Lecture 10 Sudeep

8/3/2019 Lecture 10 Sudeep

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Outline

A. Foreign Exchange Market and Its Functions

B. The Nature of Foreign Exchange Market

C. Exchange Rate Determination

D. Exchange Rate Forecasting

E. Convertibility and Government Policy

F. Managerial Implications


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A. Foreign Exchange Market and Its

Functions

People in different countries make economictransactions in different monies ($,,,,, ),requiring conversion from one type of money

(currency) to another whenever economictransactions crosses international borders.

Foreign Exchange is the termed as the currencyof another country that is needed to carry outinternational transactions.

Foreign exchange market(FOREX) is the marketwhere currencies are exchanged.


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A. Foreign Exchange Market and

Its Functions

Foreign exchange market A market for converting the currency of one country into the

currency of another. Its a global network of banks, brokers andforeign exchange dealers connected by electronic

communications systems

Exchange rate

Price determined in the FOREX market is the exchangerate.

Its the rate at which one currency is converted intoanother

Foreign exchange risk

The risk that arises from changes in exchange rates


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Mosttraded currencies

Rank CurrencyISO 4217 code

(Symbol)

% daily share

(April 2007)

1 United States dollar USD ($) 86.3%2 Euro EUR () 37.0%3 Japanese yen JPY () 17.0%4 Pound sterling GBP () 15.0%5 Swiss franc CHF (Fr) 6.8%6 Australian dollar AUD ($) 6.7%7 Canadian dollar CAD ($) 4.2%8-9 Swedish krona SEK (kr) 2.8%8-9 Hong Kong dollar HKD ($) 2.8%10 Norwegian krone NOK (kr) 2.2%11 New Zealand dollar NZD ($) 1.9%12 Mexican peso MXN ($) 1.3%13 Singapore dollar SGD ($) 1.2%14 South Korean won KRW () 1.1%

Other 14.5%

Total 200%

Source: Triennial Central BankSurvey (December 2007), BIS


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Its Functions The foreign exchange market serves two functions

Currency conversion

Conversion: companies receive payment in foreign

currencies and they have to convert these payments totheir home currency

Payments: companies pay foreign businesses for goods

or services

Investments: companies invest spare cash for shortterms in money market accounts

Currency Speculation: companies take advantage of

changing exchange rates

The short-term movement of funds from one currency to

another in the hopes of profiting from shifts in exchange rates


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Its Functions

Insuring against foreign exchange risk

To understand how the foreign exchange market

provides insurance to protect against foreign

exchange risk we need to understand

Spot exchange rate

Forward exchange rate

Currency swap


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Its Functions

Spot exchange rate

The rate of currency exchange on a particular day

Example:

When a HK tourist in London goes to a bank to convert HK$into , the exchange rate is the spot rate for that day.

Spot exchange rate is determined through the

interaction of relative demand and supply of thatcurrency compared to others (discussed later).


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Its Functions Forward exchange rate

forward exchange rates are the exchange rates governing futuretransactions such as when two parties agree to exchange currenciesand execute the deal at some specific future date.

Example: Suppose a US firm imports PCs (at 200,000 each) from

Japanese supplier and can sell them immediately at $2000 in US. Thefirm needs to pay the Japanese supplier in in 30 days when theshipment arrives.

Suppose current spot exchange rate $1 = 120

If it buys now to pay after 30 days, then costs are $1,667 (200,000/ 120)- spot transaction

But it does not have the money to pay the supplier until it can sell the

computer Suppose it expects the future spot rate after 30 days to be $1 = 95

Then if it waits till it sells the computer, it expects to pay 200,000 or$2,105 (200,000/ 95) to the Japanese supplier after 30 days (future spottransaction)

Suppose the 30-day forward exchange rate is $1 = 110

If it enters into a 30-day forward transaction at $1 = 110

Needs to pay 200,000 or $1,818 (200,000 /110) to a Japanese supplierafter 30 days


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Its Functions

Currency swap

Simultaneous purchase and sale of a given amount of

foreign exchange for two different value dates.

Moving out of one currency into another for a limitedperiod without incurring foreign exchange risk.

Common example ofSwap: spot against forward

Spot exchange rate: $1 = 120

90-day forward exchange: $1 = 110 Convert $1 and get 120 now at spot rate ($1 = 120).

Convert 120 and get $1.09 at forward rate ($1 = 110) 90 days

from now

Profit after 90 days: $1.09 - $1= $0.09!


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ACurrency Swap Illustration Swiss national comes to HK on a one-year job contract and wants to live

in the convenient company apartment. Company gives her two options: Rent the apartment for HK$400,000/year, OR

Buy the apartment for HK$5m and then resell to company for $5m after a year.

Suppose interest rate on a 1 year $5m loan in HK = 10% p.a. If she takesthe loan, interest cost = 10% of $5m = $500,000 > rent

Suppose interest rate in Switzerland on loan is 5% Assume current spot exchange rate is 1CHF = 5HKD. Then, borrow CHF1m (=

$5m) and pay interest cost = 5% of CHF1m = CHF 50,000 = $250,000 < rent

=> Borrow money in Swiss Francs (CHF)!!

But whatabout futureexchangeor currencyrisk? SUPPOSE future spot rate after one year is 1CHF = 5.2HKD. Then after one

year need to pay CHF 1.05m =$5.46m. So need to pay extra ($5.46m-$5m)=$460,000 which is > rent! (Toomuch of currencyrisk!!)

Supposeoneyear forwardexchangerate is 1CHF = 5.1HKD.

Then take loan in Swiss Francs and enter intoa CURRENCY SWAP

Convert CHF 1m into $5m spot transaction (at 1CHF = 5HKD)

Make forward transaction of converting $5.355m into CHF 1.05m (at 1CHF= 5.1 HKD) one year from now

=> Net costofowningapartment = $355,000 < RENT


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A. Foreign Exchange Market:

Turnover


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A. Foreign Exchange Market:

Composition of Turnover


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A. Foreign Exchange Market:Turnover by Currency Pair

Source: Triennial Central BankSurvey (2007)


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B. The Nature of Foreign Exchange

Market

It isa 24/7 marketbecausemajor financialinstitutions haveofficesallaroundthe world

Example: Tokyo, London and New York exchange

markets are all shut for only 3 hours out of every 24hours.

Dailytradedvolumesare HUGE: $3.2 trillionin 2007 (25 timesgreaterthanvolumeoftrade!)

Londonsdominanceasa foreignexchangemarket isexplainedby:

History (capital of the first major industrialized nation).

Geography (between Tokyo/Singapore and New York).


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B. The Nature of Foreign Exchange

Market

Foreign exchange market is an integrated and

connected electronic network, such that one virtual

market is created

A global network of banks, brokers and foreign exchangedealers connected by electronic communications systems

Banks Brokers

Foreign exchange

dealers

Connected by

electronic

communications

systems


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B. Factors Influencing Currency

Value

Economic Factors

Inflation

Interest Rates

Monetary and Fiscal Policy

Balance of Payments

International Competitiveness

Monetary Reserves

Government Controls and Incentives

Importance of Currency in World


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B. Factors Influencing Currency

Value

Political Factors

Current Political Policies and Philosophies

Uncertainty in Political Climate

Other Factors

Asset Market Models (Expectations)

Forward Exchange Market Prices


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Exchange rates are determined by the demand

and supply of one currency relative to the demand

and supply of another.

Demandfor a currency representsforeign residents needfor that currency to complete intended transactions (buy

goods or financial assets)

E.g. Japanese demand Euros () in order to buy German goods.

Supply for a currency represents domestic residents needfor foreign currency to complete intended transactions with

a foreign country

E.g. German demand Yen () when they want to buy Japanese

goods. They need to sell in order to buy .


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Market for Euros ()

D

S per

one

Quantity of (billions)Q

P

140 e*

60

150

65

e**

D/

Determinationof freely floatingexchangerates

What causes shift in demand for

Euros?

Change in taste, e.g. Japanese wantmore German goods.

Changes in relative national incomes,

e.g. Japanese incomes rise, causing an

increase in demand for German goods.

Changes in relative return on financial

assets, e.g. German bonds earn more

than Japanese bonds.

Similar reasons for supply changes.


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C. Exchange Rate Determination: Currency

Appreciation and Depreciation

Currency Appreciation

When a currency becomes more valuable its price interms of other currency increases, i.e. more of the othercurrency is needed to buy one unit of this currency and

the currency is said to have appreciated.

Currency Depreciation

When a currency becomes less valuable its price interms of other currency decreases, i.e. less of the othercurrency is needed to buy one unit of this currency and

the currency is said to have depreciated.

Note: For any currency combination, if onecurrency appreciates in terms of the other thenthe other must necessarily depreciate and vice

versa.


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Prices are related to exchange rate movements interms of:

The Law of One Price

Purchasing Power Parity (PPP) Theory Money supply and price inflation

Interest Rate and Exchange Rate

International Fisher Effect determines the relationshipbetween interest rates and exchange rates

Investor Psychology

Exchange rate can be affected by investor psychologyand Bandwagon effects


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C. Exchange Rate Determination:

Law ofOne Price

Identical products sold in different countries must sell for the sameprice when their price is expressed in terms of the same currency

Example: 1 = $1.50. A jacket selling for $75 in New York

should sell for 50 in London ($75/1.50)

If the jacket costs 40 in London

Convert $60 to get 40 andbuy a jacket in London. Sell it in NewYork for $75 => Profit of $15 per jacket (arbitrage)

Increased demand in London would raise their price

Increased supply in New York would lower their price

This will continue until prices are equalized: e.g. 44 in London and

$66 in New York (at 1 = $1.50)

In competitive markets where

transportation costs are assumed to negligible

there are no trade barriers


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Purchasing Power Parity (PPP) Theory

PPP Theory postulates that changes in relative

prices will result in a change in exchange rates

A country with high inflation should expect its currency

to depreciate against the currency of a country with alower inflation rate

Example:

A basket of goods costs $200 in US and 20,000 in Japan

=> $1 = 100 by PPP No price inflation in US but 10% in Japan => the basket of

good in Japan will cost 22,000 in future.

If there is no change in future exchange rate then PP is violated.

=> $1 = 110 in future, i.e. has depreciated by 10% against $


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Exchange Rate Determination:

Purchasing Power Parity (PPP) Theory

In real life we see evidence of departurefrom the predictions of PPP theory, thereasons for which maybe:

Transportation costs and trade restrictions(including non-tradable goods)

Menu costs

costs to firms of updating menus, price lists,

brochures, and other materials when prices change inan economy leading to sticky prices

Goods may not be perfect substitutes

Other factors, such as real interest rates, etc.,may dominate in the short-run


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Non-Tradables? Haircuts as Tradables

(Source: Greg Mankiws Blog)Economists often use haircuts as a prototypical non-tradable good. But maybe we need to find a newexample:

The financial crisis has hit Eastern Europe particularly hard,

leading to strong depreciation pressure on exchange rates. As aresult, traditional non-tradable goods have suddenly becometradable. The Polish village of Osinow Dolny at the Polish-German border has approx. 200 inhabitants, 100 of which areactive hairdressers. Germans come from as far as Berlin (70

km) to take advantage of the zloty exchange rate, which wentfrom 3.30 per euro in the summer of 2008 to well over 4 now."Salon Teresa" at the end of main street charges 9 euros forladies and 4 for men.

Illustrates the forces that tend to push exchange rates

toward purchasing-power parity.


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Menu Costs, Defeated(Source: http://gregmankiw.blogspot.com/2009/03/menu-

costs-defeated.html)


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Money Supply and Price Inflation

Inflation occurs when:

money supply increases faster than output increases

PPP Theory tells us that:

a country with a high inflation rate will see depreciation

in its currency exchange rate

Increase in a countrys money supply changes:

the relative demand and supply conditions in foreign

exchange market

The dollar will depreciate against currencies

of countries with slower monetary growth


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Interest Rates and Exchange Rates

Some theories show that interest rates reflect

expectations about future exchange rates

Fisher Effect states that:

nominal interest rate (i) is the sum of real interest rate

(r) and expected rate of inflation (I)

real interest rates in different countries are equalized

Example:

i = r + I

If r in US = 10% and r in Switzerland = 6%, investors would borrow money

from Switzerland and put it in US

(I) Demand for money in Switzerland interest rate in Switzerland

(II) Supply of money in US interest rate in US

Real interest rates in US and Switzerland are equalized


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PPP Theory provides linkage between inflation and exchange

rates

Fisher Theory provides link between interest rates and

inflation => PPP + Fisher Theory = International Fisher Theory

provides a link between interest rates and exchange rates

Since interest rates reflect expectations about inflation, it follows that

there must also be a link between interest rates and exchange rates

International Fisher Effect:

Linkage between interest rates and exchange rates


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International Fisher Effect states that for any two

countries,

the spot exchange rate should change in an equal

amount but in the opposite direction to the difference innominal interest rates between the two countries

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International Fisher Effect

International Fisher Effect Example:

Suppose the nominal interest rate is 10% in US and 6%

in Japan

Greater expected inflation rates in US Suppose the current spot exchange rate is 1$ = 100

Then the spot exchange rate in the future between

dollar and yen should be:

(100 S

2) /S

2 = (10 6)/100=> 100 (100 - S2) = 4 S2

=> 104 S2 = 10000 =>

=> S2 = 10000/104 96

in future we expect $ to depreciate by 4% against


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International Fisher Effect

International Fisher Effect Example:

Alternatively, by Fisher effect we getFor US: 10 = r$ + I$ => r$ = 10 - I$For Japan: 6 = r + I => r = 6 - I

Since real interest rate must be the same in all countries,hence r$ = r=> 10 - I$ = 6 - I

=> I$ - I = 4

US should expect a inflation rate 4% higher than Japan.B

utaccording to PPP theory a country with a 4% higherrelative inflation rate should expect a 4% depreciation inits currency. Therefore we should expect a 4% depreciation in $ with respect to


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C. Exchange Rate Determination: Investor

Psychology and Bandwagon Effects

Evidence suggests that neither PPP Theory nor

International Fisher Effect are good at explaining

short term movements in exchange rates

Possible explanations are:

Investor Psychology

The Bandwagon Effects


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C. Exchange Rate Determination: Investor

Psychology and Bandwagon Effects

Expectations on the part of traders can turn into self-fulfillingprophecies, and traders can join the bandwagon and moveexchange rate based on group expectations

Example:

Investors moved in a herd in response to a bet placed by GeorgeSoros who shorted the British pounds and bought German marks

It is hard to predict investor psychology and bandwagoneffect

Sometimes, government intervention can prevent the

bandwagon from starting, but at other times it is ineffective and only encourages traders to

further speculate


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C. Exchange Rate Determination: Other

Factors

Other factors

AssetMarketModel

Increasingly, the proportion of foreign exchangetransactions due to trading of currency based financial

assets has dwarfed the extent of currency transactionsgenerated from trading in goods and services.

The asset market approach views currencies as asset pricestraded in an efficient financial market.

BalanceofPaymentsModel

Trade deficit will reduce a nations Forex reserves whichultimately depreciates the value of its currency. Thecheaper currency gives a price advantage to the countrysexports and disadvantage to imports.

Therefore future imports fall and exports rise, thusstabilizing the trade balance and the currency towardsequilibrium.


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D. Exchange Rate Forecasting: Efficient

Markets

Efficient market hypothesis:prices inmarkets reflect all available publicinformation.

If FOREX markets are efficient then forwardexchange rates will be unbiased predictors offuture spot rates.

Traditionally, economics and finance theories

have assumed that FOREX markets areefficient, but recent studies relying onempirical evidence on markets havechallenged that assumption.


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E.Convertibility and GovernmentPolicy A currency is said to be:

Freely convertible

E.g. US currency

The government of a country allows

both residents and non-residents to

purchase unlimited amounts of foreign

currency with the domestic currency

Both residents and non-residents are

prohibited from converting their holdings of

domestic currency into a foreign currency

Non-residents can convert their holdings

of domestic currency into a foreign

currency, but the ability of residents to

convert currency is limited in some way

Non-convertible

E.g. African currency

Externally convertible

E.g. Russian currency


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E.Convertibility and Government

Policy Free convertibility is the norm in the world today

although many countries impose some restrictions on the amountof money that can be converted

The main reason to limit convertibility is to:

Preserve foreign exchange reserves Service international debt.

Purchase imports.

Prevent capital flight (when residents and nonresidents rushto convert their holdings of domestic currency into a foreigncurrency)

Countertrade refers to: a range ofbarter-like agreements by which goods and

services can be traded for other goods and services

It is used in international trade when a countrys currency isnonconvertible


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F. Managerial Implications

International businesses must understand the

influence of exchange rates on the profitability of

trade and investment deals

Transaction Exposure The extent to which the income from individual transactions is

affected by fluctuations in foreign exchange values

Translation Exposure The impact of currency exchange rate changes on the reported

financial statements of a company


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E. Managerial Implications

Economic Exposure

The extent to which a firms future international earning power isaffected by changes in exchange rates

If a company wants to know how the value of a particular currency willchange over the long term in the foreign exchange market,

it should take a close look at all those economic level fundamentalsthat appear to predict long run exchange rate movements

Example: The growth in a countrys money supply, its inflation rateand nominal interest rates

When governments restrict currency convertibility, firms must find waysto facilitate international trade and investment

Documents

Lecture 10 Sudeep