FIN407 MIDTERM REVIEW PDF

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FIN407 MT REVIEW CHP4 The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another. Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule. (See Exhibit 4.2) Supply of a currency for sale increases when the value of the currency increases, leading to an upward sloping supply schedule. (See Exhibit 4.3) Equilibrium equates the quantity of pounds demanded with the supply of pounds for sale. (See Exhibit 4.4) Factors That Influence Exchange Rates Relative inflation rates: increase in US inflation increases demand for foreign goods which increase the change rate for foreign currency. Demand increase, supply decrease, value icnreas 1. Relative Interest Rates: Increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to an increase in demand for dollars and an increased exchange rate for the dollar. Increase in int rates Demand increase, supply decrease, value icnrease FISHER EFFECT

Country with higher real int rate currency appreicates

2. Relative Income Levels: Increase in U.S. income leads to an increase in U.S. demand for foreign goods, an increased demand for foreign currency relative to the dollar, and an increase in the exchange rate for the foreign currency. Increase demand no effect on uspply 3. Government Controls via: •

Imposing foreign exchange barriers

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Imposing foreign trade barriers

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Intervening in foreign exchange markets

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Affecting macro variables such as inflation, interest rates, and income levels

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Relax import increase supply, no effect on demand, value of curreny decrease 5. Expectations

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Impact of favorable expectations: If investors expect interest rates in one country to rise, they may invest in that country, leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency.

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Impact of unfavorable expectations: Speculators can place downward pressure on a currency when they expect it to depreciate.

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Impact of signals on currency speculation: Speculators may overreact to signals, causing currency to be temporarily overvalued or undervalued.

The “Carry Trade” — Where investors attempt to capitalize on the differential in interest rates between two countries. •

Impact of appreciation in the investment currency: Increased trade volume can have a major influence on exchange rate movements over a short period.

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Risk of the Carry Trade: Exchange rates may move opposite to what the investors expected.

Capital flow for orupseo of icevstments ex intraterate more impTrade flow , t Trade flows are the buying and selling of goods and services between countries. Inflation and income level Capital flows represent money sent from overseas in order to invest in foreign markets. Interest rate driver impfactor int rate

CHP6 Central bank can revalue (appreictae) and devalue currency (deprictae ) against ther currencies 4 types of Exchange rate systems •

Fixed

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Freely floating

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Managed float

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Pegged

Fixed Exchange Rate System Advantages of fixed exchange rates

Disadvantages of fixed exchange rates

Insulate country from risk of currency appreciation. Risk that government will alter value of currency. Allow firms to engage in direct foreign investment without currency risk.

Country and M N C may be more vulnerable to economic conditions in other countries. Central banks might need to constantly intervene to maintain their currency’s value

Freely Floating Exchange Rate System •

Exchange rates are determined by market forces without government intervention.

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Advantages of a freely floating system:

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Disadvantages of a freely float exchange rate system:

Country is more insulated from inflation of other countries.

Can adversely affect a country that has unemployment.

Country is more insulated from unemployment of other countries. Does not require central bank to maintain exchange rates within specified boundaries.

Can adversely affect a country with high inflation.

 A freely floating system may help correct balance-of-trade deficits since the currency will adjust according to market forces. Also, countries are more insulated from problems of foreign countries under a freely floating exchange rate system. However, a disadvantage of freely floating exchange rates is that firms have to manage their exposure to exchange rate risk. Also, floating rates still can often have a significant adverse impact on a country’s unemployment or inflation.  Under a fixed exchange rate system, the governments attempted to maintain exchange rates within 1% of the initially set value (slightly widening the bands in 1971). Under a freely floating system, government intervention would be non-existent. Under a managed float system, governments will allow exchange rates move according to market forces; however, they will intervene when they believe it is necessary.

Managed Float Exchange Rate System Governments sometimes intervene to prevent their currencies from moving too far in a certain direction Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others. Pegged Exchange Rate System •

Home currency value is pegged to one foreign currency or to an index of currencies.

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Limitations of pegged exchange rate May attract foreign investment because exchange rate is expected to

o remain stable. o

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Weak economic or political conditions can cause firms and investors to question whether the peg will be broken. Currency Boards Used to Peg Currency Values A system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed. Interest Rates of Pegged Currencies

Interest rate will move in tandem with the interest rate of the currency

o to which it is tied. •

Exchange Rate Risk of a Pegged Currency Provides examples of countries that have pegged the exchange rate of their currency to a specific currency. Currencies are commonly pegged to the U.S. dollar or to the euro.

o

Dollarization •

Replacement of a foreign currency with U.S. dollars.

This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars

Black Markets for Currencies •

When a government sets a fixed exchange rate and imposes restrictions on residents that require them to exchange currency at that official rate, it may trigger the creation of a “black market” for foreign exchange.

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The term black market refers to an underground (illegal) network that avoids the the legal (formal) network in the economy.

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A black market for foreign exchange becomes especially active when local residents fear an impending currency crisis.

Monetary Policy in the Eurozone •

European Central Bank — Based in Frankfurt and is responsible for setting monetary policy for all participating European countries

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Objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.

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Impact on Firms in the Eurozone — Prices of products are now more comparable among European countries.

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Impact on Financial Flows in the Eurozone — Bond investors who reside in the eurozone can now invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros. Impact of a Eurozone Country Crisis on Other Eurozone Countries 

Financial problems of one bank can easily spread to other banks.

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Banks in Eurozone frequently engage in loan participations. If companies have trouble repaying, all banks may be affected.

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News about concerns in one area of Eurozone can trigger actions in other areas.

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Eurozone country governments must rely on fiscal policy when they experience serious financial problems.

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Banks lend heavily to governments. Performance is related to whether that government can repay its debts.

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ECB Role in Resolving Economic Crises

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In recent years the bank’s role has expanded to include providing credit for eurozone countries that are experiencing a financial crisis.

o

The ECB imposes restrictions intended to help resolve the country’s budget deficit problems over time.

Impact of a Country Abandoning the Euro •

Would allow a country to set its own exchange rate to encourage purchasers of exports.

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Would possibly be expelled from the European Union, which would almost certainly reduce its trade with other European Union countries. Impact of Abandoning the Euro on Eurozone Conditions

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A fear of future declines in the value of euro-denominated assets could cause the euro to weaken.

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An economic analysts contend that the mere threat to abandon the euro would create more problems for the eurozone than would an actual abandonment. Reasons for Direct Intervention (central banks may commonly intervene to manage exchange rates for three reasons)

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Smoothing exchange rate movements o If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time.

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Establishing implicit exchange rate boundaries o Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries.

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Responding to temporary disturbances o A central bank may intervene to insulate a currency’s value from a temporary disturbance.

The Direct Intervention Process (Exhibit 6.3) •

A country’s central bank can use direct intervention by engaging in foreign exchange transactions that affect the demand or supply market conditions for its currency.

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Reliance on reserves •

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The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use.

Coordinated Intervention •

Intervention more likely to be effective when it is coordinated by several central banks.

NON STRELIZED Interevns in FE MKT DOESN’T INTERFER WITH MONEY SUPPLY STERILIZED ITNERNEVNTION INTERFERS IN FOR. EXCHNAGE MTK Direct Intervention as a Policy Tool •

Influence of a Weak Home Currency o The central bank implements a direct intervention to weaken its home currency in an effort to stimulate foreign demand for the country’s products. (See Exhibit 6.5)may increase inflation

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Influence of a Strong Home Currency o The central bank may also implement a direct intervention to strengthen its home currency, which can reduce the country’s inflation. (See Exhibit 6.6) can also elad to unemplyemyn

Indirect Intervention (continued) •

Government Control of Interest Rates by increasing or reducing interest rates.

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Government Use of Foreign Exchange Controls such as restrictions on the exchange of the currency. o Intervention Warnings intended to warn speculators. The announcements could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency. ADDITIONAL IMP NOTE

Currency devaluations have the potential to reduce unemployment, while currency revaluations have the potential to reduce inflation. Central banks can use their currency reserves to buy up a specific currency in the foreign exchange market in order to place upward pressure on that currency. Central banks can also attempt to force currency depreciation by flooding the market with that specific currency (selling that currency in the foreign exchange market in exchange for other currencies). To increase the value of its home currency, a central bank could attempt to increase interest rates, thereby attracting a foreign demand for the home currency to buy high-yield securities.

To decrease the value of its home currency, a central bank could attempt to lower interest rates in order to reduce demand for the home currency by foreign investors. Currency Effects on Economy. What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? A weak home currency tends to increase a country’s exports and decrease its imports, thereby lowering its unemployment. However, it also can cause higher inflation since there is a reduction in foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local producers can more easily increase prices without concern about pricing themselves out of the market. A strong home currency can keep inflation in the home country low, since it encourages consumers to buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be obtained cheaply. This also helps to maintain low inflation. However, a strong home currency can increase unemployment in the home country. This is due to the increase in imports and decrease in exports often associated with a strong home currency (imports become cheaper to that country but the country’s exports become more expensive to foreign customers).

Intevrntion have a stronger effect on some currencies than other if the kt for the cucrnecy s less effective so itnernvention can signifcnalty alter supply and demand for the currency Indirect itnenrvation has a stronger impact because it effects the factors of foreign echange rates so efectthe natural rpcie equilibrium between the supply and demand of currency . while direvt is a superifal method of afefctign supply and demand and can be overdone y the mtk forces...