1 School of Banking and Finance Nguyen Thi Dieu Chi Assoc Prof ) Chapter 4 FUNDAMENTALS OF EXCHANGE RATE Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance 222 Main contents 11 Definitio[.]
Main contents Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Chapter FUNDAMENTALS OF EXCHANGE RATE Definition – Classifications – Exchange Rate Regimes Factors affecting to Exchange Rate Quotations of Exchange Rate Determination of Exchange Rate School of Banking and Finance Nguyen Thi Dieu Chi Assoc Prof.) 2 Definition of Exchange Rate Simple classification Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Fixed Exchange Rate: A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate A set price will be determined against a major world currency (usually the U.S dollar, but also other major currencies such as the euro, the yen or a basket of currencies) In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged Foreign Exchange Rate A foreign exchange rate is the price of one currency expressed in terms of another currency In this case, currency can be viewed as an asset and exchange rate as asset price A foreign exchange rate is the price of the domestic currency stated in terms of another currency A foreign exchange rate compares one currency with another to show their relative values Simple classification Simple classification Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Managed Floating Rate: The monetary authorities influences the Floating Exchanged Rates: a floating exchange rate is determined movements of exchange rate through active intervention in the forex market by the private market through supply and demand without specifying or committing to a preannounced path, A managed currency is an exchange rate that is basically floating in the foreign exchange markets but is subject to intervention from time to time by the monetary authorities, in order to resist fluctuations that they consider to be undesirable Normally the currency floats freely in the market - the value is determined by the forces of supply and demand for a given currency But the government and/or central bank of a country may decide to use intervention in the currency market as a way of manipulating its value to achieve given macroeconomic objectives A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services This in turn will generate more jobs, causing an auto-correction in the market A floating exchange rate is constantly changing Vietnam ? Exchange Rate Regimes Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Where is Vietnam Standing ? Exchange Rate Regimes - Fixed Exchange Rate - Floating Exchange Rate - Managed Floating Exchange Rate Floating Exchange Rate Fixed Exchange Rate Why ? Managed Floating Exchange Rate Fixed Exchange Rate Regime Fixed Exchange Rate Regime Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance In a fixed exchange rate regime, the domestic currency is tied to another foreign currency, mostly more widespread currencies such as the U.S dollar, the euro, the Pound Sterling or a basket of currencies In a fixed exchange rate system, the government (or the central bank acting on the government's behalf) intervenes in the foreign exchange market to ensure that the exchange rate stays close to a predetermined target Under this system, exchange rate stability is achieved but if the exchange rate is fixed at the wrong rate it may be at the expense of domestic economic stability Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance In a fixed exchange rate system, a rise in the exchange rate of the domestic currency with another foreign currency is called a devaluation This means that in order to buy unit of a given foreign currency more of the domestic currency is needed On the other hand, when the exchange rate falls it is termed as a revaluation These terms imply a deliberate decision on the part of the government to change the level of the exchange rate Fixed rates provide greater certainty for exporters and importers as there are no or limited exchange rate risks As businesses have the perfect knowledge that the price is fixed and therefore not going to change, it is relatively easier for them to plan ahead However, a fixed exchange rate regime may have a high administration cost A significant gap between the official rate and that determined by the market can promote black markets In a black market the bulk of foreign exchange transactions are carried out outside the banking system This may force government to draw down on reserves to meet its obligations and cause scarcity of foreign exchange 10 Managed Floating Exchange Rate Regime Floating Exchang Rate Regime Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Between the two extreme exchange rate regimes there is the In a floating exchange rate regime, the market’s demand for and supply of the currency determines the exchange rate There is no managed float (semi-fixed exchange rates) The managed floating exchange rate regime is the regime in pre-determined official target for the exchange rate set by the government Under a floating exchange rate regime, a rise in the exchange rate of the domestic currency with another foreign currency called a depreciation Besides, when less domestic currency is needed it is which the exchange rate is given a specific target and a central bank keeps the rate from deviating too far from a target band or value Under this regime, the exchange rate is the main target of economic policy-making (interest rates are set to meet the target) termed as an appreciation 11 12 Factors Affecting Foreign Exchange Rate Factors Affecting Foreign Exchange Rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Inflation Rates Changes in market inflation cause changes in currency exchange rates A country with a lower inflation rate than another's will see an appreciation in the value of its currency The prices of goods and services increase at a slower rate where the inflation is low A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates Interest Rates Changes in interest rate affect currency value and dollar exchange rate Forex rates, interest rates, and inflation are all correlated Increases in interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates 13 14 Factors Affecting Foreign Exchange Rate Factors Affecting Foreign Exchange Rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Country’s Current Account / Balance of Payments A country’s current account reflects balance of trade and earnings on foreign investment It consists of total number of transactions including its exports, imports, debt, etc A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation Balance of payments fluctuates exchange rate of its domestic currency Government Debt Government debt is public debt or national debt owned by the central government A country with government debt is less likely to acquire foreign capital, leading to inflation Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country As a result, a decrease in the value of its exchange rate will follow Terms of Trade Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value This results in an appreciation of exchange rate Political Stability & Performance A country's political state and economic performance can affect its currency strength A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency A country with sound financial and trade policy does not give any room for uncertainty in value of its currency But, a country prone to political confusions may see a depreciation in exchange rates 15 16 Factors Affecting Foreign Exchange Rate Quotations of Exchange Rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Recession When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate Speculation If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future As a result, the value of the currency will rise due to the increase in demand With this increase in currency value comes a rise in the exchange rate as well 17 Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance A pair of currencies in a quotation: - Commodity/Quote currency: The currency whose price is being quoted - Base/Term currency: The currency used to quote the commodity currency USD/EUR = 1.3450, or $ 1.3450/€, EUR = 1.3450 USD No of unit of commodity currency is always and that of term currency is change Bid/ask + dealer: buy by bid & sell by ask + customer: buy by ask sell — bid 18 Quotations of Exchange Rate Quotations of Exchange Rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance BID AND ASK RATES - Bid rate: is the price at which a dealer will buy the foreign currency (or the commodity currency) - Ask rate: is the price at which a dealer will sell the foreign currency (or the commodity currency) Note: Bid for one currency is ask for the opposite currency USD/GBP = 1.5670/1.5690 meaning: Buying GBP at $ 1.5670 and selling GBP for 1.5690 Or Buying GBP with USD equivalent to selling USD for GBP Ask price is always higher than bid, the dealers buy at bid and then sell for higher price and earn the difference A dealer could offer: A bid price of $1.3090 per € An ask price of $1.3092 per € While there are a variety of ways to quote the above, the bid-ask spread represents the dealer’s expected profit Ask Price – Bid Price Percent Spread = x 100 Ask Price $1.3092 – $1.3090 0.0153% = x 100 $1.3092 19 20 The Bid-Ask Spread The Bid-Ask Spread Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance American Terms quote these prices as 00–05 USD Bank Quotations Bid Ask Bid Ask Anyone trading $10 millions knows the “big figure.” Pounds 1.5400 1.5405 6491 6494 A dealer pricing pounds in terms of dollars would likely USD Bank Quotations American Terms Bid Ask Bid Ask Pounds 1.5400 1.5405 6491 6494 Notice that the reciprocal of the S($/£) bid is the S(£/$) ask European Terms đọc số £.6494 $1.00 Dealer $1,540 Customer £1,000 Customer sells pounds to dealer at direct bid £1.00 Dealer = always has number European Terms $1,000 Customer £649.40 $1.5400 Buy USD from dealer at indirect ask 5-21 21 5- 22 Currency Conversion with Bid-Ask Spreads Sample Problem Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance • A businessman has just completed transactions in Italy and England He is now holding €250,000 and £500,000 and wants to convert to U.S dollars sell at bid rate • His currency dealer provides this quotation: GBP/USD 0.6488 – 93 USD/EUR 1.4739 – 44 • What are his proceeds from conversion? He sells €250,000 at the dealer’s bid price:giá mua €250,000 x $1.4739 €1.00 He sells £500,000 at the dealer’s ask price: $1.00 giá bán £500,000 x £.6493 =$368,475 =$770,060.06 $1,138,535.06 5-24 23 24 Đồng tiền quy đứng trước Another Sample Problem Quotations of Exchange Rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance An Italian has just completed transactions in America and England He is now holding $100,000 and £500,000, and wants to convert both amounts to the euro His currency dealer provides this quotation: GBP/USD 0.6488 – 93 USD/EUR 1.3095 – 98 What are his proceeds from conversion? $770,060.06 = £500,000 x $1.00 £.6493 ($770,060.06 + $100,000) x €1.00 $1.3098 Two kinds of quotation of exchange rate * Direct quotation euro = 1.4212/1.4321 * Indirect quotation yết giá gián tiếp domestic currency = x foreign currency = €664,269.40 5- 25 26 Direct Quotation Indirect Quotation Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance unit of domestic currency = X unit of foreign currency unit of foregin currency = X unit of domestic currency Foreign currency is called Commodity currency An indirect quote is reverse, the price of domestic currency Domestic currency is called Term currency is terms of foreign currency A direct quote is when the commodity currency is foreign Domestic currency is commodity currency and equal unit currency and base currency in terms of domestic currency Foreign currency is term currency, and change depending on the domestic currency Ex: In Vietnam, VND/USD = 21.250/21.270 Ex: In Britain, USD/GBP = 1.5680/1.5690 Equivalent to GBP/USD = 1/1.5690; 1/5680 27 28 Determinate Exchange Rate: Cross Rate Simple cross rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Cross rate: Many currency pairs are inactively traded, their exchange rate determined through their relationship to a widely traded third currency Ex Cross rate without bid-ask spread USD/JPY = 125.12 USD/GBP = 0.8760 Ex Cross rate with bid – ask spread USD/VND = 21.250/21290 USD/JPY = 125.23/125.76 At which rate will you sell JPY for VND ? 29 Cross rate without bid-ask spread E(USD/VND) = x E(USD/HKD) = y Formula of cross rate without bid-ask spread E(HKD/VND) = 30 Complex cross rate Complex cross rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Case Cross rate of currencies at the ——base positions S(VND/USD) = (a,b) commodity S(JPY/USD) = (c,d) S(VND/JPY) = (x, y) Case Cross rate of currencies at the commodity ——— positions S(USD/EUR) = (a,b) base S(USD/GBP) = (c,d) S(EUR/GBP) = (x, y) Formula of this case: Formula: (x, y) = (c : b , d : a) (x, y) = (a : d , b : c) 31 32 Complex cross rate Cross Rates Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and that S($/£) = 2.00 (i.e., £1.00 = $2.00) What must the €/£ cross rate be? Case Cross rate of currencies at the opposite positions S(VND/USD) = (a,b) S(USD/GBP) = (c,d) $1.50 S(VND/GBP) = (x, y) €1.00 Formula: × £1.00 = $2.00 £0.75 €1.00 €1.00 = £0.75 Pay attention to your “currency algebra”! (x, y) = (a * c, b * d) 5- 33 34 £10,000 sell £ at bid $15,400 buy € at ask €11,763 €10,000 sell € at bid Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance $1.5400 €1.00 = €11,763 × €1.1763/£ £1.00 $1.3092 He has effectively sold £ at a €/£ bid price of €1.1763/£ £10,000 × buy £ at ask £8,495 Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Cross Rates with Bid-Ask Spreads Cross Rates with Bid-Ask Spreads USD Bank American Terms European Terms Quotations Bid Ask Bid Ask Pounds 1.5400 1.5405 6491 5073 Euros 1.3087 1.3092 7638 7641 €/£ €1.1763 £0.8501 To find the €/£ cross bid rate, consider a retail customer who: Starts with £10,000, sells £ for $, and buys €: $13,087 USD Bank Quotations American Terms Bid Ask European Terms Bid Ask Pounds 1.5400 1.5405 6491 5073 Euros 1.3087 1.3092 7638 7641 €/£ €1.1763 €1.1771 £0.8495 £0.8501 To find the €/£ cross ask rate, consider a retail customer who starts with €10,000, sells € for $, and buys £: $1.3087 £1.00 = £8,495 €1/£0.8495= €1.1771/£ €10,000 × × €1.00 $1.5405 He has effectively bought £ at a €/£ ask price of €1.1771/£ 5- 35 36 Cross Rates with Bid-Ask Spreads Methods to adjust exchange rate Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance indirect direct Bank Quotations American Terms Bid Ask Rediscount policy European Terms Bid Ask Open market policy £:$ $1.5400 $1.5405 £.6491 £.6494 Devaluation/Depreciation €:$ $1.3087 $1.3092 €.7638 €.7641 Appreciation €/£ €1.1763 €1.1771 £0.8495 £0.8501 Stabilization fund of exchange rate €1.1763 Recall that the reciprocal of the S(£/€) bid is the S(€/£) ask £1.00 He has bought £ at a €/£ ask price of €1.1771/£ Bid-ask quote would be €/£: 1.1763-71 = €1.00 £0.8501 37 38 Nguyen Thi Dieu Chi Assoc Prof – Course of International Finance Q&A 39 39