College of Business and Economics
Department of Economics
International Economics-II (Econ -3082)
(Group Assignment)
Prepared by:
Name [Link].
1. Mesfin Mikyas BEE/6395/14
2. Mesfin Yifru BEE/1587/14
3. Solomon Abegaz BEE/8430/14
4. Tokuma Daba BEE/6951/14
5. Yonas Zegeye BEE/9141/13
Submitted to: Instr. Endyalalu
January 2025
Addis Ababa
International Economics II Group Assignment
Review Questions and Answers
Question 1. What are foreign exchange markets? What is their most important function?
How is this function performed?
Answer:
Foreign exchange markets, commonly known as forex or FX markets, are decentralized
platforms where currencies are traded. They facilitate the buying and selling of currencies
for various purposes, including trade, investment, and hedging. The forex market is the
largest financial market in the world, operating 24 hours a day, five days a week.
The most important function of foreign exchange markets is to establish and determine
the exchange rates between different currencies. This is crucial for international trade, as
it allows businesses and individuals to convert one currency into another for transactions
across borders.
This function is performed through the continuous trading of currencies in various pairs
(like EUR/USD or USD/JPY) on a global scale. Traders—comprising banks, financial
institutions, corporations, and individual investors—engage in buying and selling
currencies based on market demand and supply dynamics. These trades influence the
value of each currency, which in turn establishes the current exchange rates. This
process is largely driven by factors such as interest rates, economic data, geopolitical
events, and market sentiment.
Question 2. What is meant by a forward discount? Forward premium? What is a currency
swap? What is a foreign exchange future? A foreign exchange option?
Answer:
a) Forward Discount: A forward discount occurs when the forward exchange rate of a
currency is lower than its spot exchange rate. This implies that the market expects that
the currency will depreciate against another currency over the specified time period.
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International Economics II Group Assignment
b) Forward Premium: A forward premium is the opposite of a forward discount. It occurs
when the forward exchange rate is higher than the spot exchange rate. This indicates that
the market anticipates the currency will appreciate against another currency in the future.
c) Currency Swap: A currency swap is a financial agreement between two parties to
exchange principal and interest in different currencies. In a currency swap, each party
agrees to pay the other interest on the principal amount denominated in their respective
currencies and will also swap back the principal amounts at the end of the swap
agreement. This is often used by companies to manage exposure to foreign exchange
risk or to obtain cheaper financing.
d) Foreign Exchange Future: A foreign exchange future is a standardized contract to
buy or sell a specific amount of a currency at a predetermined price on a specified future
date. Unlike spot contracts, which are settled immediately, futures contracts are typically
traded on exchanges and are settled at the contract's expiration date.
e) Foreign Exchange Option: A foreign exchange option gives the holder the right, but
not the obligation, to buy or sell a specific amount of a currency at a predetermined price,
known as the strike price, before or on a specified expiration date. Options provide
flexibility in managing currency risk, as they allow the investor to benefit from favorable
market movements while limiting losses if the market moves unfavorably.
Each of these instruments plays a crucial role in global finance, allowing participants to
hedge against risk or speculates on currency movements.
Question 3. Suppose 1-year US Treasury bills yield 10 percent, and 1-year Ethiopian
Treasury bills yield 6 percent. If the spot exchange rate is $0.09/Br1, what should be the
forward exchange rate? Explain why.
Answer:
To determine the forward exchange rate between the US dollar (USD) and the Ethiopian
birr (Br), we can use the interest rate parity theory. This theory suggests that the
difference in interest rates between two countries is equal to the difference between the
forward and spot exchange rates.
Given the following:
- Yield on US Treasury bills (i) = 10% or 0.10
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International Economics II Group Assignment
- Yield on Ethiopian Treasury bills (j) = 6% or 0.06
- Spot exchange rate (S) = $0.09/Br1
Using the interest rate parity formula: [F = S \times (frac {1 + i}/ {1 + j}]
Where:
- \ (F\) is the forward exchange rate
- \ (S\) is the spot exchange rate
- \ (i\) is the interest rate of the domestic currency (in this case, USD)
- \ (j\) is the interest rate of the foreign currency (in this case, Ethiopian birr)
Now, let's plug in the numbers:
[F = 0.09 \times (frac{1 + 0.10}/{1 + 0.06}]
[F = (0.09) times (frac{1.10}/{1.06}]
[F = 0.09 \times 1.0377
F = approx. 0.0934
So, the forward exchange rate should be approximately $0.0934/Br1.
Explanation:
The reasoning behind this calculation is rooted in interest rate parity. Since US Treasury
bills yield a higher return (10%) compared to Ethiopian Treasury bills (6%), investors will
prefer to invest in US Treasury bills. This demand for USD will likely increase its value in
the forward market. Therefore, the forward exchange rate adjusts to reflect this
anticipated future appreciation of the USD relative to the Ethiopian birr. If investors
anticipate that the birr will depreciate against the dollar due to the lower interest rate, the
forward rate reflects this expectation by being higher than the current spot rate.
Question 4. What is meant by a spot transaction and the spot rate? A forward transaction
and the forward rate?
Answer:
a) Spot Transaction and Spot Rate:
A spot transaction: refers to the immediate exchange of one currency for another at the
current market price, known as the spot rate. Spot transactions are typically settled within
two business days. For example, if you buy foreign currency at the spot rate today, you
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International Economics II Group Assignment
will complete the transaction and receive the currency almost immediately, with the
settlement occurring shortly thereafter.
The spot rate: is the current exchange rate at which a currency can be traded for another
currency in the spot market. It reflects the price at which a specific currency pair is
currently valued and is influenced by factors such as supply, demand, and market
conditions.
b) Forward Transaction and Forward Rate:
A forward transaction: involves an agreement to exchange currencies at a predetermined
rate on a specified future date. This transaction allows parties to lock in an exchange rate
in advance, providing a hedge against potential fluctuations in currency values. Forward
contracts are commonly used by businesses and investors to manage currency risks
associated with international transactions.
The forward rate: is the agreed-upon exchange rate established in a forward transaction.
This rate is based on the current spot rate adjusted for the interest rate differentials
between the two currencies. The forward rate reflects the market's expectations regarding
future currency movements and is typically different from the spot rate due to the interest
rate differences between the two countries involved.
In summary, spot transactions are for immediate currency exchanges using the spot rate,
while forward transactions are agreements to exchange currencies at a future date using
the forward rate.
Question 5. What is arbitrage? What is its result? Triangular arbitrage?
Answer: -
a) Arbitrage: Arbitrage is the practice of taking advantage of price differences in different
markets to generate a profit with minimal risk. In the context of foreign exchange, it
involves buying a currency in one market at a lower price and simultaneously selling it in
another market at a higher price. This can occur due to temporary inefficiencies in the
market or discrepancies in exchange rates. The goal of arbitrage is to exploit these
inconsistencies to make a profit without incurring significant risk.
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International Economics II Group Assignment
b) Result of Arbitrage: The primary result of arbitrage is the equalization of prices across
different markets. When arbitrageurs buy and sell currencies to take advantage of price
differences, their actions increase demand for the undervalued asset and decrease
demand for the overvalued asset. As a result, this helps bring the prices closer together
and contributes to market efficiency.
c) Triangular Arbitrage: Triangular arbitrage is a specific type of arbitrage that involves
three currencies and three exchange rates. It takes advantage of discrepancies in the
cross-exchange rates among these currencies. In this situation, an arbitrageur exchanges
one currency for a second, the second currency for a third, and then the third currency
back to the original currency.
For example, suppose you have three currencies: USD, EUR, and JPY. If the exchange
rates among these currencies are misaligned, an arbitrageur could:
1. Start with USD and exchange it for EUR.
2. Then take the EUR and exchange it for JPY.
3. Finally, convert the JPY back into USD.
If, after these conversions, the final amount of USD is greater than the initial amount, the
arbitrageur has made a profit without any risk. Triangular arbitrage helps correct pricing
discrepancies in the currency markets, contributing to overall market efficiency.
Question 6. What is meant by speculation? How can speculation take place in the spot,
forward, futures, or options markets? Why does speculation not usually take place in the spot
market? What is stabilizing speculation? Destabilizing speculation?
Answer: -
a) Speculation: Speculation refers to the act of buying or selling an asset, such as
currencies, stocks, or commodities, with the expectation of making a profit from future
price movements. Unlike investing, which often involves a long-term horizon based on
fundamental value, speculation is typically characterized by short-term strategies focused
on price fluctuations.
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International Economics II Group Assignment
b) Speculation in Different Markets:
Spot Market: In the spot market, speculation can occur when traders buy currencies,
hoping that their value will increase in the short term. However, due to the immediate
nature of these transactions and the need for actual delivery of the currency, speculative
strategies are often limited in scope.
Forward Market: In the forward market, speculation involves entering into contracts to
buy or sell currencies at a specific future date and rate. Traders can speculate on future
movements in currency prices without needing to own the underlying asset until the
contract matures.
Futures Market: Similar to the forward market, futures contracts allow speculators to bet
on the future price movements of currencies, providing a standardized way to engage in
speculation. Traders can enter into futures contracts to profit from anticipated changes in
exchange rates.
Options Market: In the options market, traders can purchase options contracts that give
them the right (but not the obligation) to buy or sell a currency at a predetermined rate
before a specified expiration date. Speculators can use options to take advantage of price
movements while limiting their potential losses.
c) Speculation in the Spot Market: Speculation does not usually take place in the spot
market due to the immediate settlement requirement, which necessitates actual currency
delivery. Traders in the spot market often act based on short-term needs (e.g., businesses
needing to convert currencies for transactions) rather than purely for speculative gains.
Additionally, the spot market is inherently more volatile and may not provide sufficient
liquidity for larger speculative positions.
d) Stabilizing Speculation: Stabilizing speculation occurs when traders buy an asset
that is perceived to be undervalued or sell an asset thought to be overvalued, thus helping
to reduce price volatility and correct market inefficiencies. By doing so, they contribute to
stability in the market. For instance, purchasing a currency that is expected to appreciate
may help support its value in the market.
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International Economics II Group Assignment
e) Destabilizing Speculation: Destabilizing speculation happens when traders take
positions that may exacerbate price movements or create excessive volatility. For
example, if traders notably short-sell a currency in anticipation of further depreciation, this
can lead to panic selling and a downward spiral in the currency's value. This type of
speculation can create market imbalances and contribute to financial instability.
In summary, speculation plays a crucial role in various financial markets, with different
characteristics and implications depending on the market type. While speculation can
contribute to market efficiency and price discovery, it can also result in increased volatility
and risk, depending on the nature of the speculation involved.
Question 7: -What is meant by a depreciation of the domestic currency? An appreciation?
What is the cross-exchange rate? What is the effective exchange rate?
Answer: -
a) Depreciation of the Domestic Currency: Depreciation of the domestic currency
refers to a decline in the value of that currency relative to other currencies. This means
that it takes more of the domestic currency to purchase a given amount of a foreign
currency. For example, if the exchange rate changes from 1 USD = 100 BR to 1 USD =
110 BR, the domestic currency (BR) has depreciated against the USD. Depreciation can
occur due to various factors, including economic instability, increased inflation, or lower
interest rates compared to other nations.
b) Appreciation of the Domestic Currency: Appreciation of the domestic currency is
the opposite of depreciation; it indicates an increase in the value of the domestic currency
relative to other currencies. When a currency appreciates, it takes less of that currency
to buy a foreign currency. For example, if the exchange rate changes from 1 USD = 100
BR to 1 USD = 90 BR, the domestic currency (BR) has appreciated against the USD.
Factors leading to appreciation can include strong economic performance, higher interest
rates, or increased demand for exports.
C) Cross-Exchange Rate: The cross-exchange rate is the exchange rate between two
currencies that is derived from the exchange rates of those currencies with a third
currency (often the US dollar). For instance, if you know the exchange rates of EUR/USD
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International Economics II Group Assignment
and JPY/USD, you can calculate the cross-exchange rate of EUR/JPY by dividing the
EUR/USD rate by the JPY/USD rate. Cross-exchange rates are important for arbitrage
and understanding currency relationships in the foreign exchange market.
d) Effective Exchange Rate: The effective exchange rate measures the value of a
country's currency against a basket of other currencies, reflecting the overall
competitiveness of that currency in foreign markets. This can be expressed in two ways:
Nominal Effective Exchange Rate (NEER): This rate considers the unadjusted exchange
rates against a basket of currencies weighted by trade volume. It shows how the currency
has changed in value relative to others without factoring in inflation.
Real Effective Exchange Rate (REER): This adjusts the NEER for inflation differences
between the domestic country and its trading partners. The REER provides a clearer
picture of the currency's purchasing power and competitiveness.
In summary, depreciation and appreciation reflect changes in currency value, while the
cross-exchange rate and effective exchange rate are important tools for understanding
and analyzing currency relationships in the global market.
Question 8. What is meant by foreign exchange risk? How can foreign exchange risks be covered
in the spot, forward, futures, or options markets? Why does hedging not usually take place in the
spot market?
Answer:-
a) Foreign Exchange Risk: Foreign exchange risk, also known as currency risk, refers
to the potential for financial losses arising from fluctuations in exchange rates. Businesses
and investors involved in international transactions or holding foreign assets may face
risks when the value of the currency fluctuates. For example, a company that imports
goods from another country may find that a weaker domestic currency increases its costs
when converting currencies to pay for those goods.
b) Covering Foreign Exchange Risks:
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International Economics II Group Assignment
Spot Market: While payments in the spot market occur almost immediately, using the spot
market for hedging is typically limited because it involves immediate settlement without
the ability to look in future rates.
Forward Market: To cover foreign exchange risk, businesses often use forward contracts.
A forward contract allows a company to lock in a specific exchange rate for a transaction
that will take place at a future date. For example, if a U.S. company knows it will need to
pay a foreign supplier in three months, it can enter into a forward contract to exchange
USD for the foreign currency at a fixed rate, thus protecting itself from adverse
movements.
Futures Market: Similar to forward contracts, futures contracts are standardized
agreements to buy or sell a currency at a predetermined rate on a specified future date.
Companies can use futures to hedge against currency fluctuations. For instance, a
Japanese exporter expecting to receive payments in USD could sell USD futures to
ensure they lock in a favorable exchange rate.
Options Market: Currency options allow businesses to hedge foreign exchange risk by
giving them the right, but not the obligation, to buy or sell currency at a specified rate
before a designated expiration date. For example, a European company expecting to
receive payment in USD could buy a call option on USD to protect itself against potential
appreciation of the USD, ensuring it can exchange the currency at a favorable rate if
needed.
c) Hedging in the Spot Market: Hedging does not usually take place in the spot market
because spot transactions settle immediately, making it difficult to protect against future
exchange rate fluctuations. The nature of spot transactions is that they involve direct
exchanges of currencies at current rates, which does not provide a means to manage
risks for future payments or receipts.
Example:
Imagine a U.S. company that imports machinery from Germany, with payment due in 60
days. If the company were to rely solely on the spot market, it would need to convert its
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International Economics II Group Assignment
USD to EUR at that moment based on the prevailing spot rate in 60 days. If the USD
depreciates significantly against the EUR by then, the company will have to spend more
USD to obtain the necessary EUR for payment, resulting in financial losses.
If the company uses a forward contract instead, it can lock in the current exchange rate
today, ensuring that regardless of future fluctuations, it knows exactly how much USD it
will need to pay when the time comes, thus mitigating its foreign exchange risk.
In summary, while the spot market provides immediate currency access, it is not suitable
for hedging against future exchange rate risks. Instead, businesses utilize forward
contracts, futures, and options for more effective risk management strategies.
References
Salvatore, Dominic. (1995), International Economics, Prentice Hall International, Inc. Schmitt -
Grohe, Stephanie, Martin Uribe, and Michael Woodford (Latest version 4 May 2016),
International Macroeconomics, Textbook Manuscript.
Sodersten, B. and G. Reed (1994), International Economics, New York: St. Martin’s Press, U. S.
A. (1994), International Economics, Macmillan, London.
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