Exam 20: The Foreign Exchange Market

Correct Answer:

Answered by Examlex AI Copilot

The spot rate is the current exchange rate at which a currency can be bought or sold for immediate delivery. It reflects the current market conditions and is used for immediate transactions.

The forward rate, on the other hand, is the exchange rate at which a currency can be bought or sold for delivery at a future date. It is determined by the spot rate and the interest rate differentials between the two currencies. Forward rates are used for hedging against future exchange rate fluctuations.

The real exchange rate is the nominal exchange rate adjusted for the relative price levels between two countries. It measures the purchasing power of one currency relative to another and is used to compare the cost of goods and services between countries.

The effective exchange rate is a weighted average of a country's currency relative to a basket of other currencies. It is used to measure the overall strength or weakness of a country's currency in the international market.

In a situation where a company needs to make a large purchase of foreign currency for immediate delivery, they would use the spot rate to determine the exchange rate. If the company wants to hedge against future exchange rate fluctuations, they would use the forward rate to lock in a future exchange rate. When comparing the cost of goods and services between countries, the real exchange rate would be used. And when analyzing the overall strength of a country's currency, the effective exchange rate would be used.

Correct Answer:

Answered by Examlex AI Copilot

Covered interest parity (CIP) and uncovered interest parity (UIP) are concepts in international finance that relate to the relationship between interest rates and exchange rates.

CIP refers to the condition where the interest rate differential between two countries is equal to the forward premium or discount on the foreign currency. In other words, it implies that investors can lock in a certain rate of return on their investment in a foreign currency through a combination of the spot exchange rate, the foreign interest rate, and the forward exchange rate.

UIP, on the other hand, suggests that the expected change in the exchange rate between two countries is equal to the difference in their interest rates. This means that investors should be indifferent between investing in domestic or foreign assets, as the expected return from investing in a foreign currency should be equal to the return from investing in the domestic currency.

Now, let's focus on covered interest parity and how it is conceptually attained in the context of a home country and a foreign country when the short-term interest rate in the foreign country is greater than the short-term interest rate in the home country, while the spot rate on the foreign currency equals the forward rate on the foreign currency.

Assuming that the two interest rates are on comparable assets of the same risk, let's consider a numerical example to illustrate covered interest parity.

Suppose the short-term interest rate in the home country is 3%, and the short-term interest rate in the foreign country is 5%. Additionally, let's assume that the spot rate on the foreign currency is 1.2 units of foreign currency per unit of domestic currency, and the forward rate on the foreign currency is also 1.2 units of foreign currency per unit of domestic currency.

To attain covered interest parity, investors would need to compare the returns from investing in the domestic currency and the foreign currency. If the foreign interest rate is higher, investors would expect a higher return from investing in the foreign currency. However, the forward exchange rate should reflect this interest rate differential to ensure that there is no arbitrage opportunity.

In this example, if an investor in the home country invests in the domestic currency at a 3% interest rate, they would expect to receive a return of 103 units of domestic currency after one year for every 100 units invested. On the other hand, if they invest in the foreign currency at a 5% interest rate, they would expect to receive a return of 105 units of foreign currency after one year for every 100 units invested.

Now, if the spot rate and the forward rate on the foreign currency are both 1.2 units of foreign currency per unit of domestic currency, it means that the forward exchange rate is not offering any premium or discount on the foreign currency. This ensures that the return from investing in the foreign currency is effectively equal to the return from investing in the domestic currency, accounting for the interest rate differential.

In summary, covered interest parity is conceptually attained when the interest rate differential between two countries is equal to the forward premium or discount on the foreign currency, ensuring that there are no arbitrage opportunities for investors. This equilibrium is maintained through the relationship between interest rates and exchange rates, as illustrated in the numerical example and graph.

Correct Answer:

Answered by Examlex AI Copilot

(a) The demand for foreign exchange exists because a country's economic actors, such as businesses, individuals, and the government, need foreign currency to conduct international trade, investment, and travel. This demand curve has a downward slope because as the exchange rate of the domestic currency relative to the foreign currency decreases, the quantity demanded of foreign exchange increases. This is because a lower exchange rate makes foreign goods and services cheaper for domestic consumers and businesses, leading to an increase in demand for foreign currency.

(b) The supply of foreign exchange to a country arises from economic actions such as exporting goods and services, receiving foreign investment, and earning income from foreign assets. When domestic producers sell their goods and services to foreign buyers, they are paid in foreign currency, which adds to the supply of foreign exchange. Similarly, when foreign investors bring capital into the country or when domestic entities earn income from foreign investments, it adds to the supply of foreign exchange. We cannot be sure that the supply curve will always have an upward slope because factors such as changes in government policies, international trade agreements, and global economic conditions can affect the supply of foreign exchange.

(c) When we put the demand curve and supply curve of foreign exchange together, the equilibrium exchange rate is determined at the point where the quantity of foreign exchange demanded equals the quantity supplied. If there were a sudden increase in the supply of foreign exchange to the country, the equilibrium exchange rate would decrease. This is because an increase in the supply of foreign exchange would lead to a surplus of foreign currency in the market, causing the value of the domestic currency to depreciate relative to the foreign currency. As a result, the equilibrium exchange rate would change to reflect the new balance between the demand for and supply of foreign exchange.