exchange rate determination

1Designed and Prepared By: Malik Muhammad Mehran

Exchange rate Exchange rate DeterminationDetermination


Irbaz Umer ButtIrbaz Umer ButtTanveer KashmiriTanveer KashmiriMalik Muhammad Mehran Malik Muhammad Mehran (Group Leader)(Group Leader)

Group Members:Group Members:


4

Chapter ObjectivesThis chapter will:

A. Explain how exchange rate movements are measuredB. Explain how the equilibrium exchange rate is determinedC. Examine factors that determine the equilibrium exchange rateD. Explain the movement in cross exchange rates

Designed and Prepared By: Malik Muhammad Mehran

Malik Muhammad MehranMalik Muhammad MehranMS Business Administration MS Business Administration Section “F”Section “F”NCBA&E Multan CampusNCBA&E Multan Campus

5

PresenterPresenter::


IntroductionIntroduction


7

Definition: “The price of a nation’s currency in terms of another currency.”

An exchange rate thus has two components, the domestic currency and a foreign currency.

Exchange rateExchange rate


8

Structure of FOREX Market:

-OTC

-Exchange Traded Market

FOREX Market ConceptFOREX Market Concept


9

Levels of FOREX Market:

-Tier 1: Transaction between Central Bank and

other Banks

-Tier 2: Wholesale Market

-Tier 3: Retail Market



10

Exchange Rate Systems: -Fixed Exchange Rate

• Currency Pegging-Floating Exchange Rate

• Clean Float• Dirty Float

-Managed Exchange Rate



11

‘FOREX Exposure’ Exchange rate sensitivity of the

value of the firm to expected changes in the exchange

rate.

• Transaction Exposure

• Economic Exposure

• Accounting Exposure



12

'Spot Rate’ The price quoted for immediate settlement

on a commodity, a security or a currency. The spot

rate, also called “spot price”,



13

“Forward Exchange rate” A rate applicable to a financial transaction that will take place in the future. Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time.

T+2 Settlements



14

An exchange rate has a base currency and a counter currency.

Example:

$1 = £1.1050

In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency.



15

Currency Conversion: $/£ -> 1.7350

- If 500,000 base currency then “X”

- If 500,000 price currency then “/”



16

Example: US person decides to travel UK, JAPAN, CANADAHe will spend£ 40,000¥ 600,000CAD 75,000if USD/GBP-> 1.6750 JPY/USD-> 130.30 CAD/USD-> 0.8750



17

Currency Conversion: A/B -> X/Y

$/£ -> 1.6250/1.6280



18

“Bid” The price a buyer is willing to pay for a security.

“Ask” The opposite of the bid is the ask price, which is the price a seller is looking to get for his or her shares.

Bid Can not be greater than Ask

“Bid-Ask Spread” The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it.



19

“Bid-Ask Spread” - High Liquid Assets- Currency Pairs

• Highly Traded Currencies• Less Traded Currencies

- Major Markets Open (NY, LONDON)- Market Volatility

• High- Spread high• Low- Spread low



20

“Cross Exchange Rate” The currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given.

Example: If an exchange rate between the Euro

and the Japanese Yen was quoted in an American newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is the standard currency of the U.S.



21

Question: What is Cross rate JPY/EUR?

USD/EUR is 1.3649 / 1.3651JPY/USD is 1.6789 / 1.6791

Solution:

(JPY/EUR) = (JPY/USD) x (USD/ EUR)



22

“Implied Rate” The rate that is determined by the difference between the spot rate and the forward rate. The degree of relative costliness of a future rate can be assessed by comparing the implied rate with the spot rate.

Implied rate calculated as;

“Implied rate = Forward Rate – Spot rate”



23

Question: If the spot rate of LIBOR is 5% and the forward rate for LIBOR is 6%?

Implied rate = Forward Rate – Spot rate



24

“Arbitrageur” A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits.

ARBITRAGE PROFITS



25

“Arbitrageur” A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits.

ARBITRAGE PROFITS



Depreciation: decline in a currency’s value Appreciation: increase in a currency’s value

Comparing foreign currency spot rates over two points in time, S and St-1

26

Measuring Exchange Rate Measuring Exchange Rate MovementsMovements

1

1 aluecurrency vforeign in Percent

t

t

SSS


PresenterPresenter::Tanveer KashmiriTanveer KashmiriMS Business Administration MS Business Administration Section “F”Section “F”NCBA&E Multan CampusNCBA&E Multan Campus


The exchange rate represents the price of a currency, or the rate at which one currency can be exchanged for another.

Demand for a currency increases when the value of the currency decreases, leading to a downward sloping demand schedule.

Supply of a currency increases when the value of the currency increases, leading to an upward sloping supply schedule.

In liquid spot markets, exchange rates are not highly sensitive to large currency transactions.

28

Exchange Rate EquilibriumExchange Rate Equilibrium


29

Exhibit 4.2 Demand Schedule for British PoundsExhibit 4.2 Demand Schedule for British Pounds


30

Exhibit 4.3 Supply Schedule of British Pounds for SaleExhibit 4.3 Supply Schedule of British Pounds for Sale


31

Exhibit 4.4 Equilibrium Exchange Rate DeterminationExhibit 4.4 Equilibrium Exchange Rate Determination


Irbaz Umer ButtIrbaz Umer ButtMS Business Administration MS Business Administration Section “F” Section “F” NCBA&E Multan CampusNCBA&E Multan Campus

32

PresenterPresenter::


Factors That Influence Factors That Influence Exchange RatesExchange Rates

33

rates exchange future of nsexpectatioin change controls governmentin change

level income scountry'foreign theand level income U.S.ebetween th aldifferenti in the change

rateinterest scountry'foreign theand rateinterest U.S.ebetween th aldifferenti in the change

inflation scountry'foreign theand inflation S.between U. aldifferenti in the change

ratespot in the change percentage where

),,,,(

EXPGC

INC

INT

INFe

EXPGCINCINTINFfe


Relative Inflation: Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency.

Relative Interest Rates: Increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar. Fisher Effect:

34


rateInflation rateinterest Nominal rateinterest Real Designed and Prepared By: Malik Muhammad Mehran

Relative Income Levels: Increase in U.S. income leads to increased in U.S. demand for foreign goods and increased demand for foreign currency relative to the dollar and an increase in the exchange rate for the foreign currency.

Government Controls via: Imposing foreign exchange barriers Imposing foreign trade barriers Intervening in foreign exchange markets Affecting macro variables such as inflation, interest

rates, and income levels.35



Expectations: If investors expect interest rates in one country to rise, they may invest in that country leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency. Impact of signals on currency speculation.

Speculators may overreact to signals causing currency to be temporarily overvalued or undervalued.

36



Interaction of Factors: some factors place upward pressure while other factors place downward pressure.

Influence of Factors across Multiple Currency Markets: common for European currencies to move in the same direction against the dollar.

37

Factors that Influence Factors that Influence Exchange RatesExchange Rates


If currencies A and B move in same direction, there is no change in the cross exchange rate.

When currency A appreciates against the dollar by a greater (smaller) degree than currency B, then currency A appreciates (depreciates) against B.

When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar, currency A appreciates (depreciates) against currency B by the same degree as it appreciates against the dollar.

38

Movements in Cross Exchange Movements in Cross Exchange RatesRates


exchange rate determination

Documents

price currency

foreign currency

counter currency

currency conversion

forward exchange rate

equilibrium exchange

thebase currency

nations currency