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Foreign exchange market

Introduction about Foreign Exchange Market.

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Foreign exchange market

  1. 1. Foreign Exchange Market
  2. 2. Meaning  The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies.  This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices.
  3. 3. Continue  The foreign exchange market is an over-the-counter (OTC) marketplace that determines the exchange rate for global currencies.  Participants are able to buy, sell, exchange and speculate on currencies.  Foreign exchange markets are made up of banks, forex dealers, commercial companies, central banks, investment management firms, and investors.
  4. 4. Purpose of the foreign exchange market  The purpose of the foreign exchange market is to help international trade and investment.  A foreign exchange market helps businesses convert one currency to another.  For example, it permits a U.S. business to import Rwandan goods and pay RWF, even though the business's income is in U.S. dollars.
  5. 5. PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET  All Scheduled Commercial Banks (Authorized Dealers only).  National Bank of Rwanda(NBR).  Public Sector/Government.  Resident Rwandans  Exchange Companies  Money Changers
  6. 6. Continue  Level 1: Tourists, importers, exporters, investors- immediate users & suppliers of foreign currencies.  Level 2: Commercial banks- they act as clearing houses between users and earners, do not actually buy & sell- Retail market  Level 3: Forex brokers- They deal with commercial banks.  Level 4: Nation’s central bank: Act as Lender/ Buyer of last resort- Interbank market/ wholesale market
  7. 7. Meaning of Foreign Exchange Transaction  Any financial transaction that involves more than one currency is a foreign exchange transaction.  Most important characteristic of a foreign exchange transaction is that it involves Foreign Exchange Risk.
  8. 8. Components of a Standard FX Transaction  Base Currency (USD/RWF)  Dealt’ or ‘Variable’ Currency  Exchange Rate  Amount  Deal Date  Value Date  Settlement Instructions
  9. 9. Value Date Conventions Currencies are traded both in Ready and forward value dates.  1) Ready: Settlement on the deal date. e.g. Rwanda  2) Value Tom : Settlement on next day. e.g. Canada  3) Spot Transaction : Settlement usually in two working days. In International FX transactions, Spot is the Standard value date. Why Spot Date ? Time Zone Difference  4) Forward Transaction: Settlement at some future date ahead of the spot.
  10. 10. FORWARD TRANSACTIONS  Out right sale/purchase of a currency against the other for settlement at a future date at the predetermined exchange rate  Forward rates are quoted as premium or discount over spot rate.  Forward rates depend upon interest rate differential between the two currencies.  Currency with higher interest rates is at discount w.r.t currency having lower interest rate.  Currency with lower interest rates is at premium w.r.t currency having higher interest rate.
  11. 11. continue  Forward Premium- when, Forward rate > Spot Rate  Forward Discount- when, Forward rate < Spot Rate
  12. 12. Meaning of Arbitrage  Simultaneous purchase and sale of the same assets / commodities on different markets to profit from price discrepancies.  Eg. If the dollar price of pounds were $1.98 in New York and $ 2.01 in London, an arbitrageur would purchase pounds at $1.98 in New York and immediately resell them in London for $2.01, thus realizing a profit of $0.03 per pound.
  13. 13. Appreciation and Depreciation of Currency  When a currency becomes more valuable in terms of other currencies, economists say the currency appreciates.  When a currency becomes less valuable in terms of other currencies, it depreciates.  Movements in exchange rates, ceteris paribus, affect the relative prices of goods, services, and assets in
  14. 14. Example of depreciation of currency  If US demand for Rwandan goods increased, more RWF would be needed to pay for the goods, and so the demand for RWF would increase. This change increases the dollar price of RWF, which means there has been a depreciation of the US dollar relative to the RWF.
  15. 15. Example of appreciation of currency  Conversely, if Rwanda demand for US goods increased, more dollars would be needed to pay for the goods, and the supply of RWF would increase. This change will decrease the dollar price of RWF, which means there has been an appreciation of the US dollar relative to the RWF.
  16. 16. Meaning of Exchange rate  Exchange Rate is the price of one country's currency expressed in another country's currency.  In other words, the rate at which one currency can be exchanged for another. e.g. 1 USD = 912 RWF Major currencies of the world  USD  EURO  YEN  POUND STERLING
  17. 17. Example of Exchange Rate
  19. 19. 1. FIXED EXCHANGE RATE SYSTEM  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.
  20. 20. Continue  If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the central bank will have to ensure that it can supply the market with those dollars.  In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate.
  21. 21. Continue  The central Bank can also adjust the official exchange rate when necessary. The purpose of a fixed rate system is to maintain a country’s currency value within a very narrow band.  The Central Bank holds foreign currency reserves in order to intervene in the foreign exchange market, when the demand and supply of foreign exchange (say pound) are note equal at the fixed rate. This is explained in figure 1.
  22. 22. Continue : Excess demand for pound  D and S are the demand and supply curves of Pound. They determine the exchange rate E which is the authority maintains.  Suppose the demand for pound is more than supply of pound, as shown by P,P1 in the figure given the supply (S curve). This lead to rise in the exchange rate to E2,when the new demand curves D1 intersects the supply curve S. To maintain the exchange rate at the level E, the Central bank will continue to supply additional pounds to the market from its reserves till the exchange rate E is reached.
  23. 23. Graph
  24. 24. Continue: Excess supply of Pound  In the opposite case, If there is excess supply of pounds equal to P,P2 in the market given the demand (D curve), the exchange rate falls to E2 , as shown by the rightward shift of the supply curve to S1 and it is intersecting the D curve at P2. The monetary authority will start buying these excess pounds from the market till the exchange rate E is reached.
  25. 25. Graph
  26. 26. ADVANTAGES OF FIXED EXCHANGE RATE SYSTEM  Avoid Currency Fluctuations. If the value of currencies fluctuate significantly this can cause problems for firms engaged in trade. For example : If a firm relied on imported raw materials a devaluation would increase the costs of imports and would reduce profitability.  Stability encourages investment. The uncertainty of exchange rate fluctuations can reduce the incentive for firms to invest in export capacity. Some Japanese firms have said that the UK’s reluctance to join the Euro and provide a stable exchange rates market the UK a less desirable place to invest.
  27. 27. Continue  Keep inflation Low. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur. This is because AD increases, import prices increase and firms have less incentive to cut costs.  A rapid appreciation in the exchange rate will badly effect manufacturing firms who export, this may also cause a worsening of the current account.  Joining a fixed exchange rate may cause inflationary expectations to be lower.
  28. 28. Continue  Helpful for Small Nations.  It promotes international trade.  No adverse effect of speculation. There is no fear of any adverse effect of speculation on the exchange rate, as speculative activities are controlled and prevented by the monetary authorities under a regime of fixed exchange rates.
  29. 29. DISADVANTAGES OF FIXED EXCHANGE RATE SYSTEM 1. Conflict with other objectives. To maintain a fixed level of the exchange rate may conflict with other macroeconomic objectives.  If a currency is falling below its band the government will have to intervene. It can do this by buying sterling but this is only a short term measure.  The most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures.  However higher interest rates will cause lower AD and economic growth, if the economy is growing slowly this may cause a recession and rising unemployment.
  30. 30. Continue  2. Less Flexibility. It is difficult to respond to temporary shocks. For example an oil importer may face a balance of payments deficit if oil price increases, but in a fixed exchange rate there is little chance to devalue.  3. Join at the Wrong Rate. It is difficult to know the right rate to join at. If the rate is too high, it will make exports uncompetitive. If it is too low, it could cause inflation.  4. Current Account Imbalances. Fixed exchange rates can lead to current account imbalances. For example, an overvalued exchange rate could cause a current account deficit.
  31. 31. Continue  5. It does not reflect the true value of the currency  6. It may lead to the Black markets emerge  7. It can be expensive or even impossible to hold  8. Dependence on International Institutions: Under this system, a country mostly depends upon international institutions for borrowing and lending foreign currencies.
  32. 32. FLEXIBLE / FLOATING EXCHANGE RATE  Flexible, floating or fluctuating exchange rates are determined by market force. The monetary authority (Central Bank) does not intervene for the purpose of influencing the exchange rate.  Under a regime of freely fluctuating exchange rates, if there is an excess supply of currencies, the value of that currency in foreign exchange markets will fall. It will lead to depreciation of the exchange rate.
  33. 33. Continue  Consequently, equilibrium will be restored in the exchange market. On the other hand, shortage of a currency will lead to appreciation of a exchange rate, thereby leading to restoration of equilibrium in the exchange market.  Theses market forces operate automatically without any intervention on the part of monetary authority.
  34. 34. For example  This is illustrated in Figure 2, where D and S are the demand and supply curves of pound which interest at a point P and the equilibrium exchange rate E is determined. Suppose the exchange rate rises to E2. The quantity of pounds supplied OQ3 is more than the quantity demanded OQ2. When pounds are in excess supply, the price of pounds will fall in the foreign exchange market. The value of pounds in term of dollars will depreciates. Now less
  35. 35. Continue  pound will be supplied and more will be demanded. Ultimately, equilibrium will be reestablished at the exchange rate E. on the other hand, if the exchange rate falls to E1, the quantity of pounds demanded OQ4 is more than quantity supplied OQ1.  When there is a shortage of pound in the foreign exchange market, the price of pounds will rise the value of pound in terms of dollar will appreciate. The rise in the price of pounds will reduce the demand for them and increase their supply.  This process will continue till equilibrium exchange rate E is reestablished at point P.
  36. 36. Graph
  37. 37. ADVANTAGES OF FLEXIBLE EXCHANGE RATE SYSTEM  1. Independent Monetary Policy. Under flexible exchange rate system, a country is free to adopt an independent policy to conduct properly the domestic economic affairs. The monetary policy of a country is not limited or affected by the economic conditions of other countries.  2. Shock Absorber. A fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the internal economy from the disturbing effects from abroad.
  38. 38. Continue  3. Promotes Economic Development. The flexible exchange rate system promotes economic development and helps to achieve full employment in the country. The exchange rates can be changed in accordance with the requirements of the monetary policy of the country to achieve the planned national objectives.  4. Solutions to Balance of Payment Problems. The system of flexible exchange rates automatically removes the disequilibrium in the balance of payments. When, there is deficit in the balance of payments, the external value of a country's currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment.
  39. 39. Continue  5. Promotes International Trade. The system of flexible exchange rates does not permit exchange control and promotes free trade. Restrictions on international trade are removed and there is free movement of capital and money between countries.  6. No need of Borrowings and lending short-term funds : When foreign exchange rates move freely , there is no need to have international institutional arrangements like IMF for borrowing and the lending short-term funds to remove disequilibrium in the balance of payments.
  40. 40. Continue  7. Increase in International Liquidity. The system of flexible exchange rates eliminates the need for official foreign exchange reserves, if the individual governments do not employ stabilization funds to influence the rate. Thus, the problem of international liquidity is automatically solved. In fact, the present shortage of international liquidity is due to pegging the exchange rates and the intervention of the IMF authorities to prevent fluctuations in the rates beyond a narrow limit.
  41. 41. DISADVANTAGES OF FLEXIBLE EXCHANGE RATES  1. Unstable conditions. Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long term foreign investments arc greatly reduced because of higher risks involved.  2. Adverse Effect on Economic Structure. The system of flexible exchange rates has serious consequence on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilize the economy of the country.
  42. 42. Continue  3. Inflationary Effect. Flexible exchange rate system involves greater possibility of inflationary effect of exchange depreciation on domestic price level of a country. Inflationary rise in prices leads to further depreciation of the external value of the currency.  4. Low Elasticities. The elasticities in the international markets are too low for exchange rate, variations to operate successfully in bringing about automatic equilibrating adjustments. When import and export elasticities are very low, the exchange market becomes unstable. Hence, the depreciation of the weak currency would simply tend to worsen the balance of payments deficit further.
  43. 43. HOW DO COUNTRIES CHOOSE EXCHANGE RATE REGIMES  1. Financial depth indicators. Deeper the financial markets prone to adopting Floating Exchange rates  2. Openness, size, trade concentration and economic volatility indicators. A country is less likely to adopt a fixed exchange rate if it is relatively large and closed, if its external trade is concentrated, and if the business cycle is more volatile. This suggests that what matters for the choice of the exchange rate regime is the exposure to external shocks.  3. Political variables. Fragmented policymaking calls for a Float probably because greater discretion makes it easier to settle conflicts among agents involved in the decision-making process. The use of monetary policy to raise consensus in the elections.  4. Inflation
  44. 44. DETERMINANTS OF FOREIGN EXCHANGE RATE  1. Interest Rate : Whenever there is an increase interest rates in domestic market there will be increase investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.  2. Inflation Rate : when inflation increases there will be less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).
  45. 45. Continue  3. Government budget deficit or surplus : The market usually react negatively to widening govt. budget deficits and positively to narrowing budget deficits. This will result in change in the value of countries currency.  4. Political conditions Internal, regional and international political conditions and events can have a profound effect on currency market.  5. Economic growth: Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.
  46. 46. IMPORTANCE OF EXCHANGE RATE REGIMES  1. Stock market trading  2. Symbolizes growth  3. Indicates Demand of currency  4. Position of currency in world
  47. 47. Exchange Rates in the Long Run  Exchange rates are determined in markets by the interaction of supply and demand.  An important concept that drives the forces of supply and demand is the Law of One Price.
  48. 48. Exchange Rates in the Long Run: Law of One Price  The Law of One Price states that the price of an identical good will be the same throughout the world, regardless of which country produces it.  Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.
  49. 49. Exchange Rates in the Long Run: Law of One Price
  50. 50. PURCHASING POWER PARITY  The purchasing power parity between two countries’ is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.
  51. 51. Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)
  52. 52. Continue  For example, if the same basket of goods and services costs 800 pesos in Mexico and $100 in the U.S. the PPP would be: 800 pesos = $100 8 pesos per $1
  53. 53. Continue  Nominal exchange rates almost always differ from purchasing power parities.  Some of the differences are systematic: in general, aggregate price levels are lower in poor countries than in rich countries because services tend to be cheaper in poor countries.
  54. 54. Continue  But even among countries with roughly the same amount of economic development, nominal exchange rates vary quite a lot from the purchasing power parity.  Over the long run, however, purchasing power parities are quite good at predicting actual changes in nominal exchange rates.
  55. 55. Continue  In particular, nominal exchange rates between countries at similar levels of economic development tend to fluctuate around levels that lead to similar costs for a given market basket.
  56. 56. Exchange Rates in the Long Run: Theory of Purchasing Power Parity (PPP)  Problems with PPP  All goods are not identical in both countries (i.e., Toyota versus Chevy)  2. Many goods and services are not traded (e.g., haircuts, land, etc.)
  57. 57. Exchange Rates in the Long Run: Factors Affecting Exchange Rates in Long Run  Basic Principle: If a factor increases demand for domestic goods relative to foreign goods, the exchange rate ↑  The four major factors are : a. relative price levels, b. tariffs and quotas, c. preferences for domestic v. foreign goods, and d. productivity.
  58. 58. Continue  Relative price levels: a rise in relative price levels cause a country’s currency to depreciate.  Tariffs and quotas: increasing trade barriers causes a country’s currency to appreciate.  Productivity: if a country is more productive relative to another, its currency appreciates.
  59. 59. Continue  Preferences for domestic v. foreign goods: increased demand for a country’s good causes its currency to appreciate; increased demand for imports causes the domestic currency to depreciate.  The following table summarizes these relationships. By convention, we are quoting, for example, the exchange rate, E, as units of foreign currency / 1 US dollar.
  60. 60. Factors Affecting Exchange Rates in Long Run
  61. 61. Exchange Rates in the Short Run  In the short run, it is key to recognize that an exchange rate is nothing more than the price of domestic bank deposits in terms of foreign bank deposits.
  62. 62. Exchange Rates in the Short Run: Expected Returns on Domestic and Foreign Assets  We will illustrate this with a simple example  François the Foreigner can deposit excess euros locally, or he can convert them to U.S. dollars and deposit them in a U.S. bank.  The difference in expected returns depends on two things: local interest rates and expected future exchange rates.
  63. 63. Continue  What this shows is simple.  As the relative expected return on dollar assets increases, both François and Mike respond by holding more dollar assets and fewer foreign assets.  Conversely, as the relative expected return on dollar assets decreases, both François and Mike respond by holding fewer dollar assets and more foreign assets.
  64. 64. Continue  Mike the American has a similar problem. He can deposit excess dollars locally, or he can convert them to Euros and deposit them in a foreign bank.  The difference in expected returns depends on two things: local interest rates and expected future exchange rates.
  65. 65. Exchange Rates in the Short Run: Equilibrium
  66. 66. Exchange Rates in the Short Run: Equilibrium
  67. 67. Explaining Changes in Exchange Rates  To understand how exchange rates shift in time, we need to understand the factors that shift expected returns for domestic and foreign deposits.  We will examine these separately, as well as changes in the money supply and exchange rate overshooting.
  68. 68. Explaining Changes in Exchange Rates: Increase in iD (interest rate)
  69. 69. Explaining Changes in Exchange Rates: Increase in iF (Foreign Interest Rate)
  70. 70. Explaining Changes in Exchange Rates: Increase in Expected Future Exchange Rate (FX) Rates
  71. 71. Explaining Changes in Exchanges Rates  Similar to determinants of exchange rates in the long-run, the following changes increase the demand for foreign goods (shifting the demand curve to the right), increasing :  Expected fall in relative U.S. price levels  Expected increase in relative U.S. trade barriers  Expected lower U.S. import demand  Expected higher foreign demand for U.S. exports  Expected higher relative U.S. productivity
  72. 72. Explaining Changes in Exchanges Rates
  73. 73. Continue
  74. 74. THE ROLE OF THE EXCHANGE RATE  The exchange rate, which is determined in the foreign exchange market ensures that the balance of payments really does balance.  Exchange rates are the equilibrium prices for national currencies.  An exchange rate shows how much of a nation’s currency is needed to purchase a unit of another’s currency.
  75. 75. THE EQUILIBRIUM EXCHANGE RATE  The equilibrium exchange rate is the exchange rate at which the quantity of currency demanded in the foreign exchange market is equal to the quantity of currency supplied.  Movements in the exchange rate ensure that changes in the financial account and the current account offset each other.
  76. 76. Factors that affect the Equilibrium Exchange Rate  1. Relative inflation rates- Eg. R= 2$ / £, If inflation in US in higher than in UK, then US goods will be costlier than that of UK goods and therefore, UK will export more goods to US and US will export less goods to UK.  This means that value of Dollar has Depreciated w.r.t. Pounds, or  Value of Pounds has Appreciated w.r.t. US dollars.
  77. 77. 2. Relative interest rates  If real interest rates of US are higher than that of UK, then the dollar is said to have appreciated as compared to pound.  Real interest rate = Nominal interest rate - Inflation  Therefore, real interest rate should be considered
  78. 78. Continue  3. Relative economic growth rates: Strong economic growth- attract investment  4. Political & Economic risk: High risk currency- more valuable

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