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Inter Regular Assignment 1
Inter Regular Assignment 1
Amare dagne
ID No BER/6258/11
Instructors: Dr. Girma estifanos
Transactions are affected at prevailing rate of exchange at that point of time and
delivery of foreign exchange is affected instantly. The exchange rate that prevails in the
spot market for foreign exchange is called Spot Rate. Expressed alternatively, spot rate
of exchange refers to the rate at which foreign currency is available on the spot.
For instance, if one US dollar can be purchased for birr 40 at the point of time in the
foreign exchange market, it will be called spot rate of foreign exchange. No doubt, spot
rate of foreign exchange is very useful for current transactions but it is also necessary to
find what the spot rate is. In addition, it is also significant to find the strength of the
domestic currency with respect to all of home country’s trading partners. Note that the
measure of average relative strength of a given currency is called Effective Exchange
Rate (EER).
A market in which foreign exchange is bought and sold for future delivery is known as
Forward Market. It deals with transactions (sale and purchase of foreign exchange)
which are contracted today but implemented sometimes in future. Exchange rate that
prevails in a forward contract for purchase or sale of foreign exchange is called Forward
Rate. Thus, forward rate is the rate at which a future contract for foreign currency is
made.
This rate is settled now but actual transaction of foreign exchange takes place in future.
The forward rate is quoted at a premium or discount over the spot rate. Forward
Market for foreign exchange covers transactions which occur at a future date. Forward
exchange rate helps both the parties involved.
4. How does the demand for a foreign exchange arise and how does the
supply of a foreign exchange arise? Explain
The demand (or outflow) of foreign exchange comes from those people who need it to
make payment in foreign currency.
1. When price of a foreign currency falls, imports from that foreign country become
cheaper. So, imports increase and hence, the demand for foreign currency rises.
3. When price of a foreign currency falls, its demand rises as more people want to make
gains from speculative activities.
The supply (inflow) of foreign exchange comes from those people who receive it due to
following reasons
The supply of foreign currency rises in the following situations:
1. When price of a foreign currency rises, domestic goods become relatively cheaper. It
induces the foreign country to increase their imports from the domestic country. As a
result, supply of foreign currency rises.
2. When price of a foreign currency rises, supply of foreign currency rises as people want to
make gains from speculative activities.
Foreign exchange (Forex or FX) is the conversion of one currency into another at a
specific rate known as the foreign exchange rate. The conversion rates for almost all
currencies are constantly floating as they are driven by the market forces of supply
and demand.
The nominal exchange rate E is defined as the number of units of the domestic
currency that can purchase a unit of a given foreign currency. A decrease in this
variable is termed nominal appreciation of the currency. (Under the fixed exchange
rate regime, a downward adjustment of the rate E is termed revaluation.) An
increase in this variable is termed nominal depreciation of the currency. (Under the
fixed exchange rate regime, an upward adjustment of the rate E is called
devaluation.)
Fixed exchange rate is the rate which is officially fixed by the government or
monetary authority and not determined by market forces. Only a very small
deviation from this fixed value is possible. In this system, foreign central banks
stand ready to buy and sell their currencies at a fixed price. A typical kind of this
system was used under Gold Standard System in which each country committed
itself to convert freely its currency into gold at a fixed price.
h) Arbitrage:
Arbitrage occurs when an investor can make a profit from simultaneously buying
and selling a commodity in two different markets.
i) Hedging:
Hedging – Setting up an investment positions which helps to protect against losses
from a related investment.
j) Speculation:
Speculation is the purchase of an asset (a commodity, goods, or real estate) with
the hope that it will become more valuable in the near future. In finance, speculation
is also the practice of engaging in risky financial transactions in an attempt to profit
from short term fluctuations in the market value of a tradable financial instrument—
rather than attempting to profit from the underlying financial attributes embodied
in the instrument such as value addition, return on investment, or dividends.
6) How do you distinguish between depreciation and devaluation of a
currency? Appreciation and revaluation of a currency?
Depreciation
Depreciation occurs when a country's exchange rate goes down in the market.
The country's money has less purchasing power in other countries because of the
depreciation.
Devaluation
If a government decides to make its currency less valuable, the change is called
devaluation.
7)
1. Cost-push inflation
2. Demand-pull inflation
3. Fewer incentives in long-term to cut costs.
1. Cost-push inflation
If there is devaluation then there will be an increase in the price of imported goods.
Imports are quite a significant part of the CPI; therefore they will contribute towards cost-
push inflation.
2. Demand-pull inflation
With devaluation, there is likely to be an increase in AD. (AD = C+I+G+X-M), if exports are
cheaper, there will be more exports sold and the quantity of imports will fall. If the
economy is close to full capacity then higher AD will cause inflation.
To addresses such impacts the country must increase its currency value
8)
It has certain risks which investors should be aware of, one of them being
default on securities such as commercial papers. Money market consists
of various financial institutions and dealers, who seek to borrow or loan
securities. It is the best source to invest in liquid assets.
iii) How does the use of money overcome the problems with a
barter system? Explain
Money overcomes the problem of barter system by replacing the C-C economy with
monetary economy (where 'C stands for commodity).
In the barter system, there was a problem of double coincidence of wants. It
was very difficult to match the expectations of two different individuals. Thus,
money was invented to overcome the problem of double Coincidence of
wants.
When there was no money, it was difficult to give common unit of value to
goods or commodities, but when money was evolved, it gave a common unit
of value to every goods and services.
Money facilitates the contractual future payments which were impossible at
the time of barter system.
iv) What is monetary policy and what are the tools of monetary
policy? At a theoretical level, when does monetary policy
become impotent or ineffective? Explain
Monetary policy: is an economic policy that manages the size and growth rate
of the money supply in an economy. It is a powerful tool to regulate
macroeconomic variables such as inflation and unemployment.
Central banks use various tools to implement monetary policies. The widely utilized policy
tools include:
A central bank can influence interest rates by changing the discount rate. The discount rate
(base rate) is an interest rate charged by a central bank to banks for short-term loans. For
example, if a central bank increases the discount rate, the cost of borrowing for the banks
increases. Subsequently, the banks will increase the interest rate they charge their
customers. Thus, the cost of borrowing in the economy will increase, and the money supply
will decrease.
Central banks usually set up the minimum amount of reserves that must be held by a
commercial bank. By changing the required amount, the central bank can influence the
money supply in the economy. If monetary authorities increase the required reserve
amount, commercial banks find less money available to lend to their clients and thus,
money supply decreases.
Commercial banks can’t use the reserves to make loans or fund investments into new
businesses. Since it constitutes a lost opportunity for the commercial banks, central banks
pay them interest on the reserves. The interest is known as IOR or IORR (interest on
reserves or interest on required reserves).
Open market operations
The central bank can either purchase or sell securities issued by the government to affect
the money supply. For example, central banks can purchase government bonds. As a result,
banks will obtain more money to increase the lending and money supply in the economy.
9).
The BOP consists of three main components—current account, capital account, and
financial account.
Current Account:
This part of the balance of payments is regarded as the most important, as it shows a
nation’s trading strength. If payments are greater than receipts, there is a deficit which is
undesirable.
A — Visible Trade:
The money earned from Indian exports of goods (e.g., cars sold to Nepal) is credited
(added) to this account, whilst payments for imported goods (e.g., American aircraft sold in
India) are debited. The difference between the totals is known as the Balance of Trade.
B — Invisible Trade:
The income earned from the sale of Indian services abroad is known as an invisible export,
e.g., an insurance premium paid by a British ship-owner to an Indian broker. When Indian
residents spend money on foreign services, e.g., a week’s accommodation in London, they
are creating invisible imports, because payment is going out of India.
The main invisibles are as follows:
2. Interest, profits and dividends: The earnings from loans, companies and shares,
respectively, earn substantial surpluses for the Indian economy.
3. Other financial services: The earnings of solicitors, brokers, merchants and pensioners
also contribute benefits to the invisible account.
4. Transport: The earnings on passenger carrier by sea and air are two major items.
3. Official Financing:
The Balance for Official Financing (which used to be termed Total Currency Flow) shows
the balance of monetary movements into and out of the country. A positive figure reveals a
net inflow of funds into a country
Balance of Payments Surplus: The account by which the money coming into a nation
is more than the money going out in a particular time frame.
Balance of Payments Deficit: A balance of payments deficit means the nation imports
more commodities, capital and services than it exports. It must take from other
nations to pay for their imports
These are the accommodating transactions of the government made only to bring
equilibrium in the Balance of Payment.
10.
ii) What are the criteria for evaluating an IMS? Explain each
Criteria for evaluating an IMS
Differences between the gold standard and the Bretton Woods system are as follows:
A Bretton wood is a system under which the currencies are pegged with dollar
whereas under the gold standard the currencies are pegged to gold.
The gold standard is a floating exchange rate system, whereas, the Bretton woods
system was different because it was a fixed exchange rate system.
iv) What were the reasons for the collapse of the Bretton Woods
system?
The collapse of the Bretton Woods system was due to internal inconsistency. The
American monetary discipline served as the nominal anchor for the Bretton
Woods system. But when the US started to inflate its economy, the international
monetary system based on the US dollar began to disintegrate.
It was destroyed, in the first place, on the most general level, because of
insufficient flexibility in the system. Exchange rates had hardened, a discussion
of alteration had become impossible outside of the dramatic circumstances of a
major crisis, and other sorts of adjustment (for instance, in fiscal policy) were
too contentious politically.
Second, the immediate disturbance that destroyed the system had a particular
cause, the monetary expansion of the United States in the late 1960s associated
with the Viet Nam war, and a very loose approach to monetary policy in the face
of an exchange crisis in 1971. The criticism that had been most cogently
expressed by General de Gaulle in the mid-1960s now seemed vindicated by the
manner of the collapse.
Third, the trigger that demonstrated the incompatibility of different national
policy stances within the system was given by the larger flows of capital.
11. Write short notes on each of the following. Give examples,
where necessary
i) The Mint Parity Theory
When the currencies of two countries are on a metallic standard (gold or
silver), the rate of exchange between them is determined on the basis of
parity of mint ratios between the currencies of the two countries. Thus, the
theory explaining the determination of exchange rate between countries
which are on the same metallic standard (say, gold coin standard) is known
as the Mint Parity Theory of foreign exchange rate.
ii) Stocks versus Bonds
Bonds Stocks
Bonds are financial instruments that
Stocks are instruments that
highlight the debt taken of the issuing
highlight the interest of ownership
Meaning body towards the holders and a promise
issued by the company in exchange
to pay back at a later stage with interest
for funds
Govt. institutions, financial institutions,
Issuers companies, etc. Corporates
Status Holders are the lenders to the firm Stockholders are the owners of the
Relatively low
Risk Levels High
Form of Interest, as a fixed payment
Dividend, which is not guaranteed
Return
Liquidation and preference in terms of
Additional
repayment Shareholders get voting rights
benefit
Over the Counter
Market Centralized/Stock Market
Type of Debt
Equity
investment
Fixed at the time of purchase
Time of Depends on investors
maturity
12.
i) What are the major factors (or forces) that have led to
increasing interdependence between or among nations?
Please make your own evaluation of these factors
Think of those individuals as a country and the flour as the products and
services we consume. This gives you an idea of the interdependence of
human societies. We fulfill our needs by relying on a massive network of
other people.
13.
ii) What are the reasons for an IMPC and how does such
coordination take place? Discuss
The reasons for an IMPC
1. Trade flows:
Countries are connected via trade flows, for example, the exports of
one country are the imports of another and vice versa.
Changes in the volume of exports and imports will affect the
national incomes and employment levels of the trading partners.
In general, the policies that influence the current account position
of a country will have spillover effects on its trading partners’
current account positions.
2. International capital movement:
Like, policies that influence the domestic interest rate (and
thus affecting capital – inflow of capital outflow) will have effect on
trading partners.
How does such coordination take place?
a) The Exchange of Information:
• A minimal type of coordination is the exchange of information
between/among the authorities of two/more countries.
b) Mutually Consistent Policies:
• The exchange of information may provide the basis for
more active coordination in that the countries concerned
agree either formally or informally to adopt consistent
macroeconomic policy stances.
• In other words, each country takes into account the aims
and policies stance of other countries when formulating its
own policy stance.
c) Joint Action
• Having exchanged information and agreed on mutually
consistent target values for the objectives of economic
policy, the authorities could go one step further and
agree on joint action to achieve desired targets.
• Joint action would mean a concerted action (collective
action) to achieve the desired objective.
• In joint action, for example, fiscal and monetary
policies could be adjusted to maximize joint welfare.
iii) What are the benefits (advantages) and the costs
(disadvantages) of an IMPC and what should be the way
forward? Explain
Advantages
The benefits are associated with
the gains from trade and access to international capital markets.
It reduces of uncertainty and avoidance of
excessive deflation.
It has the potential to reduce the possibility of serious
conflict through the exchange of information.
It competitive manipulation of
exchange rates (or competitive devaluations) and can remove the
danger of excessive deflation.
Disadvantages
14.
Foreign investment, quite simply, is investing in a country other than your home one. It
involves capital flowing from one country to another and foreigners having an ownership
interest or a say in the business. Foreign investment is generally seen as a catalyst for
economic growth and can be undertaken by institutions, corporations, and individuals.
Investors interested in foreign investment generally take one of two paths: foreign
portfolio investment or foreign direct investment.
Foreign portfolio investment (FPI) refers to the purchase of securities and other
financial assets by investors from another country. Examples of foreign portfolio
investments include stocks, bonds, mutual funds, exchange traded funds, American
depositary receipts (ADRs), and global depositary receipts (GDRs).
ii) What are the basic motives for FDI and FPI? Discuss
References