Foreign exchange markets

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Presentation transcript:

Foreign exchange markets Financial Management Foreign exchange markets

Foreign Exchange Rates Currency quotation Indirect: $1 = AED 3.67 Direct: $0.2725 = AED 1 Inverse relationship: 1/indirect = direct Currency appreciation/depreciation Indirect quote increase = appreciation Direct quote increase = depreciation FX rate driver: supply and demand of currency

Spot and Forward Exchange Rates Spot rate: foreign exchange rate now Forward rate: foreign exchange rate in future Why are they different? Why do FX rates change? Interest rate differences between countries Inflation differences between countries Default risk differences between countries

Forward Exchange Rate Premium/Discount Formula: (spot-forward) / spot Example:

Purchasing Power Parity “Balancing” relationship between prices and FX rates

Fixed Exchange Rates Some countries “override” market factors by created a fixed exchange rate with a major currency Examples: Oman: OMR 0.3845 = USD $1 Mali: CFA 655.957 = €1 Nepal: NPR 1.600 = INR 1

Exchange Rate Risk Risk that exchange rates change unfavorably Example:

Hedging and Derivatives To protect against exchange rate risk, a company can use a hedge transaction Example: option to buy $2,500 at MXN 20/USD 1 by date of loan repayment

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