3 - Financial Institutions - Chapter Three - Foreign Exchange Market

8/6/2019 3 - Financial Institutions - Chapter Three - Foreign Exchange Market

1/32

Lecturer Accounting and FinanceLecturer Accounting and Finance

Chapter 3Chapter 3

ForeignForeign

ExchangeExchange

MarketMarket

Financial InstitutionsFinancial Institutions

Prepared by: Imran HasnainPrepared by: Imran Hasnain

1


2/32

2

Meaning

Foreign exchange is the monetary resources of thegovernment of country in terms of the currencies of other

countries of the world.

The central bank of a country keeps the foreign exchange

reserves of that country.

Foreign exchange market

Foreign exchange markets are markets in which cash

flows from the sale of products or assets denominated in a

foreign currency are transacted. Most foreign exchange transactions are channelled

through the world-wide interbank market.

Interbank market is the wholesale market in which major

banks trade with each other.

Foreign exchange


3/32

3

Characteristics of foreign exchange market

The important features of a foreign exchange market areas follows:

An electronic market usually with no physical place.

Geographically dispersed throughout the leading financial

centres of the world. Facilitate the transfer of purchasing power speculation in

currency values.

Intermediary between the buyers and sellers of foreign

exchange. Facilitate foreign trade i.e. volume of transactions

spreading across the boarders of a country.

Provide credit through specialized financial instruments

i.e. letter of credit.

Minimizing the risk by providing hedging facilities.

Foreign exchange market


4/32

4

Participants of foreign exchange market

The participants in the foreign exchange market includesthe following:

Importers who pay for goods using foreign currency.

Exporters who receive foreign currency and may want to

convert to the domestic currency. Portfolio managers who buy or sell foreign stocks and

bonds.

Foreign exchange brokers who match buy and sell

orders. Traders who make a market in foreign currencies.

Speculators who try to profit from changes in exchange

rates.

Central bank, to enable it to manage, or try to manage,

the exchange rate between the two currencies.

Foreign exchange market - continued


5/32

5

Foreign exchange rate

Foreign exchange rate is the price at which the currencyof one country is exchanged for a foreign currency.

Foreign exchange rate enables the international

transactions (i.e. import and export, collections and

payment) to take place.

Example

11 UnitedUnited StateState DollarDollar == 33..6868 UnitedUnited ArabArab EmiratesEmirates

DirhamDirham

In the above statement if we want to convert United State

dollars into UAE dirham we will get 3.68 dirham against 1

US dollar.

In this case USD is referred to as base currency while

AED is the counter base currency or variable currency.

Foreign exchange - continued


6/32

6

Types of foreign exchange rate

Fixed exchange rateThe international financial arrangement in which exchange

rates are pegged or held constant by direct government

intervention in the foreign exchange market is called fixed

exchange rate. Fixed exchange rate is also called constantexchange rate.

Floating exchange rate

The international financial arrangements in which

exchange rates are allowed to change in response to the

market forces of demand and supply with occasional

government intervention is called floating exchange rate.

Floating exchange rate is also called variable exchange

rate.

Foreign exchange rates


7/32

7

Types of foreign exchange rate - continued

Spot exchange rate

The spot rates are exchange rates for currency exchanges

on the spot, or when trading is executed in the present.

Forward exchange rate

The forward rates are exchange rates for currencyexchanges that will occur at a future date.

- Forward dates are typically 30, 90, 180 or360 days in the

future.

- rates are negotiated between individual institutions in thepresent.

Nominal exchange rate

The bilateral exchange rate that is unadjusted for changes

in the two nations price levels.

Foreign exchange rates - continued


8/32

8

Types of foreign exchange rate - continued Real exchange rate

The bilateral exchange rate that has been adjusted for

price changes that occurred in the two nations.

Cross exchange rate

A cross rate is an exchange rate between the currencies of

two countries that are not quoted against each other, but

are quoted against one common currency.



9/32

9

Other methods of currency exchange -continued

Foreign exchange swaps

- A combination of a spot sale with a forward repurchase,

both negotiated between individual institutions.- Swaps often result in lower fees or transactions costs

because they combine two transactions

Future contracts

- A promise that a specified amount of foreign currency will

be delivered on a specified date in the future. The futures

may be sold to a third party.

- Contracts can be bought and sold in markets, and only

the current owner is obliged to fulfill the contract.



10/32

10

Other methods of currency exchange -continued

Option contracts

- Option contracts give its owner the right to buy or sell a

specified amount of foreign currency at a specified price atany time up to a specified expiration date.

- An option contracts can be bought and sold in markets.

- An option contract gives the owner the option, but notobligation, of buying or selling currency if the need arises.

Note: An option which conveys the right to buy a financial

instrument is called a call option and an option which

conveys the right to sell a financial instrument is called a

put option.



11/32

11

Foreign exchange rate quotations

Direct quotation

When the exchange rate between two currencies is quoted

per unit of the domestic currency, it is referred to as direct

quote.

11 AEDAED == 00..2717427174 USDUSD

Indirect quotation

When the exchange rate between two currencies is quoted

per unit of foreign currency, it is referred to as indirectquote.

11 USDUSD == 33..6868 AEDAED


quoteDirect

1quoteIndirect !


12/32

12

Users of foreign exchange rate

Market maker

Market maker is the party who is quoting bid price and offer

price for the exchange of foreign currencies. Market maker

offers two foreign exchange rates i.e.

-B

id priceBid price is the buying or purchasing rate of a foreign

currency in exchange of local currency.

- Offer price

Offer price is the selling rate of foreign currency inexchange of local currency by the market maker.

Market user

Market user is the party who is using bid and offer price for

the exchange of foreign currencies.

Foreign exchange users


13/32

13

Users of foreign exchange rate - continuedThe difference in the bid price and the offer price is called

spread and smallest fraction in any quotation or the

smallest move in the exchange rate is called pips or points.

The market maker buys the base currency on the bid sideand sells the base currency on the offer side whether the

quotation is direct or indirect.

Foreign exchange users - continued


14/32

14

Law of one price

The value of a particular product or service will have thesame price in all countries and foreign exchange rates will

adjust to make it true.

In other words we can say if two countries produce an

identical product, the price of product should be the samethroughout the world no matter which country produces it.

Example

Suppose that the exchange rate between British pound

(GBP) and American dollar (USD) were:

1 GBP = 1.95 USD

then a product or service costing USD 19.50 in the USAshould cost GPB 10/- in UK. Where this temporarily not

true, market forces would force it to be true. Suppose again

Foreign exchange theories


15/32

15

Law of one price - continuedthat a particular product cost GPB 11/- in the UK and USD

19.50 in the USA. Then traders would seek to make a profit

by buying the product in the USA and selling it in the UK.

This would have several effects simultaneously. i.e. It would create additional demand in the USA, which

would force up the price there.

In the UK it would create additional supply, which would

force down the price there. The action of selling a US-derived product in the UK

market would also lead to conversion of sterling into

dollars, that is, increase the demand for dollars and

increase the supply of sterling.

Foreign exchange theories -

continued


16/32

16

Law of one price - continued

These adjustments in the supply and demand, both of the

product and of the two currencies, should derive the

effective cost of the product to be the same on both side of

theA

tlantic.Limitations

The law of one price does not always work due to the

following reasons:

Currency conversion costs. Legal restrictions on the import of product from other

countries.

Transportation costs involve in import and export.

Government intervention in the foreign exchange market.


continued


17/32

17

Purchasing power parityThe different inflation rate in different countries will cause

foreign exchange rates to alter so that law of one price

holds.

In other words we can say if in one country the generalprice level rises relative to another country, its currency

should depreciate and the currency of other country should

appreciate.

Purchasing power parity theory can be summarized asfollows:

ee11 == 11 ++ iihh

ee00 11 ++ iiff


continued


18/32

18

Purchasing power parity - continuedWhere:

e0 = The value in terms of the home country currency of

one unit of the foreign currency at the start of a period.

e1 = The value in terms of the home country currency ofone unit of the foreign currency at the end of the period.

ih = The rate of inflation in the home country during the

period.

if = The rate of inflation in the foreign country during the

period.

Example

To illustrate how this works, continue to assume a current


continued


19/32

19

Purchasing power parity - continuedExample - continued

exchange rate of 1GBP = 1.95USD. Let us also assume

the inflation rate during the next year will be 10 percent in

UK and 5 percent in USA. At present according to the lawof one price, a product that costs GBP 1/- in UK will cost

USD 1.95 in USA.

At the end of the year, the product will cost GBP (1 + 10%)

= GBP 1.10 in the UK and USD 1.95 (1.95 + 5%) = USD2.05 in the USA. This should mean that, by the end of the

year, GBP 1/- will be worth 2.05/1.10 = USD 1.86.

Going back to the PPP equation and bearing in mind that

at the start of the period 1 USD = 0.51 GBP (that is 1/1.95):


continued


20/32

20

Purchasing power parity - continuedExample - continued

e1 = (1 + ih) e0

if

e1 = (1 + 0.10) 0.51 = 0.53

(1 + 0.05)

that is:

USD 1 = GBP 0.53GBP 1 = USD 1.86

Note: Due to low rate of inflation in USA as compared to

UK, the vale of USD is increased and GBP is decreased.


continued


21/32

21

Interest rate parityWhere nominal interest rates are different between

countries, the exchange rate will shift over time.

ff11 == 11 ++ rrnnhhee00 11 ++ rrnnff

Where:

f1 = The future value, in the currency of the home country,of one unit of the foreign currency.

e0 = The value in terms of the home country currency of

one unit of the foreign currency at the start of a period.


continued


22/32

22

Interest rate parity - continued

rnh = The nominal (or money) interest rate in the home

country.

rnf = The nominal (or money) interest rate in the foreign

country.Example

For example, assume that the spot rate if GBP 1 = USD

1.95 or USD 1 = GBP 0.51. Assume also that the interest

rates expected to prevail for the next year are 10 percent inthe USA and 5 percent in the UK. If we convert GBP 0.51

now, we should have USD 1/- , which we could invest in

the USA and it would grow to USD 1.10 by the end of the

year. The person who received our GBP 0.51 could invest


continued


23/32

23

Interest rate parity - continued

this in the UK such that it would grow to GBP 0.54 by the

end of the year. By that time, taking account of the interest

that we could each earn, the effective rate of exchange is

USD 1=

GBP0.49 (that is,

0.54/

1.10). This would be thefuture rate for a transaction to be carried out in one years

time.

The formula will give the same result:

f1 = (1 + ih) e0

if

e1 = (1 + 0.05) 0.51 = 0.49

(1 + 0.10)


continued


24/32

24

Exchange rate risk

Exchange risk is the risk that the domestic currency valueof cash flows, denominated in foreign currency, may

change because of the variation in the foreign exchange

rate. There would not be any foreign exchange risk if the

exchange rates were fixed. Exchange rate risk can becategorized into:

Transaction risk - The risk that the revenues or costs

associated with a transaction expressed in terms of the

domestic currency changes due to exchange ratevariations.

Economic risk - The risk that involves changes in

expected future cash flows, and hence economic value,

caused by a change in exchange rates.

Foreign exchange risk


25/32

25

Exchange rate risk - continued

Translation risk - The risk resulting from the conversionof a firms foreign-currency-denominated assets and

liabilities into the domestic currency value.

Political risk - The risk as results from the discontinuity

or seizure of an international business operations in a hostcountry due to the hosts implementation of specific rules

and regulations.

- Micro political risk is the subjection of an individual firm,

a specific industry, or companies.

- Macro political risk is the subjection of all foreign firms

to political risk by a host country because of political

change, revolution, or adoption of new policies.

Foreign exchange risk - continued


26/32

26

Currency depreciation

When a countrys currency falls in values relative to othercurrencies, meaning the countrys goods become cheaper

for foreign buyers and foreign goods become more

expensive for foreign sellers. It is called depreciation of

domestic or local or home currency. Currency appreciation

When a countrys currency rises in value relative to other

currencies, meaning that the countrys goods are more

expensive for foreign buyers and foreign goods arecheaper for foreign sellers (all else constant). It is called

appreciation of domestic or local or home currency.



27/32

27

Minimizing foreign exchange rate risk

Hedging - The act of offsetting or eliminating riskexposure. Companies can hedge their foreign exchange

exposure in the following two ways:

On-balance-sheet hedging involves matching foreign

assets and liabilities.- As foreign exchange rates move any decreases in foreign

asset values are offset by decreases in foreign liability

values (and vice versa).

Off-balance-sheet hedging involves the use of forwardcontracts.

- Forward contracts are entered into (at t = 0) that specify

exchange rates to be used in the future (i.e., no matter

what the prevailing spot exchange rates are at t = 1).



28/32

28

Minimizing foreign exchange rate risk -

continued Covered exposure - A foreign exchange risk that has

been completely eliminated with a hedging instrument.

- Forward contract - The guarantee of an exchange rate

(used for non standardized contract) at a future date thatcan eliminate foreign exchange risk, or cover an exposure.

The forward exchange rate is fixed for the whole life of the

contract.

- Derivative instruments - An document containing anagreement between two parties to exchange a standard

quantity of a financial instrument at a predetermined price

and at a specified date in future.



29/32

29

A financial institutions position in foreign

exchange markets

A financial institutions position in foreign exchange

markets generally reflects four trading activities:

Purchase and sale of foreign currencies for customers

international trade transactions.


investments.


hedging.

Purchase and sale of foreign currencies for speculation

(i.e., profiting through forecasting foreign exchange rates).

Foreign exchange and financial

institution


30/32

30

Balance of payment

Balance of trade is the difference between the foreign

exchange collections and foreign exchange payments of a

country in one financial year.

The balance of payment of a country is considered:

Favourable

If the foreign exchange collections are greater than the

foreign exchange payments. Zero

If the foreign exchange collections are equal to the foreign

exchange payments.

Foreign exchange market -

miscellaneous issues - continued


31/32


32/32

32

Foreign exchange market -

miscellaneous issues - continued

Balance of payment - example

3 - Financial Institutions - Chapter Three - Foreign Exchange Market

Documents

Transcript of 3 - Financial Institutions - Chapter Three - Foreign Exchange Market