3772 international finance 2011 weehuyjjujk # 2

8/4/2019 3772 International Finance 2011 Weehuyjjujk # 2

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Course Instructor: OLUYELE AKIN.AKINKUGBEOffice: X 108E-mail: [email protected]: Tuesdays 17:45 18:45

Thursdays 17:45 18:45

04/19/12ECO 316 -International Finance1

DEPARTMENT OF ECONOMICSCEIF3772 (International Finance)


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ore gn xc ange orex ,Foreign Exchange Rates, and

Foreign Exchange Markets

04/19/12ECO 316 -International Finance

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Most obvious difference between Domestic andInternational Transactions and MonetaryRelationsPresence of a single currency unit in one and a

multiplicity in the other;

Todays world and the problem of transferringpurchasing power internationallyHow are payments made when different currencies are

concerned?

Instruments devised for this purpose iscollectively known as foreign exchangeMeans of making payments across national

currency boundariesBank deposits denominated in a foreign currencyForeign currency itself (coins, notes, traveler's cheques,

etc.)Bank Draft, electronic transfers, bills of exchangeShort term claim on foreigners expressed in foreign

currencies.


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Introduction


Foreign exchange is bought and sold inorganized markets through dealers

Purchases and sales are made at specifiedprices known as rates of exchange

Foreign Exchange Market:Organizational/institutional framework throughwhich individuals, firms and banks buy and sellforeign currencies or forex.

Forex markets for all currencies comprises alllocations where the currencies can be bought orsold; can be exchanged for other currencies(Paris, London, Milan, New York, Tokyo,

Frankfurt, Amsterdam, Johannesburg,WindHoek, Lusaka, Dar es Salaam, Harare, etc).Forex markets are in constant contact linkedtogether by telecommunications network(Tokyo-London-New York), thus forming a single

international foreign exchange market.


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Introduction


Permit the conversion and transfer of

funds/purchasing power between nations(or from one currency to another), in anefficient manner electronic transfer,internet, etc.;

Facilitates the implementation ofcontractual arrangements for extension ofcredits and subsequent payment for theobligations involved;

Provide facilities for hedging andspeculation;


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Exchange

Why do individuals, firms, and Banks want

to exchange one national currency foranother DemandTourists visit another country and need to

exchange their national currency for the

currency of country visited;Domestic firms want to import from other

nations;Individuals want to invest abroad, etc

Supply Foreign tourists expenditures in the nation

visited;

Export Earnings;Receivin orei n Investments etc.



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MarketFour Levels of participants can be identified in the

Foreign Exchange Market:

At the Bottom (first level) are the traditional users offorex: tourists, importers, exporters, investors, etc;who constitute the immediate users or suppliers offoreign currencies;

Next (second Level), are commercial banks (forexbureau), which act as clearinghouses between usersand earners of foreign exchange;

At the third level are foreign exchange brokers,through whom the nations commercial banks even

out their forex inflows and outflows among themselves(interbankor wholesale market);

At the 4th and highest level is the nations centralbank, which acts as the seller or buyer of last resort,

when the nations total forex earnings and 04/19/12ECO 316 -International Finance

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Exchange RatesPrice of one currency in terms of another; it

provides the link/bridge that connects differentnational currencies making international costsand price comparisons possible;

Can be defined as the number of units of thedomestic currency that can purchase 1 unit of aforeign currency;

Assume there are only 2 economies, Namibia

and the UK, with the N$ as the domesticcurrency and British pound (GBP or ) as theforeign currency. The exchange rate betweenthe N$ and (R) is equal to the number of N$

needed to purchase one . That is, R = N$/ . IfR = N$/ is 10.8; this means that 10.8 Namibian04/19/12ECO 316 -International Finance7


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Exchange Market

Under the flexible exchange rate system thatthe world operates today, exchange rates are

determined by the forces of demand andsupply in the forex market just like the priceof any other commodity.


R=N$/

Million of /day

D

S

10.8

200

E

S

D

E

E


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As shown in the diagram, the vertical axismeasures N$ price of the GBP, or the exchangerate R=N$/, and the horizontal axis measures the

quantity of GBP. The market demand and supplycurves for GBP intersect at point E, defining theequilibrium exchange rate of R = 10.8; at whichpoint, the quantity of GBP demanded and supplied

are equal at GBP200 million per day. At a higherexchange rate, the quantity of GBP suppliedexceeds the qty demanded; the exchange ratefalls gradually toward the equilibrium rate. At an

exchange rate lower than R=10.8; the quantity ofGBP demanded exceeds supply, the exchange ratewill be bid up toward equilibrium.If the exchange rate were not allowed to rise or fall to

its equilibrium (as under the fixed exchange rate04/19/12ECO 316 -International Finance9


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Appreciation

Suppose the Namibian Demand curve for GBP shiftsup (increased taste for UK goods), and intersects the

supply curve for GBP at E; the equilibrium exchangerate would be R=12.5, and the equilibrium quantityof GBP would be 300 million per day. The NamibianDollar is then said to have depreciated, since it now

requires N$12.5 (instead of 10.8) to purchase oneGBP. A home currency Depreciation or foreigncurrency appreciation thus refers to an increase inthe domestic price of the foreign currency, or an

increase in the number of units of domestic currencyrequired to purchase 1 unit of the foreign currency.The home currency synonymously becomes less

valuable with a depreciation. On the other hand,home currency appreciation or foreign currencydepreciation refers to a decline in the domestic04/19/12ECO 316 -International Finance10


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The Reciprocal PrincipleThe Exchange rate could also be defined as the

foreign currency price of a unit of the domesticcurrency. This is the inverse or reciprocal , ofour previous definition. This then implies thatthe GBP price of 1 unit of the N$ would be 1/R

= 1/10.8 (=0.092592593). That is, it wouldtake 0.093 unit of the GBP to purchase 1 unitof the N$. Sometime, you come across this inthe dailies or other publications, no cause for

alarm, just reciprocal matters.So far, we have talked about only 2 currencies

and 1 exchange rate between the pair. Inreality, there are numerous currencies and

exchange rates US$, Euro, Yen, Yuan, N$,04/19/12ECO 316 -International Finance11


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Cross Exchange RatesThe currency exchange rate between two

currencies, both of which are not the official

currencies of the country in which the exchangerate quote is given in.

For example, if an exchange rate between theEuro and the Japanese Yen was quoted in a

Namibian newspaper, this would be considered across rate in this context, because neither theeuro or the yen is the standard currency ofNambia

Once the exchange rates between each of a pairof currencies with respect to the dollar isestablished (assuming here that the US$ is thevehicle/base currency), then the exchange rate

between the two currencies themselves, calledECO 316 -International Finance12


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For example, if the exchange rate (R) were

2.0 between the US$ and the GBP, and 1.25

between the US$ and the Euro, then theexchange rate between the Euro and thePound would be 1.60 (i.e, it takes 1.6 topurchase 1). That is:

R = / = US$ value of the /US$ value of the

= 2/1.25 = 1.60

If the Exchange rate between the Namibiandollar and currency a is given as R$/a; andthe rate between the dollar and currency bis R$/b; then the cross rate between a andb is given as:

Ra/b = (R$/a)/(R$/b)04/19/12ECO 316 -International Finance13


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Table


T a b le 1 :K e y C r o ss R a t e s L a te N e w Y o r k T r a d in g F r id ay, M ar c h 3 , 200 6

U S

D o l l a r

E u ro P o u n d S F ran c P eso Y en C an D ir

C an ad a 1 .1 3 91 1 .3 6 6 1 1 .9 9 0 8 0 .8 7 4 7 0 .1 0 7 3 8 0 .0 0 9 7 5 -Jap an 1 1 6 .39 1 4 0 .1 0 2 0 4 .1 6 8 9 .7 0 0 1 1 .0 1 1 - 1 0 2 .5 4 9

M ex ico 1 0 .5 69 7 1 2 .7 2 2 8 1 8 .5 4 0 8 .1 4 6 1 - 0 .0 9 0 8 1 9 .3 1 3 0

S w itz e rla 1 .2 9 75 1 .5 6 1 8 2 .2 7 6 0 - 0 .1 2 2 7 6 0 .1 1 1 5 1 .1 4 3 2

U K 0 .5 7 01 0 0 .6 8 6 2 - 0 .4 3 9 4 0 .0 5 3 9 4 0 .0 0 4 9 0 0 .0 5 0 2 3 1

E u ro 0 .8 3 08 0 - 1 .4 5 7 3 0 .6 4 0 2 8 0 .0 7 8 6 0 0 .0 0 7 1 4 0 .7 3 1 9 9U S - 1 .2 0 3 7 1 .7 5 4 1 0 .7 7 0 7 0 0 .9 4 6 1 0 .0 0 8 5 9 0 .8 8 1 1 0So urce : R epr in ted b y pe rm ission o f t he W al l S t r ee t Journa l, 2 0 0 6 , D o w J o n e s & C o , I n c .


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Types of Exchange RatesEffective Exchange Rate

Real Exchange Rates

Real Effective Exchange Rates (REER)

Nominal Effective Exchange Rates (NEER)

All of the above are alternative ways of looking

at the exchange rate, such that importantfactors that may taken into consideration inexchange rate measures. For instance, wemay need information about the overall

strength of the domestic currency with respectto all of the home countrys trading partners;we may want to examine the real cost ofacquiring foreign goods and services in a

world of ever changing prices etc. All of these04/19/12ECO 316 -International Finance15


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Effective exchange Rates: Over time, a

currency can depreciate with respect to somecurrencies and appreciate against others.Given this, it is important to compute theeffective exchange rate. This is the

weighted average of the exchange ratesbetween the domestic currency and thenations most important trade partners, withthe weights given by the relative importance

of the nations trade with each of the tradepartners.

Real Exchange Rates (RER): This is thenominal exchange rate, deflated by relative

price indices. It enables us to account for04/19/12ECO 316 -International Finance16


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Using the real exchange rate, we are able tofactor into the exchange rate the fact that

prices of good and services are constantlychanging in either the home country or in thepartner country, (or both).RER2010 = R/$ X (Namibian Price Index2010/British Price

Index 2010)

RER = R x (Id/If)

RER enables us to then measure the competitiveness of anations goods in international markets.

The real effective exchange rate (REER), shows aneffective or trade-weighted exchange rate based on realexchange rates instead of on nominal rates. Exchangerate indices are calculated using real exchange rates; the

indexes are then weighted by the trade importance ofrespective trade partners.



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Exchange Rates

As we said earlier, the forex market consists of

many different markets and institutions. Yet, atany given point in time, all markets tend togenerate the same exchange rate for a givencurrency, regardless of geographical location.

This is because ofarbitrage. This refers to thepurchase of a currency in the monetary centerwhere it is cheaper, for immediate resale in themonetary center where it is more expensive, in

order to make a profit. As arbitrage continues,the exchange rate between the two currenciestends to be equalized in the two monetarycenters; or until they differ only by the

transaction costs involved in arbitraging.Because currenc are bou ht are sold04/19/12ECO 316 -International Finance18


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Example: Dollar price of Euro was $0.99 in NY

and $1.01 in Frankfurt

Note: When only two currencies and twomonetary centers are involved in arbitrage, as

in the example above, we have two-pointarbitrage. When three currencies and threemonetary centers are involved, we havetriangular, or three-point arbitrage. Even

though, triangular arbitrage is not verycommon, it operates in exactly the samemanner to ensure consistent , indirect, or cross,exchange rates between the three currencies in

the three monetary centers. 04/19/12ECO 316 -International Finance19


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MARKETSThe most common type of FOREX transaction

involves the payment and receipt of the foreign

exchange within two business days, after thetransaction is agreed upon. The two day period orvalue date gives enough time for the partiesinvolved to send instructions to debit and credit

the appropriate nbank accounts at home andabroad. This type of transaction is called thespot transaction, and the exchange rate atwhich the transaction takes place is called the

SPOT RATE.This implies that our discussion of the forex market so far has

focused on this type of transaction. Daily quotations of thecurrencies of many countries in major newspapers involve thistype of rates and transactions; you may also get this by

contacting many banks and financial exchange centers. 04/19/12ECO 316 -International Finance20


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Besides spot transactions, there are also forwardtransactions this involves an agreement today

to buy or sell a specified amount of a foreigncurrency at a specified future date, at a rateagreed upon today (the forward rate). Thisimplies that in this case, delivery date of the

foreign currency is more than two days in thefuture. That is, FOREX agreement is made at thepresent time, but actual exchange of currenciesdoes not take place until the day the foreign

currency is needed.Example: I could enter into an agreement today topurcahse US$ 100 million, three months from today at arate of N$6.6 = US$1. Note that no currencies will be paidout at the time the contract is signed (but for the usual

10% security margin). After 3 months, I get the US$100million or N . million re ardless o what the s ot rate is



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The equilibrium forward rate is also determinedat the intersection of the market demand andsupply curves of foreign exchange for future

delivery. The demand for and supply of forwardforeign exchange arise in the course ofhedging,from FOREX speculation, and from coveredinterest arbitrage.

Note: The forward rate can be equal to, above,or below the corresponding spot rate.If the forward rate is below the present spot rate,

the foreign currency is said to be at a forward

discount (FD), with respect to the domesticcurrency. If the forward rate is above the presentspot rate, the foreign currency is said to be at aforward premium (FP).

FD and FP are usually expressed as percentages peryear from the corresponding spot rate and can be04/19/12ECO 316 -International Finance22


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FD or FP = (FR SR)/SR x 4 x 100Multiplication by 4 is to express the FD(-) or FP(+) on a yearly basis; by100 is to express in percentages.

Example (1) SR is N$7.00 = US$1, and three-month FRis N$6.75 = US$1

Example (2) SR is N$7.00 = US$1, and three-month FRis N$7.1975 = US$1

Compute the FD or FP as the case may be and explain the answers.

Currency SWAPS: A currency swap refers to a spot sale of acurrency, combined with a forward repurchase of the samecurrencyas part of a single transaction. For example; FNBreceives a N$100 million payment today, that it will need in three

months time. In the meantime, it wants to investment this sum inEuros. FNB will incur lower brokerage fees by swapping the N$100million for Euros with Frankfurts Deutshe Bank, as part of a singledeal/transaction, instead of selling N dollars for euros in the spotmarket today and at the same time repurchasing N dollars for

euros in the forward market for delivery in 3 monthsin twoseparate transactions The swap rate (expressed on yearly basis)04/19/12ECO 316 -International Finance23

3772 international finance 2011 weehuyjjujk # 2

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