- Know the pros and cons of weak and strong currencyo WEAK HOME CURRENCY Pros- Stimulate foreign demand for US goods- Reduce unemploymeny Cons- Prevent US consumers from importing foreign goods- Higher US inflationo STRONG HOME CURRENCY Pros- Stimulate US Imports- Encourage consumers to buy from foreign countries- Lower inflation Cons- Higher Unemployment- Know how the central bank can intervene to stimulate the economy or reduce inflationo Stimulate the US Economyo Reduce Inflation- Know the three types of arbitrage and how to calculate the profits.o International Arbitrage = capitalizing on a discrepancy in quotedprices by making a riskless profito Arbitrage will cause prices to realigno LOCATIONAL ARBITRAGE = the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. Gains are based on the amount of money used and the size of the discrepancy Realignment drives prices to adjust in different locations to eliminate discrepancieso TRIANGULAR ARBITRAGE = currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies Accounting for the Bid/Ask Spread : Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage. Realignment forces exchange rates back into equilibriumo COVERED INTEREST ARBITRAGE = the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk wit a forward contract Consists of two parts:- Interest arbitrage : the process of capitalizing on thedifference between interest rates between two countries.- Covered : hedging the position against interest rate risk. Realignment due to covered interest arbitrage causes market realignment. Timing of realignment may require several transactions before realignment is completed.- Know what interest rate parity is and how to calculate the forward premium from the IRP relationshipo INTEREST RATE PARITY = In equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.p=1+ih1+if−1o Forward Premiump=F−SS@ih−if- Know the three considerations when assessing interest rate parityo Transaction costso Political risko Differential tax
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