Articulate why an export business would prefer a rising or declining exchange rate for their domestic currency.
Exchange rate shows the price of one currency in terms of another one. Modern economies are open to international trading and business, thus the value of the national currency is regularly monitored and interpreted in terms of the foreign currencies. Mostly, a direct exchange rate is used, which defines the price of a unit of the foreign currency in terms of the national one. However, sometimes. An indirect quote is used to express the price of a unit of the domestic currency in terms of the foreign one.
Most economies now use floating exchange rates that determine currency rates by the market forces. Therefore, it is crucial to either rise or decline domestic currency so that to strengthen the country’s positions in the market, especially in regards to the trading vector. In case the country is export oriented, it needs to use cheaper raw materials but receive high profits. Which is why, the government policy is most often oriented on raising the direct exchange rate, or declining indirect one. Making the domestic currency cheaper than the currencies of the main trading partners, will lower the raw materials costs and enlarge the profit gained. Although, lower domestic currency will turn foreign investments to be more expensive for consumers, it will increase the country’s balance of trade.
Explain the effects of a fluctuating dollar with respect to a European tourist visiting the Grand Canyon.
Since both the USD and EUR are currencies with floating exchange rate systems, fluctuations are a usual thing in a USD/EUR pair, as for many other currencies in different economies. Currency fluctuations depend on numerous factors: inflation rates, interest rate shifts, capital flows, etc. Difference between the interest rates of the European Central Bank (for EU) and the Federal Reserve (for US) has the greatest impact on the currency’s value respectfully. (Van Bergen)
The EUR/USD cross means that 1 EUR can be exchanged to x USD. The Fed may adopt various policies to strengthen or weaken the USD positions, hence the EUR/USD cross will decline or improve correspondingly. These fluctuations have direct influence on the international business as well as on individual tourists, who have to exchange currencies while travelling.
In case EUR/USD declines, a European tourist will be able to purchase less, while travelling to the Grand Canyon. Meanwhile, if the EUR/USD improves, his purchasing power will increase, as Euro’s value will be higher than the US dollar’s. So, for a European tourist EUR/USD improvement is more preferable. Hereby, currency fluctuations may influence the country’s economy by attracting more investors and visitors, or by enlarging exports and tradings.
Explain the method that the Federal Reserve System (the Fed) uses most often to expand or contract the money supply.
While the Congress and the President control national fiscal policy, the Federal Reserve System is called to supervise and regulate national monetary policy. Among the main responsibilities of the Fed is to control the money supply. There are different tools and mechanisms that can be used for this purpose.
The Fed regulates reserve ratios for the Banks and other financial institutions. Reserve ratio is a defined percentage of involved deposits, which has to be saved as a reserve against potential withdrawal. Hence, the Fed increases reserve ratio ,so that to accumulate the oversupplied amount of money. Taking extra accumulated money from banks even in amount of 1-2% will decrease their possibility to increase money supply through the lending. Reserve ratio can be also used as a tool in order to enlarge money supply. In this case the Fed would decrease the ratio so that to free extra money for lending.
Discount rate is another option to regulate money supply. In case a bank overcommits itself, it can borrow from the Fed to secure the funds; however the bank is obliged to pay a discount rate for the sum borrowed. Thus, in case the Fed needs to shorten money supply the discount rate will be increased, and banks will not have a chance to borrow large sums. Contrarily, the discount rate will be decreased in case money supply needs to be increased. (Cloutier)
The third tool used by the Fed is open-market operations. This tool is the most commonly used and has a variety of Treasury bonds, bills, and notes to be traded. Once the money supply needs to be decreased the Fed starts selling government securities, exchanging by this oversupplied money to the Treasury bills. If the money supply needs to be enlarged, the government securities will be bought. Basically, the Fed will exchange bills for money.
The Fed increases money supply to boost the slumping economy, and shortens the money supply to diminish rapid inflation growth.
Differentiate among the following: a stock option price, strike price, put options, and call options.
An option is a financial contract under which its buyer has a right, but not obliged to purchase or sell an asset, mentioned in this contract at a specified price (called strike price) at a certain time. There are different types of options. For example, put option gives its owner a right to sell some specified amount of an underlying security at a strike price within a certain time frame. While a call option gives its holder the right to buy shares or other instrument within a specified period. (Wagner)
A strike price is the price at which an option contract or any other derivative can be exercised. Basically, it the price of an underlying asset or share traded through the option contract. While the option price, is the price for a contract itself. Option price can be higher or lower than the strike price defined in it, depending on the market situation.
Assess the advantages and disadvantages of purchasing stock options versus purchasing the stocks themselves.
As it was mentioned above, an option gives the investor a right to purchase or sell a stock at a set price. Therefore, the owner of an option is secured from unexpected stock price failure or raise, until the contract expires. In case the stock price has increased, but there is an option traded in the market, which can grant the investor a right to buy that stock for a lower price, the investor will pay for such option contract, even if its price is higher than the strike price in it. Both parties will benefit, as the seller of the option will get a profit of a difference between the option price and strike price, and purchaser will save the same amount.
Articulate the functions that mutual funds have with respect to equity investing.
Mutual fund is a financial organization which consists of a number of funds joined by the investors. Mutual funds are operated by managers who invest in different securities so that to produce capital and receive extra income for the investors. There are main types of mutual funds according to their predetermined investment objectives: (1) Equity funds; (2) Fixed income funds; (3) Money market funds. All other types of mutual funds are only subtypes of these three. Any kind of mutual fund offers a number of benefits for its investors besides the possible profit. First of all, trading through the mutual funds allows to diversify risks. Secondly, small investors have an opportunity to access large and professionally managed portfolios. Thirdly, trading through mutual funds (i.e. equity funds) is cheaper as it allows to avoid high transaction costs. (Wagner)
Even though money market funds are recognized as the most secure funds, the largest amount of investors participates in equity funds. The main objective of the equity funds is a long term capital growth. Each equity fund differs by the investment style and the scale of the investment companies involved. Due to the fact that there is a great diversity of equities, there exist thousands of different equity funds.
Differentiate among the discount rate, prime rate, and the subprime rates of interest in terms of function and purpose.
The prime interest rate is a rate which is charged by commercial banks from their largest and most credit-worthy borrowers -clients. This rate is usually the lowest among other charged, as such clients are assumed to be the most reliable with the lowest chances to default. Meanwhile, other customers will be charged higher interest rates. The prime rate can also serve as a benchmark for lending rates, since it makes the service more valuable for large corporate clients.
Prime rate has an interrelation with a discount rate, defined by the Fed. The discount rate is offered to the banks by the Fed in case financial institutions need their reserves to meet the defined minimum. The higher the discount rate, the higher the mortgage rate and interest rate for lending (including prime rate), and vice versa.
Once a customer has a poor credit score from at least one credit bureau, he will be defined as a subprime client and offered a subprime interest rate. This rate is usually higher than the prime rate, and depends on the amount of loan requested, the income rate, the amount of the down payment, etc. Prime rate is the same for all customers of the corresponding category, while the subprime rate is calculated for each client on the “risk based pricing” model.
All these rates are called to control and minimize possible credit risks, as well as to monitor and regulate money supply.
Explain the difference between the Fed targeting the interest rate versus the inflation rate using the current monetary policy as an example.
The Fed uses interest rate to regulate money supply. However, this monetary tool is linked to the inflation rate. Once the interest rate is decreased, loans become cheaper and people can spend more money. As a result the economy growth as the inflation does. Thus, in case the inflation rate is growing rapidly, an interest rate will be increased. This will lead to the money supply shorten and prices’ growth, and finally the inflation will slow down as will the economy do.(Cloutier)
Eight times per year the Fed sets interest rate short term targets, which help to control the inflation rate along with the employment rate and economic growth. According to the latest Minutes of the Federal Open Market Committee, that the inflation runs below the committee’s expectations, which is why the economy’s growth has slowed down (FOMC Minutes). Since the recent short-term interest rate was close to zero, it was agreed that interest rates will be increased, so that to boost the economy.
Illustrate monetarist theory using former Fed Chairman Volker’s policy approach to controlling inflation.
Monetarist theory is mainly associated with the M.Friedman’s name. Its main concept was to support a free-market positions. Monetarists proposed that in a long-term monetary neutrality money supply will increase for X percent, and after all changes have taken place the general price level will raise for X percent, with no significant effect on consumption, output, relative prices of individual commodities.
In 1970’s the US faced an economic crisis. This economic failure was caused by a number of facts: the Vietnam War, the oil price increase and especially the demise of the Bretton Woods system. As a result, inflation rose very fast, although all attempts of the Fed to take it under control were unsuccessful, until the policy of the Fed’s chairman, Paul Volcker, was adopted in October 1979. The discount rate was decreased so that to increase money supply, and the old policy of supporting the interest rate through the government securities was abandoned. (McCallum ) Paul Volcker applied monetarists’ theory and the inflation was decreased and put under control.
Compare the effect of changing interest rates on treasury bills versus medium-term corporate bonds.
Treasury bills belong to the short term market instruments with a maturity of no longer than one year. Investors put their money into treasury bills in case the profit and the money may be needed within a short term. Thus, this market is highly liquid. Intermediate-term (medium-term) bonds pay a yield for a given credit quality within a maturity of 3-10 years.
Once the interest rate of treasury bills is increased, the money supply will be increased within the shortest time (one year). Thus, these instruments are used to regulate short-term monetary policy, or prevent possible economic threats. Meanwhile, medium-term bonds allow the government to regulate economic situation within a longer period of time. Thus, any shifts of the medium-term bonds interest rate must be very accurate and slight, as an effect caused may be unpredictable. The longer the maturity period is, the more careful should be the interest rate established, as planned rates of inflation, unemployment, currency exchange, etc. do not always meet the future exact rates.
Compare the characteristics of financial assets that typically serve as a safe haven during periods of market uncertainty with those of common stock.
Any asset that increases its value through the time, regardless the market volatility can be considered as a safe haven. For many decades, the gold is recognized worldwide as a safe haven. Treasury bills are now considered a the US safe haven as they are secured by the full faith and credit of the U.S. government. All investors seek for safe havens, as these assets and stocks are granted to be paid and bring profit under any market conditions. Hence, it is more secure to convert money into safe havens.
Shares, bonds, and derivatives may be considered as financial assets of common stock, as they are widely traded in the market and grant some benefits, although they are more risky than safe havens. These assets are not secured from the market volatility and may bring benefits only if the investor or trader monitors market tendencies carefully.
Van Bergen, J. (n.d.) 6 Factors That Influence Exchange Rates. Available at: http://www.investopedia.com/articles/basics/04/050704.asp
Cloutier, R. (n.d.) How The Federal Reserve Manages Money Supply. Available at: http://www.investopedia.com/articles/08/fight-recession.asp
Wagner, H. (25 Feb 2007) Understanding Option Pricing. Available at: http://www.investopedia.com/articles/optioninvestor/07/options_beat_market.asp
FOMC Minutes (15-16 Dec 2016) Available at: http://www.federalreserve.gov/monetarypolicy/fomcminutes20151216.htm
McCallum, B.T. (n.d.) Monetarism. Available at: http://www.econlib.org/library/Enc/Monetarism.html