DEPARTMENT OF ECONOMICS CEIF3772 (International Finance)

Course Instructor: AKINKUGBE Office: E-mail: Consultation: 18:45 OLUYELE AKIN. X 108 oakinkugbe@unam.na Tuesdays 17:45 Thursdays
1 ECO 316 -International Finance

17:45 18:45
04/19/12

Foreign Exchange (Forex), Foreign Exchange Rates, and Foreign Exchange Markets
Most obvious difference between Domestic and

International Transactions and Monetary Relations

Presence of a single currency unit in one and a

multiplicity in the other; Todays world and the problem of transferring purchasing power internationally
concerned?

How are payments made when different currencies are

Instruments devised for this purpose is

collectively known as foreign exchange

currency boundaries

Means of making payments across national

Bank deposits denominated in a foreign currency Foreign currency itself (coins, notes, traveler's cheques,

etc.) Bank Draft, electronic transfers, bills of exchange 04/19/12 Short term claim on foreigners expressed in foreign ECO 316 -International Finance currencies.

Introduction
organized markets through dealers Purchases and sales are made at specified prices known as rates of exchange Foreign Exchange Market: Organizational/institutional framework through which individuals, firms and banks buy and sell foreign currencies or forex. Forex markets for all currencies comprises all locations where the currencies can be bought or sold; can be exchanged for other currencies (Paris, London, Milan, New York, Tokyo, Frankfurt, Amsterdam, Johannesburg, WindHoek, Lusaka, Dar es Salaam, Harare, etc). Forex markets are in constant contact linked together by telecommunications network (Tokyo-London-New York), thus forming a single international foreign exchange market. ECO 316 -International Finance 04/19/12
Foreign exchange is bought and sold in

Introduction
Permit the conversion and transfer of

funds/purchasing power between nations (or from one currency to another), in an efficient manner electronic transfer, internet, etc.; Facilitates the implementation of contractual arrangements for extension of credits and subsequent payment for the obligations involved; Provide facilities for hedging and speculation;

ECO 316 -International Finance

04/19/12

Demand and Supply for Foreign Exchange

Why do individuals, firms, and Banks want

to exchange one national currency for another Demand

Tourists visit another country and need to

exchange their national currency for the currency of country visited; Domestic firms want to import from other nations; Individuals want to invest abroad, etc Supply Foreign tourists expenditures in the nation visited; Export Earnings; ECO 316 -International Finance 04/19/12 Receiving foreign Investments, etc.

Market
Four Levels of participants can be identified in the

Foreign Exchange Market: At the Bottom (first level) are the traditional users of forex: tourists, importers, exporters, investors, etc; who constitute the immediate users or suppliers of foreign currencies; Next (second Level), are commercial banks (forex bureau), which act as clearinghouses between users and earners of foreign exchange; At the third level are foreign exchange brokers, through whom the nations commercial banks even out their forex inflows and outflows among themselves (interbank or wholesale market); At the 4th and highest level is the nations central bank, which acts as the seller or buyer of last resort, ECO 04/19/12 6 when 316 -International Finance the nations total forex earnings and

Exchange Rates
Price of one currency in terms of another; it

provides the link/bridge that connects different national currencies making international costs and price comparisons possible; Can be defined as the number of units of the domestic currency that can purchase 1 unit of a foreign currency; Assume there are only 2 economies, Namibia and the UK, with the N$ as the domestic currency and British pound (GBP or ) as the foreign currency. The exchange rate between the N$ and (R) is equal to the number of N$ needed-International Finance one . That is, R = N$/04/19/12 . If ECO 316 to purchase 7 R = N$/ is 10.8; this means that 10.8 Namibian

Equilibrium in the Foreign Exchange Market

Under the flexible exchange rate system that

the world operates today, exchange rates are determined by the forces of demand and supply in the forex market just like the price of any other commodity. R=N$/ S

S
E E
10.8

D D
200

Million of /day
04/19/12

ECO 316 -International Finance

As

shown in the diagram, the vertical axis measures N$ price of the GBP, or the exchange rate R=N$/, and the horizontal axis measures the quantity of GBP. The market demand and supply curves for GBP intersect at point E, defining the equilibrium exchange rate of R = 10.8; at which point, the quantity of GBP demanded and supplied are equal at GBP200 million per day. At a higher exchange rate, the quantity of GBP supplied exceeds the qty demanded; the exchange rate falls gradually toward the equilibrium rate. At an exchange rate lower than R=10.8; the quantity of GBP demanded exceeds supply, the exchange rate will be bid up toward equilibrium.
If the exchange rate were not allowed to rise or fall to
ECO 316 -International (as 04/19/12 its equilibrium Finance under the fixed exchange rate

Exchange Rate Depreciation and Appreciation

Suppose the Namibian Demand curve for GBP shifts

up (increased taste for UK goods), and intersects the supply curve for GBP at E; the equilibrium exchange rate would be R=12.5, and the equilibrium quantity of GBP would be 300 million per day. The Namibian Dollar is then said to have depreciated, since it now requires N$12.5 (instead of 10.8) to purchase one GBP. A home currency Depreciation or foreign currency appreciation thus refers to an increase in the domestic price of the foreign currency, or an increase in the number of units of domestic currency required to purchase 1 unit of the foreign currency. The home currency synonymously becomes less valuable with a depreciation. On the other hand, home currency appreciation or foreign currency ECO 316 -International Finance 04/19/12 10 depreciation refers to a decline in the domestic

The Reciprocal Principle

The Exchange rate could also be defined as the

foreign currency price of a unit of the domestic currency. This is the inverse or reciprocal , of our previous definition. This then implies that the GBP price of 1 unit of the N$ would be 1/R = 1/10.8 (=0.092592593). That is, it would take 0.093 unit of the GBP to purchase 1 unit of the N$. Sometime, you come across this in the dailies or other publications, no cause for alarm, just reciprocal matters. So far, we have talked about only 2 currencies and 1 exchange rate between the pair. In reality, there are numerous currencies and ECO 316 -International Finance 04/19/12 11 exchange rates US$, Euro, Yen, Yuan, N$,

The

currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given in. For example, if an exchange rate between the Euro and the Japanese Yen was quoted in a Namibian newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is the standard currency of Nambia Once the exchange rates between each of a pair of currencies with respect to the dollar is established (assuming here that the US$ is the vehicle/base currency), then the exchange rate ECO 316 -International Finance 12 between the two currencies themselves, called

Cross Exchange Rates


For example, if the exchange rate (R) were

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2.0 between the US$ and the GBP, and 1.25 between the US$ and the Euro, then the exchange rate between the Euro and the Pound would be 1.60 (i.e, it takes 1.6 to purchase 1). That is: R = / = US$ value of the /US$ value of the = 2/1.25 = 1.60 If the Exchange rate between the Namibian dollar and currency a is given as R$/a; and the rate between the dollar and currency b is R$/b; then the cross rate between a and b316 -International Finance is given as: ECO 04/19/12 Ra/b = (R$/a)/(R$/b)

The Cross Exchange Rate Table

T a b le 1K ey C ro ss R atesa te N ew Y o rk T r a d in gy,FM a rch 3 , 2 0 0 6 : L rid a US D o llar C an ad a 1 .1 3 9 1 Jap an 1 1 6 .3 9 M ex ico 1 0 .5 6 9 7 S w itz erlan d .2 9 7 5 1 UK 0 .5 7 0 1 0 E u ro 0 .8 3 0 8 0 US E u ro 1 .3 6 6 1 1 4 0 .1 0 1 2 .7 2 2 8 1 .5 6 1 8 0 .6 8 6 2 1 .2 0 3 7 Pound 1 .9 9 0 8 2 0 4 .1 6 1 8 .5 4 0 2 .2 7 6 0 1 .4 5 7 3 1 .7 5 4 1 S F ran c 0 .8 7 4 7 8 9 .7 0 0 8 .1 4 6 1 0 .4 3 9 4 0 .6 4 0 2 8 0 .7 7 0 7 0 P eso 0 .1 0 7 3 8 1 1 .0 1 1 0 .1 2 2 7 6 0 .0 5 3 9 4 0 .0 7 8 6 0 0 .9 4 6 1 Y en 0 .0 0 9 7 5 0 .0 9 0 8 1 0 .1 1 1 5 0 .0 0 4 9 0 0 .0 0 7 1 4 0 .0 0 8 5 9 C an D ir 1 0 2 .5 4 9 9 .3 1 3 0 1 .1 4 3 2 0 .0 5 0 2 3 1 0 .7 3 1 9 9 0 .8 8 1 1 0

S o urc e: R ep rin ted b y p erm issio n o f the W a ll S,treet 6 , Drnw Jo n es & C o , In c. 2 0 0 Jo u o al

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Types of Exchange Rates

Effective Exchange Rate Real Exchange Rates Real Effective Exchange Rates (REER) Nominal Effective Exchange Rates (NEER)

All of the above are alternative ways of looking at the exchange rate, such that important factors that may taken into consideration in exchange rate measures. For instance, we may need information about the overall strength of the domestic currency with respect to all of the home countrys trading partners; we may want to examine the real cost of acquiring foreign goods and services in a ECO 316 -International changing prices etc. All of these 04/19/12 15 world of ever Finance

Effective

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exchange Rates: Over time, a currency can depreciate with respect to some currencies and appreciate against others. Given this, it is important to compute the effective exchange rate. This is the weighted average of the exchange rates between the domestic currency and the nations most important trade partners, with the weights given by the relative importance of the nations trade with each of the trade partners. Real Exchange Rates (RER): This is the nominal exchange rate, deflated by relative ECO 316 indices. It 04/19/12 price -International Finance enables us to account for

Using the real exchange rate, we are able to

factor into the exchange rate the fact that prices of good and services are constantly changing in either the home country or in the partner country, (or both).
RER2010 = R/$
X

(Namibian Price Index2010/British Price

Index

2010

RER = R x (Id/If)

RER enables us to then measure the competitiveness of a nations goods in international markets. The real effective exchange rate (REER), shows an effective or trade-weighted exchange rate based on real exchange rates instead of on nominal rates. Exchange rate indices are calculated using real exchange rates; the ECO 316 -International Finance indexes are then weighted by the trade importance of 04/19/12 respective trade partners.

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Arbitrage and Foreign Exchange Rates

As we said earlier, the forex market consists of

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many different markets and institutions. Yet, at any given point in time, all markets tend to generate the same exchange rate for a given currency, regardless of geographical location. This is because of arbitrage. This refers to the purchase of a currency in the monetary center where it is cheaper, for immediate resale in the monetary center where it is more expensive, in order to make a profit. As arbitrage continues, the exchange rate between the two currencies tends to be equalized in the two monetary centers; or until they differ only by the transaction costs involved in arbitraging. ECO 316 -International Finance 04/19/12 Because currency are bought are sold

Example: Dollar price of Euro was $0.99 in NY

and $1.01 in Frankfurt

Note: When only two currencies and two

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monetary centers are involved in arbitrage, as in the example above, we have two-point arbitrage. When three currencies and three monetary centers are involved, we have triangular, or three-point arbitrage. Even though, triangular arbitrage is not very common, it operates in exactly the same manner to ensure consistent , indirect, or cross, exchange rates between the three currencies in ECO 316 -International Finance 04/19/12 the three monetary centers.

MARKETS
The most common type of FOREX transaction

involves the payment and receipt of the foreign exchange within two business days, after the transaction is agreed upon. The two day period or value date gives enough time for the parties involved to send instructions to debit and credit the appropriate nbank accounts at home and abroad. This type of transaction is called the spot transaction, and the exchange rate at which the transaction takes place is called the SPOT RATE.
This implies that our discussion of the forex market so far has

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focused on this type of transaction. Daily quotations of the currencies of many countries in major newspapers involve this type of rates and transactions; you may also get this by ECO 316 -International Finance 04/19/12 contacting many banks and financial exchange centers.

Besides spot transactions, there are also forward

transactions this involves an agreement today to buy or sell a specified amount of a foreign currency at a specified future date, at a rate agreed upon today (the forward rate). This implies that in this case, delivery date of the foreign currency is more than two days in the future. That is, FOREX agreement is made at the present time, but actual exchange of currencies does not take place until the day the foreign currency is needed.
Example: I could enter into an agreement today to

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purcahse US$ 100 million, three months from today at a rate of N$6.6 = US$1. Note that no currencies will be paid out at the time the contract is signed (but for the usual ECO security margin). 04/19/12 10% 316 -International Finance After 3 months, I get the US$100


The equilibrium forward rate is also determined

at the intersection of the market demand and supply curves of foreign exchange for future delivery. The demand for and supply of forward foreign exchange arise in the course of hedging, from FOREX speculation, and from covered interest arbitrage. Note: The forward rate can be equal to, above, or below the corresponding spot rate.
If the forward rate is below the present spot rate,

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the foreign currency is said to be at a forward discount (FD), with respect to the domestic currency. If the forward rate is above the present spot rate, the foreign currency is said to be at a forward premium (FP). FD and FP are usually expressed as percentages per ECO 316 -International Finance 04/19/12 year from the corresponding spot rate and can be

FD or FP = (FR SR)/SR x 4 x 100

Multiplication by 4 is to express the FD(-) or FP(+) on a yearly basis; by

100 is to express in percentages. Example (1) SR is N$7.00 = US$1, and three-month FR is N$6.75 = US$1 Example (2) SR is N$7.00 = US$1, and three-month FR is N$7.1975 = US$1 Compute the FD or FP as the case may be and explain the answers.
Currency SWAPS: A currency swap refers to a spot sale of a

currency, combined with a forward repurchase of the same currencyas part of a single transaction. For example; FNB receives a N$100 million payment today, that it will need in three months time. In the meantime, it wants to investment this sum in Euros. FNB will incur lower brokerage fees by swapping the N$100 million for Euros with Frankfurts Deutshe Bank, as part of a single deal/transaction, instead of selling N dollars for euros in the spot market today and at the same time repurchasing N dollars for euros ECOthe -International Finance for delivery in 3 monthsin two in 316 forward market 04/19/12 23 separate transactions. The swap rate (expressed on yearly basis)