International Economics & FinanceChapter 11: Foreign ExchangeRequired Reading: Carbaugh, Chap 11

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Learning Objectives• Introduction of Foreign Exchange Market• Different Types of Forex Transactions and

Markets• Understand Demand and Supply of

Currency• Short-run and Long-run Determinants of

Exchange Rates

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Foreign Exchange Market

• Largest and Most Liquid Market in the World• Average Daily Turnover in 2010: $3.98 trillion• No Organized Structure, No Centralized

Meeting Place• Transaction can Occur Anywhere as long as it is

within the international telecommunication system

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Foreign Exchange Market: • OPEN 24 hours

• Dominated by 4 major currencies USD, EUR, JPY, GBP

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Market Turnover by Location, by Currency, and by Instrument

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• Report from BIS (Bank for International Settlements)• http://www.bis.org/publ/rpfx13fx.pdf

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Foreign-Exchange Market 3 Levels of Transactions

1. Commercial Banks and Commercial CustomersE.g.) SG Exporter & DBS

2. Domestic Interbank through BrokerE.g.) DBS vs OCBC

3. Active Trading in Foreign Exchange with Banks Overseas

E.g.) DBS vs Barclays

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Foreign Exchange 101:Basic Terminology• Foreign Exchange Rate = Price of Currency• Bid Rate - Price which Bank is willing to Pay• Offer Rate - Price which Bank is willing to Sell• Spread - difference between the bid and the

offer rate• Bank’s Bid Quote < its Offer Quote

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Foreign Exchange 101:Basic Terminology• Exchange rate• Example: S$ to one unit of foreign currency

Sell (Ask) Buy (Bid)US dollar 1.258 1.21

• If you bring SGD100 and Change to USD: SGD 100 / 1.258 = USD 79.49

• If someone else brings USD79.49 to change to SGD: USD 79.49*1.21 = SGD 96.18

Money Changer will keep SGD 100 - 96.18 = SGD3.82

• Exchange rate reported - The Midrange between bid and offer 11

Foreign Exchange 101:Basic Terminology• On the spreadBid Offer Vol$0.5851 per Franc $0.5854 per Franc 1 Million

• Profit = 0.0003 (spread) x 1 M = $300

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Foreign Exchange 101:Basic Terminology• Depreciation

• It takes more units of a nation’s currency to purchase a unit of some foreign currency

• Appreciation • It takes fewer units of a nation’s currency to purchase

a unit of some foreign currency• Cross exchange rate

• Exchange rate between any two currencies (such as the Euro and AUD)

• Derived from the rates of these two currencies in terms of a third currency (USD) 13

In S$ (S$ to one unit of given foreign currency)

Per S$ (No. of foreign currency to buy one unit of S$)

Wed Tues Wed Tues

US dollar 1.234 1.22 0.810 0.812

How did the S$ move against the US$ from Tues to Wed?Ans: _________________appreciated _________________ depreciated

Cross Exchange Rate between 2 non-dollar currencies

In US$ (US$ to one unit of given foreign currency)

Euro 1.41

Australian dollar 1.053

US dollar -

Find the cross exchange rate between Euro and Australian dollar.Ans: Each Euro can buy about 1.34 Australian dollars 14

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Types of FX Transactions

• Spot Transaction• Transaction on the Spot; for those who need to change currency

Now• Forward Transactions / Future Contract / Options

• Transaction for the future date; for those who wants to hedge the risk (or take more risk) of exchange rate movement

• Currency Swap (FX Swap / Cross-Currency basis Swap)• Conversion of one currency to another at one point of time, with

Agreement to reconvert it back at specified time

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Spot Transactions• Outright Purchase or Sale of Currency “On the

Spot”• Cash Settlement < 2 business days after Trade

Date• Greatest Risk of Exchange Rate Fluctuations

Takes place in Spot Market• Highest Volume in Foreign-Exchange

Transactions

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Forward / Future Transactions• Used Mainly by Importers & Exporters to reduce Risks of

Exchange Rate Movement (Hedging)• However, No Risk means No Gain even if Exchange Rate

move in your Favour• Purchase / Sale of Foreign Currency on a Specific Future Date • Forward Rate = Quoted as a Premium or Discount from Spot

Rate• Forward Market = Over the Counter by Telephone, Delivery

Date & Size can be Customized• Futures Market = Date & Size are Standardized, Listed in Large

Exchange Market such as Chicago, Tokyo, and Singapore

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Currency Swap Transactions• Conversion of One Currency to Another with Agreement to Re-

convert it to Original Currency at Specified Time in Future• Rates of Both Exchanges are Agreed to in Advance• Provide an efficient means by which Banks and Corporations

can Meet FX Needs Over a Period of Time• Example: Company Taking Loan in Foreign Currency

A Singapore Company take USD 1million loan over 3 years

Company generates income in SGD, but need to make repayments for Loan in USD every quarter Swap arrangement to convert USD SGD on the date

which they took loan, and convert SGD USD on the days which company make repayment over next 3 years 19

Exchange-Rate Determination• Exchange Rate = Price of Currency• Demand & Supply of Currency

• Demand for GBP in USA = Correspond to Debit Items of Balance-of-Payment for USA

• Supply of GBP in USA = Correspond to Credit Items of Balance-of-Payment for USA

Supply & Demand will indicate “Equilibrium” Exchange Rate

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Demand & Supply of GBP in US

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Pound Appreciation

Pound Depreciation

Price of Pound in terms of Dollars

(GBP 1 = USD ??)

Factors Affect Demand• Demand for GBP in US

• More Americans want to import British goods, they need more GBP to make payments Demand Curve will shift Rightward

• Less Americans want to invest in UK – Need Less GBP for Buying UK stocks, bonds, etc Demand Curve will shift Leftward

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• Less American wants to invest in UK, they will demand less GBP• As a Result, Demand of GBP will shift leftward• GBP will Depreciate (USD will Appreciate)

Factors Affect Supply• Supply of GBP in US

• More British want to import US goods (US Export Increase), they supply more GBP to change into USD Supply Curve will shift Rightward

• Less British want to invest in US – Supply Less GBP Supply Curve will shift Leftward

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• More British wants to import goods from US (US export increase), Supply of GBP increases.

• As a Result, GBP will Depreciate (USD will Appreciate).

Appreciation• Advantages

• Import becomes Cheaper• Lower Import Price = Low Inflation• Benefit when We Travel Abroad

• Disadvantages• Exporting Industries Suffer (Export Price Increase)• Import-Competing Industries Suffer• Foreign Tourists find us Expensive

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Depreciation• Advantages

• Exporting Industries Benefit• Foreign Tourist find our Country’s Goods Cheap

• Disadvantages• Import becomes More Expensive (consumers suffer)• Inflationary Pressure from Expensive Import• Disadvantage for us to Travel Abroad

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Managing Foreign Exchange risk

• Manage foreign exchange risk using forward contract • Hedging

• Process of avoiding or covering a foreign-exchange risk• Used by Importers & Exporters• Also Used to Secure the Returns from Investments

Overseas• Some firms do not hedge

• Currency fluctuations even out over the long term• Spread the Location of Production

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Example: Hedging• SG importer orders furniture from Italian manufacturer. They

need to make a Payment of €50,000 due in 3 months’ time• SG importer can choose the following:

• Do nothing, take on exchange rate risk (uncovered position), or• Enter into spot transaction now (covered position), or• Enter into a 3 month forward/ futures contract (Hedging)

• Which one has More/Less Risk?

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Hedging• Jan spot rate is S$1.603: €1

Apr spot rate is S$1.700: €1

• Option 1: Do nothing• If spot rate were S$1.7 to €1 in Apr, SG importer would have

to pay €50K x 1.700 = S$85,000

• Option 2: Buy € now in Jan & Prepare for Apr payment• Amount paid in Jan = 1.603 x 50K = S$80,150• Must Incur Opportunity Cost of SGD exchanged into €

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Hedging• Assume:

• Jan spot rate is S$1.603: €1• In Jan, 3 mth forward rate for Apr Settlement is S$1.65: €1

• Option 3: In Jan, Enter into 3 mth forward contract • Amount due in Apr= 1.65 x 50K = S$82,500

• Amount Saved Compared to No Hedging: 85,000 - 82,500 = 2,500

• SG importer hedged against depreciation• However, must give up the gain if exchange rate appreciates 31

Interest Arbitrage• Process of Moving Funds into Foreign Currencies to take

advantage of Higher Yields Abroad• Uncovered Arbitrage (Carry Trade)

• Example: Singaporean investor exchange SGDEUR at spot rate, invest in Spanish Govt Bond, and when the Bond matures, exchange EURSGD at spot rate

• Spanish Govt Bond offers much higher yields than SG Govt Bond, Taking Advantage of Interest Rate Difference + Taking Risk of FX Rate Change (If EUR were to appreciate in future, Return becomes even Higher)

• Covered Arbitrage• Example: Singaporean investor exchange SGDEUR at spot rate,

invest in Spanish Govt Bond, and Enter into Forward Contract to secure the amount of Return in SGD

• Remove the Risk of FX Rate Change32

Determination of Forward Rate• Interest Rate Parity

• Theory that Return of Investment will be the Same because the Difference in Interest Rates are offset by the Change in Exchange Rate

• Forward Rate = Set in order to Offset Gain from Difference in Interest Rate between 2 Countries

• However, Parity Does Not Always Hold – Often Rates can Fluctuate Due to Change in Monetary Policy, Economic Condition, and How Traders (Market) View the Country

• Important Concept for Next Week’s Topic33