Foreign Exchange

Market
GROUP 4
 OBJECTIVES
1. Understand what factors significantly influence the currency
exchange rates of a country
2. Describe how foreign exchange market provides the mechanism
for the transfer purchasing power from one currency to another
3. Understand what exchange rate is
4. Distinguish between spot transactions and forward transactions
5. Distinguish between spot exchange rate and forward exchange
rate
6. Understand what direct and indirect quotes are
7. Explain what cross rate is
8. Discuss what arbitrage is
9. Know the significance of foreign exchange risks
10. Understand how exchange rate risk in Foreign currency market
can be avoided
 THE FOREIGN CURRENCY
EXCHANGE MARKET
From the end of World War II until the early 70's, the world was on a fixed
exchange rate system administered by the International Monetary Fund
(IMF).
Under this system, all countries were required to set a specific parity rate
for their currency vis-a-vis the United States dollar. A country could effect a
major adjustment in the exchange rate by changing the parity rate with
respect to the dollar.
Then the currency was made cheaper with respect to the dollar, this
adjustment was called a devaluation. An upvaluation or revaluation resulted
when a currency became more expensive with respect to the dollar.
 THE FOREIGN CURRENCY
EXCHANGE MARKET
A Floating rate international currency system has been operating since
1973. Most major currencies fluctuate freely depending upon their values
as perceived by the traders in foreign exchange markets. The
determination of exchange rates are influenced by such important factors
as
(a) the country's economic strengths.
(b) its level of exports and imports,
(c) the level of monetary activity, and
(d) the deficits or surpluses in its balance of payments.
Short term, day-to-day fluctuations in exchange rates are caused by supply
and demand conditions in the foreign exchange market.
 THE FOREIGN CURRENCY
EXCHANGE MARKET
The forex market provides a service to individuals, businesses, and
governments who need to buy or sell currencies other than that used in
their country.

This might be in order to travel abroad, to make investments in another

country, or to pay for import products or convert export earnings.

It is also a marketplace in which currencies are bought and sold purely to

make profit via speculation. When trading very large volumes of currency,
even small fluctuations in price can provide profits or losses.
 THE FOREIGN CURRENCY
EXCHANGE MARKET
The forex market is open 24 hours, 5 days a week, which makes it unusual,
as equity markets have set daily trading hours and are closed overnight.

The foreign exchange (or forex) market provides a mechanism for the
transfer of purchasing power from one currency to another.

Currency trading entails no specific physical location; instead, it is an

over-the-counter market whose main participants are commercial and
investment banks, and foreign exchange dealers and brokers around the
world.
 THE FOREIGN CURRENCY
EXCHANGE MARKET

New York Tokyo

London Singapore

Zurich Hongkong

Frankfurt
 THE FOREIGN CURRENCY
EXCHANGE MARKET
the currencies are efficiently priced; or the market is efficient.

it is difficult to make a profit by shopping around from one bank to

another.
 EXCHANGE RATE
An exchange rate is simply
the price of one country's
currency expressed in
terms of another country's
currency. In practice,
almost all trading of
currencies takes place in
terms of the U.S. dollar.
 EXCHANGE RATE INFLUENCES
Several factors influence why one currency might be significantly stronger
or weaker than another:
Economic Stability: Countries with stable economies and lower inflation
rates typically have stronger currencies.
Interest Rates: Higher interest rates can attract foreign investment,
increasing demand for the currency and thereby strengthening it.
Trade Balances: Countries that export more than they import generally
have stronger currencies due to higher demand for their goods and
services.
Government Debt: Higher national debt can lead to a weaker currency,
as investors might see the country as a riskier investment.
EXCHANGE
RATE
EXCHANGE
RATE
 WHY ARE EXCHANGE
RATES IMPORTANT?
Exchange rates are important because they affect the relative price of
domestic and foreign goods. The dollar price of French goods to an
American is determined by the interaction of two factors: the price of French
goods in euros and the euro / dollar exchange rate.

Appreciation of a currency can make it harder for domestic manufacturers

to sell their goods abroad and can increase competition at home from
foreign goods because they cost less.
FACTORS INLUENCING

EXCHANGE
RATES
 Factors that tend to increase the supply or decrease the demand schedule for a
given currency will bring down the value of the currency in foreign exchange
markets.
The major reasons for exchange rate movements which include inflation, interest
rates, balance of payments, government’s policies or intervation and others:

1. INFLATION - tends to deflate the value of currency because holding the

currency results in reduced purchasing power.
2. INTEREST RATE - if interest return in a particular country are higher relative
to other countries, individuals and companies will be enticed to invest in that
country. as a result, there will be an increased demand for the country’ currencies.
3. BALANCE OF PAYMENTS - used to refer to a system of accounts that
catalogs the flow of goods between the residents of two countries.
4. GOVERNMENT INTERVATION - the central bank of a country may support or
depress the value of its currency.
5. OTHER FACTORS - may affect exchange rates are political and economic
stability, extended stock market rallies and significant declines in the demand for
major exports.
 HOW IS FOREIGN EXCHANGE
TRADED?
The foreign exchange market is organized as over the counter
market in which several hundred dealers(mostly banks) stand
ready to buy and sell deposits denominated in foreign
currencies.

An important point to note is that while banks, companies, and

governments talk about buying and selling currencies in foreign
exchange markets, they do not take a fistful of dollar bills and
sell them for british pound notes.
 INTERACTION IN
FOREIGN CURRENCY
MARKETS
EXCHANGE RATE DETERMINATION
Equilibrium exchange rate in floating markets are determined by the
supply of and demand for the currencies.

FIXED EXCHANGE RATE 03

A fixed exchange rate is a regime applied by a government or central bank that ties the
country's official currency exchange rate to another country's currency or the price of gold.
The purpose of a fixed exchange rate system is to keep a currency's value within a narrow
band.

The purpose of a fixed exchange rate system is to keep a currency's value within a narrow
band.
02 01
Fixed exchange rates provide greater certainty for exporters and importers and help the
government maintain low inflation.

Many industrialized nations began using the floating exchange rate system in the early
1970s
MANAGED
FLOAT
 A managed float is the current method
of exchange rate determination.
During periods of extreme fluctuation
in the value of a nation's currency,
intervention by governments or
central banks may occur to maintain
fairly stable exchange rates.

MANAGED Floating rates permit

adjustments to eliminate
balance of payments deficits

FLOAT or surpluses.

For example, if the Philipine has a

deficit in is trade with Japan, the
Philippine peso will depreciate
relative to Japan's currency. This
adjustmen should decrease
imports from and increase
exports to Japan.
 THEORY OF
PURCHASING POWER
PARITY
 The theory of PPP suggests that if one
It states that exchange rates between any tivo
country's price level rises relative to
currencies will adjust to reflect changes in the price
another's, its currency should depreciate
levels of the two countries. The theory of PPP is
(the other country's currency should
simply an application of the law of one price to
appreciate).
national price levels

PPP theory furthermore does not take into

The PPP conclusion that exchange rates are account that many goods and services (whose
determined solely by changes in relative price prices are included in a measure of a country's
levels rests on the assumption that all goods are price level) are not traded across borders.
identical in both countries. When this Housing, land, and services such as restaurant
assumption is true, the law of one price states meals, haircuts. and golf lessons are not traded
that the relative prices of all these goods (that is, goods. So even though the prices of these
relative price level between the two countries) items might rise and lead to a higher price level
will determine the exchange rate. relative to another country's, there would be
little direct effect on the exchange rate.
WHAT ARE THE
FOREIGN CURRENCY
EXCHANGE RATE
TRANSACTIONS?
Next slide
 The two kinds of Foreign Exchange
Rate Transactions are:

Spot Transactions Forward Transactions

Spot transactions are those Forward transactions involve the
which involve immediate (two- exchange of bank deposits at some
day) exchange of bank deposits. specified future date. The forward
The spot exchange rate is the exchange rate is the exchange rate for
exchange rate for the spot the forward transaction. In major
transactions. financial newspaper (e.g., Wall Street
Journal), two exchange rates for most
major currencies are published — the
spot rate and the forward rate.
SPOT EXCHANGE
RATES
 SPOT EXCHANGE
RATES
If we are exchanging one currency for another immediately, we
participate in a spot transaction. A typical spot transaction may
involve a Philippine firm buying foreign currency from its bank and
paying for it in Philippine pesos (or an American firm buying
currency from its bank and paying for it in US dollar).

For example. if you walk into a local commercial hamk, ask for US
dollars. The banker will indicate the rate at which the US dollar is
selling, say P52.60 per US$1. If you like the rate, you buy what you
need and walk out the door. This is a spot market transaction at the
retail level.
DIRECT AND INDIRECT
QUOTES
 DIRECT AND INDIRECT
QUOTES
In the spot exchange market, the quoted exchange
rate is typically called a direct quote. A direct quote
indicates the number of units of the home currency
required to buy one unit of the foreign currency. An
indirect quote indicates the number of units of foreign
currency that can be bought for one unit of the home
currency. In summary, a direct quote is the peso/ foreign
currency rate, and an indirect quote is the foreign
currency / peso rate.
Therefore, an indirect quote is the reciprocal of a direct
quote and vice versa.
 Cross Rate
It is a foreign currency exchange transaction between two currencies that are both valued against a
third currency. It also important in understanding the spot-rate mechanism and it's the indirect
computation of the exchange rate of one currency from the exchange rates of two other currencies. It
computation make in possible to use quotations in New York to compute, the exchange rate between
pounds, euros and so forth in other foreign currency exchange markets.
P 63.9424 = 1 Pound
P 58.1028 = 1 Euro
P 63.9424 / P 58.1028 =1.1005 euro per 1 pound
P 58.1028 / P 63.9424 = .90867 pound per 1 euro
 Arbitrage
Buy Sell

Investor
 Arbitrage
- is the practice of taking advantage of a difference in prices in two or more
market striking a combination of matching deals to capitalize on the difference,
the profit being the difference between the market prices at which the unit is
traded. The process of of buying and selling in more than one market to make a
riskless profits.

Buy
Exchange 1

Sell
Profits
Exchange 2
Forward Rates
 Forward Rates
is a specified price agreed on by all parties involved for the delivery of a good at a
specific date in the future. The use of forward rates can be speculative if a buyer
believes the future price of a good will be greater than the current for ward rate.
It is the exchange rate at which the currency for future delivery is quoted.
Forward exchange rate could be slightly different from the spot rate prevailing at
the that time. Since the forward rates with a future time, the expectations
regarding the future value of that currency are reflected in that forward rate.
It may be greater than the current spot rate or less than the current spot rate.
Factors that Affect Exchange Rates in the Long Run
Relative Price Levels
In the long run, a rise in a country's price level (relative to the foreign price level)
causes its currency to depreciate, and a fall in the country's relative price level
causes its currency to appreciate.
Trade Barriers
Increasing trade barriers causes a country's currency to appreciate in the long
run.
Preferences for Domestic vs. Foreign Goods
Increased demand for a country's exports causes its currency to appreciate in the
long run; conversely, increased demand for imports causes the domestic currency
to depreciate.
Productivity
In the long run, as a country becomes more productive relative to other countries, its
currency appreciates.
Exchange Rates in the Short Run
refers to the price of one currency in terms of another over a short period. It can be
affected by various factors including interest rates, inflation, and political stability among
others. The key to understanding them short-run behavior of exchange rates is to
recognize that an exchange rate is the price of domestic bank deposit (those dominated in
the domestic currency) in terms of foreign bank deposits (those denominated in the
foreign currency). Because the exchange rate is the price of one asset in terms of another,
the natural way to investigate the short-run determination of exchange rates is through an
asset market approach thatrelies heavily on our analysis of the determinants of assets
demand.
 Managing Foreign
Exchange Risk
Foreign exchange risk refers to the possibility of a drop in revenue or an
increase in cost in an international transaction due to a change in foreign
exchange rates. Importers, exporters, investors and multinational firms are all
exposed to this foreign exchange risk.

When the parties associated with a commercial transaction are located in the
same country, the transaction is denominated in a single currency.
International transactions inevitably involve more than one currency. Since
most foreign currency values fluctuate from time to time, the monetary value
of an international transaction measured in either the seller's currency or the
buyer's currency is likely to change when payment is delayed. As a result, the
seller may revenue than expected or the buyer may have have to pay more than
the expected amount for the merchandise.
THANKYOU