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International Finance Flashcards
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International Finance Flashcards
Final 2
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1
Question
What is the difference between currency and foreign exchange?
Answer
Currency: is the legal tender of a country (cash) Foreign currency (foreign exchange, FX): is a broader term that refers to a claim on the legal tender of another country (e.g. bank deposits denominated in a different currency, which are traded in the foreign exchange market)
2
Question
Identify the main factors that affect exchange rates in the short run
Answer
Short-Run Factors: These factors influence exchange rates over days, weeks, or months: Interest Rates • Higher interest rates in a country attract foreign capital, increasing demand for its currency. Speculation • Expectations of future currency movements can lead traders to buy or sell currencies in anticipation, affecting current exchange rates. Political Stability and Economic Performance • Countries with stable governments and strong economic performance tend to have stronger currencies in the short term.
3
Question
Identify the main factors that affect exchange rates in the long run
Answer
Long-Run Factors➔ These affect exchange rates over years: Purchasing Power Parity (PPP) • Based on the idea that identical goods should have the same price across countries when expressed in a common currency. • If a country’s inflation is higher, its currency is expected to depreciate in the long run. Balance of Payments • A persistent trade surplus or deficit can influence long-term exchange rates. Productivity • Higher productivity can lead to stronger currencies over time, as it often means more competitive exports.
4
Question
Define nominal (direct/ indirect) rates!
Answer
Exchange rate: price of one currency in terms of another ▬ The most common is the bilateral nominal exchange rate: Expresses the exchange rate of two currencies: ▬ A nominal exchange rate can be quoted in two ways: • Direct: The price of the currency (HUF) in terms of EUR/dollars➔ 375,00 HUF/EUR • Indirect: The price of EUR/dollars in terms of the foreign currency (HUF)➔ 0,00298268EUR/HUF
5
Question
What is the real exchange rate (RER) and how is it calculated?
Answer
The real exchange rate adjusts the nominal exchange rate for differences in price levels (inflation) between two countries, reflecting the relative purchasing power of currencies. It is calculated as: Real Exchange Rate = (Nominal Exchange Rate × Foreign Price Level) / Domestic Price Level.
6
Question
How does an increase in domestic inflation affect the real exchange rate and domestic goods' competitiveness?
Answer
If domestic inflation rises while the nominal exchange rate remains constant, the real exchange rate appreciates, making domestic goods more expensive relative to foreign goods, reducing their competitiveness abroad.
7
Question
What are the implications of real exchange rate depreciation for a country's exports, imports, and trade balance?
Answer
Real exchange rate depreciation makes domestic goods cheaper compared to foreign goods, leading to increased exports, decreased imports, and an improvement in the trade balance.
8
Question
Differentiate between appreciation/depreciation and revaluation/devaluation in exchange rate systems.
Answer
In a flexible exchange rate system, appreciation means the currency value increases due to market forces, and depreciation means it decreases. In a fixed exchange rate system, revaluation is the official increase in currency value by the government, and devaluation is the official decrease, set by the government.
9
Question
Explain the theory of Purchasing Power Parity (PPP) and its main assumptions.
Answer
PPP states that similar goods or baskets of goods should have the same price in terms of the same currency across countries. Its main assumptions are: all goods are identical in both countries; trade barriers and transportation costs are low; and many goods and services are not tradable across borders.
10
Question
Why do price levels often differ significantly between richer and poorer countries despite PPP theory?
Answer
PPP mostly applies to tradable goods, but many goods and services (like housing and healthcare) are non-tradable and vary widely in price. Additionally, productivity differences (Balassa-Samuelson effect), taxes, tariffs, and transportation costs distort prices, preventing full PPP.
11
Question
What is the 'Big Mac Index' and how does it relate to the theory of Purchasing Power Parity?
Answer
The Big Mac Index compares the prices of a Big Mac burger in different countries to assess if currencies are at their 'correct' PPP-based level. It implies how overvalued or undervalued a currency is by comparing the local price to the US price, converted at the current exchange rate.
12
Question
How do changes in domestic and foreign real interest rates impact exchange rates and net exports?
Answer
When a domestic real interest rate rises, demand for domestic currency increases, causing currency appreciation and reducing net exports. Conversely, if a foreign real interest rate rises, it increases the supply of domestic currency (currency depreciates), which typically raises domestic net exports.
13
Question
What are the main functions of the foreign exchange market?
Answer
The foreign exchange market enables currency conversion, hedging against exchange rate risk, arbitrage to exploit price differences, speculation to profit from changes in rates, and determines exchange rates through supply and demand.
14
Question
Who are the main participants/actors of the foreign exchange market; what are the main types of FX instruments/transactions?
Answer
Main participants/actors of the foreign exchange market include: 1. Commercial banks 2. Central Banks 3. International Corporations 4. Nonbank financial institutions Main types of FX instruments/transactions: 1. Spot Transactions – immediate exchange of currency at current rates 2. Forward Contracts – agreements to exchange currency at a set rate on a future date 4. Options – contracts giving the right, but not the obligation, to exchange currency at a set rate before a specified date 5. Swaps – simultaneous purchase and sale of a currency for two different value dates
15
Question
Define the international financial system and its subsystem
Answer
International financial system: worldwide framework of legal agreements, institutions, and both formal and informal economic actors that together facilitate international flows of financial capital for purposes of investment and trade financing ○ It governs the use and exchange of money around the world and between countries. ○ The international monetary system, a component of this larger system➔ establishes the rules for valuing and exchanging different national currencies. ○ Sub-systems: ▬ International Financial markets ▬ International Monetary systems ▬ International Regulatory systems
16
Question
What is the Balance of Payment system?
Answer
The Balance of Payment system is a record of all economic transactions between the residents of a country and the rest of the world during a specific period. It includes the trade of goods and services, financial capital, and financial transfers. International BoP: the difference between all money inflows to the country in a particular period of time (e.g., a quarter or a year) and the outflow of money to the rest of the world.
17
Question
Understand the items of current account and capital account
Answer
The current account➔ a nation's net trade in goods and services, its net earnings on cross-border investments, and its net transfer payments. The trade balance➔ the total value of exports of goods and services minus the total value of imports. • When imports exceed exports➔ a country runs a trade deficit. • When exports exceed imports➔ runs a trade surplus. • The trade balance=net exports ▬ The capital account➔ nation's transactions in financial instruments and central bank reserves. When a country's residents increase their net holdings of foreign assets➔ recorded as a net acquisition of financial assets. When foreigners increase their net holdings of that country's assets➔ it's recorded as a net incurrence of liabilities. The difference➔ financial account balance ▬ The financial account➔ all incoming investments (FDI, portfolio and other investments)
18
Question
Interpret the relationships among the current account, the capital account, and official reserve transactions balance
Answer
- The balance of payments must sum to zero. So, if the current account is in deficit, this must be financed by a surplus in the capital account and/or drawing down official reserves. - A current account deficit (more imports than exports) must be offset by net capital inflows (foreign investments, loans) or by a reduction in official reserves. - Conversely, a current account surplus implies a capital account deficit or accumulation of reserves.
19
Question
Define Gross Domestic Product (GDP), Gross National Product (GNP), and Gross National Income (GNI).
Answer
GDP is the total output of goods and services produced within a country's borders by residents and non-residents. GNP is the total income earned by a country's residents and businesses regardless of location, including income from abroad but excluding income by foreigners domestically. GNI is GDP plus net factor income from abroad (income residents earn overseas minus income foreigners earn domestically).
20
Question
Define International capital flows; its main asset classes
Answer
International capital flows refer to the movement of money for the purpose of investment, trade, or business production across countries. The main asset classes involved in international capital flows are: 1. Portfolio investment (stocks, bonds of foreign countries) 2. Other investments (bank loans, deposits, trade credit) 3. Foreign direct investment (FDI) 4. Derivatives and financial instruments (options, futures, swaps)
21
Question
What is foreign direct investment (FDI) and why is it important for international capital flows?
Answer
FDI is a long-term investment where a firm or individual in one country establishes business operations or acquires assets in another country, typically involving ownership or control (>10%). FDI is important as it brings investment, know-how, and can drive economic growth, especially via multinational corporations.
22
Question
What is the paradox of international capital flows?
Answer
The paradox of international capital flows refers to the observation that capital tends to flow from poorer to richer countries (Lucas paradoxon), contrary to the expectation that it would move from capital-rich (developed) countries to capital-poor (developing) countries where returns on investment should be higher.
23
Question
List some negative impacts (8 factors) of foreign direct investment (FDI) on host countries, with examples from Central and Eastern Europe.
Answer
Negative impacts include dual economy creation, crowding out domestic firms, unequal competition with cherry-picking of assets, limited innovation spillovers, minimal income effects retained domestically, increased imports leading to trade deficits, balance of payment, and growth impact.
24
Question
What is the Eurodollar market and why is it significant in international finance?
Answer
The Eurodollar market involves U.S. dollar-denominated deposits held in banks outside the U.S., not subject to U.S. regulations. It plays a crucial role by providing liquidity, enabling global dollar transactions, and supporting international banking and cross-border investments.
25
Question
Explain the main functions and the necessity of an international monetary system.
Answer
The international monetary system sets the rules governing currency use and exchange globally, facilitating international trade and investment. It ensures exchange rate stability, balance of payments adjustments, and provides confidence and a framework to manage global financial flows and imbalances.
26
Question
What were the stages of the international monetary system?
Answer
The stages of the international monetary system are: 1. The Gold Standard (1870s–1914): fixed exchange rates, Currencies pegged to the value of gold 3. The Bretton Woods System (1944–1971): Fixed exchange rates using U.S. dollar 4. Floating era (1971-1997): exchange rates have become much more volatile and less predictable
27
Question
What caused the collapse of the Bretton Woods fixed exchange rate system?
Answer
Bretton Woods collapsed due to different national monetary policies, inflation, conflicting interests between national and global goals (Triffin's dilemma), growing U.S. balance of payments deficits undermining confidence in the dollar, oil price shocks, and speculative pressures exacerbating instability.
28
Question
What is the fixed exchange rate regime?
Answer
A fixed exchange rate regime is a system where a country's currency value is pegged or tied to another major currency, a basket of currencies, or a commodity like gold, maintaining a set exchange rate. e.g Gold Standard, Bretton Woods
29
Question
What is the Floating (flexible) exchange rate regime?
Answer
A floating (flexible) exchange rate regime is a system where the value of a currency is allowed to fluctuate against all other currencies. Exchange rates are not officially fixed, and are determined by conditions of supply and demand in the foreign exchange market.
30
Question
What is the Managed float regime (dirty float)?
Answer
The Managed float regime, or dirty float, is an exchange rate system where a country's currency value is allowed to fluctuate in the open market but is occasionally intervened in by the central bank to stabilize or steer its value. e.g current international financial system.