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Chapter 4

Q1 What are the factors that influence the exchange rates?

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Relative interest rates: rate leads to increase in demand for U.S Deposits and decrease demand for foreign deposits leading to increase U.S currency demand.

Relative income levels: Increase leads to increase in U.S demand for foreign goods and increased demand for foreign currency relative.

Expectations: if an investor expects interest rate to increase in a country, he may invest in that country

Interest rate factors: some factors place upward pressure while other factors place download. Ex; Turkish Lira

Inflation factors: multiple currency markets. Common for European currencies to move in the same direction against the dollar

Fisher effect à Real interest = Nominal interest rate – Inflation rate

Q2 Define the following terms

Currency depreciation: Indicates the decrease the value in a currency.

Currency Appreciation: Indicates a rise in the value of a currency.

Exchange rate: Represents the price of currency to another currency in terms of exchanged transaction occurred.

Currency Demand: Increase when the volume of currency decrease, leading to a downward sloping in the supply schedule.

Currency Supply: Increase when the value of currency increases, leading to upward sloping in the supply schedule.

Exchange rate equilibrium: Equates the quantity of currency demanded with the supply of the same currency for sale.

Fisher Effect: Fisher effect àReal interest = Nominal interest rate – Inflation rate

Chapter 5

Q1 What are the currencies call & put option? What makes them different from each other?

Call: Grants the right to buy a specified currency at designated exercise price or strike price within a specific period of time.

  • The buyer of the option pays a call premium

Buy: Grants the right to sell a specified currency at designated exercise price or strike price within a specific period of time.

  • The buyers of the option pays a put premium

Q2 What are the factors affecting currency call and put option premiums?

Call & Put

  1. Spot price relative to the strike price (S-X)
  2. Length of time before Expiration (t)
  3. Potential Variability of currency (GQNBCybvGEXLKoi7d73iGr0NHpf93x6zAlWegPZa

Q3 Define the following terms

  1. Forward contract: is an agreement between a corporation and financial institution to exchange currency in specified rate and date.
  2. Forward rate: The specific rate which the contract specifies.
  3. Arbitrage: if the forward rates and spot rate is symmetric, arbitrage is possible.
  4. Non-deliverable forward contracts: can be used for emerging market currencies when no currency delivery takes a place at settlements
  5. Currency contract efficiency: Similar to forward contract in terms of obligation in terms of purchasing or selling a currency.

Chapter 8

Q1 How can we test PPP does not occur?

-1 Simple tests of PPP (Exhibit 8.4)

Choose two countries (such as the United States and a foreign country) and compare the differential in their inflation rates to the percentage change in the foreign currency’s value during several time periods.

-2 Statistical Test of PPP: Apply regression analysis to historical exchange rates and inflation differentials.

-3 Limitation of PPP Tests

Results  vary with the base period used. The base period chosen should reflect an equilibrium position since subsequent periods are evaluated in comparison to it. If a base period is used when the foreign currency was relatively weak for reasons other than high inflation, most subsequent periods could show higher appreciation of that currency than what would be predicted by PPP.

Q2 What are the factors to be considered when assessing interest rate parity (IRP)?

Confounding effects: A change in a country’s spot rate is driven by more than the inflation differential between two countries.

No Substitutes for Traded Goods: If substitute goods are not available domestically, consumers may not stop buying imported goods.

Q3 Do a comparative analysis of IRP, PPP and IFE Theories

Although all three theories relate to the determination of exchange rates, they have different implications.

  • IRP focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. It relates to a specific point in time.
    • PPP and IFE focus on how a currency’s spot rate will change over time.
    • Whereas PPP suggests that the spot rate will change in accordance with inflation differentials, IFE suggests that it will change in accordance with interest rate differentials.
    • PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries.