International-Financial-Management---Bekaert-2e---

©2012PearsonEducation,Inc.Chapter5ExchangeRateSystemsQUESTIONS1.Howcanyouquantifycurrencyriskinafloatingexchangeratesystem?Answer:Tocharacterizetheriskofacurrencyposition,youmusttrytocharacterizetheconditionaldistributionofthefutureexchangeratechanges.Withfloatingexchangerates,historicalinformationprovidesusefulinformationaboutthisdistribution.Forexample,youcanusedatatomeasuretheaveragehistoricaldispersion(standarddeviationorvolatility)ofthedistribution.Thehigherthisvolatility,theriskierarepositionsinthiscurrency.Itisalsopossibletorelyonmoreforward-lookinginformationusingtheoptionsmarkets(seeChapter20).Finally,weshouldpointoutthatvolatilityisanadequateindicatorofriskwhenexchangeratechangesareapproximatelynormallydistributed.Inreality,thedistributionofexchangeratechangesdisplaysfattails,eveninfloatingexchangeratesystems,andthisincreasestheriskofcurrencypositions.2.Whymightitbehardtoquantifycurrencyriskinatargetzonesystemorapeggedexchangeratesystem?Answer:Ifthepegortargetzoneholdsforalongtime,historicalvolatilityappearstobezeroorverylimited,butthismaynotaccuratelyreflectunderlyingtensionsthatmayultimatelyresultinadevaluationorrevaluationofthecurrency.Hence,thetruecurrencyriskdoesnotshowupinday-to-dayfluctuationsoftheexchangerate.Itishardtoquantifythis“latentvolatility.”3.Whatislikelytobethemostcredibleexchangeratesystem?Answer:Amongfixedexchangeratesystems,amonetaryunionwithacommoncurrencyislikelythemostcredibleexchangeratesystem.Butevenhere,weseetensionswithintheEconomicandMonetaryUnioninEuropethatcouldleadtoabreakupoftheeuro.TheinabilityofGreeceandtheotherperipheralcountriestodevaluetheircurrenciesisleadingtoaprotractedperiodofhighunemploymentwithassociatedfiscaldeficitsandaninabilitytoregenerategrowth.Ultimately,oneoftheproblemcountriesmightwithdrawfromtheEMUorthestrongcountries,likeGermanyandFinland,mightwithdrawratherthansubsidizetheirinefficientneighbors.4.Howcanacentralbankcreatemoney?Chapter5:ExchangeRateSystems©2012PearsonEducation,Inc2Answer:First,becausethecentralbankoperatestheonlyauthorizedprintingpressinthecountry,itcanactuallyprintmoneytopayitsbillsortoacquireassets,therebyincreasingthemoneysupply.Second,thecentralbankcancreatemoneybyincreasingthereserveaccountsfinancialinstitutionsholdwithit.Forexample,ifthecentralbankbuysanasset(agovernmentbondsay)fromafinancialinstitution,itcreditsthefinancialinstitution’sreserveaccountatthecentralbankforthepurchasepriceofthebond.Becausethisfinancialinstitutioncannowusethiscredittoitsaccounttolendmoneytoindividualsandbusinesses,thecentralbankhas,essentially,createdmoney.5.Whatareofficialinternationalreservesofthecentralbank?Answer:Officialreservesconsistofthreemajorcomponents:foreignexchangereserves,goldreserves,andIMF-relatedreserveassets,withthefirstbeingbyfarthemostimportantcomponent.Foreignexchangereservesarealltheforeigncurrencydenominatedassetsthecentralbankholds,andmostlyconsistofforeigngovernmentbonds.6.Whatislikelytohappenifacentralbanksuddenlyprintsalargeamountofnewmoney?Answer:Whereastherearetheoriesthatpredictthatchangesinthesupplyofmoneyhaverealeffectsontheeconomyintheshortrun,itislikelythatifthecentralbankshowerstheeconomysuddenlywithmoney,theonlyresultwillbehigherinflation.Thisisbecausethedemandformoneyultimatelydependsontheamountofrealtransactionsintheeconomyandhowmuchmoneyisneededtofacilitatethesetransactions.Additionalsupplyofmoneyisunlikelytomakepeopleconsumemoreorworkharder.7.Whatistheeffectofaforeignexchangeinterventiononthemoneysupply?Howcanacentralbankoffsetthiseffectandstillhopetoinfluencetheexchangerate?Answer:Whenacentralbankbuys(sells)foreigncurrency,itsinternationalreservesincrease(decrease),andthemoneysupplyincreases(decreases)simultaneously.Tooffsettheeffectonthemoneysupply,theforeignexchangeinterventioncanbesterilized;thatis,thecentralbankcanperformanopenmarketoperationthatcounteractstheeffectonthemoneysupplyoftheoriginalforeignexchangeintervention.Thedirecteffectsofasterilizedinterventionaretwo-fold.First,itforcesaportfolioshiftonprivateinvestors,byreplacingforeignbondswithdomesticbonds(orviceversa).Thismayaffectexpectationsandprices.Second,theactionsofthecentralbankintheforeignexchangemarkets,whileverysmallrelativetothenominaltradingvolumes,maystillmanagetosqueezeforeignexchangeinventoriesatdealerbanksandgeneratepricingeffects.Indirectly,thecentralbankcansignalitsopiniononthefundamentalvalueoftheexchangeratethroughaninterventionthatconsequentlyaffectsmarketexpectations.Thereisnoconsensusonhoweffectivesterilizedinterventionsareinaffectingthelevelandvolatilityofexchangerates.Chapter5:ExchangeRateSystems©2012PearsonEducation,Inc38.Howcanacentralbankpegthevalueofitscurrencyrelativetoanothercurrency?Answer:Topegthevalueofitscurrencytoanothercurrency,thegovernmentmustmakeamarketinthetwocurrencies.Ifthereisexcesssupplyoftheforeigncurrency(whichisequivalenttoexcessdemandforthedomesticcurrency)thatwoulddrivedownthedomesticcurrencypriceoftheforeigncurrency,thegovernmentmustbuytheprivateexcesssupplyofforeigncurrencyanddeliverdomesticcur