prohibit investments by foreign entities in industries considered to be important for national security . For example, telecommunications.

Question 13

Absorption Approach

Answer 13

Considers capital flows and good flows

Domestic spending and income is equivalent to increasing domestic savings.

Increase savings relative to domestic investment will move the balance of payments toward surplus under absorption approach.