7 1 reading 20 currency exchange rates pdf

LOS Economics • Topics in Demand and Supply Analysis • The Firm and Market Structures • Aggregate Output, Prices, And Economic Growth • Understanding Business Cycles • Monetary and Fiscal Policy • International Trade and Capital Flows • Currency Exchange Rates LOS LOS Define an exchange rate and distinguish between nominal and real exchange rates and spot and forward exchange rates An exchange rate is the price of one currency in relation to another • The exchange market (FOREX) is world’s largest financial market • The exchange rate formula: If the Chinese Yuan and South African Rand exchange rage is 1.93, that means: Chinese Yuan (CNY) 1.93 Base Currency = = South African Rand (ZAR) Price Currency In this example, you can buy ZAR with 1.93 CNY LOS LOS Define an exchange rate and distinguish between nominal and real exchange rates and spot and forward exchange rates • Real Exchange Rates i It is similar to the previous formula for spot exchange rates, but also incorporate varied price levels between two countries ii Because countries have different price levels (due to inflation), the rates will be affected differently • Forward Exchange Rates i Whereas spot exchange rates are quoted for exchanged currency right now, forward rates are for exchanges at a future date ii Rates are agreed upon today for an exchange that will take place at a specified date in the future LOS LOS Describe functions of and participants in the foreign exchange market • Firms that business in different currencies are exposed to fluctuations in relative values of exchange rates over time  Foreign exchange markets allow for hedging these exposures  They also allow for investors to take positions to take advantage of expected changes in rates over time • Foreign Exchange Market Participants: i Corporations: buying goods and services in different markets, allows for transactions in multiple currencies ii Real Money Accounts: Investments from mutual funds, insurance companies, and pension funds who are limited in how they can use derivatives iii Government: Many government agencies make foreign transactions iv Central Banks: Central banks use foreign exchange market transactions to influence domestic exchange rates LOS LOS Calculate and interpret the percentage change in a currency relative to another currency • Percentage change values (appreciation and depreciation) of currencies relative to one another is very dependent on which currency is the price currency and which one is the base currency • Example: ZAR/CNY rate increases from 1.6459 to 1.8356 1.8356 − = 11.5256% 1.6459  This represents an 11.5% appreciate in the Yuan against the Rand • If we calculate that as the depreciation of the Rand against the Yuan, however, we get: 1.8356 − = −10.3358% 1.6459  Therefore, the depreciation of the Rand against the Yuan is not equal to the appreciation of the Yuan against the Rand LOS LOS Calculate and interpret currency cross-rates Cross-currency rates allow you to interpret exchange rates for different currencies using multiple rates Example • The South African Rand and Russian Ruble exchange rate is 1.4876 • The Chinese Yuan and South African Rand Exchange rate is 1.6459 What is the Chinese Yuan and Russian Ruble exchange rate? Solution RUB ZAR RUB ZAR RUB ∗ = ∗ = ZAR CNY ZAR CNY CNY 1.4876 ∗ 1.6459 = 2.4484 LOS LOS Calculate and interpret currency cross-rates Remember that you can always “inverse” a currency by dividing by the currency • • If RUB CNY Then = 2.4484 CNY RUB = 𝐶𝑁𝑌 𝑅𝑈𝐵 = 2.4484 = 0.4084 LOS LOS Convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation • Forward rates can be expressed in several ways: i Outright forward quotation: actual rate for the transaction ii Percentage Terms: as percentage of the spot rate iii Forward Points: basis points of premium/discount to spot rate • One basis point is equal to one one-hundredth of one percentage point (0.01%) Therefore, 100 basis points would be equivalent to 1% • Converting between expressions: i Given spot rate of 1.6459 and 6-month forward of -12.7 points:  1.6459 + (-12.7 * 10,000) = 1.64463 (outright forward rate) ii This rate expressed as percentage:  1.64463 1.6459 -1 = -0.001% LOS LOS Explain the arbitrage relationship between spot rates, forward rates, and interest rates • Since different countries will have different interest rates, their respective spot and forwards rates are constrained by the relationship in their relative rate differences • An investor with investable capital and access to foreign markets has two options: i Invest domestically and receive the domestic risk-free rate ii Invest in foreign currency, receive foreign risk-free rate, and have to convert back to local currency at end of the period • The relationship is expressed as: 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 = 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 𝒙 𝟏:𝐅𝐨𝐫𝐞𝐢𝐠𝐧 𝐫𝐢𝐬𝐤;𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞 𝟏:𝐃𝐨𝐦𝐞𝐬𝐭𝐢𝐜 𝐫𝐢𝐬𝐤;𝐟𝐫𝐞𝐞 𝐫𝐚𝐭𝐞 LOS LOS Explain the arbitrage relationship between spot rates, forward rates, and interest rates • The Fisher Effect tell us interest rate differences between countries are due to differences in inflation High-interest rate countries experience higher inflation rates • The Interest Rate Parity states the difference between interest rates in two countries is the same as the difference between spot exchange rates and forward exchange rates • The Purchasing Power Parity is the principle that the rate depreciation in one country’s currency will be roughly equal to the excess inflation rate in one country over another This relationship tell us an investor would come out the same whether they invest at domestic risk-free rate or at foreign riskfree rate and convert through the exchange rate LOS LOS Calculate and interpret a forward discount or premium The basic relationship is: • Forward premium = Forward rates > Spot rates • Forward discount = Forward rates < Spot rates 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 𝒙 𝟏 + 𝐅𝐨𝐫𝐞𝐢𝐠𝐧 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝒓𝒂𝒕𝒆 𝟏 + 𝐃𝐨𝐦𝐞𝐬𝐭𝐢𝐜 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝒓𝒂𝒕𝒆 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑻𝒓𝒂𝒅𝒊𝒏𝒈 𝒑𝒓𝒆𝒎𝒊𝒖𝒎 = 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑭𝒐𝒓𝒘𝒂𝒓𝒅 𝑹𝒂𝒕𝒆 – 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑺𝒑𝒐𝒕 𝑹𝒂𝒕𝒆 Example >> LOS LOS Calculate and interpret a forward discount or premium Example Two hypothetical currencies, ABC and XYZ, are trading at the spot rate of 1.60 ABC/XYZ If the interest rate in ABC's country is 7% and 5% in XYZ's country, and the actual 1-year forward rate is 1.62, identify if an arbitrage profit opportunity exists Solution The forward rate is: 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑅𝑎𝑡𝑒 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒 𝑥 = 1.60 ∗ 1.07 1.05 + F𝑜𝑟𝑒𝑖𝑔𝑛 interest 𝑟𝑎𝑡𝑒 + D𝑜𝑚𝑒𝑠𝑡𝑖𝑐 interest 𝑟𝑎𝑡𝑒 = 1.63 Since the actual forward rate of 1.62 is lower than the arbitrage-free forward rate of 1.63, an arbitrage opportunity exists Arbitrage profit can be earned by buying the forward contract at 1.62 LOS LOS Calculate and interpret the forward rate consistent with the spot rate and the interest rate in each currency • The spot market currencies are exchanged for immediate delivery in the forward rate market whereas contracts are made to sell or buy currencies for delivering in the future  For example, when a company in the U.S buys goods from England worth in British Pounds (£), the importer then owes British Pounds (£) for future deliveries  The importer can be protected from this risky exchange by quickly negotiating a 90-day forward contract with a bank  In 90 days, the bank will provide the importer with a nominal amount while the importer gives the bank the agreed rate LOS LOS Calculate and interpret the forward rate consistent with the spot rate and the interest rate in each currency Interest Rate Parity (IRP) • According to IRP theory, the currency of a nation with a lower interest rate should be at a forward premium in terms of the currency of the nation with the better rate • Since the amount of forward points is proportional to the spread between the foreign and the domestic interest rates if – id, we shall evaluate this relationship below: 𝑖𝑓 − 𝑖𝑑 𝐹𝑓 − 𝑆𝑓 = 𝑆 𝑓 𝑇 + 𝑖 𝑇 𝑑 𝑑 𝑑 𝑑 Where T = Actual days/360 LOS LOS Describe exchange rate regimes Exchange rate regimes describes the policy by which a given country manages its exchange rates relative to other currencies • Floating Rate Regime  Allows for free floating of exchange rate over time  May intervene occasionally to influence rates if values change too much • Pegged Rate Regime  Exchange rates are pegged to another currency  Government intervenes regularly to maintain exact exchange rate • Floating Peg Regime  Hybrid approach that allows for some movement in exchange rates but within tight constraints  Often used by countries transitioning from a pegged regime to a floating regime over time LOS LOS Explain the effects of exchange rates on countries’ international trade and capital flows • Changing Prices of Currencies  Foreign currencies change in value due to domestic economic trends These price changes impact supply and demand of currencies between countries • Increase in Demand for Imports  When domestic income rises, demand for imports also rises  Investors will invest in other countries when they see favorable interest rate differences • Prices of Products Being Expensive  Some countries are more reliant on imports than on domestically produced goods  A devalued currency makes imports more expensive LOS LOS Explain the effects of exchange rates on countries’ international trade and capital flows • Self-Correcting Tendencies  A strong domestic currency will make imports cheaper and exports more expensive, but that trading over time will cause the currency to devaluate as more is spent on foreign currencies • Development of a Trade Deficit  A strong domestic currency will lead to more imports and few exports This creates a trade deficit as the trend continues • Effect on Standard of Living  Currency values affect the ability to buy imports and sell exports  A country with no demand for its currency will suffer in its trading relationships with other countries  Limited trade opportunities will hurt domestic growth and limit consumer options LOS Economics • Topics in Demand and Supply Analysis • The Firm and Market Structures • Aggregate Output, Prices, And Economic Growth • Understanding Business Cycles • Monetary and Fiscal Policy • International Trade and Capital Flows • Currency Exchange Rates  Remember to practice! ... dependent on which currency is the price currency and which one is the base currency • Example: ZAR/CNY rate increases from 1. 6459 to 1. 8356 1. 8356 − = 11 .5256% 1. 6459  This represents an 11 .5% appreciate... (0. 01% ) Therefore, 10 0 basis points would be equivalent to 1% • Converting between expressions: i Given spot rate of 1. 6459 and 6-month forward of -12 .7 points:  1. 6459 + ( -12 .7 * 10 ,000) = 1. 64463... Forward Exchange Rates i Whereas spot exchange rates are quoted for exchanged currency right now, forward rates are for exchanges at a future date ii Rates are agreed upon today for an exchange