Foreign Exchange Rate

Countries deals with each other in two main ways, which are: trade and investment. Trade consist as export and import of goods and services and consequently trade balance is an important international .... variable. On the other hand, investment involves borrowing and lending of money and the foreign ownership of property a stock within a country. Here exchange rate is the other international macroeconomic variable.

Foreign exchange definition

A foreign exchange rate is the price at which one currency (e.g. USD) can be exchanged for another currency (e.g. GBP)

Normally foreign exchange rates are listed in two ways, namely:

1.       the direct quote 'domestic currency units per unit of foreign currency'

2.       the indirect quote 'foreign currency units per unit of domestic currency'

Example:

Let us say that the pound sterling is the domestic currency and approximately £0.547 was required to buy one USD. Then we shall write:

1.       Direct quote: £0.547/$1

2.       Indirect quote:$1.828/£1

Foreign exchange transaction

There are 2 basic types of foreign exchange rate and foreign exchange transactions: Spot and forward.

Spot exchange rate: It is the quotation between two currencies for instant delivery. Such transactions can be conducted through the foreign exchange division of commercial banks or a bank foreign currency dealer.

Forward exchange rate: here economic agents agree today to exchange currencies at a specific date in the future at an agreed exchange rate. Normally, forward contracts are written in 30 days (1 month), 180 days (6months), 270 days (9months) or 360 days (1 year) period.

Trading in currencies

The foreign exchange or forex market is an international market in national currencies. This kind of market is highly competitive and there is no difference between the price of one market to another (e.g. no price difference between a market in London to a market in New York.)

Bid price/offer price

Bid price is the highest price a buyer will pay to buy a specified number of shares of a stock at any given time. In short, it is the price at which you can sell your shares.

Offer price refers to the lowest price at which a seller will sell the stock. In short, it is the price at which you can buy the share.

The difference between the bid price and the ask price is called the 'spread'

spread are often stated as 'pips'

The spread quoted by the dealer depends on:

a)      The spread in the interbank market for same currency pair. Dealer spreads vary directly with spread quoted in the interbank market.

b)      The size of the transaction, larger liquidity- demanding transaction generally get quoted a larger spread.

c)       The relationship between the dealer and the client. Sometimes dealers will give favorable rates to preferred clients based on other ongoing business relationships.

The interbank spread in a currency pair depends on:

·         currencies involved.
Similar to stock, high-volume currency pairs (e.g. USD/EUR, USD/JPY and USD/GBP) command lower spreads than do lower-volume currency pairs (e.g. AUD/CAD)

·         Time of day
The time overlap during the trade day when both the NY and London currency markets are open is considered the most liquid time window, spreads are narrower during this period than at other times of the day.

·         Market volatility
Spreads are directly related to the exchange rate volatility of the currencies involved. Higher volatility leads to higher spreads to compensate market traders for the increased risks of holding those currencies. Spreads exchange overtime in response to volatility changes.
Spread = [(offer - bid)/offer] X 100
Normally, the bid price is lower than the offer price. Consider a dealer quote of a price of £1 $ of 1.340 - 1.345. The lower bid rate is 1.340, is the rate at which the dealer will buy the variable currency (USD) in exchange of the basic currency £.

The higher offer rate 1.345 is the rate at which the dealer will sell the variable currency (USD) in exchange of the basic currency £.
Hard currencies like USD, GBP, EUR which are heavily traded have lower volatility, thus lower spread (range: 0.05% - 0.08%)

Gross currency rates

Many currency pairs are inactively traded so their exchange rate is determined through their relationship to a wildly traded third currency.
E.g. An Australian importers needs Danish Kroner to pay for purchases in Copenhagen. The Australian Dollar (AUD) is not widely quoted against the Danish kroner (DKr)
However, both currencies are quoted against the USD. Assume the following quotes:

AUD:AUD 1.4419 - 1.4436/USD

DKR:DKR 0.6250 - 0.6267/USD

Calculate the cross rate AUD/DKR

Step 1:

                  

Step 2: Bid (low): go for bottom AUD in numerator and top DKr in denominator

               

Step 3: Ask (High) : Go for a top AUD in numerator and bottom DKR in denominator

               

Therefore: AUD 2.3008 - 2.3098 DKR

Arbitrage in forex market

Arbitrage means there are no opportunities for exploiting price differentials for risk free profit. With cloth and direct contact between sellers and buyers and increased transparency through the use of the internet has created instantaneous arbitrage across currencies and financial centres in forex.

There are two type of arbitrage in the forex market:

·         Financial centre arbitrage
The exchange rate of two currencies is the same in all forex exchange.

·         Cross currency arbitrage
The exchange rate of two currencies against a third currency is linked to their exchange rate. E.g. Financial centre arbitrage. If the exchange rate USD - GBP is USD |1.81| GBP in NY and USD |1.79| GBP in london, then its profitable to buy GBP in London and sell it in NY. A 2 cent profit is made per GBP sold. The excessive demand for GBP in London will push up the price and the excessive supply of GBP in NY will push the price down.
E.g. Cross currency arbitrage
Assume the exchange rate of a currency (USD) to other two (GBP and EUR) are USD 1.80/GBP and 1.20/EUR. This implies that exchange rate of EUR/GBP =   = EUR 1.5 GBP

If the EUR/GBP rate is EUR 1.75/GBP you can make risk free profit by using pounds to buy Euros and sell USD.

Sell GBP 1 to buy 1.75 EUR. Then use these proceeds to buy USD (1.75 x 1.2)2.1 USD. Then use USD 1.8 of these proceed to 1 GBP. (leaning profit = 2.1 - 1.8 = USD 0.30)

This sequence of transactions is known as triangular currency arbitrage opportunities for profitable currency arbitrage have been greatly reduced in recent years, given the extensive network of people aided by high speed, computerised into systems which are continually collecting, company and acting on currency quotes mall financial markets. The practice of quoting rates against the USD makes currency arbitrage even simpler.  The result of this activity is that rates for a specific currency tend to be the same everywhere with only minimal deviation due to transactions cost.

Why exchange rates fluctuate?

Exchange rate fluctuates due to change in demand and supply for the currency. This may result from capital flaws between economic changes in international trade amongst others.

a)      Balance of payment (BOP)

Balance of payment is a method used to follow up transactions between a country and its international trading partners. It includes government transactions, consumer transactions and business transactions. The BOP accounts reflect all payments and liabilities to foreigners as well as payments and obligations received from foreigners. International trade, currencies are required to finance the activities. A change in trade will lead to a change in exchange rate.

A demand for imports represent a demand for foreign currency. (e.g. there is a demand for imports in the UK, then it represents a supply of GBP)

A demand for exports represent a supply for foreign currency (e.g. there is a demand for exports in UK, then it represents a demand of GBP)

Therefore a country with a currency account deficit (i.e. where imports is greater than exports) will see a depreciation in its exchange rate since supply for the currency (imports) will be greater than the demand for the currency (export)

b)      Capital movements between economies
Those transactions switch bank deposits form one currency to another. Hence, supply or demand for currency may reflect on the capital account. Some of the factors which may cause the inflows or outflows of capital are:

                                 i.            changes in interest rates: A fall in interest rate will attract a capital outflow and supply for that currency.

                               ii.            Inflation: asset holder will not want to hold financial assets in a currency whose value is falling due to inflation.

Exchange rate regimes

Different countries use different currencies since a country has its own national currency. In international trade and investment, there is an exchange of currency. Hence, in order to buy something in another country, we must first exchange our national currency into the foreign currency. Government must decide not only how to issue its currency but how international transactions will be conducted.

The IMF maintains a list of country currency regimes which displays a wide variety of systems currently being used. The value of the floating currency is set according to their exchange rate based on its supply and demand on private markets. Those floating currencies' value fluctuate over time. Floating currencies include the USD, Japanese yen, Brazilian Real, South Korean won and South African Rand.

China is a crawling peg. India is in a managed float as well as Indonesia. This means that the countries' central banks will sometimes allow the currency to float freely but at  other times will hedge the exchange rate in one direction or another.

Crawling peg, which means that the currency is essentially fixed except that the Chinese central bank is allowing its currency to appreciate slowly with respect to the USD. In other words, the fixed rate is itself gradually but unpredictably adjusted.

Russia is listed as fixing to a composite currency. This means that instead of fixing to one other currency, such as the USD or the euro, Russia fixes to a basket of currencies also called a composite currency. The most common currency basket to fix is the Special Drawing Rights (SDR), a composite currency issued by the IMF used for central bank transactions.

All countries in the European Union (EU) are currently members of the euro area. Within this area, the countries have retired their own national currencies in favour using a single currency, the euro. When all countries circulate the same currency, it is the ultimate in fixing, meaning that they have fixed exchange rates among themselves because there is no need to exchange.

However, with respect to the other external currencies, like the USD or the JPY, the euro is allowed to float freely. By fixing the exchange rate, countries tend to reduce transaction costs and exchange rate risks that can discourage trade and investment. At the same time, a fixed exchange has been used as a credible nominal anchor for monetary to pursue independent monetary policy. A flexible exchange rate allows countries to respond to shock through changes in the exchange rate and interest rate to avoid going into recession. Under the combination of fixed exchange rate and complete integration of financial markets monetary policy becomes completely powerless. Any fluctuations in the currency or currencies to which the country fixes its exchange rate will impact the domestic currency. Under a fixed exchange rate regime, other variable need to do the adjustments.