Exchange Rates and Forex Markets: Comprehensive Notes - Chapter 6

EXCHANGE RATE

• The exchange rate is the value of one currency expressed in terms of another currency, such as £, $, €, and ¥.

FOREX EXCHANGE MARKET

• The Forex Exchange Market is an over-the-counter market where foreign currencies are traded.

• It is a place where traders buy and sell currencies.

• It is distinct from a financial market where currencies are borrowed and lent.

DAILY FX TRADING VOLUME

• In April 2016, trading in foreign exchange markets averaged $5.1 trillion$ per day.

• Global FX volume reached $5.3 trillion$ a day in 2013.

GLOBAL FOREIGN EXCHANGE MARKET TURNOVER

• Daily averages in April in US$ billion:

  • Spot Transactions: $2000 billion$

  • Outright Forwards

  • Foreign Exchange Swaps

  • Currency Swaps

  • Options and Other Products

GROSS INTERNATIONAL RESERVES (OCTOBER 2019)

• Preliminary data shows that the Philippines' gross international reserves (GIR) rose by US$0.12 billion$ to US$85.7 billion$ as of end-October 2019.

• The month-on-month increase in the GIR level reflects the National Government's (NG) foreign currency deposits and #BSP's income from its investments abroad.

• The end-Oct 2019 level of GIR serves as an ample external liquidity buffer and is equivalent to $7.5$ months' worth of imports of goods and payments of services and primary income.

FX MARKET VS OTHER MARKETS (Estimated Values)

• NY Stock Exchange: $28 Billion$

• Equities Market: $191 Billion$

• Futures Market: $437.4 Billion$

• FX Market: $5.3 Trillion$

ACTORS IN THE FOREX MARKET

• Forex brokers

• Remittance companies

• Investment banks and other banks

• Retail / individual speculation / hedge funds

• Central banks

SETTLEMENT OF TRANSACTIONS

• Fedwire

• CHAPS (Clearing House Automated Payment System)

• CHIPS (Clearing House Interbank Payment Service)

• SWIFT

INTERNATIONAL PAYMENTS WITH SWIFT

• Illustrates the process of wire transfer request from Company A in the UK to Company X in the US, involving London Bank, Detroit Bank, correspondent banks in New York, SWIFT payment order (MT103), and payment via CHIPS or FEDWIRE.

SWIFT CODE OF PHILIPPINE BANKS FOR WIRE TRANSFER OR REMITTANCE

• Lists Swift Codes (BIC) for various Philippine Banks:

  • Banco de Oro (BDO): BNORPHMM

  • Bank of the Phil. Islands (BPI): BOPIPHMM

  • Dev't Bank of the Phils. (DBP): DBPHPHMM

  • Landbank of the Philippines (LBP): TLBPPHMM

  • Metrobank (MBT): MBTCPHMM

  • Philippine National Bank (PNB): PNBMPHMM

CLEARING HOUSE INTERBANK PAYMENT SYSTEM (CHIPS)

• It is a United States private clearing house for large-value transactions.

• By 2015, it was settling well over US$1.5 trillion$ a day.

• Around $250,000$ interbank payments in cross border and domestic transactions.

• Foreign exchange and Euro dollar transactions are settled through CHIPS.

PHILIPPINE DEALING SYSTEM HOLDINGS CORP.

• Official service provider for the USD/PHP spot trading (which involve the purchase or sale of the US dollar for immediate delivery, i.e., within one day for US dollars).

• Through its subsidiaries, provides financial market infrastructure to operate trading platforms, manage sound settlement highways, and render essential securities services in the Philippines.

QUOTE

• A Quote is the last price at which a security or commodity traded.

• The most recent price to which a buyer and seller agreed and at which some amount of the asset was transacted.

• Quote specifically refers to the bid price or ask price of an instrument.

FIXED EXCHANGED RATE

• “Pegged Exchange Rate”

• “pegged” or linked to another currency or asset (often gold) to derive its value.

• Pegging one currency to another.

FIXED EXCHANGE RATES

• Fixed exchange rates are usually pegged to a more stable or globally prominent currency, such as the euro or the US dollar.

• For example, the Php is pegged to the USD at a central rate of $746.038$ Php per $100$ USD, with a ‘fluctuation band’ of +/- $2.25$ per cent.

  • This means that the USD to Php exchange rate must be with $2.25$% of the central rate,

  • cannot drop below $729.252$ Php per $100$ USD

  • or exceed more than $762.824$ per $100$ USD

COUNTRIES FOLLOWING A FIXED RATE SYSTEM

• Denmark

• Hong Kong

• Bahamas

• Saudi Arabia

FIXED EXCHANGE RATES: ADVANTAGES

• Avoids currency fluctuations

• Encourages firms to invest

• Incentive to keep inflation low

• Avoids devaluation

FIXED EXCHANGE RATES: DISADVANTAGES

• Conflict with other macro-objectives

• Less flexibility

• Current account imbalance

• May require higher interest rates

THE WORLD ONCE PEGGED

• Between 1870 and 1914, there was a global fixed exchange rate.

• Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces.

• This was known as the “gold standard”.

FLOATING EXCHANGED RATE

• Rate of a currency is determined by the market forces of demand and supply

• Currency's value is allowed to fluctuate in response to foreign-exchange market mechanisms

FLOATING EXCHANGE RATES: ADVANTAGES

• No need for international management of exchange rate

• No need for frequent central bank intervention

• No need for elaborate capital flow restrictions

• Greater insulation from other countries’ economic problems

• Avoiding Inflation

FLOATING EXCHANGE RATES: DISADVANTAGES

• Higher Volatility

• Use of scares resources to predict exchange rates

• Tendency to worsen existing problems

• Lack or low Investments such as Foreign direct investments

• Speculation

FORWARD VS. SPOT E.RATE

• Spot exchange rates

  • Apply to exchange currencies "on the spot"

• Forward exchange rates

  • Apply to exchange currencies on some future date at a prenegotiated exchange rate

• Forward and spot exchange rates, while not necessarily equal, do move closely together.

FORWARD EXCHANGE RATE

• Generally entered into by exporters and importers who are exposed to Forex fluctuations.

SPOT EXCHANGE RATE

• Exchange of currency from tourists at the airport, for example.

DUAL EXCHANGE RATE

• Currency has two official exchange rates, one pegged to another currency and the other floating

  • "non-essential" sectors are allowed to float

  • “essential”, such as food, is fixed

DIRECT & INDIRECT QUOTES

• Direct Quote: Number of Home currency units per unit of FX (e.g., USD/EUR 1.17)

• Indirect Quote: Number of FX units per of home currency (e.g., EUR/USD 0.87)

FOREX QUOTES

• The price of a currency pair (e.g., EUR/USD 1.23456)

BASE AND QUOTE CURRENCIES

• EUR(a) / USD(b) 1.23456(c)

  • (a) = Base currency (currency that is actually traded)

  • (b) = Quote/counter currency (currency used to determine the base currency value)

  • (c) = Quote (shows the amount of quote currency units needed to acquire one unit of the base)

FOREX DIRECT QUOTE DEFINITION

• From a US perspective: USD/GBP 0.66 means one US dollar can purchase 0.66 GB pounds.

FOREX INDIRECT QUOTE DEFINITION

• From a European perspective (EUR): USD/EUR 0.8765 means one US dollar is sold for 0.8765 euros.

EXAMPLE: DIRECT VS. INDIRECT QUOTE

• A European traveling to the US wants to purchase a laptop for $1,500$ USD.

  • Indirect quote (USD/EUR) is $0.8500$. Calculation: $1,500 \text{ USD} \times 0.8500 = 1,275 \text{ EUR}$.

  • Direct quote (EUR/USD) is $1.17647$. Calculation: $1,500 \text{ USD} / 1.17647 = 1,275 \text{ EUR}$.

BID & ASK PRICE

• Buying rate for the bank/trader: BID PRICE (e.g., USD/EUR 1.1681)

• Selling rate for the bank/trader: ASK PRICE (e.g., USD/EUR 1.1685)

• Example: USD/EUR 1.1681-1.1685

BID-ASK SPREAD

• Spread = Ask - Bid

• Example: EURUSD 1.1013/1.1015

EMERALD MONEY CHANGER (Example)

• Lists "We Buy" and "We Sell" rates for various currencies, including US Dollar, Thailand Baht, Euro, Hong Kong Dollar, Australian Dollar, Taiwan NT, UK Sterling Pound, Philippines Peso, Japan Yen, Indian Rupees, Swiss Franc, New Zealand Dollar, China Yuan, Indonesia IDR, Vietnam Dong, Malaysian Ringgit, Korea Won, Canada Dollar, Denmark, UAE Dirham, and Saudi Rial.

CROSS CURRENCY RATE

• A cross rate is an exchange rate of two currencies expressed in a third different currency, such as the exchange rate between the euro and the yuan expressed in yen.

EXAMPLE: CROSS CURRENCY RATE

• A manufacturer in Germany wants to obtain certain automobile parts from a supplier in Australia. The supplier only accepts payment in Australian Dollars (AUD). Therefore, the German manufacturer will be compulsorily required to convert EUR to USD; then USD to AUD to close the contract. The amount payable to the Australian Supplier is AUD $350000$

CROSS CURRENCY RATE CALCULATION

• The following quotes are quoted by the exchange.

  • EUR/USD 1.1670-1.1674

  • USD/AUD 1.3561-1.3570

  • \frac{EUR}{AUD} = \frac{EUR}{USD} \times \frac{USD}{AUD}

• simple multiplication of (bidbid)- (askask) gives the required cross rate = (1.16701.3561) -(1.16741.3570) = 1.5826-1.5841

• Therefore, the amount payable to the bank to obtain AUD 350,000 is (350,000/1.5841) EUR $220,945$.

FACTORS AFFECTING EXCHANGE RATES

• Inflation

• Interest Rate

• Current Account

• Terms of Trade

• Public Debts

• Political Stability & Econ Performance

CURRENCY APPRECIATION AND DEPRECIATION

• Depreciation/devaluation: decrease in the value of currency – exchange rate becomes weaker

• Appreciation: Increase in the value of currency – exchange rate becomes stronger

DEVALUATION / DEPRECIATION

• Winners:

  • Exporters

  • Domestic tourist industry

  • Workers gaining jobs in export industry

  • Economic growth might increase

  • Current account deficit should improve

• Losers:

  • 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

SITUATIONS AFFECTING THE D AND S USD - YEN

• US Tourist love JAPAN

• U.S . Government cuts income Taxes

• Higher INFLATION in Japan

• Higher INTEREST rates in Japan

• Japan places Tariffs on US Imports

• U.S> has Huge Recession

• APPRECIATION AND DEPRECIATION / SUPPLY AND DEMAND OF CURRENCIES

SITUATIONS AFFECTING THE D AND S USD - PESO (PHP)

• CITIBANK doing business in our country.

• BDO branch in Honkong

SITUATIONS AFFECTING THE D AND S - USD - PESO (PHP)

• US Citizens opened account in Col Financial (Stock Brokerage Company) and bought stocks from JFC, SMC, and Double Dragon

• YEN, HKD, SGD - PESO (PHP)

• Individual and firms from neighboring Asian countries opened account to our local banks like BDO, BPI, MBTC. There’s a high Interest rates offered by these banks.

SITUATIONS AFFECTING THE D AND S YEN - PESO (PHP)

• Philippine’s prices went up from 4% to 5.2% this month.

• Export products of Philippines is exporting products to Japan

• USD - PESO (PHP)