Chapter 9 - The foreign exchange market. The main goals of this chapter are to: Define foreign exchange and explain the fundamental economic factors that determine exchange rates; examine the functions, structure and size of the foreign exchange market as well as the main types of foreign exchange transactions; map out the implications for international businesses of exchange rate movements.
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Chapter 9 The foreign exchange market
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Lecture plan
• Determination of exchange rates
– supply of and demand for currencies.
• Functions of the foreign exchange market
– currency conversion
– reduction of foreign exchange risk (spot and
forward exchange rates; currency swaps.)
• Structure of Forex by type of transactions
• Economic theories of exchange rate determination
• Factors affecting the Australian dollar exchange rate
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Foreign exchange transactions
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Determination of the exchange rates
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Floating currencies: demand for the national currency
• Nation’s exporters paid in other hard currencies
• Foreign companies undertaking direct
and portfolio investment in the nation’s economy
• ‘Bull’ speculators in the nation’s currency
• Nation’s Central Bank (RBA) selling US$ and other hard currencies for the nation’s currency
• Foreign tourists visiting your country
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Floating currencies: supply of the national currency
• Nation’s importers paying in US$, Yen
• Domestic firms investing abroad
• ‘Bear’ speculators in the national currency
• Nation’s central bank buying US$, Yen
• Individual residents travelling overseas
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Impact of A$ depreciation
Commodity export price
(beef)
US$1000 per tonne
Commodity import price
(computer)
US$1500 per unit Exchange
rate for A$ Exporter receives rate for A$ Exchange Importer pays
US$0.75 A$1333 US$0.75 A$2000 US$0.60 A$1666 US$0.60 A$2500 E/R effect + A$333
(25%)
E/R effect + A$500
(25%)
Source: Table 9.1
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Impact of A$ appreciation
Commodity export price
(beef)
US$1000 per tonne
Commodity import price
(computer)
US$1500 per unit Exchange
rate for A$ Exporter receives rate for A$ Exchange Importer pays
US$0.75 A$1333 US$0.75 A$2000 US$0.90 A$1111 US$0.90 A$1600 E/R effect - A$333
(- 17%)
E/R effect - A$500
(- 20%)
Source: Table 9.2
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Geographical distribution of global
reported foreign exchange market
turnover, %, April 2004.
31.3 19.2
8.3 5.2 4.9 3.3 4.2 3.4 2.7
United Kingdom
United States
Japan Singapore
Germany Switzerland
Hong Kong
Australia France
FOREX %
Source: adapted from Bank for International Settlements (BIS),
Press Release, 28 September 2004
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Functions of the foreign exchange market
• Currency conversion
• Reduction of foreign exchange risk
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Australian importer purchase of
computers (purchase price: US$1400
FOB)
1A$ =
Customs value – FOB price
Customs duty @ 5% x $2000 100 100 Int’l transport & insurance 100 100 Value of taxable importation
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Reduction of FX risk
• Spot exchange rates
• Forward exchange rates
• Currency swaps
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Spot transactions
• Spot transaction = the purchase of FX with
delivery and payment (referred to as
settlement on the following business day.
• Foreign exchange traders always quote a bid (buy) and offer (sell) rate.
• The spread = difference between the bid
and offer rates and is the margin on which the trader earns a profit.
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Market quotations
• Dealers always ‘buy low’ and ‘sell high’.
• Selling rates and buying rates are always from the perspective of the dealer/bank.
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Forward transactions
• A forward rate = the price agreed on today
for purchase or sale of foreign exchange at
a future date.
• Usually agreed for less than 1 year.
• Premiums and discounts: forward
quotations are either at a
– premium: forward > spot
– discount: forward < spot
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Australian exporter to receive
Euro 1 million in 6 months
• Spot rate on contract date:
A$1 = Euro 0.60): estimated income = A$1.67m
• Payment made after 6 months from delivery.
• If A$ appreciates by 10% over 6 months, the
exporter will receive 10% less: A$1.51 (loss
A$160,000).
• The exporter will take a forward contract in order to protect the company income and ensure stable
planning of operations.
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Speculative operations
• 1991: Clifford Hatch, finance director of
British food and drink company Allied Lyons bet on a higher BP against the US$.
• Over the previous 3 years he had made
US$25 million for the company.
• Feb–April 1991 the BP depreciated from
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Currency swaps
• Foreign exchange swaps commit two
counterparties (e.g banks) to the exchange of two cash flows and involve the sale of one currency for another in the spot market with the simultaneous repurchase of the first currency in the forward
market.
• The difference between the spot and the forward rates, called the swap rate, is expressed in terms of points and it is fixed.
• Peak of 54% of the total traditional FX market in
2001 (down to about 50% in 2004).
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% share of ‘traditional’ foreign exchange
transactions in the total turnover, by type
0 10 20 30 40 50 60
FX Swaps
Source: adapted from BIS, Press release, 28 September 2004
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Economic theories of exchange rate determination
• Prices and exchange rates
– the law of one price
– the Purchasing Power Parity (PPP)
• Money supply and price inflation
• Interest rates and exchange rates
• Investor psychology and band wagon
effects
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Factors affecting the Australian
dollar exchange rate
• Relative interest rates
• Commodity prices and terms of trade
• Relative inflation rates
• The external account
• The role of the Central Bank
– fall of the Baht