Foreign Exchange

Lecture 18, 18th February 2010Dr Michael Wynn-Williams wm97@gre.ac.uk

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It affects the bottom line Currency appreciation increases export prices,

but reduces import prices Depreciation reduces export prices but

increases import prices Invisibles, payments on account of services will

increase FDI, with devaluation, the ROCE will change as will

the IRR Commercial borrowing, devaluation will increase

the cost of debt servicing

But There are opportunities for arbitrage. Companies can protect themselves through hedging,

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The exchange rate is the price at which the national currency is valued in relation to a foreign currency.

It also occupies a central position in monetary policy, where it may serve as a target, an instrument or simply an indicator-depending upon the chosen framework of monetary policy.

The exchange rate provides governments short term flexibility for their monetary policies – it acts as a pressure relief valve

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Only 2% of total transactions is trade related BIS coordinated survey 2007

Daily forex turnover $ 3.99 trillion

US$ involved in 88% of trade volumes –has declined after the Euro US$/GBP – 12% US$/EURO – 27%

Main centres of trade UK – 34.1% US – 16.6% Japan - 6.0% France – 3.0% Germany – 2.5%

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Classification of ratesSpot: delivery in two daysForward contract: delivery at agreed price

any day in the futureFuture: standardised contract for amount and

maturity, usually 3 monthsSwap: currencies are exchanged for a period,

then exchanged back. Comprises spot and forward rates

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Buying and selling : both from view point of the bank. e:g £/$ buying rate = 1.75 £/$ selling rate = 1.65 Spread = 0.10 (this is where the bank makes

profits)

Transaction types Telegraphic Transfer TT – funds already with

the bank Bills for collection - funds reach the bank after

a delay

Institutions Commercial banks Investment banks Securities exchanges Auctions Company to company

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Activity Customer Bank Profit Opportunity

TT Buying Receives money by wire

Changes money on receipt

BC Buying Receives money on credit

Changes money and issues bill

TT Selling Sends money by wire

Changes money on receipt

BC Selling Sends money by wire

Changes money and issues bill

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Purchasing power parity

Currency supply – import spending

Interest rates

Confidence in the government

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Purchasing power parity (PPP) compares the prices of identical goods in different markets

PPP shows how much can be bought assuming that the money spent is generated locally

This implies an exchange rate between countries A basket of goods in the US costs $100, the same in

the UK costs £50 The PPP exchange rate is £1 = $2 (direct), or $1 =

£0.50 The “Law of One Price” suggests that prices will

equalise in a free global market The PPP exchange rate can indicate if the nominal

exchange rate is sustainable PPP exchange rate: £1 = $2 Nominal exchange rate: £1 = $1.50 Therefore current pound spot rate is undervalued by

25%

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Source: The Economist

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The demand for imports depends on Income level The relative prices of foreign and domestic products The current exchange rate

If income levels rise… Demand for imports (and domestic products) will rise There is a greater need for foreign currency to pay for

the imports The local currency falls in value

If inflation is higher in one country, Year 1 to Year 2… Local prices will rise relative to the foreign country Local currency falls in value to account for the change

If there is a current account deficit… There is an over-supply of domestic currency The value of the currency will fall

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Investment funds will seek out the highest interest rates around the world

If the UK raises interest rates, foreign investors must buy sterling in order to make the investment

Raising interest rates, or the threat of it, will therefore boost the value of the currency

The currency would stop rising once it had eliminated the gains from transferring funds from the low interest rate region to the high interest rate region

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Influencing the exchange rate Responsibility of the central bank Uses money supply to regulate currency demand Holds currency reserves as ballast

Official Foreign Reserves Dec 2009

1. China $2,399.2 billion ( 10.4) 6. Korea $270.0 billion ( -0.9)

2. Japan $1,049.4 billion ( -24.3) 7. Hong Kong $255.8 billion ( -0.5)

3. Russia $439.0 billion ( -8.8) 8. Brazil $238.5 billion ( 1.8)

4. Taiwan $348.2 billion ( 1.0) 9. Germany $189.5 billion ( 12.5)

5. India $283.5 billion ( -4.6) 10. Singapore $187.8 billion ( -1.1)

Fixed/pegged exchange rate – eg. China Open to black market exploitation At the mercy of the partner currency Often used to support export strategy, but restricts

imports of foreign capital and technology

Source: Bank of Korea

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Economic risk High rates of inflationDefaults on paymentsCounter party risk – partner defaults Interest rate changes

Transaction riskUS$ moves adversely against GBP£ for

specific transaction Translation risk

Accounting problems over the life of the investment

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Judgemental forecasts Takes a sophisticated view, including

politics, social trends and personal experience

Based on a “feel for the market” Subjective

Technical forecasts Based on trend analysis Chartism – identifies patterns in the data Relies on moving averages, filters and

market momentum Generally only valid in the short-run

Fundamental forecasts Attempt to identify and quantify the

underlying economic variables Statistical basis Generally valid only in the long-run

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Choose one of the following forecast methods Judgement Technical Fundamental

Use the method to make a forecast for today’s US$/JPY spot rate

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Choose one of the following forecast methods Judgement Technical Fundamental

Use the method to make a forecast for today’s US$/JPY spot rate

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The forex markets are like any other market- determined by demand and supply

They have their own rules and peculiarities A lot is based on convention and individual trust

Exchange rates can also be used as a instrument of monetary policy They allow short term flexibility

Exchange rates will also reflect the confidence in the country Stable vs volatile exchange rates

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Read the case on “Currency Crisis” (uploaded on WebCT, Xtra resources for Tutorials)

Take a print out

You will be working in your groups to answer the question…Which country is likely to devalue?

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Foreign exchange risk <http://www.exinfm.com/board/foreign_exchange_risk.htm>

Bank of International Settlements <http://www.bis.org/>

BIS Triennial Review 2004-2007<http://www.bis.org/publ/rpfxf07t.pdf>

Bank of Korea <http://eng.bok.or.kr/> Big Mac Index

<http://www.economist.com/daily/chartgallery/displaystory.cfm?story_id=15210330>