Exchange Rates

Exchange Rate = Relative Price of Currencies

Direct or Natural or Right Quote/American Terms

rupee price of 1 unit foreign currency; Rs./FX1 = rupee per unit foreign exchange

Indirect or Reverse or Left Quote/European Terms

foreign currency price of Rs.; FX/Rs.1 used in Cash market. Most currencies quoted this way, except

Indirect Quote is inverse of Direct Quote

Here, E = exchange rate in American Terms

Using Exchange Rates

Comparing Prices in Different Currencies
P = E P*, where P = price (* = foreign), E = exchange rate
E = Rs. depreciation (lower value of Rs.)
Rs. price of foreign goods higher; FX price of Indian goods lower Indian Net Exports (Exports less Imports in rupee terms) increase; foreign net exports (in foreign currency terms) fall

E = Rs. appreciation
Rs. price foreign goods lower; FX price of Indian goods higher.
Indian Net Exports fall; foreign net exports increase

Example Indian made computer, Rs. price = Rs.2000

E1 = .5162 Rs./DM; E2 = .6 Rs./DM

DM price P* = P/E P1* = DM 3874.47; P2* = DM 3333.33 Rs. has depreciated; Rs. costed good has lower DM price!

DM price of Rs.: 1/E1 = 1.937 DM/Rs.; 1/E2 = 1.667 DM/Rs.

Economic Theories of Exchange Rate Determination

1. 2. 3. 4. Purchasing Power Parity Law of one Price Money Supply & Price Inflation Big Mac Index Limited Empirical Support for the Theory

International Fisher Effect [ (S1 S2)/S2] x 100 = i$-i where i$ & i are the respective nominal interest rates in U.S & Japan S1 is the spot exchange rate at the beginning of the period S2 is the spot exchange rate at end of the period

 Investor Psychology 1. Bandwagon Effects shift in the value of the currency[ short run exchange rate movements ] not due to shift in macroeconomic fundamentals but due to speculation

2. Short Selling the domestic currrency with a view of a better exchange rate which later became a self fulfilling prophecy due mass action by forex traders

Participants in the Foreign Exchange Market

Commercial & Investment Banks (Inter-bank market)
amounts > $1m, typically $10m liquid market (vis--vis loans) with limited credit exposure for clients and themselves allows bit players to economize on transactions costs

Central Banks
non-commercial motives relatively small portion of trading volume may intervene to address perceived economic/financial imbalances

Hedge Funds
partnership of high net-worth individuals highly leveraged global investing add liquidity, flexibility, and sometimes instability to FX markets

Corporations
mostly act through intermediaries

Individuals
tourists ~ insignificant volume

 Intermediaries Brokers
mostly service commercial banks and trading houses anonymous connected to many banks ~ shop for best price (exchange rate)

Direct Dealing
through dealing system ~ e.g., Reuters, Quotron quotes valid for 20 sec.

Physical Market
Daily Turnover in excess of$1.5 trillion
more than 50 times U.S. daily GDP; more than 30 times global goods and services trade
FX market activity far in excess of that necessary to purchase global output.

Major Markets: London, New York, Tokyo

trading around the clock

 US$ as vehicle currency

A currency that is widely used to denominate international contracts made by parties who do not reside in the country that issues the vehicle currency. more than half of all trades against Dollars lower transactions costs when trading indirectly against dollars, even if $ not actually needed. , also function as lesser vehicle currencies

Spot Market for Foreign Exchange

Spot Market value date = 2 days (to clear)
WSJ gives Ask/Offer Rate ~ selling price Any published rate is for a specific time may change 15,000 times a day or more.

Spreads
BID (buying) rate and ASK rate
e.g., monitor might show CAD 1.5223-28 (per Rs.). BID = 1.5223, ASK = 1.5228. Spread is 5 pips, where pip is last decimal.

Spread is a transaction cost Spread is larger for more thinly traded (lower liquidity) currencies

Rate Determination ~ supply of and demand for currencies.

Central Bank intervention influences supply and/or demand

Arbitrage: Buy Low, Sell High

Exchange Rates will be equalized across markets/actors

Example: let $/DM = .5 in NY, and = .55 in Frankfurt

profitable to buy DM in NY, sell DM in Frankfurt
$.1000 DM2000 in NY $.1100 in Frank. profit $100

Demand for DM in NY, ENY Supply DM in Frankfurt, EFrank. : Exchange rates converge!

Foreign Exchange Risk

Spot Rates may change in a way that makes a transaction less (or more) profitable.
You are uncovered if you depend on spot market
e.g., 10m account payable due in 90d. If you wait 90d to buy yen and Rs. depreciates, the 10m costs you more.

Managing foreign exchange risk: Forward, Futures, and Option Markets

Forward Markets
Buying & Selling currency for future delivery ~ 30, 90, or 180 days Contract stipulates amount traded, the price, and value date
price = forward rate = F (Rs./unit foreign currency)

F may be quoted outright (actual quote), or by forward spread (from spot rate; used by dealing systems).

Forward Premiums and Discounts

F < E ~ fewer Rs. to buy FX in future than now; Rs. trading at forward premium

F > E ~ forward discount signs reversed if use indirect quote

e.g., CAD 1.5228 (per US$.) spot, 1.5244 180d fwd CAD at forward discount, $ at forward premium Forward rates reflect relative rates of return and expectations of future exchange rates. Actors using forward contracts are covered or hedged.

Problems with Forwards

Default Risk Illiquidity ~ contracts customized, limited transferability Solutions: short maturity; margins; limited clientele.

Swaps

Combine two transactions into one Foreign Exchange Swap: spot trade with opposing forward trade Currency Swap: firms borrow domestic currency, swap principal w/ foreign firm in net present value terms ~ cheaper foreign currency borrowing.

Futures
Similar to forward agreements except active secondary market standardized contracts ~ fewer currencies, standardized value and expiry date

smaller than forwards ~ more accessible to smaller businesses

a clearing house guarantees contract against default, requires margin against unprofitable positions. day-to-day losses & gains posted against margin deposit; defaulting only saves last days losses, not cumulative losses. if margin account falls too low, have to top it off

Options
Underlying Asset = future or spot cash

Right, but not obligation, to buy or sell at strike price

CALL ~ right to buy
PUT ~ right to sell

Premium ~ up-front cost of obtaining right

Protects against unfavorable spot XR changes, while not limiting ability to exploit favorable spot XR changes
In the money ~ can profitably exercise option CALL in the money when currency appreciates; hedge accounts payable in foreign currencies PUT in the money when currency depreciates; hedge accounts receivable in foreign currencies

Hedging and Speculation

Distinction can be fuzzy, but
hedge = reduced risk; speculation = increased risk
Speculation
long position ~ buy FX (any contract) to sell at higher-thanexpected future spot XR (future spot higher than expected by market)
short position ~ sell FX you dont have for future delivery at what you think is higher than expected future spot price; buy spot in future, close your position at a profit (future spot less than expected)

 Example
Rs.5m account payable due 90d. E (spot) = .69Rs./CAD, F = .67Rs./CAD. Call option strike = .68Rs./CAD. Expect Rs. depreciation. Future spot = .72 exercise option, save .03/CAD or Rs.150,000 over previous spot, though F @ .67 was better. Future spot = .65 just buy spot; save .02/CAD over fwd