Foreign Exchange Rates and Currency Dynamics

Indirect Quote

• An indirect quote indicates the amount of foreign currency one can obtain for one unit of the base currency.

• For someone from a European country using EUR, a quote like USD/EUR 0.8765 means one USD can be exchanged for 0.8765 EUR.

• To calculate the value in domestic currency when traveling abroad and seeing an indirect quote, multiply the purchase amount by the indirect quote.

  • For instance, a European buying a $1,500 USD laptop with a USD/EUR quote of 0.8500 would pay: $1,500 \text{ USD} \times 0.8500 = 1,275 \text{ EUR}$

• This is the opposite of direct quotes, where division is needed.

  • Using a direct quote of EUR/USD 1.17647, the same $1,500 USD laptop would cost: $1,500 \text{ USD} / 1.17647 = 1,275 \text{ EUR}$

Bid & Ask Price

• Currency quotes are presented with a bid and ask price (e.g., USD/EUR 1.1681-1.1685).

• Bid Rate: The rate at which a bank buys a currency from you (e.g., USD/EUR 1.1681).

  • This is the buying rate for the bank.

• Ask Rate: The rate at which a bank sells a currency to you (e.g., USD/EUR 1.1685).

  • This is the selling rate for the bank.

• Example: EUR/USD = 1.3600/05 (or 1.3600/1.3605).

  • Bid: 1.3600

  • Ask: 1.3605

• Pip: The smallest unit of value in a forex currency quote.

  • In the example EUR/USD = 1.3600/1.3605, the difference between bid and ask is 5 pips.

• Spread: The difference between the bid and ask prices (e.g., 5 pips in the example above).

Cross Currency Rate

• A reserve currency (or anchor currency) is the currency in which most other currencies are expressed and held in large amounts by governments as Forex reserves (e.g., USD, EUR).

• A cross rate is a currency quote not expressed in terms of USD.

• Cross rates are used when transactions do not involve the USD.

  • For example, a German manufacturer needs to pay an Australian supplier in AUD.

• To calculate the EUR/AUD cross rate, the following quotes are used:

  • EUR/USD 1.1670-1.1674

  • USD/AUD 1.3561-1.3570

• The EUR/AUD rate is calculated by multiplying the bid and ask prices:

  • $(1.1670 \times 1.3561) - (1.1674 \times 1.3570) = 1.5826 - 1.5841$

• If the amount payable to the Australian supplier is AUD 350,000, the equivalent in EUR is calculated as:

  • $350,000 / 1.5841 = 220,945 \text{ EUR}$

Key Factors Affecting Foreign Exchange Rates

• The foreign exchange rate reflects a country's economic health and stability.

• The exchange rate is the rate at which one country's currency can be converted into another and fluctuates based on market forces.

1. Inflation Rates

• Changes in inflation rates impact currency exchange rates.

• A country with lower inflation tends to see its currency appreciate because goods and services prices increase at a slower rate.

2. Interest Rates

• Interest rates, forex rates, and inflation are correlated.

• Higher interest rates can cause a country's currency to appreciate because they attract foreign capital.

3. Country's Current Account / Balance of Payments

• A country's current account reflects its balance of trade and earnings on foreign investment.

• A current account deficit can cause currency depreciation.

4. Government Debt

• High government debt can lead to inflation and a decrease in the exchange rate.

• Foreign investors may sell bonds if they predict government debt within a country.

5. Terms of Trade

• Terms of trade is the ratio of export prices to import prices.

• Improved terms of trade lead to higher revenue and increased demand for the country's currency, resulting in appreciation.

6. Political Stability & Economic Performance

• Political stability attracts foreign investors, leading to increased foreign capital and currency appreciation.

7. Recession

• During a recession, interest rates tend to fall, decreasing the chances to acquire foreign capital and weakening the currency.

8. Speculation

• If a currency's value is expected to rise, demand increases, leading to an increase in its value and the exchange rate.

• To avoid fluctuations, using a locked-in exchange rate service is recommended.

Appreciation and Depreciation

• Appreciation and depreciation refer to currencies traded in foreign exchange markets without government interventions.

• In the absence of government interventions, exchange rates are determined by market participants buying and selling currencies.

• Depreciation/Devaluation: A fall in the value of the exchange rate, making the exchange rate weaker.

• Appreciation: An increase in the value of the exchange rate, making the exchange rate stronger.

• Example: Pound Sterling depreciating against the Dollar:

  • Previously, £1 = $2

  • Now, £1 = $1.75

  • This means buying goods from America becomes more expensive.

  • A $10 meal used to cost £5 ($10/2$), but now costs £5.71 ($10/1.75$).

• Effects of Depreciation:

  • Makes US imports into the UK more expensive, potentially reducing UK imports.

  • UK exports become more competitive.

• Winners of Devaluation/Depreciation:

  • Exporters.

  • Domestic tourist industry.

  • Workers gaining jobs in export industry.

  • Potential increase in economic growth.

  • Improvement of the current account deficit.

• Losers of Devaluation/Depreciation:

  • Consumers who buy imports.

  • Residents who holiday abroad.

  • Firms who buy imported raw materials.

  • Those on fixed incomes/wages who see inflation rise faster.

  • Foreign exporters/tourist industry.

• Summary of Depreciation:

  • Makes exports more competitive and imports more expensive.

  • Helps UK exporters and improves UK growth prospects but causes higher prices and inflation.

• Effects of Appreciation:

  • A higher value of sterling makes US imports cheaper for British consumers, but, UK exports become more expensive.

  • An appreciation in the exchange rate will tend to reduce aggregate demand (assuming demand is relatively elastic) Because exports will fall and imports increase.

  • An appreciation is likely to worsen the current account (assuming Marshall Lerner condition and demand is relatively elastic)

  • Import prices are lower.

  • Fall in aggregate demand

  • Firms have more incentives to cut costs.

• Reasons for Currency Appreciation:

  • Increased demand for that currency on world markets, and its value in the world market increases.

  • High exports increase the need for its currency.

  • Central bank increases interest rates.

  • Increased employment and per capita income increases demand for goods, services, and the currency itself.

  • High demand in the foreign exchange market.

  • Government borrowing or loosening of fiscal policy.

Foreign Exchange Market in Philippine Setting

• The Bangko Sentral ng Pilipinas (BSP) maintains a floating exchange rate system where exchange rates are determined by supply and demand.

• The BSP ensures orderly market conditions.

• Peso-dollar trading occurs through the Philippine Dealing System (PDS) among Bankers Association of the Philippines (BAP) member-banks and the BSP.

• The Philippine Dealing and Exchange Corp. (PDEX) is the official service provider for USD/PHP spot trading.

• Reuters is the exclusive distributor of all PDEX data.

• Commercial banks can engage in spot, outright forward, and swap transactions in Philippine pesos/US dollar and other third currency transactions.

• Interbank trading occurs among BAP member-banks and between these banks and the BSP.

• Payment-versus-Payment (PvP) system ensures the settlement of the US dollar and Philippine peso legs of the PDS transactions.

• The Philippine Payments and Settlements System (PhilPaSS) and the Philippine Domestic Dollar Transfer System (PDDTS) are linked for real-time gross settlements.

• The PDDTS allows online, real-time gross settlement of domestic interbank US dollar transfers without using correspondent banks in the US.

• The PDS has both on-line, real time and end-of-day batch netting transfer capabilities with final settlement on the same day.