CHAPTER 7

FOREIGN EXCHANGE
MARKET
 Introduction

 Financial transactions between two countries do not involve

physical movement of currency from one country to another.
 It is carried out through the banking system of the two countries
concerned because the banks keep accounts in foreign currency
with other banks throughout the world.
 Every country of the world has their own unique currency which
only valid in the country of origin.
 However, goods and services are traded widely among countries
in the world. Therefore, there is need to exchange one currency to
another in order to the settle the international transaction.
 HISTORY OF INTERNATIONAL
MONETARY SYSTEM
 Bimetallism: Before 1875 – The time when gold and silver were
used as money
 Classical Gold Standard: 1875-1914 - During this period in most
major countries used gold alone as unrestricted coinage
 Interwar Period: 1915-1944 - Exchange rates are pegged to gold
 Bretton Woods System: 1945-1971 - Named for a 1944 meeting of
44 nations at Bretton Woods, New Hampshire. The result was the
creation of the IMF and the World Bank. Under the Bretton Woods
system, the U.S. dollar was pegged to gold at $35 per ounce and
other currencies were pegged to the U.S.
 The post Bretton Woods system/Floating Exchange Rate: 1971 –
present - Between years 1971 to 1973 are the transition years for
gold exchange standard moving to free floating system. Floating rates
mean the value of the currencies will be allowed to rise and fall in
accordance with the market forces
 Types of floating exchange rate
1. Managed Exchange Rate
 The exchange rate will be intervene by central banks to obtain a politically
desirable exchange rate
 The examples of countries practicing this system are Malaysia (before 1999),
Thailand, Brazil, China and Singapore.
2. Free Floating Rate or Flexible rate
 The exchange rate is solely determined by market supply and demand
 This system is normally practice by big countries in term of economic and
countries that are not dependent to one country as its trading partner.
 Such countries are The United States, Australia, Japan, Indonesia, Mexico and
Philippines.
3. Pegging
 Countries that trade largely with a single foreign country tend to peg their
exchange to that country currency
 These countries normally peg their currency with one country but float against the
rest of the world.
 The countries practicing this system are Iraq, Panama, Barbados, Angola, and
Argentina.
 OVERVIEW OF THE FOREIGN EXCHANGE
MARKET
 Foreign exchange is the conversion of the country’s currency for
another country’s currency.
 The rate of exchange is simply the price of one country’s currency
in exchange for another country’s currency.
 For example; the same good that is worth 1USD in the US is worth
of RM4.14 in Malaysia.
 Therefore, the exchange rate is USD1.00 = RM 4.14.
 The foreign exchange market is the mechanism by which one is
able to transfer purchasing power from one country’s currency to
another.
 Customers usually buy and sell foreign exchange through
commercial banks, as only commercial banks are authorized to
deal in foreign exchange.
  Normally the banks quote their rates for buying and selling of
various currencies on a direct basis.
 Exchange Rate Quotation
Quotation Direct basis Indirect basis

Implementation A direct quote is a An indirect quote is a

quotation of one unit quotation of one unit of
of foreign currency to local currency to foreign
local currency currency
Quotation USD1 = RM 4.14 RM1 = USD 0.2415
 

USD/RM Selling Buying

Direct basis 4.1400 4.0200
(1 unit of USD)
Indirect basis 0.2415 0.2488
(1 unit of RM)
 Con’t
 For direct basis, the bank makes profit from the “spread” that
is the difference between the bank’s buying and selling rates
of foreign currency.
 Selling rate is always higher than buying rate that ‘sell high,
buy low’.
 For indirect basis, the selling rate is lower than buying rate.
 The currency dealer will be ‘buy high, sell low’, because
when buying he want as many units as possible of foreign
currency for each unit of the home currency,
 and when selling he will want to hand over as few units of
foreign currency as possible for each unit of the home
currency.
 The different is the profit margin to the dealer.
 SPOT AND FORWARD MARKETS

 Foreign exchange transactions can be divided into two

types of rates that are SPOT rates and FORWARD rates.
 A SPOT RATE is the rate of exchange at which foreign
currency is bought or sold with delivery and settlement to
be completed immediately or on the spot.
 Selling TT/OD the rate quoted from the bank’s point of
view. The rate is used when the bank sells the foreign
currency.
 Buying OD rate is used when the foreign currency is to be
delivered to the bank at later date (traveler cheque,
foreign cheque, and trade bills)
 Buying TT rate is used when the foreign currency is
already delivered for exchange to take place.
 Con’t
 FORWARD RATE is a rate quoted at present for the purchase or sale of a
stated amount of foreign currency at a specified time in the future.
 The exchange rate is established at the time the contract is agreed on, but
payment and delivery are not required until maturity.
 The forward rates are normally quoted at PREMIUM OR DISCOUNT.
 A currency is at PREMIUM when it is MORE EXPENSIVE to buy it in future
than at a spot rate.
 In premium situation, RM depreciates and USD appreciates
 To calculate forward rate, we have to ADD PREMIUM to the spot rate.
 A currency is at a DISCOUNT when it is CHEAPER to buy it in future than at
a spot rate.
 In discount situation, RM appreciates and USD depreciates
 To calculate forward rate, we have to SUBTRACT DISCOUNT rate from the
spot rate.
  Example A Example B

US dollar RM 4.2500 RM4.2500

 

One month forward 0.0025 (Dis) 0.0025 (Pm)

 

Contract rate RM 4.2475 RM 4.2525

•In example A, shows that the US dollar is at a discount in

the forward exchange market.
•It means that the buyer will pay less RM for US dollars after
one month.
•In example B, the importer would be paying more RM when
the US dollars were at a premium in the forward market.
•He needs more RM to buy the same unit of USD in the
future
 CALCULATION AND CONVERSION OF FOREIGN CURRENCIES

 Forward exchange rates are quoted in terms of premium and

discount on the spot rate.
 When the forward is at a premium the abbreviation “PM” is used.

 A discount is shown as “DIS”, and

 the word “PAR” means that the forward rate is at parity with the
spot rate.
 A currency at a premium means that the forward rate is higher
that the spot rate. The PREMIUM RATE MUST BE ADDED TO SPOT
RATE to calculate forward rate. . In this case the foreign
currency is at appreciating, and RM is depreciating.  
 A discount means a lower forward rate, and a DEDUCTION MUST
BE MADE FROM THE SPOT RATE. In this case the foreign
currency is at depreciating, and RM is appreciating.
  
ILLUSTRATION OF THE FORWARD RATE CALCULATION

1. USD/RM Selling Buying

US dollars spot 4.2671 4.1524

1 month forward 0.0010pm 0.0008pm

2 month forward 0.0020pm 0.0015pm

3 month forward 0.0030pm 0.0020pm

Calculate the answer :    

1. USD/RM Selling Buying

US dollars spot 4.2671 4.1524

1 month forward    

2 month forward    

3 month forward    
 2. UK Sterling/RM Selling Buying

UK Sterling spot 5.5884 5.4128

1 month forward 0.0010dis 0.0015dis

2 month forward 0.0015dis 0.0018dis

3 month forward 0.0017dis 0.0020dis

Calculate the answer:    

2. UK Sterling/RM Selling Buying

UK Sterling spot 5.5884 5.4128

1 month forward    

2 month forward    

3 month forward    
Please do the exercise…..
PROCEED WITH PAST SEMESTER EXAM QUESTIONS…
 CLOSE-OUT OF FORWARD
CONTRACTS
 Close out occurs when a customer who has entered into a
forward contract to sell foreign currency to a bank but he
could not fulfill his contract because the payment he was
expecting has not arrived.
 On the due date the must be closed regardless the payment
is or not.
 Therefore, the customer must buy that foreign currency from
bank at the spot rate on the day of completion and then he
sell back that foreign currency to the bank at the rate agreed
in the forward contract.
 Then the forward contract is considered closed.
Cont’
 Close out could also occur in a situation
where the customer contracted to buy
foreign currency but could not fulfill it at
the completion date.
 Close out in actual fact does not involve
the actual delivery of cash money, but it
is simply by debiting or crediting the
customer’s account on the transactions or
by crediting customer on the difference
between contract rate and spot rate.
DETERMINANTS OF FOREIGN EXCHANGE
RATE

1. Interest rate differentials

 A country with a high interest rate will attract foreign investment and
an inflow of funds, and its currency will strengthen.
 These will create additional demand for the currency.
 A fall in interest rate will have the opposite effect.

2. Inflation rate
 A country with a consistently lower inflation rate exhibits a rising
currency value, as its purchasing power increases relative to other
currencies
 Those countries with higher inflation typically see depreciation in
their currency in relation to the currencies of their trading partners.
 3. Confidence in the currency
 Investor will feel safe and confidence to invest if that
particular country is stable and strong in term of politic,
economic, and financial.
 Foreign investors inevitably seek out stable countries with
strong economic performance in which to invest their capital

4. Public Debt
 Countries will engage in large-scale deficit financing to pay
for public sector projects and governmental funding.
 While such activity stimulates the domestic economy,
nations with large public deficits and debts are less
attractive to foreign investors
 5. Balance of payment
 If the price of a country's exports rises by a greater
rate than that of its imports, its terms of trade have
favorably improved.
 Increasing terms of trade shows greater demand for
the country's exports.
 This, in turn, results in rising revenues from exports,
which provides increased demand for the country's
currency
 FOREIGN EXCHANGE RISKS
1. Translation risk
 It is also known as accounting risk or exposure.
 The exchange rate risk associated with companies that deal in foreign currencies or
list foreign assets on their balance sheets.
 The greater the proportion of asset, liability and equity classes denominated in a
foreign currency, the greater the translation risk
2. Economic risk
 Economic risk is the risk that changes in the relative strengths of different
economies will affect the value of foreign earnings.
 This is exposure of firm’s value to changes in exchange rate, which can affect future
profitability, and current value of the firm
3. Transaction risk
 Transaction risk on the other hand refers to loses that may arise from the
settlement of transactions whose terms are stated in a foreign currency.
 This is due to uncertain domestic currency value against a foreign currency, and
transaction to be completed at some future date.
 The most common example of this risk is purchasing or selling of goods or services
on credit, whose prices are stated in foreign currencies.
HEDGING AGAINST FOREIGN
EXCHANGE RISKS

1. Forward Contract 
 This is a customized contract between two parties to buy or sell an
asset at a specified price on a future date.
 A forward contract settlement can occur on a cash or delivery basis.
 Forward contracts do not trade on a centralized exchange and are
therefore regarded as over-the-counter (OTC) instruments.

2. Future Contract
 A futures contract is a financial contract giving the buyer an
obligation to purchase an asset (and the seller an obligation to sell an
asset) at a set price at a future point in time.
 The assets often underlying futures contracts include commodities,
stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange
juice, and natural gas are traditional examples of commodities, but
foreign currencies, emissions credits, bandwidth and certain financial
instruments are also part of today's commodity markets.
Differences between Forward and
Future Contract
 Cont’
3. Swap
 Swap is exchange of two currencies on the spot with the agreement to re-
exchange them back at some future date.
 A swap is another method used to minimize the risk of loss in the foreign
exchange transaction.
 Usually a swap transaction involves a spot maturity date against a
forward maturity date

4. Option 
 An option is a contract which gives the buyer (the owner) the right, but
not the obligation, to buy or sell an instrument at a specified strike price
on or before a specified date.
 The seller /buyer has the corresponding obligation to fulfill their contract
 . When the time comes and the rate is not favorable, he can let the
contract expires.