Exchange Rates and Forex Markets
Chapter 6:Exchange Rates in International Business and Trade
Introduction
Exchange rates are the price of one currency in terms of another.
Example: 1.5 \text{ USD} = 1 \text{ GBP}
An exchange rate is the amount of domestic currency needed to obtain one unit of foreign currency.
Example: A Subway sandwich costs €3. The exchange rate is $1.17 per €1. To buy the sandwich, you need (1.17 \times 3) = $3.51.
The Foreign Exchange Market
A foreign exchange market is where currencies are bought and sold, distinct from financial markets where currencies are borrowed and lent.
The foreign exchange market (forex or currency market) is considered a perfectly competitive market.
Prices are widely known due to telecommunications.
Products (currencies) are homogeneous.
Millions of buyers and sellers participate daily.
It operates 24 hours a day, except weekends, globally.
Prices are updated constantly via telecommunications and the internet.
Profit margins are low, with profits made through high sales volume.
General Features
The foreign exchange market is an OTC (Over the Counter) market, with no physical meeting place.
It involves an informal network of banks and brokers in financial centers connected by telecommunications (telex, telephone, SWIFT).
The term refers to the wholesale segment where banks deal with each other.
Actors in the Foreign Exchange Market
Retail/Individuals: Buy currency, often at the retail level, from small traders who source from forex brokers.
Forex Brokers: Buy and sell currency to various actors, earning profits through service fees or the spread between buying and selling prices.
Central Banks: Buy and sell currency to influence exchange rates, though their power can be less than brokers.
Remittance Companies: Exchange money for foreign workers sending money home.
Investment Banks and Hedge Funds: Engage in forex trading, often for speculation, aiming to buy low and sell high.
Settlement of Transactions
Foreign exchange markets use advanced telecommunications for transmitting and settling transactions.
Banks use SWIFT and electronic clearing houses like CHIPS for communication and settlement.
SWIFT
SWIFT: Society for Worldwide Interbank Financial Telecommunications.
A cooperative society owned by about 250 banks in Europe and North America, registered in Brussels, Belgium.
A communications network for international financial market transactions, linking over 25,000 financial institutions globally with bank-identified codes.
Messages are transmitted via interconnected operating centers in Brussels, Amsterdam, and Culpeper, Virginia, with regional processors in each country.
Functions: Enables member banks to transact:
International payments.
Statements.
Other messages related to international banking.
Advantages:
Reliable method for sending and receiving messages globally.
Enhanced reliability and accuracy with built-in authentication.
Instantaneous message relay.
Access to a vast number of global banks for new cross-border initiatives.
Clear communication using structured formats for various banking transactions.
Promotes internal automation in local banks due to the requirement for structured formats.
CHIPS
CHIPS: Clearing House Interbank Payment System.
An electronic payment system owned by 12 private commercial banks forming the New York Clearing House Association.
Began operations in 1971 and has grown to be the world's largest payment system.
Settles foreign exchange and Euro dollar transactions.
Provides a mechanism for daily settlement of payments and receipts among member banks in New York, without physical exchange of funds.
Settlement occurs in two stages:
Clearance at CHIPS to determine the net position for each bank.
Transfer of fed funds (balances held at Federal Reserve Banks) for the net position.
CHIPS expedites reconciliation and reduces the number of entries passing through Fedwire.
CHAPS: Clearing House Automated Payment System, a similar arrangement in London.
Types of Exchange Rates
Fixed Exchange Rate
Also known as a pegged exchange rate, linked to another currency or asset (often gold) for its value.
Ensures exchange rate stability by linking to a stable currency.
Relatively well-protected against rapid inflation fluctuations.
Examples include Denmark, Hong Kong, Bahamas & Saudi Arabia.
Advantage: Attracts foreign investors due to stability.
Disadvantage: Requires maintaining large foreign exchange or gold reserves, making it expensive.
Flexible Exchange Rate (Floating)
Determined by market forces of demand and supply.
Does not derive value from any underlying asset.
Some economists prefer it as it absorbs shocks from global crises and automatically adjusts to equilibrium.
Central banks may intervene in extreme situations (recession or boom) to stabilize the currency (managed float).
Advantage: Self-sufficient mechanism with minimum dependence on government or international organizations; promotes efficiency and robustness.
Disadvantage: Prone to greater volatility, increasing risk for foreign investors.
Forward Rate
Determined by a forward contract, stipulating the purchase or sale of a foreign currency at a predetermined rate on a future date.
Used by exporters and importers exposed to Forex fluctuations.
Quoted at a premium or discount to the spot price.
Involves agreeing on contract terms today, with delivery and payment in the future.
Example: A Chinese electronic manufacturer sells 20 \text{ million} forward at $0.80 per yuan, obligated to deliver the dollars at that rate regardless of currency fluctuations.
Advantage: Eliminates uncertainty by freezing the exchange rate, providing a hedge against market movements.
Disadvantage: Possibility of default due to lack of exchange backing; rate freezing may be disadvantageous in some market conditions.
Spot Rate
The current exchange rate for a currency.
The rate at which a currency is converted for immediate execution of a foreign transaction.
Represents the day-to-day exchange rate, varying by a few basis points daily.
Involves purchase or sale of a commodity, security, or currency for immediate delivery and payment, typically two business days after the trade date.
Example: A wholesale company wanting immediate delivery of orange juice will pay the spot price.
Advantage: Straightforward rate without ambiguity, requiring no deep analysis.
Disadvantage: Can be misleading during economic crises, demand/supply imbalances, or transitional phases.
Dual Exchange Rate
Currency rate maintained separately by two values: one for foreign transactions and another for domestic transactions.
Typically adopted by countries transitioning from one system to another for a smooth changeover.
Allows a country to devalue its currency without causing high inflation.
Critics argue it's less efficient than straightforward devaluation and acts as a tariff on industries seen as luxuries.
Advantage: Governments can enforce separate rates for capital and current account transactions, controlling revenues and protecting domestic markets.
Disadvantage: May cause misallocation of resources, leading to black markets, arbitrage opportunities, and inflation.
Interpreting Currency Exchange Quotes
Direct & Indirect Quotes
Direct Currency Quote: Uses the domestic currency as the base.
Example (for an American): USD/EUR 1.17.
Indirect Currency Quote: Denotes the domestic currency as the quoted currency.
Example: EUR/USD 0.87 (a European gives up 0.87 Euros to acquire 1 USD).
Forex Quotes
Involve trading currency pairs (currencies from different countries).
The price of a currency pair is known as a quote.
Displayed as currency symbols with a price (e.g., EUR/USD 1.23456).
The first currency (EUR) is the base currency; the second (USD) is the quote currency.
Quotes explain the amount of quote currency units needed to purchase one unit of the base currency.
In the quotation EUR(a) / USD(b) 1.23456(c):
(a) is the base currency.
(b) is the quote currency.
(c) is the quote, showing the amount of quote currency units needed to acquire one unit of the base currency.
Forex Direct Quote
A foreign exchange price quotation easily understood, depending on geographical location and domestic currency.
Example (for someone from the USA): USD/GBP quote of 0.66 (one US dollar can purchase 0.66 GB pounds).
Shows how many foreign currency units could be bought for a single unit of the domestic currency.
Forex Indirect Quote
Shows the value of the domestic currency in a foreign one.