foreignexchangemarket-100825001951-phpapp01

7/28/2019 foreignexchangemarket-100825001951-phpapp01

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Presentation on

Wasim Yousuf,MIB 3rd Sem.,Bangalore City College.


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WHATIS FOREX? The FOREX is the worlds biggest financial market.

The FOREX or FOReign EXchange is the planetsbiggest most liquid financial marketplace handsdown.

Foreign exchange refers to money denominated

in the currency of another nation or group ofnations. Any person who exchanges moneydenominated in his own nations currency for

money denominated in another nations currencyacquires foreign exchange.


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WHATIS FOREX? (CONTD.) Foreign exchange can be cash, funds available on credit

cards and debit cards, travelers checks, bank deposits, or

other short-term claims. It is still foreign exchange if it is ashort-term negotiable financial claim denominated in acurrency other than the U.S. dollar. Sam Cross The

Federal Reserve Bank

The Foreign Exchange is made up of anyone who exchangesthe currency of one country for that of another.

The FOriegn EXchange does not have a centralizedexchange like the stock market in New York or thecommodities markets with centralized exchanges in cities likeNew York and Chicago.


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WHYDOFLUCTUATIONSOCCURIN FOREX? There are many reasons but the most influential

are:

General condition of a countrys economy and economic

influences like interest rates and inflation.

Political Factors

Trade Balance

Purchase Power Parity

Social Factors

Government and central bank policies and policychanges


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CURRENCYTRADING VS STOCK TRADING Many find trading currency much more attractive

than trading stocks for the following reasons::

Focused Attention

When you trade stocks, there are literally tens of thousands of companies to

choose from when trying to decide which ones to invest in. That is a lot ofinformation to assimilate and keep track of. With the Foreign Exchange thenumber of choices is dramatically reduced making it much easier toconcentrate on trading. While many countries are traded, there are five main

players in this global arena... The United States (USD)

The European Union (EURO)

Great Britain (GBP)

Japan (JPY)

Switzerland (CHF)


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CURRENCYTRADING VS STOCK TRADING:(CONTD.)LIQUIDITY

Because FOREX is literally the biggest "market" onearth, whether you are entering or exiting, getting yourorder filled is almost instantaneous which is not alwaysthe case with stocks.

PROFIT POTENTIALYou can open a currency trading account for less than$500 but the profit potential is greater than stocks, withFOREX you can profit regardless of whether or not thevalue of a currency is rising or falling.


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CURRENCYTRADING VS STOCK TRADING:(CONTD.)CONVENIENT

The FOReign EXchange is open for business 24 hours aday, 5 days a week offering trading opportunities foreven the busiest people.

AMPLE TRADING OPPORTUNITIESBecause the currency process are always fluctuating upand down, there are plenty of trading opportunities.


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CURRENCYTRADING VS STOCK TRADING:(CONTD.)FREE TRADING AIDS -

There are plenty of free trading resources for anyonethat wants to trade currency. Check out the resourcessection of this site to learn more.

PRACTICE ACCOUNTYou can open a practice account with most brokers thatallow you to "play" with cyber cash until you are ready totrade real funds.


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NOMINAL VS. REAL EXCHANGE RATES Nominal Exchange Rates are value of one currency

in terms of another.

They do not, however, measure purchasing power,or Real Exchange Rate.

Example:

Suppose you can exchange $1 for 1818 Italian lira (L).

Though L1818 seems a large number, but in Rome ahamburger may cost L4500.

In other words, purchasing power of lira is very less ascompared to that of dollar.


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NOMINAL VS. REAL EXCHANGE RATES (CONTD.) Let a McDonald burger cost $2.56 in N.Y, U.S. and

L4500 in Rome, Italy.

$1 buys L1818 on foreign-exchange markets.

We can find real exchange rate by comparing thecost of burgers in dollar terms.

Let

EX = nominal exchange rate in foreign currency perdollar.

Pf= foreign currency price of goods in foreign country.

P = domestic-currency price of domestic goods.

EXr= real exchange rate.


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NOMINAL VS. REAL EXCHANGE RATES (CONTD.)

EXr = 1.03 Italian

Thus, $2.56 will buy 1 McDonald burger in U.S. but1.03 McDonald burger in Italy.


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NOMINAL VS. REAL EXCHANGE RATES (CONTD.) Countries produce many different goods.

Real Exchange Rate computed from price indexes,which compare price of basket of goods in onecountry with price of it in another.

The relationship between nominal and realexchange rates depends on rates of inflation in twocountries.

We can calculate % change in real exchange rateas % change in numerator of previous equationminus the % change in denominator.


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NOMINAL VS. REAL EXCHANGE RATES (CONTD.) The equation shows % change in nominal

exchange rate has two parts:

% change in real exchange rate.

difference in foreign and domestic inflation rate.

If exchange rate rises:

rise in real exchange rate.

or higher foreign inflation rate, or maybe both.

If exchange rate falls:

fall in real exchange rate.

or higher domestic inflation rate, or maybe both.


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NOMINAL VS. REAL EXCHANGE RATES (CONTD.) Suppose Peynolds and Barker are companies in

two countries whose currencies are crown androyal.

Peynolds makes ball pens sold at 2 crown each.

Barker makes high-quality ink pens sold at 10royals each.

Real exchange rate between Peynolds and Barkerpens is 10 ball pens per ink pen.

What is the nominal Exchange rate?


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FOREIGN EXCHANGE MARKETS From perspective of individual consumers or

investors, exchange rates can be used to convertone currency into another.

International currencies are traded in foreign-

exchange-markets around the world. Market forces determine the exchange rate that

prevails for consumers and investors.

Exchange rates affect the cost of acquiring foreignfinancial assets or foreign goods and services.

Major participants are importers and exporters,banks, investment portfolio managers, and centralbanks.


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FOREIGN EXCHANGE MARKETS (CONTD.) The worldwide volume of foreign exchange trading

is enormous, and it has ballooned in recent years.

New technologies, such as Internet links, are usedamong the major foreign exchange trading centres(London, New York, Tokyo, Frankfurt, andSingapore).

The integration of financial centres implies thatthere can be no significant arbitrage.

The process of buying a currency cheap and selling itdear.


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FOREIGN EXCHANGE MARKETS (CONTD.) Two types of transactions take place in foreign

exchange markets.

1) Spot Market Transactions: Currencies or bank deposits are exchanged

immediately (two day settlement period). Spot rate is the price quote at which you can buy

immediately.

2) Forward Transactions: Currencies or bank deposits are exchanged at a set

date in the future. Investors sign a contract for a given quantity of

currency and exchange rate.

At future date, actual exchange takes place at rateknown as forward rate.


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DETERMINING LONG RUN EXCHANGE RATES We will look at four key factors that account for

long-run trends in the supply of and demand forcurrencies in the foreign exchange markets:

o Price level differences.

o Productivity differences.

o Preference for domestic or foreign goods.

o Trade barriers


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DETERMINING LONG RUN EXCHANGERATES: PRICE LEVEL DIFFERENCES When price levels rise in U.K. relative to price levels

in U.S., then U.K. goods or financial assets becomemore costly as compared to similar U.S. goods orfinancial assets.

In such case where U.K. experiences higherinflation rate, pound is less useful as store of valuethan dollar.

All else being equal, relative increase in price levelslead to depreciation of domestic currency.

Example: In late 1970s excess growth of U.K.s price levels over

U.S. price levels lead pound to depreciate againstdollar.


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DETERMINING LONG RUN EXCHANGERATES: PRODUCTIVITY DIFFERENCES Productivity growth measures the increase in output

level of a country for a given input level.

Higher productivity leads to cheaper production ofdomestic goods than foreign goods.

Hence domestic goods can be supplied at lower pricesthan foreign goods, leading to higher demand.

This higher demand for domestic goods leads to higherdemand for domestic currency.

Thus higher productivity leads to appreciation of

domestic currency. Example:

In late 1970s and early 1980s U.S. productivity level washigher than U.K. leading to appreciation of dollar againstpound.


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DETERMINING LONG RUN EXCHANGE RATES:PREFERENCE FOR DOMESTIC OR FOREIGN GOODS. If U.S. consumers prefer British-made goods, they

will demand more pounds to buy these goods.

It will put upward pressure on pound and depreciatethe dollar.

Example:

In mid 1980s U.S. consumers in second half of decade

They preferred U.K. goods leading to depreciation ofdollar.


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DETERMINING LONG RUN EXCHANGE RATES:TRADE BARRIERS Countries do not always allow goods to be traded

freely with no market intervention.

Example of trade barriers are quotas and tariffs.

They increase demand for domestic currency,leading to higher exchange rates in the long run forthe country imposing these barriers.

Example:

Suppose U.S. imposes tariff on U.K. leather goods, thiswill lead to higher price of the U.K. leather goods thanU.S. made leather goods.

There will be higher demand for domestic U.S. madeleather goods leading to higher dollar demand.


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LAWOF ONE PRICEAND THE PURCHASING POWERPARITYTHEORY The Law Of One Price states that identical goods

should be sold at identical prices.

Profit opportunities should ensure that its price issame.

Lets start with an example: Suppose a yard of cloth produced by manufacturers in

U.S. sells for $10

Same type of cloth produced by British manufacturers inU.K. sells for 5 pounds.

Law of one price says that exchange rate should be 5pound per 10 dollar or 0.5 pound/dollar.

Lets consider two cases if starting exchange rate is notwhat is supposed to be.


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LAWOF ONE PRICEAND THE PURCHASING POWERPARITYTHEORY If current exchange rate is 0.25 pound /dollar.

Then U.S. cloth will be cheaper as compared to theU.K. cloth.

Consumers would demand dollars for purchasingU.S. cloth.

This will lead to appreciation of dollar till exchangerate reaches 0.50 pound/dollar.


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LAWOF ONE PRICEAND THE PURCHASING POWERPARITYTHEORY If current exchange rate is 0.75 pound /dollar.

Then U.K. cloth will be cheaper as compared to theU.S. cloth.

Consumers would demand dollars for purchasingU.K. cloth.

This will lead to depreciation of dollar till exchangerate reaches 0.50 pound/dollar.


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LAWOF ONE PRICEAND THE PURCHASING POWERPARITYTHEORY When we extend law of one price from one good to

basket of goods, it becomes Purchasing PowerParity theory of exchange rate determination.

The Purchasing Power Parity (PPP) theory is based

on the assumption that real exchange rates arefixed.

Thus it means that differences in the inflation rate inthe two countries causes changes in nominalexchange rate between two countries.

It states that whenever a countrys price level isexpected to fall relative to other countrys pricelevel, its currency should appreciate relative toothercountrys currency.


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LAWOF ONE PRICEAND THE PURCHASING POWERPARITYTHEORY Movements in exchange rates not completely

consistent with PPP theory:

For differentiated products, law of one price does nothold, e.g. Kodak and Sony camera.

Not all goods and services (e.g. haircut, sandwich) areinternationally traded.

Significant differences in prices of non-traded goods andservices are not completely reflected in exchange rates.

The assumption of constant real exchange rate is notreasonable. There may be shifts in preferences fordomestic or foreign goods and trade barriers.


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EXPECTED RETURNSON DOMESTICAND FOREIGNASSETS Suppose you want to invest $1000 for one year.

You have choice between U.S. Treasury bill or aJapanese government bond.

U.S. instrument pays you interest and principal in

dollars with nominal interest rate of 5% per year. Japanese instrument pays you interest and

principal in yen and carries nominal interest rate of5% per year.

You should invest in one which will give you higherreturn.

To compare the returns you should compare theirreturns in dollar terms.


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EXPECTED RETURNSON DOMESTICAND FOREIGN ASSETS you invest in U.S. Treasury bill, you will receive an

interest return of $50, so your investment will beworth $1050 after one year.

If you want to calculate the expected return fromthe Japanese bond you must convert it into yen andthen a year from now you must convert the interestand principal from yen into dollars.

Then you can compare it with the return from U.S.Treasury bill.


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EXPECTED RETURNSON DOMESTICAND FOREIGN ASSETS Suppose current nominal exchange rate is 100

yen/dollar.

You expect the exchange rate will rise by 5% in thenext year, thus the expected future nominal

exchange rate EXe will be 100*1.05 = 105yen/dollar.

Now when you convert $1000 into yen you have aninvestment of 100000 yen.

After receiving and interest rate of 5%, yourinvestment is worth 105000 yen after a year.

At that time expected exchange rate EXe is 105yen/dollar.


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EXPECTED RETURNSON DOMESTICAND FOREIGN ASSETS Thus the expected value of your investment in

dollar terms will be 105000 yen/105 = $1000. !!!

Hence even though Japanese bond pays you thesame stated interest rate as the U.S. Treasury bill,but it carries a lower expected return: $0 instead of$50.


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EXPECTED RETURNSON DOMESTICAND FOREIGN ASSETS

$1 Investment

i Earns Interest i

(1 + i) Yielding total $(1 + i)


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$1 Exchanged for foreign currency.

EX

Value of investment in foreigncurrency.

if Earns foreign interest rate.

EX(1 + if) Yielding this total value


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EX(1 + if) Value of investment.

EX(1 + if)/EXe

Convert to domesticcurrency.

1 + if-EXe/EX

Yielding approximately


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INTEREST RATE PARITY Nominal Interest Rate Parity Condition:

When domestic and foreign assets have identical risks,liquidity and information characteristics, their nominalreturns (measured in same currency) must be identical.

Thus any difference between the nominal interest rateson U.S. assets and Japanese assets reflect currencyappreciation and depreciation.

This condition states:

i = if- EX

e/EX

When domestic interest rate is higher than theforeign interest rate, the domestic currencydepreciates.


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THANK YOU!WASIMYOUSUF

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