A-Level Economics on Currency Exchange

Definitions

1. Exchange Rate: The price at which one currency can be converted into another currency.
2. Spot Exchange Rate: The exchange rate for immediate delivery of currencies.
3. Forward Exchange Rate: The exchange rate at which two parties agree to exchange currencies on a specified future date.
4. Floating Exchange Rate System: An exchange rate system where the value of a currency is allowed to fluctuate according to the foreign exchange market.
5. Fixed Exchange Rate System: An exchange rate system where a country’s currency value is tied to another major currency like the U.S. dollar or gold.
6. Managed Float System (Dirty Float): An exchange rate system where the currency value is predominantly determined by the market but the central bank intervenes occasionally to stabilize or steer the currency’s value.
7. Currency Appreciation: An increase in the value of one currency relative to another currency.
8. Currency Depreciation: A decrease in the value of one currency relative to another currency.
9. Devaluation: A deliberate downward adjustment to a country’s currency value, relative to another currency or standard, by the country’s government or central bank.
10. Revaluation: A deliberate upward adjustment to a country’s currency value, relative to another currency or standard, by the country’s government or central bank.
11. Foreign Exchange Market: A global decentralized or over-the-counter market for trading currencies.
12. Balance of Payments (BOP): A record of all economic transactions between residents of a country and the rest of the world in a given period.
13. Current Account: A component of the balance of payments that includes the trade balance, net primary income, and net secondary income.
14. Capital Account: A component of the balance of payments that records all transactions involving the purchase or sale of assets.
15. Financial Account: A component of the balance of payments that records investment flows.
16. Exchange Rate Regime: The way a country manages its currency in relation to other currencies and the foreign exchange market.
17. Purchasing Power Parity (PPP): A theory that states that in the long run, exchange rates should adjust to equalize the price of an identical basket of goods and services in any two countries.
18. Interest Rate Parity (IRP): A theory that suggests the difference between two countries’ interest rates is equal to the differential between the forward exchange rate and the spot exchange rate.
19. Hedging: Taking an investment position intended to offset potential losses that may be incurred by a companion investment.
20. Currency Futures: Financial contracts to buy or sell a specific currency amount at a specific price on a set future date.
21. Currency Options: Contracts that give the investor the right, but not the obligation, to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.
22. Direct Quote: An exchange rate quoted as the domestic currency per unit of the foreign currency.
23. Indirect Quote: An exchange rate quoted as the foreign currency per unit of the domestic currency.
24. Cross Rate: An exchange rate between two currencies, calculated from their common relationships with a third currency.
25. Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the price in different markets.
26. Speculation: The act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain.

Introduction to Currency Exchange

• Definition: Currency exchange involves the swapping of one currency for another. It is the basis of foreign trade and investment.
• Exchange Rate: The price of one currency in terms of another, determined in the foreign exchange market.
• Participants: Central banks, commercial banks, corporations, brokers, investors, tourists, and others.

Functions of the Foreign Exchange Market

• Transfer of Purchasing Power: Facilitates the transfer of purchasing power between countries, necessary for international trade.
• Credit for International Trade: Provides credit for international trade. Letters of credit are used in conjunction with foreign exchange.
• Minimizing Foreign Exchange Risk: Offers instruments like futures and options to hedge against foreign exchange risk.

Types of Exchange Rate Systems

• Fixed Exchange Rate: The value of a currency is pegged to another currency or a basket of currencies.
• Floating Exchange Rate: The value of the currency is allowed to fluctuate according to the foreign exchange market.
• Managed Float: A hybrid where a currency mostly floats in the open market, but the central bank may intervene.

Determinants of Exchange Rates

• Interest Rates: Higher interest rates offer lenders a better return relative to other countries.
• Inflation Rates: A country with a lower inflation rate will see an appreciation in the value of its currency.
• Current-Account Deficits: The trade balance affects currency value; a deficit could lead to depreciation.
• Public Debt: Countries with large public debts are less attractive to foreign investors due to the risk of inflation and default.
• Political Stability and Economic Performance: Foreign investors inevitably seek out stable countries with strong economic performance.

Balance of Payments

• Current Account: Includes trade balance, net income from abroad, and net current transfers.
• Capital Account: Records all transactions between a country’s residents and the rest of the world involving asset changes.
• Financial Account: Includes investment flows and changes in foreign ownership of assets.

Exchange Rate Theories

• Purchasing Power Parity (PPP): Suggests that in the long run, exchange rates will adjust to equalize the price of an identical basket of goods and services in any two countries.
• Interest Rate Parity (IRP): States that the difference in national interest rates for financial assets of similar risk and maturity should be equal to the forward rate discount or premium for foreign currency.

Currency Exchange Calculations

• Spot and Forward Rates: The spot rate is the current exchange rate, while the forward rate is the agreed-upon exchange rate for a future date.
• Cross Rates: The exchange rate between two currencies, calculated based on their common relationships with a third currency.

Foreign Exchange Risk Management

• Hedging: Using financial instruments or market strategies to offset potential losses/gains in another investment.
• Options: Contracts offering the right, but not the obligation, to buy or sell currency at a set price on a future date.
• Futures: Contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price.

The Role of Central Banks

• Exchange Rate Regimes: Central banks may manage their currency through different regimes, influencing exchange rates through monetary policy.
• Foreign Exchange Reserves: Central banks hold reserves to manage the currency’s value and ensure the smooth operation of foreign exchange markets.
• Intervention: Central banks may buy/sell currencies to influence their value.

Impact of Exchange Rates on the Economy

• Trade Competitiveness: Exchange rates affect a country’s trade competitiveness. A weaker currency makes exports cheaper and imports more expensive.
• Inflation: Exchange rates can affect inflation. For example, a weaker currency can lead to higher import prices, which can increase inflation.
• Interest Rates: Central banks may adjust interest rates to control currency value, affecting economic growth.