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 used in futures market

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.

Actors 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

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

Exchange Rates and International Transactions 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. Example: In 2001, around 90% of transactions between banks involved exchanges of foreign currencies for U.S. dollars.

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 Rs.100

Demand for DM in NY, ENY Supply DM in Frankfurt, EFrank. : Exchange rates converge! Highest ASK no lower than lowest BID ~ Difference in Exchange Rates no larger than transaction cost!

Triangular Arbitrage
Cross-rates must correspond to pairs of direct rates
$./DM in NY = .5; DM/ in Frank. = 3; then /$ in London must be 0.667

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 USRs.) spot, 1.5244 180d fwd CAD at forward discount, Rs. at forward premium

Forward Markets, cont.

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 ~ cheaper foreign currency borrowing.

Futures
Like Forward, 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 American vs. European options

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 STRADDLE: CALL and PUT ~ in the money for any large swing in exchange rates ~ useful for highly volatile 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
CRs.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.

Economic theories of Exchange Rate Determination

Purchasing Power Parity

Increased Money Supply, Price Inflation & Currency Depreciation

Interest Rates & Exchange Rate 1. Fisher Effect Nominal Interest Rate = Real Interest Rate + Expected rate of Inflation for the time period of lending 2. International Fisher Effect Relationship between Interest Rates & Exchange Rates

[( S1 S2)/S2]* 100 = i$ -i
Where S1 is the spot exchange rate at the beginning of the period S2 spot exchange rate at the end of the period i$ & i - nominal interest rates in the United States & Japan

The Demand for Foreign Currency Assets The demand for a foreign currency bank deposit is influenced by the same considerations that influence the demand for any other asset. Assets and Asset Returns

Defining Asset Returns The percentage increase in value an asset offers over some time period. The Real Rate of Return The rate of return computed by measuring asset values in terms of some broad representative basket of products that savers regularly purchase.

The Demand for Foreign Currency Assets

Risk and Liquidity Savers care about two main characteristics of an asset other than its return: Risk The variability it contributes to savers wealth Liquidity The ease with which it can be sold or exchanged for goods

The Demand for Foreign Currency Assets Interest Rates Market participants need two pieces of information in order to compare returns on different deposits: How the money values of the deposits will change How exchange rates will change A currencys interest rate is the amount of that currency an individual can earn by lending a unit of the currency for a year. Example: At a dollar interest rate of 10% per year, the lender of $1 receives $1.10 at the end of the

Exchange Rates and Asset Returns The returns on deposits traded in the foreign exchange market depend on interest rates and expected exchange rate changes. In order to decide whether to buy a euro or a dollar deposit, one must calculate the dollar return on a euro deposit. A Simple Rule The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. The rate of depreciation of the dollar against the euro is the percentage increase in the dollar/euro exchange rate over a year.

The Demand for Foreign Currency Assets

The expected rate of return difference between dollar and euro deposits is:

R$ - [R + (Ee$/ - E$/ )/E$/ ] = R$ - R - (Ee$/ -E$/ )/E$/

where: R$ = interest rate on one-year dollar deposits R = interest rate on one-year euro deposits E$/ = todays dollar/euro exchange rate (number of dollars per euro) Ee$/ = dollar/euro exchange rate (number of dollars per euro) expected to prevail a year from today

When the difference in Equation is positive, dollar deposits yield the higher expected rate of return.
When it is negative, euro deposits yield the higher expected rate of return

Equilibrium in the Foreign Exchange Market How Changes in the Current Exchange Rate Affect Expected Returns:

Depreciation of a countrys currency today lowers the expected domestic currency return on foreign currency deposits.
Appreciation of the domestic currency today raises the domestic currency return expected of foreign currency deposits.

The Effect of Changing Interest Rates on the Current Exchange Rate

An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against foreign currencies. A rise in dollar interest rates causes the dollar to appreciate against the euro. A rise in euro interest rates causes the dollar to depreciate against the euro

Currency Convertibility
A countrys currency is said to be freely convertible when the countrys government allows both residents & non-residents to purchase unlimited amounts of foreign currency with it.

A currency is said to be externally convertible when only non-residents may convert it to foreign currency without any limitations.