Lecture 11 International Markets: Foreign Exchange Market

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Lecture 11International Markets Foreign
Exchange Market
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Topics

• Foreign Exchange Markets and Exchange Rates
• International finance terminology
• Participants in Foreign Exchange Market
• Determinants of exchange rate
• Purchasing Power Parity
• Interest Rate Parity
• Exchange Rate Risk
• Management of exchange risk

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Foreign Exchange Market

• No actual market, instead a communications
  network linking banks, non-banks, foreign
  exchange brokers in foreign exchange.
• This market determines the prices of foreign
  currencies.
• These prices are called exchange rates.

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Australian foreign exchange market The fact

• Foreign exchange turnover in Australia is
  currently around A1.9 trillion a day.
• This makes the Australian market the seventh
  largest in the world, though the two largest
  London and New York are much larger than the
  remainder.
• About half the turnover in the Australian foreign
  exchange market is against the Australian dollar.
  The remaining half is largely made up of trade in
  major currencies against the US dollar (such as
  USD/JPY and EUR/USD).

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Australian foreign exchange market The fact

• Activity in the Australian market has been very
  strong during recent times. In particular, trade
  in the euro has increased, in part due to some
  large European and US investment banks moving
  their Asia-Pacific trading desks to Sydney.
• Much of the pick-up has come from transactions
  executed with overseas banks, and trade in less
  traditional currencies has begun to expand.

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Australian foreign exchange market The fact

• There is considerable trading of the Australian
  dollar in other markets.
• Global trade in the Australian dollar averaged
  US103 billion per day in April 2004.
• This makes the Australian dollar the sixth most
  traded currency in the world, and the AUD/USD the
  fourth most traded currency pair.
• Source Reserve bank 2007, The exchange rate and
  the reserve banks role in the foreign exchange
  market.

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Exchange rate Definition

• It is a price at which one countrys currency can
  be exchanged for another countrys currency in
  the foreign exchange market.
• For instance, suppose the RBA quotes a foreign
  exchange rate of AUD/US 0.90. This means that
  one Australian dollar can be exchanged for 90
  cents of US currency.
• Alternatively, the inverse of this relationship
  is US/A 1.14. That is, one US dollar can be
  exchanged for 1.14 of Australian currency.

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International Finance Terminology

• Floating exchange rate system exchange rates are
  largely allowed to shift in response to market
  forces of demand and supply for currencies.
• Appreciation the rise in value of a currency in
  terms of another currency or currencies
  (AUD/US0.74 to 0.8)
• Depreciation the fall in value of a currency in
  terms of another currency or currencies.
• Arbitrage the simultaneous buying and selling of
  currencies to realise profits from anomalies
  between exchange rates prevailing at the same
  time in different markets.

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Participants in Foreign Exchange Market

• Importers
• Exporters
• Portfolio managers
• Foreign exchange brokers
• Foreign Investors
• Speculators
• Reserve bankers

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Financial Instruments used in the foreign
exchange markets

• Spot deal (contract) ? an agreement to trade
  currencies based on the exchange rate today for
  settlement within two business days.
• Spot exchange rate ? the exchange rate on a spot
  deal.
• Forward deal (contract) ? an agreement between
  two parties to exchange currency for a forward
  price at a decided date agreed in advance.
• Forward exchange rate ? the agreed-upon exchange
  rate to be used in a forward deal.

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Source Commonwealth bank foreign exchange rate ,
4th Oct 2007.
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Exchange Rate QuotationsBanks bid ask spread
Bid (buy)
Ask (sell)
US 0.91 0.87
Rate at which the bank buy US or sell A
Rate at which the bank sell US or buy A
Rate at which you buy US or sell A
Rate at which you sells US or buy A
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The Forward Exchange Rate

• Forward rate exchange rate that is established
  now, but with payment and delivery to occur at a
  specified future date.
• Commonly for time periods of 1, 3 or 6 months.
• Forward exchange rates are usually quoted in
  terms of the difference between the spot rate and
  the forward rate. Referred to as the forward
  points (difference between spot rate and forward
  rate).
• The reason for the existence of forward market is
  that it allows businesses and individuals to lock
  in a future exchange rate today, thereby
  eliminating any risk from unfavourable shifts in
  the exchange rate.

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The Forward Exchange Rate (cont.)

• Suppose that for US dollars (per one AUD) you are
  told that the spot rate is 0.7050/90 and the 3
  months forward (5-10).

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The Forward Exchange Rate (cont.)

• Suppose that for US dollars (per one AUD) you are
  told that the spot rate is 0.7050/90 and the 3
  months forward (20-15).

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Determination of exchange rates

• What determines the level of spot exchange rate?
• What determines the rate of exchange rate change
  through time?
• What is the relationship between the spot
  exchange rates, forward exchange rates and
  interest rates?

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Equilibrium in the exchange rate market

• Forces of supply and demand decide.

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Factors affecting exchange rate

• Long run factors
• Government policy (eg trade policy, barrier,
  monetary policy.)
• Preferences for the home countrys goods and
  services over those of the foreign country
• The relative efficiency of production of goods
  and services
• Relative price levels (explained by PPP theory)

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Factors affecting exchange rate

• Short run factors
• Expectations
• Balance of payments changes
• Foreign currency reserves
• Interest rate parity (IRP)

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Two important theories explaining the change in
foreign exchange ratean equilibrium concept

• Purchasing power parity (PPP)
• Interest rate parity (IRP)

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Purchasing Power Parity (PPP)

• The theory states that changes in exchange rates
  are influenced by the purchasing power of one
  currency vis-à-vis another.
• The idea implies that the exchange rate adjusts
  to keep purchasing power constant among
  currencies (if not arbitrage would occur).
• Absolute purchasing power parity (PPP)a
  commodity costs the same regardless of what
  currency is used to purchase it or where it is
  selling.
• For absolute PPP to hold
• transaction costs must be zero
• there must be no barriers to trade
• the items purchased must be identical in all
  locations.

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Absolute purchasing power parity (PPP)

• Absolute purchasing power parity (the law of one
  price)
• Puk S0 PA
• For example, suppose that the a KFC family bucket
  costs A24 in Sydney, while in London it costs
  10. Absolute PPP implies that the spot exchange
  rate is 0.416.
• Puk S0 PA
• 10 S0 A24
• S0 0.416

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Relative Purchasing Power Parity

• The idea that the change in the exchange rate
  between two currencies is determined by the
  difference in inflation rates between the two
  countries.
• Relative PPP, therefore, explains the changes in
  exchange rates over time rather than the absolute
  levels of exchange rates.

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Relative PPP Equation
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ExampleRelative PPP

• The US exchange rate is currently 0.88 US per
  A. The inflation rate in USA over the year is
  estimated to be 5 per cent, while the Australian
  inflation rate is estimated to be 3 per cent next
  year. What will be the estimated exchange rate in
  next year?

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SolutionRelative PPP

• The US will become less valuable A will become
  more valuable.
• The inflation rate change will be 5 3 2
  per year.

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Implication of purchasing power parity

• A country with a high inflation rate can expect
  to have a depreciating exchange rate (a currency
  is weakened or a weak currency), whereas a
  country with a low inflation rate can be expected
  to have an appreciating exchange rate (a currency
  is strengthened or a strong currency).

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Interest Rate Parity (IRP)

• Interest rate parity states that relative
  interest rates determine the relativity between
  the forward exchange rate and the spot exchange
  rate
• IRP occurs when any premium or discount in
  forward exchange rates equals interest rate
  differences and no one can make risk-free returns
  by trading currencies at these levels. (Sathye et
  al. 206)

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Interest Rate Parity (IRP)

• Covered interest arbitrage (CIA)
• movement of funds between two currencies to
  profit from interest rate differences, while
  using forward contracts (lock in forward exchange
  rate today) to eliminate exchange risk.
• This arbitrage occurs because the premium or
  discount of forward exchange market does not
  fully reflect the underlying interest rate
  differentials between the two countries
• Such arbitrage will continue to be exploited
  until the interest rates and /or exchange rates
  adjusted so as to eliminate the possibility of
  further arbitrage.

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ExampleCovered Interest Arbitrage (CIA)
Assume S0 A1/66.42 F1 A1/64.80 RA
7 RJ 5
A1 000 000 _at_ 7 A1 070 000 A1 076 250
Profit
_at_ 66.42 1 year _at_ 64.80
66 420 000 _at_ 5 69 741 000
Where RA is Australian interest rate and RJ is
Japanese interest rate S0 is spot rate, F1 is
forward rate
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Interest Rate Parity (IRP)

• Assume covered interest arbitrage opportunities
  do not exist, then there must be some
  relationship between spot exchange rates, forward
  exchange rates, and relative interest rates.

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Interest Rate Parity (IRP)

• Because of interest rate parity (IRP), a foreign
  investment with forward cover is equivalent to a
  domestic investment. (in terms of one dollar)

Foreign investment
Foreign investment
Domestic investment
Domestic investment
Where RA is Australian interest rate RFC is the
interest rate of foreign country S0 is spot rate,
F1 is forward rate
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Interest Rate Parity (IRP)

• The interest rate differential between two
  countries is equal to the percentage difference
  between the forward exchange rate and the spot
  exchange rate.

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Implication

• A countrys currency will tend to appreciate
  (depreciate) relative to another currency if its
  interest rate is lower (higher) than the interest
  rate on the other currency.
• From the International Fisher theory point of
  view
• Suggests a exchange rate will change in relation
  to the interest rate differences (and expected
  inflation rate) in two countries.
• The country with the higher relative interest
  rate will see its exchange rate depreciate.

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Exchange Rate Risk

• The variability of an entitys value that is due
  to changes in exchange rates.
• The exchange risk arising from trade-related
  contracts is often termed transaction risk.
• The exchange risk arising from capital-related
  contracts is often termed translation risk. Ex
  borrow or lend foreign currency.

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The Management of Exchange Risk

• Who Faces Exchange Risk?
• Exchange risk arises whenever a company needs to
  deal, now or in the future, in a currency other
  than the currency that shareholders use to
  finance their consumption.
• However, a retail jeweller may never transact in
  the foreign currency market, yet it will face
  exchange risk because it may obtain watches from
  Australian jewellery wholesalers who, in turn,
  import watches from overseas.

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The Management of Exchange Risk (cont.)

• The Hedging Principle
• A financial strategy that will ensure that the
  domestic currency value of a commitment to pay or
  receive a sum of foreign currency in the future
  is not affected by changes in the exchange rate.
• The basic principle of hedging is to undertake
  another, offsetting commitment in the same
  foreign currency. For example, forward rate hedge.

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The Management of Exchange Risk (cont.)

• Forward Rate Hedge
• For example, suppose that an Australian importer
  is committed to paying a future sum in UK pounds.
  In effect, this is a contract to buy UK pounds in
  the future.
• By entering into a forward contract to buy UK
  pounds, the value of the commitment can be fixed
  in Australian dollar terms.
• The future outflow of UK pounds required by the
  import contract is matched by an inflow of UK
  pounds required by the forward contract.

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• Example
• Playworld committed itself on 31 July to the
  payment of 1.1 million on 31 Oct.
• 3 month forward rate on 31 July was A 0.49
• Spot rate is A 0.50, so the cost indicated
  is 1100000/0.5 A2.2 million
• Playworld is afraid that more payment will be if
  the spot rate on 31 Oct decrease. So it adopts a
  hedging strategy by entering into a forward
  contract to buy 1.1 million pounds (1100000/0.49
  A2,244,898
• The extra A 44898 is sometimes regarded as an
  insurance premium which must be paid in order to
  exchange the risky position for a hedged
  position.

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The Management of Exchange Risk

• An Australian shipping company is due to collect
  USD 100,000 in three months time under a contract
  of affreightment. The current exchange rate is
  USD0.88AUD1
• If the market expects the USD to strengthen
  against Australian dollar to USD0.861AUD, what
  action would the company take?
• If the market expects the USD to be weak against
  Australian dollar, what action would the company
  take?
• Forward
• Currency option

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The Management of Exchange Risk

• Currency option
• A currency option is the right - but not the
  obligation - to buy (in the case of a call) or
  sell (in the case of a put) a set amount of one
  currency for another at a predetermined price at
  a predetermined time in the future.

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• The shipping company could seek to buy a put
  option with a strike price of 0.92, and has a
  right to convert USD into AUD at the strike price
  on the expired date (assume the premium on a
  transaction is 3000 AUD). After three months, if
• The US dollar depreciates to 0.97 1 AUD, the
  company will exercise the option and would have
  gained AUD 2602.
• (100000/0.92)-(100000/0.97)-3000 2602
• The AUD/AUS exchange rate is 0.89, the company
  will not exercise the option and sell the US
  dollars at the spot rate in the market, and would
  have gained AUD663.
• (100000/0.89)-(100000/0.92)-3000663

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The Management of Exchange Risk (cont.)

• Hedging by Borrowing or Lending
• A hedging technique consisting of establishing an
  offsetting cash flow by borrowing or lending the
  foreign currency.

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• Example
• Playworld committed itself on 31 July to an
  outflow (liability) of 1.1 million on 31 Oct.
• To establish a claim to an inflow (asset) of 1.1
  million in 3 months time, Playworld can lend UK
  pounds on 31 July to be repaid on 31 October.
• If the interest rate on 3 month loan of UK pounds
  is 3.25, then Playworld should lend current
  value of 1.1 million/1.0325 1065375
• At the spot rate is A1 0.500, 1065375 is
  equivalent to a loan in Australian dollar terms
  of 1065375/.5000 A 2130750