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Lecture
FOREIGN EXCHANGE
MARKET
Foreign Exchange Market
Foreign exchange market:
A market for converting the
currency of one country into
the currency of another.
Exchange rate:
The rate at which one currency
is converted into another.
Foreign Exchange Market
Foreign exchange risk:
The risk that arises from changes in exchange rates: the
likelihood that unpredictable or unexpected changes in
exchange rates will have an impact (positive or negative)
on the value of various activities of a company’s
business.
Examples:
An unexpected change in exchange rates will change
the home currency value of foreign currency cash
payment that is expected from a foreign source;
An unexpected change in exchange rates will change
the amount of home currency needed to make a
payment or service a debt that requires payment in a
foreign currency.
Foreign Exchange Market
MAD’S MONEY CLASS MONEY
2 MM/1CM
1MM/1CM
4MM/1CM
FOREIGN EXCHANGE RATES
Exchange rates are quoted in two ways:
Price of the foreign currency price in terms of
dollars [or of home currency per foreign currency]
e.g. $0.00854/yen
Known as direct or sometimes as American quote
Price of dollars in terms of the foreign currency
Hill, 5th
ed.
FOREIGN EXCHANGE RATES
Foreign exchange traders have nicknames for
currencies:
“Cable” is the exchange rate between US Dollars and
Pounds Sterling
Canadian dollar is a “loonie”
French franc used to be known as “Paris”
New Zealand dollar is a “kiwi”
Australian dollar is an “aussi”
Swiss Franc is a “Swissie
Singapore dollar is a “Sing dollar”
TERMS: CURRENCY VALUES
Forex deals with exchange, so the value of one currency is
often discussed in comparison to another currency. (e.g. value
of currency “A” against currency “B”)
APPRECIATION (rise): a currency increases in value against a
foreign currency in response to market demand; it is getting
stronger, therefore, less of this currency is needed to convert to
a weaker foreign currency; in other words, the currency that is
appreciating will buy more of a weaker currency.
DEPRECIATION(fall): a currency decreases in value against
another currency in response to market forces; it is growing
weaker, therefore, more of this currency is needed to convert to
a stronger foreign currency; in other words, the currency that is
depreciating will buy less of a stronger currency.
UNDERVALUED: a currency is too weak against another
currency; is not as strong as it should be.
OVERVALUED: a currency is too strong against another
currency; should have less value than it does.
Foreign Exchange Market
Is currency appreciating or depreciating?
Twogeneral functions:
Converting currencies
Reducing risk
HOW TO CONVERT
EXAMPLE: You arrive at the train station in Switzerland early in
the morning. You go to the exchange office to trade your U.S.
dollars for Swiss francs. You ask the exchange office: “How
many Swiss francs do I receive for every dollar? The clerk
answers:
“The rate is 1.5625 Swiss Francs per dollar.” You exchange
US$50.00. How many Swiss francs do you receive?
A. US$50 x SF1.5625 = SF 78.13
You stop for a moment and think to yourself, “Well, then, how
many dollars are in one Swiss franc?”
A. ____1USD__ = US$0.6400/SF
SF 1.5625/S
You are back at the train station and it is time to leave
Switzerland and you have a bunch of Swiss francs in your pocket
which you want to convert into Euros. You are told that the
exchange rate for SF to Euros is: SF1.5466/Euro.
So how many Euros do you get for the 152 Swiss Francs you
have?
A. ____152SF____ = 98.28 Euros
SF 1.5466/Euro
CURRENCY CONVERSION
Fundamentally, currency conversion involves a transfer of
purchasing power: this is necessary because international
trade and capital transactions usually involve parties living
in different countries with different national currencies.
Countries either transfer power to or from their home
currency in order to be active in the global economy.
When a company is importing goods from another country,
it will usually give up its domestic currency in the foreign
exchange market to get the foreign currency needed to pay
for the import.
Result: demand for the foreign currency increases,
supply in the foreign exchange market of the home
currency increases.
CURRENCY CONVERSION:WHEN
Companies receiving payment in foreign
currencies need to convert these payments
to their home currency
EXAMPLE: A Japanese components
manufacturer receives payment in US$ from
their U.S. customer ; the manufacturer may
want to convert it so it can be spent in Japan.
Companies paying foreign businesses for
goods or services
EXAMPLE: A U.S. company must obtain
Japanese yen to pay for an order they
received because the contract specified
“payment in yen.”
CURRENCY CONVERSION:WHEN
Companies investing spare cash for short
terms in money market accounts
U.S. company has dollars that they want to
invest short term, but the interest rate is
only 2% in U.S. but 12% in South Korea.
Amsterdam
Hamburg
Brussels
Dusseldorf
London
Frankfurt
Toronto Zurich
Paris
Basel
Rome
San Chicago Madrid
Vienna
Francisco New Tokyo
York
Hong Kong
Mexico
City Bombay
Singapore
Sydney
Rio de Janiero
Melbourne
São Paulo
THE MARKET THAT NEVER
SLEEPS
SOURCE: Eitman, David K.,
Stonehill, Arthur L., Moffet, Michael
H. MULTINATIONAL
BUSINESS FINANCE.
Addison Westley: New York,
2001.
Foreign Exchange Market
Think of the Foreign Exchange Market like
Las Vegas
24 hours
Many players
Presence of risk
Action happening
all the time
Economic Theories about How
Exchange Rates are
Determined
Many different theories exist. No true consensus
exists.
If the factors which influence the value of
exchange rates can be identified, then we may be
able to forecast exchange rate fluctuations and
movements.
This knowledge, in turn, can help companies to
protect against foreign exchange risk and
preserve profitability of international trade and
investment and manage price competitiveness.
WHAT FACTORS INFLUENCE THE
FOREIGN EXCHANGE MARKET
Investor psychology
and “Bandwagon”
effects: the “People”
effect
Role of the
Government
Forex: Supply and Demand
The spot exchange rate depends on supply
and demand for a foreign currency throughout
the day. This is in response to the changes in
the supply and demand for goods and
services.
Differences in spot rates reflect differences in
supply and demand for currencies. These
differences will affect the value of the
currency.
Example: If spot demand for U.S. dollars is high and U.S.
dollars are in short supply but the spot demand for British
pounds is low and the supply of British pounds is plentiful,
the dollar will most likely appreciate against the pound.
This reflects the supply and demand for U.S. and British
goods.
ARBITRAGE: moments of opportunity
which impact supply and demand for
FOREX
Arbitrage: a trading strategy based on the purchase of
foreign exchange in one market at one price while
simultaneously selling it in another market at a more
advantageous price in order to obtain a risk-free profit on
the price differential. “Buy low/sell high.”
Arbitrage in foreign exchange takes advantage of the
disequilibrium (imbalance) which exists in foreign exchange
markets. It overcomes differences in geography, currency
type, and time.
Example: At 8:00 a.m. in New York, the Swiss franc is quoted for sale at
$.46 and in Zurich at that same time for $.48. Traders and arbitrageurs
will buy Swiss francs in New York and sell then in Zurich. Demand in New
York would increase and raise the price in New York and the increased
supply in Zurich would cause the price to lower. Eventually, these trades
would cause the price to be stabilized.
Currency Conversion: Transfer
of Purchasing Power
Trade in home currency for
foreign currency: increases
demand for foreign currency
Foreign Exchange
[and decreases supply];
Market
increases supply of home
currency [decreases demand]
in foreign exchange market
FOREIGN
HOME
CURRENCY
CURRENCY
Forex: Supply and Demand
Supply and demand as it relates to import/export
activity.
WHEN…..
Domestic currency is appreciating: imports tend
to increase because foreign goods are less
expensive and exports tend to decrease because
they cost more to foreigners.
Domestic currency is depreciating: exports tend to
increase because domestic goods cost less for
foreigners and imports tend to decrease because
they cost more to local consumers in the domestic
market.
Supply in Forex market of a domestic currency is
increased under imports.
Demand in Forex market of a domestic currency is
increased under exports.
Forex : Changes in Income
Changes in income due to increased
employment, more workers in the workforce,
periods of economic growth etc. give residents
of a country more expendable income.
An increase in domestic income of a country
will usually encourage residents to spend a
portion of their additional income on imports.
When income of a nation grows rapidly, imports
tend to rise rapidly.
Results: More domestic currency is traded for
more foreign currency and the domestic
currency will usually depreciate.
Forex : Changes in Income
If incomes in both trading partners are
increasing, the country with the faster
growing income will increase demand for
imports relatively more.
This may lead to a depreciation in currency
of the more rapidly growing national
economy
Forex: Changes in Prices
Basic concept: Law of One Price
How is the exchange rate between two currencies determined? In
theory, the exchange rate should be the medium to transfer and
equalize purchasing power from one currency to another. What is
the relationship between prices and exchange rates? We must
examine two theories: The Law of One Price and Purchasing Power
Parity.
LAW OF ONE PRICE
Basic premise: If an identical product or service can be sold in two
different markets, and no restrictions exist on the sale or
transportation costs of moving the product between markets, the
product’s price should be the same in both markets.
therefore :Price currency A = Price currency B x exchange rate
How would this come about?
This is the result of the occurrence of arbitrage and markets seeking
equilibrium. Prices that are different will tend to equalize in markets
free of transportation costs and trade barriers.
Example: US/British pound exchange rate: $1.50/ £1 A jacket selling for
US$75 in New York should sell for £50 in London ($75/1.50)
If jackets in London sell for £40, demand would increase, and price would go
up in London while extra supply would lower the price in New York. (this
explains why companies export—to take advantage of differences in price)
Net result: eventually, in theory, prices will tend to equalize:
P$ = P£ x E$/£
Forex: Change in Prices
Basic concept: Purchasing Power Parity
PURCHASING POWER PARITY: in theory, the “ideal” is that
the exchange rate should represent equivalence of
purchasing power between two currencies.
Basic premise: If the Law of One Price were true for all
goods and services, the PPP could be found from any
individual set of prices, assuming the market is efficient.
Thus, E$/£ = P $ /P £
By extension: In relatively efficient markets (few
impediments to trade and investment) then a ‘basket of
goods’ should be roughly equivalent in each country.
Forex: Change in Prices
Purchasing Power Parity (PPP)
Extension of PPP/Law of One Price: applicable to a basket of
goods and their prices.
If relative prices change in a basket of goods, the exchange rates
should change to reflect the difference in purchasing power for a
given currency PPP.
Example:
Jan 1: a basket of goods costs U.S. $200 and Japan ¥ 20,000
22,000
Result: it takes 10% more yen to buy the same basket of
goods(22,000/20,000) so the value of the yen is
depreciating by 10%. The dollar is appreciating and will buy
10% more.
The change is reflected in both the price of the goods and
the price of the currencies.
Forex: Change in Prices
Purchasing Power Parity (PPP)
Extension of PPP/Law of One Price: if it is known that
prices are going to change in the future, can we project
what the forward rate will be?
Example: Two countries, Great Britain and United States
produce just one good: beef. Suppose the price of beef in
the United States is $2.80 per pound and in Britain, it is
£3.70 per pound.
According to PPP theory, what should the $/£ be?
Hill, p. 349
royalties, etc.
Impositions of trade barriers blocking or
discouraging imports
Forex: Role of Government
The monetary and fiscal policies of the
Government can impact the exchange rate.
Examples:
Management of the money supply
Management or creation of inflation
Central bank intervention
Management of unemployment
Economic growth policies
Rates of taxation
Forex: Influence of People
Market sentiment: based on
Perception of market performance
Expectation of market performance
Explanation may be investor psychology and the
bandwagon effect
Studies suggest they play a major role in short
term movements
Hard to predict
Shock in world politics and social
events can incite investor reaction
“Unexpected events may move markets for a matter of
a few hours or a day at the most. It is peoples
perceptions of fundamentals that move markets.” Stuart
Frost, Technical Analyst
EXAMPLE of Factors affecting
Forex
Invester’s Business Daily, Vol.
21, No 170. Friday, Dec 10,
2004 p. A1 (faster-growing
economy in U.S.)
San Jose Mercury News, Dec
4, 2004, p. C-1 (U.S.
employment data weaker than
expected)
Forex: Influence of People
Impact of reactions by FX dealers
based on
What the chartists are showing
What people are saying the market
What central banks are doing
“The trend is my friend.”
“Buy the rumour, sell the fact”
What are Good Predictors of
Forex Rates?
Evidence suggests that neither PPP nor the International
Fisher Effect are good at explaining short term movements
in exchange rates.
Complications with empirical tests conducted on PPP or IFE:
Identical “basket of goods” is often not
Time periods for testing are not free from government
intervention, so markets are not as efficient
As part of globalization, capital and financial markets have
been deregulated and cross border flow has increased; this
has had a considerable impact on supply and demand of
currency, which is not taken into account by PPP.
Transportation costs still a factor
What are Good Predictors of
Forex Rates?
General wisdom is:
Short term (spot rates): supply and demand,
investor psychology/people factor, especially
for floating rates
Longer term: Purchasing Power Parity
(changes in prices based on impacts of
changes in income, interest rate, inflation,
actions of the government, etc.)
Some economists maintain that that the
forward rate is also a good unbiased predictor
of the future spot rate.
Approaches to Forecasting
Fundamental analysis
Draws on economic theory to construct
sophisticated econometric models for
predicting exchange rate movements.
Looks at variables such as inflation rates,
money supply, balance of payments, etc.
Technical analysis
Uses price and volume data to determine
trends
Special Issue: Currency
Convertibility