Chapter 5 Models of Exchange-rate Determination
Exercises
1.Single-choice questions
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cbcab
bdbad
cddaa
dbbbad
2.Fill in the blanks
purchasing power
forward contract
Appreciation/ Revalue
PPP
differentials
value
3.Noun explanation
(1)Spot exchange rate
The rate applicable to foreign exchange transactions requiring contemporaneous delivery and payment.
(2)Forward exchange rate
The exchange rate applicable to foreign exchange transactions agreed upon today for later delivery (usually in 30, 90, or 180 days).
(3)Triangular arbitrage
The process that ensures consistency among the sets of bilateral “cross rates” of the world’s traded currencies.For example, if the British pound trades for US$2, and 100 Japanese yen trade for US$1, the exchange rate between the yen and the pound must be 200 yen per pound.Otherwise, there is an opportunity for an arbitrageur to buy a currency cheaply in one market and sell it for a higher price in another market.
(4)Hedging
The act of exactly matching assets and liabilities, such as foreign currencies, so as to avoid exchange rate risk is the act of balancing your assets and liabilities in a foreign currency to become immune to risk resulting from future changes in the value of foreign currency.
(5)Speculating
Deliberately assuming a net asset (long)position or net liability (short)position in an asset, such as a foreign currency, in the hope of profiting from price changes.
Speculating means taking a long or a short position in a foreign currency, thereby gambling on its future exchange value.There are a number of ways to hedge or speculate in foreign currency.
Speculating means committing oneself to an uncertain future value of one’s net worth in terms of home currency.
4.Essay questions
(1)
Foreign exchange arbitrage is the act of buying a currency at one price and immediately selling it at a different price.Spatial arbitrage refers to arbitrage activities that span separate markets.Triangular arbitrage refers to arbitrage activities in which the foreign exchange transaction involves more than two currencies.
(2)
we assume that there is no transaction cost, and capital can flow freely, and capital scale for arbitrage is unlimited.
Covered interest parity is a condition that says that the difference between the interest rate on a domestic financial asset and the interest rate on a foreign financial asset should approximately equal the forward premium or discount.
(3)
According to PPP, forward rate/spot = indexdom/index for the exchange rate of the pound will depreciate by 4.7 percent.Therefore, the spot rate would adjust to $1.90 × [1 + (-.047)] =$1.8107
(4)
According to the IFE, St+1/St = (1+Rh)/(1+Rf)
$0.70 × (1+0.04)= $0.728
(5)
The firm could borrow the amount of Singapore dollars so that the 100,000 Singapore dollars to be received could be used to pay off the loan.This amounts to (100,000/1.02)=about S$98,039, which could be converted to about $49,020 and invested.The borrowing of Singapore dollars has offset the transaction exposure due to the future receivables in Singapore dollars.
(6)
Foreign exchange risk is the effect that uncertain future values of the exchange rate may have on the value of a foreign-currency-denominated obligation, receipt, asset, or liability.If economic entities are in foreign exchange activities, they are likely to suffer the loss due to a change in foreign exchange rates.There are three types of exposure to foreign exchange risk:transaction exposure, translation exposure, and economic exposure.In principle, an individual or firm can offset, or hedge, some or all of the exposure to foreign exchange risk.The individual or firm covers the exposure by completely eliminating the risk.
(7)
An individual or firm may be exposed to foreign exchange risk in any of three different ways.
Transaction exposure is the risk that the cost of a transaction, or the proceeds from a transaction, in terms of the domestic currency, may change.A transaction exposure is created when a firm agrees to complete a foreign-currency-denominated transaction sometime in the future.
The second type of foreign exchange risk is translation exposure, which arises when translating the values of foreign-currency-denominated assets and liabilities into a single currency value.
The final type of foreign exchange risk is economic exposure, which is the effect that exchange-rate changes have on a firm’s present value of future income streams.Economic exposure affects the ability of a firm to compete in a particular market over an extended period.Some economists believe that at least a portion of foreign direct investment results from firms trying to avoid economic exposure.By owning a plant or office in a foreign location of operation, the firm may avoid some of the foreign exchange risk that it would have incurred if all its plants and offices were in domestic locations only.
(8)
PPP is a condition that states that if international arbitrage is unhindered, ignoring transportation costs, tax differentials, and trade restrictions, the price of a good or service in one nation should be the same as the exchange-rate-adjusted price of the same good or service in another nation.
(9)
Uncovered interest parity is a condition relating the interest differential of similar financial instrument of two nations to the excepted change in spot exchange rate between the two nations.
Uncovered interest arbitrage refers to funds from the low interest rate currencies to high interest rate currencies, thereby earning the rate difference of income, but not at the same time trade against unwinds positions.This kind of arbitrage to withstand the high interest rate currencies devalues risk, speculative.
Covered interest parity is a condition that says that the difference between the interest rate on a domestic financial asset and the interest rate on a foreign financial asset should approximately equal the forward premium or discount.
Covered interest arbitrage is defined in the lower interest rate borrows a currency, through spot foreign exchange transaction will change into higher interest rates of national currency and invested to earn interest income.At the same time, in order to prevent the investment period exchange rate risk, this kind of arbitrage usually swaps with combination, namely from the higher interest income minus do swap cash, buy sell Fore cost, earn certain profit.