bus awein hi

8/7/2019 bus awein hi

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Quoting Exchange Rates

Bid Price Ask Price

Rs 45.50 Rs. 46.00

These are given from the Pov of the bank so if the bank has to buy dollars it will buy at Bid Price(Rs

45.50/$) and if it has to sell dollars it will sell at the ask price(Rs. 46.00/$).

Thus if I want to buy dollars Ill have to give Rs. 46.00 for each $ and if I want to sell dollars Ill receive Rs.

45.50 for each $.

Effect of Exchange Rate Depreciation

A depreciation of the pound sees the market value of the pound fall against other currencies.The economic effects of a lower pound take time to happen - economists say that there are timelags between a change in the exchange rate and changes in, for example, inflation and thebalance of payments.

The last major depreciation in the value of sterling came in the early-mid 1990s followingsterling's departure from the exchange rate mechanism. The pound was devalued by nearly 15%against a range of currencies in September 1992 and continued to drift lower in value for the next

three years.

This revision note suggests some of the main economic effects of a lower value for the pound

INFLATION

A fall in the exchange rate makes imported goods and services more expensive in the UK.Producers may then pass on higher costs of imported components and raw materials ontoconsumers. This causes extra "cost-push" inflation. Wages may rise in response to this triggeringoff the possibility of a wage-price spiral.

The extent to which a depreciation of the pound causes inflation depends in part on howdependent producers are for their imported components and also their willingness to "price to themarket" and pass on costs to consumers.

In a recession demand for many goods is elastic and a lower pound may have little effect onretail price inflation.


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EXPORTS AND THE BALANCE OF PAYMENTS

Exporters should benefit from a lower pound (even allowing for the inevitable time lags). Adepreciation makes UK goods cheaper priced in a foreign currency.

Demand for exports will grow faster if the demand for UK goods overseas is elastic

IMPORTS

The demand for imports should fall as imports become more expensive. However, some importsare essential for production or cannot be made in the UK and have an inelastic demand - we endup spending more on these when the exchange rate falls in value. This can cause the balance ofpayments to worsen in the short run (a process known as the J curve effect)

WAGE DEMANDS

Partly due to higher inflation and falling real incomes, wages may rise. This depends on whatstage of the economic cycle the economy is in. When unemployment is high, workers may havelittle confidence that their wage demands will be met.

ECONOMIC GROWTH (GDP)

Higher exports (an injection into the circular flow) and falling imports leads to rising GDPlevels.

A lower exchange rate accompanied by lower interest rates will stimulate consumer spendingand general economic recovery. This was the case for the UK between 1993-95 after the poundleft the exchange rate mechanism.

Effects of Exchange Rate Appreciation

1.The is stronger therefore, exports are more expensive to buy. More foreign currency is

needed to get the same amount of British goods

2. Imports will be cheaper.

3. Therefore, we will get a rise in the quantity of imports and a fall in quantity of exports.

4. Assuming demand is relatively elastic this will cause a fall in the value of exports and rise in

value of imports.


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5. AD = C + I + G + X - M. Therefore, a fall in exports and rise in imports will reduce AD, or

lower the growth of AD.

6. A fall in AD will cause a lower rate of economic growth and a lower rate of inflation.

7. A fall in exports and rise in imports will lead to a worsening of the current account, e.g. deficit

will get bigger

The J curve

As depreciation makes imports more expensive and exports cheaper (both in terms of the buyer'scurrency), it should increase exports and decrease exports.

However, there may be a period of adjustment while the volumes of imports and exports adjustto the new prices. It takes time for importers and exporters to find new products, deals alreadyagreed will have to be fulfilled, manufacturers of substitutes may take time to adjust theirproduction, etc.

The result is that a depreciation initially causes a sharp worsening of the balance of trade (valueof exports less the value of imports), which then gradually recovers to a higher level thanpreviously.

Similarly, an appreciation in the value of a currency would, if this argument is correct, cause aninverted J-curve.


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Transaction Exposure

Changes in the amount of future cash flows, for contracts entered in foreign currency but not

settled. A business contract may extend over a period of months. Foreign exchange rates can

fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specificquantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can

change the value of that contract.

Example:-

Dayton, a U.S.-based manufacturer of gas turbine equipment, has just concluded negotiations for

the sale of a turbine generator to a British firm for the sum of 1,000,000. The sale is concluded

in March but payment will be made three months later, in June.

Assumptions

1) Spot exchange rate: $1.7640/.2) Three-month forward rate: $1.7540/.3) Daytons forecast of the spot rate in June: $1.76/.4) Daytons minimum acceptable exchange rate: $1.7000/.5) Daytons cost of capital: 12%.6) U.K. three-month borrowing (lending) rate: 10% (8%) per annum.7) U.S. three-month borrowing (lending) rate: 8% (6%) per annum.

Dayton can:

1) Remain unhedged2) Hedge in the forward market

Unhedged Position:-

Suppose Dayton decides to accept the transaction risk.

If the future spot rate is $1.76/, Dayton will receive 1;000;000$1:76== $1;760;000 in 3

months. However, if the future spot rate is $1.65/, then Dayton will receive only $1,650,000,

well below the acceptable rate.


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Forward Market Hedge:-

The forward contract is entered at the time the A/R is created, i.e. in March. The sale is recorded

at the spot rate, in this case $1.7640/. If Dayton does not have an offsetting A/P of the same

amount, then the firm is considered uncovered.

Hedging in the forward market here means selling 1,000,000 forward at the 3-month forward

rate of $1.7540/. In 3 months, Dayton will receive 1,000,000 and exchange them at the rate

$1.7540/, receiving $1,754,000 with certainty.

This is $6,000 less than the uncertain $1,760,000 expected from the unhedged position.

The forward contract creates a foreign exchange loss of $10,000 (1;000;000*(1:7640-1:7540)).

Normally reckoned by the forward premium/ discount over spot rate.(F1 S0)/S0

True cost of forward hedge cannot be calculated in advance. Should be dependent upon the future spot rate.

True cost of forward hedge:

(F1 S1)/S0

Money Market Hedge:-

A money market hedge also includes a contract and a source of funds, similar to a forward

contract. In this case, the contract is a loan agreement. The firm borrows in one currency and

exchanges the proceeds for another currency. Hedges can be left open (i.e. no investment) or

closed (i.e. investment).

To hedge in the money market, Dayton will borrow pounds in London, convert the pounds to

dollars and repay the pound loan with the proceeds from the sale.

To calculate how much to borrow, Dayton needs to discount the PV of the 1,000,000, i.e.

1;000;000/1:025

= 975;610:

Thus Dayton must borrow 975,610 today and repay 1,000,000 in 3 months with the proceeds

from the sale.


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This hedge creates a pound denominated liability that offsets with a pound denominated asset,

thus creating a balance sheet hedge.

In order to compare the forward hedge with the money market hedge, Dayton must analyze the

use of the loan proceeds.

What can Dayton do with the loan?

It can exchange the 975,610 at the spot rate of $1.7640/, which gives $1,720,976, and invest it

in a US$-denominated asset. Unlike the funds involved in a forward contract, the loan amount

can be used immediately.

SWAP

Two parties exchange principle and interest in one currency for principal and interest in another

currency.

In interest rate swap the notional principal is not exchanged but in the currency swap the first

step is generally the exchange of principal.

History:-

In 1981 the relevant interest rate in the U.S. was at 17 percent, an extremely high rate due to the

anti-inflation tight monetary policy of the Fed under Paul Volcker. In West Germany the

corresponding rate was 12 percent and Switzerland 8 percent. The problem for the World Bank

was that the Swiss government imposed a limit on World Bank could borrow in Switzerland. The

World Bank had borrowed its allowed limit in Switzerland and the same was true of West

Germany.

IBM at that time, 1981, had large amounts of Swiss franc and German deutsche mark debt and

thus had debt payments to pay in Swiss francs and deutsche marks. IBM and the World Bank

worked out an arrangement in which the World Bank borrowed dollars in the U.S. market and

swapped the dollar payment obligation to IBM in exchange for taking over IBM's Swiss franc

and deutsche mark obligations.

Types:-

1) Currency Swap.

2) Interest Rate Swap.


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Futures Hedge:-

Exporter is expecting 10,000$ , but comes to know that Rs. is appreicating which would render

him to a loss.

Thus in the physical market he would go long on $ (as it is depreciating wrt Rs.)

But in the futures market one takes a reverse position than the physical market, it will go short on

$ ( sell $ futures ) and buy them back .

Importer has to pay 10,000$ , but comes to know that Rs is depreciating which would force him

to pay more .

Thus in the physical market he would go short on $(as it is appreciating wrt Rs)

But in the futures market one takes a reverse position so he will go long on $(buy $) and sellthem back at a future date.


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With An exchange rate appreciation the average cost of domestic financing is reduced in the

banking system

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