CURRENCY EXCHANGE RATE
READING 18
SECTION 1 : SECTION 2 : ORGANISATION
AND MAJOR PLAYERS OF
INTRODUCTIONS FOREX MARKETS
SECTIONS
SECTION 3 : SECTION 5 : EFFECT OF
SECTION 4 :
EXCHANGE RATES ON
EXCHANGE RATE EXCHANGE RATE INTERNATIONAL TRADE
MECHANICS REGIMES AND CAPITAL FLOWS
FOREIGN EXCHANGE MARKET
• WORLD’S LARGEST MARKET BY FAR – 10 TO 15 TIMES LARGER THAN GLOBAL
FIXED INCOME MARKETS AND ABOUT 50 TIMES LARGER THAN GLOBAL
EQUITY MARKET IN TERMS OF DAILY TURNOVER.
• OPERATES 24 HOURS A DAY, EACH BUSINESS DAY.
• INVOLVES PARTICIPANTS FROM EVERY TIME ZONE CONNECTED THROUGH
ELECTRONIC COMMUNICATIONS NETWORKS.
SECTION 1 : SECTION 2 : ORGANISATION
AND MAJOR PLAYERS OF
INTRODUCTIONS FOREX MARKETS
SECTIONS
SECTION 3 : SECTION 5 : EFFECT OF
SECTION 4 :
EXCHANGE RATES ON
EXCHANGE RATE EXCHANGE RATE INTERNATIONAL TRADE
MECHANICS REGIMES AND CAPITAL FLOWS
THE FOREIGN EXCHANGE MARKET
EXCHANGE RATE
The number of units of one currency (called the price currency) that
one unit of another currency (called the base currency) will buy.
PRICE CURRENCY
A/B
BASE CURRENCY
DIRECT QUOTE INDIRECT QUOTE
FOREIGN CURRENCY/DOMESTIC
DOMESTIC CURRENCY/FOREIGN
CURRENCY
CURRENCY
d/f f/d
REAL EXCHANGE RATES = (Sd/f× Pf)/Pd = Sd/f× (Pf/Pd)
• INCREASE IN REAL EXCHANGE RATE – REDUCTION IN PURCHASING POWER OF
DOMESTIC CURRENCY
MARKET FUNCTIONS
HEDGE THE RISK
AFRAID OF
FOREX MARKET EXCHANGE
PARTICIPANTS RATES MOVING
AGAINST THEM
SPECULATE ON
THE SAME
AMOUNT AND TIMING OF FOREIGN REVENUE
Depend on -
• PACE OF FOREIGN SALE
• SALE PRICES REALISED
• PACE AT WHICH FOREIGN CLIENTS PAY FOR THEIR PURCHASES
SPOT TRANSACTIONS
• INVOLVES EXCHANGE OF CURRENCIES FOR IMMEDIATE SETTLEMENT.
• T+2 FOR MOST CURRENCIES. T+1 FOR CAD AGAINST USD
EXCHANGE RATE USED HERE IS
CALLED SPOT EXCHANGE RATE
HOWEVER…..
COMPOSITION OF FOREX MARKET INSTRUMENTS
S N
TIO
AC
NS
TRA T
SPO
OUTRIGHT FORWARD
CONTRACTS
FX OPTIONS
FX SWAPS
OUTRIGHT FORWARD CONTRACTS
• AGREEMENTS TO DELIVER FOREIGN EXCHANGE AT A FUTURE DATE AT AN
EXCHANGE RATE AGREED UPON TODAY
• FORWARD TRANSACTIONS ARE ANY EXCHANGE RATE TRANSACTIONS THAT
OCCOUR WITH CURRENCY SETTLEMENT LONGER THAN USUAL T+2 SETTLEMENT
FOR SPOT DELIVERY
• TWO SPECIFICATIONS OF THESE CONTRACTS – 1) DATE AT WHICH CURRENCIES
ARE TO BE EXCHANGED.
2) EXCHANGE RATE APPLIED ON
THE SETTLEMENT DATE.
• GENERALLY TRADED IN OVER THE COUNTER MARKETS – WHERE CONTRACTS
CAN BE OF ANY SIZE BETWEEN THE COUNTERPARTIES – HOWEVER, LIQUIDITY
DECLINES THE LONGER THE TIME TO MATURITY AND LARGER THE TRADE SIZE.
• THE COMBINATION OF AN OFFSETTING SPOT TRANSACTION AND A NEW
FORWARD CONTRACT IS REFERRED TO AS AN FX SWAP
MARKET PARTICIPANTS
BUY SIDE SELL SIDE
CLIENTS WHO USE THESE BANKS TO UNDERTAKE LARGE FX TRADING BANKS LIKE CITIGROUP, UBS,
FX TRANSACTIONS DEUTSCHE BANK
• LARGEST DEALING FX BANKS AND FEW
• CAPITAL ACCOUNTS OTHER MULTINATIONAL BANKING
• REAL MONEY ACCOUNTS BEHEMOTHS
• LEVERAGED ACCOUNTS • 2ND AND 3RD TIER OF FX MARKET SELL
SIDE – ALL OTHER BANKS
• RETAIL ACCOUNTS
• GOVERNMENTS
• CENTRAL BANKS
• SOVEREIGN WEALTH FUND (SWF)
SECTION 1 : SECTION 2 : ORGANISATION
AND MAJOR PLAYERS OF
INTRODUCTIONS FOREX MARKETS
SECTIONS
SECTION 3 : SECTION 5 : EFFECT OF
SECTION 4 :
EXCHANGE RATES ON
EXCHANGE RATE EXCHANGE RATE INTERNATIONAL TRADE
MECHANICS REGIMES AND CAPITAL FLOWS
CURRENCY EXCHANGE RATE
CALCULATIONS
EXCHANGE RATE QUOTATIONS
DIRECT CURRENCY INDIRECT CURRENCY
QUOTE QUOTE
QUOTES DOMESTIC CURRENCY AS THE PRICE QUOTES FOREIGN CURRENCY AS THE PRICE
CURRENCY AND FOREIGN CURRENCY AS THE CURRENCY AND DOMESTIC CURRENCY AS THE
BASE CURRENCY BASE CURRENCY
d/f -INVERSE OF EACH OTHER- f/d
TWO SIDED PRICE QUOTATION
BID RATE the price at which the BANK is willing to BUY the currency
ASK RATE the price at which the BANK is willing to SELL the currency
BID RATE
USD/EUR – 1.3648/1.3652
ASK RATE
CHANGES IN EXCHANGE
RATE
BASE CURRENCY
(S1-S0 )/S0 * 100
=
(S1/S0) –1 * 100
PERCENTAGE APPRECIATION IN
CURRENCY PRICE CURRENCY
(S0/S1) –1 * 100
CROSS RATE CALCULATIONS
Given two exchange rates involving three currencies, it is possible to back out what the cross-rate
must be
example
AVAILABLE FX CONVENTION –
USD/EUR
AVAILABLE FX CONVENTION – CAD/USD
GIVEN THESE CONVENTIONS, IT IS POSSIBLE TO
BACK CALCULATE CAD/EUR :
• MULTIPLY
AVAILABLE FX CONVENTION –
USD/EUR
AVAILABLE FX CONVENTION – USD/USD
• DIVIDE
FORWARD CALCULATIONS
FORWARD
RATES
• RATE AT WHICH, A DEALER AGREES TO EXCHANGE ONE CURRENCY FOR
ANOTHER AT A FUTURE DATE, WHICH IS AGREED UPON TODAY
• GENERALLY QUOTED AS PIPS OR POINTS
Difference between the Forward Exchange Rate Quote and the Spot Exchange Rate
Quote, with the points scaled so that they can be related to the last decimal in the Spot
Quote.
BASE CURRENCY IS AT A FORWARD PREMIUM
FORWARD RATES > SPOT RATES
PRICE CURRENCY IS AT A FORWARD DISCOUNT
BASE CURRENCY IS AT A FORWARD DISCOUNT
FORWARD RATES < SPOT RATES
PRICE CURRENCY IS AT A FORWARD PREMIUM
• Typically, quotes for forward rates are shown as the number of forward points at each maturity.
• These forward points are also called swap points because an FX swap consists of simultaneous
spot and forward transactions.
• To convert percentage of Forward premium/discount, into points, the rule is to divide the rate by
10000.
• Generally quoted in four decimal places, however, in case of USD/JPY, is quoted in two decimal places,
hence, to calculate forward points, the rate is divided by 100 instead of 10000.
RELATIONSHIP BETWEEN SPOT RATES, FORWARD
RATES AND INTEREST RATES
COVERED INTEREST RATE PARITY
FORWARD EXCHANGE RATES SIMPLY ACT AS A PRODUCT OF THE ARBITRAGE
EQUATION OUTLINED AND FORWARD POINTS AS BEING RELATED TO THE (time scaled)
INTEREST RATE DIFFERENTIAL BETWEEN THE TWO COUNTRIES
FORWARD MARKETS
PLATFORM WHERE FORWARD CONTRACTS ON CURRENCY TAKES PLACE. ANY EXCHANGE RATE
THAT HAS A SETTLEMENT DATE LONGER THAN T+2 IS A FORWARD CONTRACT
MUST SATISFY THE ARBITRAGE RELATIONSHIP THAT EQUATES THE INVESTMENT RETURN ON
TWO ALTERNATIVE BUT EQUIVALENT INVESTMENTS
COVERED INTEREST RATE PARITY
FOREX TWO MARKETS INVOLVED MONEY
MARKET MARKET
FOREX MONEY
MARKET MARKET
• DEALS WITH SPOT AND • DEALS WITH PERIODIC
FORWARD EXCHANGE RATES INTEREST RATE
EQUATION TO BE SATISFIED FOR COVERED
INTEREST RATE PARITY :
Ff/d = S f/d(1+if[Actual/360]/1+id[Actual/360])
Ff/d FORWARD RATE FOREIGN / DOMESTIC
S f/d SPOT RATE FOREIGN / DOMESTIC
if FOREIGN RISK FREE RATE
id DOMESTIC RISK FREE RATE
IF COVERED INTEREST RATE PARITY EQUATION IS NOT SATISFIED, THEN
COVERED INTEREST ARBITRAGE
CONCLUSION
CURRENCY WITH :
INTEREST RATE INTEREST RATE
FORWARD FORWARD
DISCOUNT PREMIUM
SECTION 1 : SECTION 2 : ORGANISATION
AND MAJOR PLAYERS OF
INTRODUCTIONS FOREX MARKETS
SECTIONS
SECTION 3 : SECTION 5 : EFFECT OF
SECTION 4 :
EXCHANGE RATES ON
EXCHANGE RATE EXCHANGE RATE INTERNATIONAL TRADE
MECHANICS REGIMES AND CAPITAL FLOWS
EXCHANGE RATE REGIMES
• THE AMOUNT OF FOREIGN EXCHANGE RATE VOLATILITY DEPEND, ATLEAST IN PART, ON
INSTITUTIONAL AND POLICY ARRANGEMENTS ASSOCIATED WITH TRADE IN ANY GOVEN CURRENCY.
• VIRTUALLY EVERY EXCHANGE RATE IS MANAGED TO SOME DEGREE BY CENTRAL BANKS – THE
POLICY FRAMEWORK THAT EACH CENTRAL BANK ADOPTS IS CALLED EXCHANGE RATE REGIME
PROPERTIES OF AN IDEAL CURRENCY REGIME
• THE EXCHANGE RATE BETWEEN ANY TWO CURRENCIES WOULD BE
• CREDIBLY FIXED
ALL CURRENCIES WOULD BE FULLY CONVERTIBLE
• EACH COUNTRY WOULD BE ABLE TO UNDERTAKE FULLY INDEPENDENT MONETARY POLICY
IN PURSUIT OF DOMESTIC OBJECTIVES, SUCH AS GROWTH AND INFLATION TARGETS
HOWEVER, THERE CAN BE NO IDEAL CURRENCY REGIME, AS THESE THREE CONDITIONS ARE
NOT CONSISTENT
A TAXONOMY OF CURRENCY REGIMES
ARRANGEMENTS WITH • CURRENCY BOARD SYSTEM
NO SEPARATE LEGAL
TENDER • FIXED PARITY
• DOLLARIZATION
• TARGET ZONE
• MONETARY UNION
• ACTIVE AND PASSIVE
CRAWLING PEGS
• FIXED PARITY WITH
CRAWLING BANDS
• MANAGED FLOAT
• INDEPENDENTLY FLOATING
RATES
SECTION 1 : SECTION 2 : ORGANISATION
AND MAJOR PLAYERS OF
INTRODUCTIONS FOREX MARKETS
SECTIONS
SECTION 3 : SECTION 5 : EFFECT OF
SECTION 4 :
EXCHANGE RATES ON
EXCHANGE RATE EXCHANGE RATE INTERNATIONAL TRADE
MECHANICS REGIMES AND CAPITAL FLOWS
EXCHANGE RATES, INTERNATIONAL TRADE
AND CAPITAL FLOWS
THE IMPACT OF EXCHANGE RATES AND OTHER FACTORS ON THE TRADE BALANCE MUST BE
MIRRORED BY THEIR IMPACT ON CAPITAL FLOWS – THEY MUST AFFECT EACH OTHER.
X-M = (S-I) + (T-G)
IMPACT OF EXCHANGE RATES ON TRADE BALANCE
ELASTICITY APPROACH ABSORPTION APPROACH
THE ELASTICITIES APPROACH
DEVALUATION
TRADE
CURRENC OR
DEFICI
Y DEPRECIATION EFFECTS
T
MARSHALL -LERNER CONDITION
GENERALISED MARSHALL – LERNER XEX + (EM – 1) > 0
CONDITION
XEX + (EM – 1) > 0
X SHARE OF EXPORT
M SHARE OF IMPORT
EX PRICE ELASTICITY OF FOREIGN DEMAND FOR DOMESTIC
COUNTRY EXPORTS
EM PRICE ELASTICITY OF DOMESTIC COUNTRY DEMAND FOR
IMPORTS
SPECIAL CASE
WHEN, X = M
EX + EM >1
IN CONJUNCTIUON WITH THE MARSHALL – LERNER CONDITION, THE FACTOERS THAT DETERMINE
PRICE ELASTICITIES SUGGESTS THAT EXCHANGE RATE CHANGES WILL BE MORE EFFECTIVE FOR
TRADE BALANCE ADJUSTMENT IF A COUNTRY IMPORTS AND EXPORTS THE FOLLOWING :
• GOODS FOR WHICH THERE ARE SUBSTITUTES
• GOODS THAT TRADE IN COMPETITIVE MARKETS
• LUXURY GOODS, RATHER THAN NECESSITIES
• GOODS THAT REPRESENT A LARGE PORTION OF CONSUMER EXPENDITURES OR A
LARGE PORTION OF INPUT COSTS FOR FINAL PRODUCERS
THE J CURVE EFFECT
TRADE BALANCE
DEVLAUATION
TIME
SHORT TERM PRICE ELASTICITIES DONOT SATISFY MARSHALL – LERNER CONDITION –
BALANCE WORSENS
LONG TERM PRICE ELASTICITIES SATISFIES MARSHALL – LERNER CONDITION – BALANCE
IMPROVES
IMPACT OF EXCHANGE RATES ON TRADE BALANCE
ELASTICITY APPROACH ABSORPTION APPROACH
THE ABSORPTION APPROACH
Y–A=X-M
A = DOMESTIC ABSORPTION – C + I + G
Y = INCOME OR GDP
• DEPRECIATION/DEVALUATION - TRADE BALANCE CAN ONLY IMPROVE
IF INCOME (Y), RELATIVE TO ABSORPTION (A) RISES
S-I=X-M
S = SAVINGS ; I = INVESTMENT
• DEPRECIATION/DEVALUATION - TRADE BALANCE CAN ONLY IMPROVE
IF SAVINGS RISE RELATIVE TO INVESTMENT.
REASON – WEALTH EFFECT
