8/3/2019 7. FOREX new

1/61

FOREIGN EXCHANGE

jan surya sharma

8/3/2019 7. FOREX new

2/61

EXCHANGE

RELATED TERMSFOREIGN EXCHANGE: a financial instrument issued by a foreigncountry.

FX MARKET :a market for converting the currency of one countryinto that of another country.RATE OF EXCHANGE :the number of units of a given currencyneeded to buy one unit of another currency

49.03

1

www.xe.com

1 0.0204

http://www.xe.com/http://www.xe.com/

8/3/2019 7. FOREX new

3/61

FOREIGN

EXCHANGE

FOREX or FX: A mechanism by which currency of onecountry gets converted into the currency of anothercountry.

[a financial instrument issued by a foreign country]

Can form of cash, funds available on debit & creditcards, travelers cheques, bank deposits or othershort-term claims i.e., Foreign currency or claimsrelating to foreign currency

E.g.

In India, a US$ 10 currency note or a US$ 10 travelersche ue or a demand draft drawn on New York Bank

8/3/2019 7. FOREX new

4/61

EXCHANGE

MARKET banks & currency exchanges that buy & sell foreign currenciesand other exchange instruments [a market for converting the currency of one country into

that of another country]

FOREX MARKET OVER-THE-COUNTER (OTC)

Venue of maximum forex activity

Composed of commercial banks, investment banks &

financial institutions MARKET EXCHANGE TRADED MARKET

Composed of securities exchanges

Venue of specific forex instruments like exchange-traded

options & futures

8/3/2019 7. FOREX new

5/61

RATE OF

EXCHANGE

the price of one currency expressed in terms ofanother currency. [the number of units of a given currency needed to buy

one unit of another currency]

Expressed in two ways : DIRECT QUOTATION: One unit of foreign currency

expressed in terms of domestic currency. Method also knownas American terms

E.g. In India: US$1 / INR 49.03 INDIRECT QUOTATION: One unit of domestic currency

expressed in terms of foreign currency. Method also knownas European terms

E.g. India: INR1 / US$ 0.0204

8/3/2019 7. FOREX new

6/61

&CONVENTIONS

BID (Buyers rate): price at which trader is willing to buyforeign currency

ASK/Offer (Sellers rate): price at which trader is willing

to sell foreign currency SPREAD :The amount by which ask price exceeds the

bid, i.e., the difference between ask & bid price (themargin of trader) = (Ask price Bid price) / Ask price X

100 E.g., A customer exchanges US dollar against rupee in India

Bid rate = Rs. 48.63 (bank will buy US $ at 48.63 fortransaction)

Ask rate = Rs. 49.03 (bank will sell US $ at 49.03)

8/3/2019 7. FOREX new

7/61

EXCHANGEINSTRUMENTS

TYPES : TRADITIONAL FOREX INSTRUMENTS

SPOT FORWARD FX SWAP

DERIVATIVE INSTRUMENTS CURRENCY SWAPS OPTIONS

FUTURES EQUITY & DEBT INSTRUMENTS

ADR GDR FOREIGN BONDS

EURO BONDS

8/3/2019 7. FOREX new

8/61

SPOT MARKET

Spot transactions :the market in which foreignexchange transactions occur on the spot,

Spot rate : rate quoted for transactions that

require immediate delivery, i.e. within twodaysValue date/ Settlement date : Day on which delivery

of currency takes place i.e. on the second day of theagreement

A deal in spot market is executed on Thursday, theexchange of currency has to take place by Saturday

& if the particular market is closed on Saturday &

8/3/2019 7. FOREX new

9/61

ARBITRAGE IN SPOTMARKET

Arbitrageurs buy a particular currency atcheaper rate in one market and sell it at ahigher rate in another.

E.g., bid rate in :New York : US$ 1.382 Euro 1Frankfurt : US$ 1.372 Euro 1

The arbitrageurs will buy Euro in Frankfurt and willsell the Euro in New York.Assuming zero transaction costs, Arbitrageurs willprofit:

US$ 1.382 US$ 1.372 = US$ 0.010 per Euro

8/3/2019 7. FOREX new

10/61

FORWARD

MARKET

Forward Market :where foreign exchangetransactions occur at a set rate for delivery beyondtwo business days following the date of agreement

to trade. Rates are negotiated in present but exchange occurs

in future, say after 30, 90, 180 or 360 days

Forward Rate :a contractually established

exchange rate between a foreign exchange trader andthe client for delivery of foreign currency on aspecified date

E.g.: for the one month forward contracts signedrespectively on 28th & 29th January 2010. What would

8/3/2019 7. FOREX new

11/61

SPOT RATERELATION

Forward exchange rate is expressed in relation toprevalent spot rate at the time when forward rate isquoted.

Forward quotations can be made at forwarddifferential or at par with spot rate:

forward premium: when forward rate > spot rate

at a premium on the spot rate

forward discount: when forward rate < spot rate

at a discount on the spot rate

8/3/2019 7. FOREX new

12/61

EXCHANGE OR FXSWAP

a simultaneous spot & forward trans-action, i.e., one currency isswapped for another on one date and then swapped back on a futuredate (but accounted as a single transaction). FIRST LEG : SPOT TRANSACTION (Trader buys or sells on the spot market)

SECOND LEG : FORWARD TRANSACTION - reverse (Trader buys or sells onthe forward market)

E.g., : Parties BNP Paribas & HDFC Currency - Euro

FOR BNP Paribas: It is long on current holdings of Euro expecting Euro to go upand considers itself short one-month forward because of net forward sales.

FOR HDFC : It is short expecting Euro to go dpwn on current holdings of Euro butlong one-month forward.

Transactions: First Leg : Spot Transaction BNP Paribas will sell Euro Spot to HDFC & HDFC

will buy Euro Spot from BNP Paribas

Second Leg: Forward Transaction BNP Paribas will buy Euro forward from HDFC& HDFC will sell Euro forward to BNP Paribas Long buy

Short sell

CURRENCY

8/3/2019 7. FOREX new

13/61

CURRENCY

SWAP A currency swap is a foreign-exchange agreement betweentwo parties to exchange the principle & interest payment of a

loan in one currency for equivalent aspects of an equal in netpresent value loan in another currency. Currency swaps aremotivated by. comparative advantage

Currency swaps are OTC derivatives covering an exchangeof debt or assets denominated in one currency for debt orassets denominated in another currency. E.g. : Company X ofUS issues bond of $ 20 m in US. Another

company Y of Europe issues bond of Euro 10 m. Bothcompanies agree for exchanging the principal & interest of bothbonds. X will get Euro 10 m Bonds with its interest paymentand Company Y will get $ 20 m bond for exchanging hisprincipal and interest. This is the simple example of currencyswap

Suzuki wishes to obtain US $ to finance business expansion in

USA but has access to Yen capital market at relatively attractiveterms. A counterparty existence with a net asset position in US$

8/3/2019 7. FOREX new

14/61

OPTIONS

an instrument traded both OTC & on exchangesthat gives the purchaser the right (but not theobligation) to buy or sell a certain amount of foreigncurrency at a specified exchange rate within aspecified amount of time [more expensive but alsomore flexible than a forward contract] Parties: option buyer and option seller/writer Strike priceThe exchange rate specified in the option to

purchase or sell the currency, i.e., exercise price

Premium:The fee or cost of the option paid to the writerof the option.

OPTIONS - types : CALL OPTION: It gives the right but not the obligation to

purchase an option PUT OPTION : It gives the right but not the obligation to sell

8/3/2019 7. FOREX new

15/61

FUTURES

an agreement between two parties to buy or sell a givencurrency at a given (negotiated) price on a particular futuredate, as specified in a standardized contract to all participantsin that currency futures exchange. (Started in 72 with CMEdivision for currency futures. )

Its market is an organized market like an exchange and notlike OTC. [not as flexible as a forward contract]

Futures contracts traded currencies: Euro, J.Yen, Poundsterling, Canadian $, Sfr, Mexican pesos, Australian dollars

Futures deals are struck sitting face-to-face under a trading roof

known as pits. Deal is not settled on maturity instead rates are matched daily

with the movements in spot market and gains and losses arecredited and debited to the traders account everydayrespectively. This is known as marking to market.

Parties : Traders, Exchanges, Clearing houses. Costs in futures deal : brokera e commission, floor tradin and clearin

8/3/2019 7. FOREX new

16/61

DEPOSITORY

RECEIPTS - ADRs A dollar denominated negotiable certificate that

represents a non-US companys publicly tradedequity

Devised in late 1920s to help non-US companies tohave their stock traded in the American markets

Regulatory framework for the ADRs is provided bySecurities and Exchange Commission operating

through Securities Act of 1933 and the SecuritiesExchange of Act of 1934

To raise money from US market via ADRs requirescompliance with US GAAP and parting with voting

rights to individual investors with directors of

8/3/2019 7. FOREX new

17/61

DEPOSITORY

RECEIPTS - GDRs A negotiable instruments denominated in dollars or otherfreely convertible currency which represents publicallytraded local currency-equity shares.

A global finance vehicle that allows an issuer to raisecapital simultaneously in two or more markets through aglobal offeringExample : A European investor wanting an exposure inIndian securities could do so via two routes : i) Enter Indian stock market & buy the companys stock on

one of the Indian markets exposing him to exchange risksand statutory rules & regulations governing purchase & saleof securities in Indian markets.

ii) Through GDRs giving the investor ownership of the Indiancompanys stock without being subject to Indian stock market

regulations to a large extent.

INTERNATION

8/3/2019 7. FOREX new

18/61

INTERNATION

AL BONDS Bonds floated in a particular domestic capital market and

in the domestic currency of that market by non-residententities. Yankee bonds: Dollar denominated bonds issued in US

markets by non-US companies. Samurai bonds: Yen denominated bonds issued in

Japanese markets by non-Japanese companies.

Bulldog bonds: Pound denominated bond in UK are

Unsecured debt securities issued & sold in marketsoutside the home currency of the issuer(borrower) anddenominated in a currency different from that of thehome country of the issuer. EURO (dollar) bond: A dollar denominated bond issued in

8/3/2019 7. FOREX new

19/61

THANKS !

8/3/2019 7. FOREX new

20/61

INTERNATIONALBUSINESS

Determinationof

Exchange Rates

8/3/2019 7. FOREX new

21/61

10-21

Objectives

To describe the International Monetary Fund andits role in the determination of exchange rates

To discuss the major exchange rate arrangementsthat countries use

To explain how the European Monetary Systemworks and how the euro came into being as thecurrency of the euro zone

To identify the major determinants of exchange

rates To show how managers try to forecast exchange

rate movements To explain how exchange rate movements

influence business decisions

8/3/2019 7. FOREX new

22/61

10-22

Monetary Fund

(IMF)A multi-national institution established in1945 as part of the Bretton WoodsAgreement to maintain order in the

international monetary system is now anorganization of 187 nations.

Initially the Bretton Woods Agreement established asystem of fixed exchange ratesunder which eachIMF member country set a par value[benchmark]for its currency quoted in terms of gold and the U.S.

dollar.

Obj ti

8/3/2019 7. FOREX new

23/61

10-23

Objectives

of the IMF

To promote exchange rate stability

To facilitate the international flow of currenciesand hence the balanced growth of internationaltrade

To promote international monetary cooperation

To establish a multilateral system of payments

To make resources available to member nationsexperiencing balance-of-payments difficulties*

*IMF loan criteria are designed to help stabilize a countrys

economy. However, they are often unpopular with affectedconstituencies.

Wh t th IMF

8/3/2019 7. FOREX new

24/61

10-24

What the IMFDoes ?

Three main functions: Surveillance: involves the monitoring of economic &

financial developments, and the provision of policyadvice specially at crisis-prevention.

Lending: to those countries with BOP difficulties, toprovide temporary financing and to support policiesaimed at correcting the underlaying problems: loans tolow-income countries are also aimed at povertyreduction.

Technical Assistance: provides technical assistanceand training in its areas of expertise.

All the three activities is IMF work in economic research & statistics

IMF is also supporting fight against money-laundering & terrorism

Th IMF

8/3/2019 7. FOREX new

25/61

10-25

The IMF

Quota

IMF Quota: the sum of the totalassessments levied on member countriesto form the pool of money from which the

IMF draws to make loans to membernations

National quotas are based upon countries

national incomes, monetary reserves, tradebalances, and other economic indicators.

Quotas form the basis for the voting power of

each member nationthe higher the quota, the

Special Drawing

8/3/2019 7. FOREX new

26/61

10-26

Special DrawingRights (SDRs)

An artificial international reserve asset created in1969 to supplement IMF members existing reserves ofgold and foreign exchange

The SDR is used as the IMFs unit of account for purposes

of financial record-keeping, but it has not assumed therole of gold as a primary reserve asset. The value of the SDR is based upon the weighted average

of a basket of four currencies.

Weights as of Dec. 31, 2004

U.S. dollar 39%

Euro 36%

Japanese yen 13%

British pound 12%

8/3/2019 7. FOREX new

27/61

10-27

Role of IMF

Articles of Agreement influenced by financial collapse,competitive devaluations, trade wars, high unemployment,hyperinflation & general economic disintegration

Discipline: fixed exchange rate Control inflation Prevent competitive devaluation

Flexibility IMF lending facilities lend foreign currencies during

periods of balance of payment deficits (Member pool ofgold & currencies)

Adjustable parities IMF mandated targets on domesticmoney supply growth, exchange rate policy, tax policy,

government spending & other macroeconomic policies

8/3/2019 7. FOREX new

28/61

10-28

Role of World Bank (IBRD International Bankfor Reconstruction & Development)

Initial mission to help finance the building of Europes economy Marshal Plan supplanted

1950s 3rd World public sector projects (power stations, roadbuilding, transportation)

1960s Agriculture, education, population control & urbandevelopment

Lending IBRD bond sales in international capital markets low interest

loans to risky customers with poor credit ratings banks cost offunds + margin for expenses

IDA Wealthy member subscriptions (US, Japan, Germany) goonly to poorest countries 50 year repayment at 1% interest rateper year

8/3/2019 7. FOREX new

29/61

10-29

IMS Evolution

Gold standard: Pegging currencies to gold & guaranteeing convertibility

Gold par value amount of currency needed to buy 1 oz of gold

By 1880 US, GB, Germany, Japan - Breakup 1930s with wars

Mechanism for achieving BOT equilibrium ($ Xport = $ Mports)

Bretton Woods System 1944 Competitive devaluation with gold standard during war

Fixed Xchange rates against USDmaintain within 1% of par value

Commitment not to use devaluation as weapon of competitive trade policy Established IMF (maintain order in IMS) & World Bank (promote

development)

Jamaica Agreement - IMS since 1973

Mixed system with some currencies allowed to float freely, some managedby government intervention & some pegged to another currency

8/3/2019 7. FOREX new

30/61

10-30

Collapse of Fixed Rate System

Dollar occupied central role in system Only one converted into gold Reference point for all others

US Macroeconomic policy of 1965-68 US importing more than exporting US Govt. spending on Vietnam War & welfare Dollar devalued only if all other countries agree to

simultaneously revalue against dollar

1971 Nixon announce in dollar no longer convertible intogold

8/3/2019 7. FOREX new

31/61

10-31

The Evolution to Floating Exchange Rates

The Smithsonian Agreement of 1971:a restructuring of the international monetary systemthat widened exchange rate flexibility from 1 percentto 2.25 percent from par value

The Jamaica Agreement of 1976:an amendment to the original IMF rules thateliminated the concept of fixed exchange rates and par

values in order to accommodate greater exchange rateflexibility via a spectrum of exchange rate regimes

E h R A

8/3/2019 7. FOREX new

32/61

10-32

Exchange Rate Arrangements:Three Broad Categories

Peg the exchange rate to another currency or basketof currencies with little or no flexibility

[Ecuador, El Salvador, Finland, Niger]

Peg the exchange rate to another currency or basketof currencies with trading occurring within a band [Denmark, Cyprus, Hungary]

Allow the currency to float in value against othercurrencies, either managed or not managed[Britain, Brazil, India, Norway, Turkey, So. Africa, USA]

IMF member countries are permitted to select & maintain their exchange

rate regimes, but they must be open & act responsibly with respect to theirexchange rate policies.

8/3/2019 7. FOREX new

33/61

International monetary system: Institutional arrangements

that countries adopt to govern exchange rates

Floating exchange rate: Exchange rate for converting onecurrency to another is continuously adjusted based on supply &

demand

Pegged exchange rate: Currency value is fixed relative to areference currency (Before 2005 US dollar $ 1 = 8.28 Chineseyuan)

Dirty float system: Currency nominally allowed to float &Government will step in if it deviates too far from fair value

Fixed exchange rate: Exchange rate for changing one currency

into another is fixed

10-33

IMS Terms

E h R t A t

8/3/2019 7. FOREX new

34/61

10-34

Exchange Rate Arrangements:Three Broad Categories

Peg the exchange rate to another currency or basket ofcurrencies with little or no flexibility

[Ecuador, El Salvador, Finland, Niger]

Peg the exchange rate to another currency or basket ofcurrencies with trading occurring within a band[Denmark, Cyprus, Hungary]

Allow the currency to float in value against othercurrencies, either managed or not managed

[Britain, Brazil, India, Norway, Turkey, So. Africa, USA]

IMF member countries are permitted to select and maintain their exchangerate regimes, but they must be open and act responsibly with respect to their

exchange rate policies.

8/3/2019 7. FOREX new

35/61

10-35

Exchange Rate Regimes: 2004

NO. OF

REGIMES COUNTRIES

Arrangements with no separate legal tender 41

Currency board arrangements 7

Other conventional fixed peg arrangements 41

Pegged exchange rates within horizontal bands 4

Crawling pegs 5

Exchange rates within crawling bands 5

Managed float with no pronounced path 49Independently floating 35

Total 187

Source: International Monetary Fund, IMF Annual Report, 2004, pp. 118-120.

8/3/2019 7. FOREX new

36/61

10-36

The Role of Central Banks

Each country has a central bank responsible for thepolicies affecting the value of its currency.

[The RBI is the central bank of India and intervenes in foreign exchangemarkets on behalf of the Govt. of India under its monetary policies]

Central banks intervene in currency markets by

buying or selling a particular currency in order toaffect its price; central banks are primarilyconcerned with liquidity. SDRs

[Selling a currency puts downward pressure on its value; buying acurrency puts upward pressure on its value.]

Central banks keep their reserve assets in threemajor forms: gold, foreign exchange, and IMF-related assets (SDRs).

[continued]

Depending on market conditions a

8/3/2019 7. FOREX new

37/61

10-37

Depending on market conditions, acentral bank may:

coordinate its actions with other central banks or go italone

aggressively enter the market to change attitudes

about its views and policies call for reassuring action to calm markets

intervene to reverse, resist, or support a market trend

be very visible or be very discrete

operate openly or operate indirectly through brokers

The Bank for International Settlements (BIS)inBasel, Switzerland, acts as the central bankerscentral bank & also serves as a place to gather &discuss monetary cooperation.

8/3/2019 7. FOREX new

38/61

10-38

The Euro

European Monetary System (EMS): established bythe EU (then the EC) in 1979 as a means of creatingexchange rate stability within the bloc

European Central Bank: established by the EU on

July 1, 1998, to set monetary policy and to admin-ister the euro Euro: the common European currency established

on Jan. 1, 1999 as part of the EUs move towardmonetary union as called for by the Treaty of

Maastricht of 1992 European Monetary Union (EMU): a formal

arrangement linking many but not all of thecurrencies of the EU

[continued]

Th E h R t M h i (ERM) i th

8/3/2019 7. FOREX new

39/61

10-39

The Exchange Rate Mechanism (ERM), i.e., theStability and Growth Pactthat defines the criteria thatEU member nations must meet to qualify for adoptionof the euro, requires: an annual government deficit not to exceed 3% of GDP total outstanding government debt not to exceed 60% of GDP rates of inflation within 1.5% of the three best performing EU

countries average nominal interest rates within 2% of the average rate in

the three countries with the lowest inflation rates exchange rate stability, i.e., for at least two years, ex-change

rate fluctuations within the normal margins of the ERM

The UK, Sweden, and Denmark are the only members of theinitial group of 15 that opted not to adopt the euro.

E h R t D t i ti Fi d t

8/3/2019 7. FOREX new

40/61

10-40

Exchange Rate Determination: Fixed toFloating Regimes

Floating rate regimes: currencies floatfreely, i.e., free from govt. intervention, in responseto demand & supply conditions

Managed fixed rate regimes: a nations centralbank intervenes in the foreign exchange market inorder to influence its currencys relative price

Demand for a countrys currency is a function of thedemand for that countrys goods, services, andfinancial assets.

Equilibrium exchange ratesare achieved when supply equals demand.

[continued]

8/3/2019 7. FOREX new

41/61

10-41

Meaning of Exchange Rate & MeasuringChanges in Exchange Rates

Value of one currency in units of another currency

A decline in a currencys value is referred to as

depreciationand an increase in currencys value iscalled appreciation.

If currency A can buy you more units of foreigncurrency, currency A has appreciated & foreigncurrency depreciated

If currency A can buy you less units of foreign

Exchange Rate Equilibrium in

8/3/2019 7. FOREX new

42/61

10-42

Exchange Rate Equilibrium inFloating Rate Regime

Forces of Demand & Supply

Demand for foreign currency negatively related to

the price of foreign currency.

Supply of foreign currency positively related to the

price of foreign currency.

Forces of demand and supply together determine

the exchange rate

8/3/2019 7. FOREX new

43/61

10-43

Demand for Foreign Currency

$1.50

$2.00

D

D

50m 75 m

Price for Foreign Currency

Units of Foreign Currency (Yen)

8/3/2019 7. FOREX new

44/61

10-44

Supply of Foreign Currency

Units of Foreign Currency (Yen)

$1.50

50 m 75 m

S

S

$2.00

8/3/2019 7. FOREX new

45/61

10-45

Equilibrium Exchange Rate

S

SD

D

Units of Foreign

Currency(Yen)

Exchange Rate Determination

8/3/2019 7. FOREX new

46/61

10-46

Exchange Rate Determination

An interaction of factors

Is it possible for a country with high real returnsto have a low currency value?

Is it possible for a country with low real returns

to have a high currency value?

Th E ilib i E h R t

8/3/2019 7. FOREX new

47/61

10-47

The Equilibrium Exchange Rate

Factors that influence the Exchange

8/3/2019 7. FOREX new

48/61

10-48

Factors that influence the ExchangeRate Expectations of the Market: High expected returns

from currency instruments increase the demand & thusvalue

Political Events: Uncertainty affects the currency rates

Relative Inflation Rates: Inflation at home makes thehome currency less valuable making it to depreciate

Relative Interest Rates: High interest rates at homerelative to a foreign country cause domestic currency toappreciate.

Relative Income Levels: Increase in domestic incomerelative to foreign income may reduce the value ofdomestic currency

8/3/2019 7. FOREX new

49/61

10-49

The prices of tradable products, when expressed in acommon currency, will tend to equalize across countries asa result of exchange rate changes.

If economic policies and intervention are ineffective,

governments may be forced to revalue or devalue theircurrencies.

A currency that is pegged is usually changed on a formalbasis.

The G20 group of finance ministers meets often to discussglobal economic issues, including exchange rate valuesand policies.

Black markets closely approximate prices based on supply and demand forcurrencies, rather than government-controlled prices.

Purchasing Power Parity:

8/3/2019 7. FOREX new

50/61

10-50

Purchasing Power Parity:School of Salamanca (16 AD) later Gustav Cassel

Purchasing power parity: the number of unitsof a countrys currency required to buy thesame amount of goods and services in the

domestic market that one unit of incomewould buy in another country

Purchasing power parity [PPP] is estimated by calculatingthe value of a universal basket of goods that can be

purchased with one unit of a countrys currency.

8/3/2019 7. FOREX new

51/61

10-51

Purchasing Power Parity: The Theory

Purchasing power paritypredicts that the ex-change rate will change if relative prices change.

A change in the comparative rates of inflation in two

countries necessarily causes a change in their relativeexchange rates in order to keep prices fairly similar. An example: If the domestic inflation rate is lower than the rate in

the foreign country, the domestic currency should be stronger thanthe currency of the foreign country.

The alternative example: If the domestic inflation rate is higher than

the rate in the foreign country, the domestic currency should beweaker than the currency of the foreign country.

Inflationrepresents a monetary phenomenon in which a nations money supplyincreases faster than its stock of goods and services, thus causing prices to

rise.[continued]

8/3/2019 7. FOREX new

52/61

10-52

Purchasing power parity seeks to define therelationships between currencies.

While PPP may be a reasonably good long- term

indicator of exchange rate movements, it is lessaccurate in the short run because:

the theory falsely assumes that no barriers to trade existand that transportation costs are zero

it is difficult to determine an appropriate basket ofcommodities for comparative purposes

profit margins vary according to the strength of

competition

Th R l f I R

8/3/2019 7. FOREX new

53/61

10-53

The Role of Interest Rates

Fisher Effect Theory: [links interest rates and inflation]r: the nominal interest rate, i.e., the actual rate of interest earned onan investment

R: the real interest rate, i.e., the nominal interest rate less inflation

A countrys nominal interest rate ris determined by the realinterest rate Rand the inflation rate i as follows:

(1 + r) = (1 + R)(1 + i).

International Fisher Effect Theory (IFE):

[links interest rates and exchange rates]

The currency of the country with the lower interest rate willstrengthen in the future because the interest ratedifferential is an unbiased redictor of future chan es in

8/3/2019 7. FOREX new

54/61

10-54

Like PPP, the International Fisher Effect is not aparticularly good predictor of short-run changes in spotexchange rates.

An example of the Fisher Effect: Because the interest rateshould be the same in every country, the country with thehigher interest rate should have higher inflation.Thus, if R= 5%, the U.S. inflation rate is 2.9%, and theJapanese inflation rate is 1.5%, the nominalinterest rates are:

rus = (1.05)(1.029) 1 = .08045 or 8.045%rj = (1.05)(1.015) 1 = .06575 or 6.575%

On the other hand, if inflation rates were the same, investorswould place their money in countries with higher interest ratesin order to get higher real returns.

Forecasting Exchange Rates:

8/3/2019 7. FOREX new

55/61

10-55

Forecasting Exchange Rates:Fundamental vs. Technical Approaches

Fundamental forecasting: trend analyses andeconometric models that use economic variablesto predict future exchange rates

Technical forecasting: analyses that use pasttrends in exchange rate movements to predictfuture exchange rates

Forecasters need to provide ranges or pointestimates within subjective probabilities basedon available date and subjective interpretations.

Forecasting Exchange Rates:

8/3/2019 7. FOREX new

56/61

10-56

Forecasting Exchange Rates:Factors to Monitor

The institutional settingthe extent and nature ofgovernment intervention

Fundamental factorsPPP rates, balance-of-

payments levels, macroeconomic data, levels offoreign exchange reserves, fiscal and monetarypolicies, etc.

Confidence factors

Critical events, e.g., Failures of Leading FinancialInstitutions of the world.

Technical factorsexpectations and market trends

Operational Implications of

8/3/2019 7. FOREX new

57/61

10-57

Operational Implications ofExchange Rate Fluctuations

Exchange rate changes can affect:

marketing decisions, i.e., demand for a firms

products, both at home and abroad production decisions, i.e., production site

locations, insourcing vs. outsourcing

financial decisions, i.e., sourcing of funds (debtand equity), the timing and level of the remit-tance of funds, and the reporting of financialresults

Implications/Conclusions

8/3/2019 7. FOREX new

58/61

10-58

Implications/Conclusions

- Central banks are the key institutions in countries thatopt to intervene in foreign exchange markets toinfluence currency values.

- Exchange rates affect business operations in threeprimary areas: marketing, production, and finance.

- A country may change the exchange rate regime that ituses, so managers must monitor country policies

carefully.- A country that strictly controls and regulates the

convertibility of its currency is likely to have a blackmarket that maintains a currency exchange rate which

8/3/2019 7. FOREX new

59/61

MARKET

8/3/2019 7. FOREX new

60/61

MARKETInterbank

Market

FX Future/OptionsMarket

FXBrokers

FinancialCenter Banks:

Foreign Exchange

Market

Customer BuyFX withDollars

LocalBanks:

RetailMarket

LocalBanks:

RetailMarket

Customer SellFX forDollars

Stockbrokers

8/3/2019 7. FOREX new

61/61

10-61

Thanks !