Foreign Exchange market & international parity relations.

P.HARKA (Asst.prof.)

FOREIGN EXCHANGE MARKET

The Foreign Exchange Market is the framework of individuals, firms, banks and brokers who buy and sell foreign currencies.

Foreign exchange markets tend to be located in national financial centers near the local financial markets.

There are main three types of transactions undertaken in these foreign exchange markets:

1. Spot Transactions Currencies or bank deposits are exchanged immediately (two day settlement period).Spot rate is the price quote at which you can buy immediately.

2. Forward deals

Forward Transactions:

Currencies or bank deposits are exchanged at a set date in the future. Investors sign a contract for a given quantity of currency and exchange rate. At future date, actual exchange takes place at rate known as forward rate.

PLAYERS IN THE FOREIGN EXCHANE MARKET

Companies.

Individuals.

Commercial Banks.

Central Bank.

Brokers.

FOREIGN EXCHANGEForeign Exchange- money denominated in the

currency of another nation or group of nations.

It includes:

1. Deposits, credits, and balances payable in any foreign currency.

2. Drafts, travellers cheques, letters of credits or bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency and Vice Versa.

FOREIGN EXCHANGE RATE-The price of a currency

An exchange rate is the rate at which one currency can be exchanged for another.

In other words, it is the value of another country's currency compared to that of your own.

Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other

TYPES OF CURRENCY Hard currency:- It is usually fully convertible and

strong or relatively stable in value in comparison with other currencies.

Exotic currency:- It is currency of a developing country and is often unstable, weak and unpredictable.

There are five main players in this global arena... The United States (USD) The European Union (EURO) Great Britain (GBP) Japan (JPY) Switzerland (CHF)

Exchange Rate Quotations

An exchange rate quotation is given by stating the number of units of "term currency" or "price currency" that can be bought in terms of 1 unit currency (also called base currency).

Quotations can be of two types:-

1. Direct quotation (1 foreign currency = x home currency)

2. Indirect quotation (1 home currency = x foreign currency )

Role of Central Banks

The central Banks controls the policies that effects the value of currencies.

It involves buying and selling of home currency and foreign currencies with a view of ensuring that exchange rates move in line with established targets of governments.

Arbitrage

Arbitrage is the practice of taking advantage of a state of imbalance between two or more markets. A person who engages in arbitrage is called an arbitrageur. The arbitrageur exploits the imbalance that is present in the market by making a couple of matching deals in different markets, with the profit being the difference between the market prices.

Example of an Arbitrage

Suppose that an iPhone is selling for $800 in the US and for £500 in the UK. For simplicity sake, let us assume that the current exchange rate is £1 = $2. A simple conversion will tell us that an iPhone is worth more in the UK, since £500 = $1,000, which is more than $800. With the presence of such mispricing, an investor can seek to take advantage of such a situation by adopting the following strategy:

1) Buy an iPhone in the US for $800. 2) Sell it in the UK for £500. 3) Convert £500 into $1,000. This simple strategy will help yield an arbitrage profit of $1,000 - $800 = $200 per iPhone. Therefore, if one were

to follow this strategy for 500 iPhones, the profit would be a whopping 500 x $200 = $100,000.

Triangular Arbitrage Triangular arbitrage is in similar to the iPhone

example given above exploiting the mispricing that exists in the market.

But what exactly is triangular arbitrage? Basically, triangular arbitrage is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three differentcurrencies

in theforeign exchange market. A typical triangular arbitrage strategy involves three trades:

1) Exchanging the initial currency for a second 2) Trading second currency for a third 3) and the third currency for the initial.

Nominal exchange Rate

When we say that $1=Rs. 40 we are talking about nominal exchange rate. This is the rate at which you can purchase dollars.

Now that we understand what is “Nominal” exchange rate, let’s understand what “Real” exchange rate is all about…

Contin… To understand this let’s consider an

analogy:- Let’s say the nominal exchange rates

between the currencies of US & India are in the ratio of 1:40.

This means that $1 = Rs. 40. Now let’s say the cost of a McDonald’s

Burger in the US is $1 . This means that for a US resident earning

in US dollars, the cost of the Burger in India should be Rs. 40.

Contin…

Now suppose the rate of inflation in India is 10% while the rate of inflation in US is 0%. Due to this, the cost of the Burger in India would actually be equal to Rs (40x1.1) = Rs. 44. Therefore, although the US resident can buy Rs. 40 for $1, he cannot purchase the Burger for $1 in India.

Real Exchange rate By the same token, the Burger becomes more

expensive for an Indian resident too even though the nominal exchange rate does not change. This is because, although $1 is still equal to Rs 40, an Indian resident needs Rs. 44 to purchase the same Burger. Thus this exchange rate, which is in the ratio of 1:44, gets impacted by inflation from the perspective of purchase of products. This is known as the “Real Exchange Rate”.

Economic theories of exchange rate determination Exchange rates are determined by the

demand and supply of one currency relative to the demand and supply of another Price and exchange rates:

Law of One Price Purchasing Power Parity (PPP) Money supply and price inflation Interest rates and exchange rates Investor psychology and “Bandwagon”

effects

Law of one price In competitive markets free of

transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

Example: US/French exchange rate: $1 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78).

Purchasing Power Parity

It claims that a change in relative inflation between two countries must cause a change in exchange rates in order to keep the prices of goods in two countries fairly similar.

If the domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than that of the foreign country.

Interest Rates To understand the interrelationship between

interest rates and exchange rates, two key finance theories are used:

1. The Fisher Effect: The nominal interest rate r in a country is determined by the real interest rate R and the inflation rate i as follows:

(1+r) = (1+R)(1+i)2. International Fisher Effect (IFE): The IFE implies

that the currency of the country with the lower interest rate will strengthen in the future.

For any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries

Money supply and inflation

PPP theory predicts that changes in relative prices will result in a change in exchange rates.

a. A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate

b. Inflation occurs when the money supply increases faster than output increases

Investor psychology and bandwagon effects

Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates

Explanation may be investor psychology and the bandwagon effect

a. Studies suggest they play a major role in short term movements

b. Hard to predict

Other Factors In Exchange Rate Determination

Confidence.

Technical Factors like release of Economic Statistics, seasonal demand for a currency etc.

Social factors like terrorist attacks, scandals and a swelling budget deficit