Exchange Rate

Tighter monetary policy in one country tends to strengthen its currency against others. What is the mechanism that produces that result?

1. A.Higher yields attract foreign capital, and buying those assets requires buying the currency.Correct. Cross-border investors must acquire the currency in order to buy its assets, and that demand bids it higher.
2. B.Tighter policy reduces imports, so fewer of the country's own units are sold abroad.Wrong. Weaker imports can help a trade balance, but that channel is far slower and smaller than capital flows.
3. C.Central banks agree to support one another's currencies whenever their policies diverge.Wrong. No such standing arrangement drives ordinary exchange rate moves between floating currencies.
4. D.A smaller money supply means each remaining unit is redeemable for more reserves.Wrong. Modern currencies are not redeemable for anything, so scarcity does not work through a redemption claim.

Why: Exchange rates in the short run are driven mostly by capital flows rather than by trade. When one country's yields rise relative to others, investors move funds to capture the difference, and buying assets denominated in that currency requires first buying the currency itself. That demand bids its value up. The effect can be swamped if investors doubt the country's stability or expect its inflation to run higher, which is why this is a tendency rather than a rule.

A dollar-based investor holds fifty foreign stocks spread across many countries and industries. The dollar strengthens broadly and her portfolio falls in dollar terms even though local prices held steady. What does this demonstrate?

1. A.Currency exposure is systematic for her, and adding more foreign names cannot remove it.Correct. Every non-dollar holding faces the same translation, so holding more of them changes nothing.
2. B.Her portfolio was insufficiently diversified across the industries she selected.Wrong. Industry spread addresses company and sector risk and does nothing at all about exchange rates.
3. C.Currency risk is nonsystematic and would disappear at roughly a hundred holdings.Wrong. No number of foreign holdings escapes the dollar, because the exposure attaches to the currency itself.
4. D.The decline reflects credit deterioration among the particular issuers she chose.Wrong. Local prices held steady, which rules out any deterioration in the issuers' finances.

Why: Whether a risk is systematic depends on the investor's frame of reference. For someone measuring results in dollars, the exchange rate is a common factor running through every foreign holding, so it behaves exactly like market risk and cannot be diversified away by adding names. Diversification addresses what differs between holdings, and here what differs is the companies while what is shared is the currency. The exposure can be reduced only by hedging the currency or by holding assets denominated in dollars.