Foreign Exchange Exchange rate is the price of a currency in terms of a foreign currency.

Foreign Exchange The exchange rate of a country's currency is determined by the demand for and supply of the country's currency. There are three factors to consider, namely   1.   the balance of payment of the country, 2.   the economic performance of the country, and 3. the interest rates and inflation rate in the country.

Foreign Exchange For example, a favourable balance of payment is a surplus balance while an unfavourable balance of payment is a deficit balance. A long favourable balance results in the appreciation of the country's currency, i.e. the rise of the exchange rates of the country's currency to other currencies, such as the appreciation of Japanese Yen in 1990s. Whereas a long unfavourable balance results in the depreciation of the country's currency, i.e. the fall of the exchange rates of the country's currency to other currencies, such as the depreciation of Sterling Pound in 1990s.

Foreign Exchange Market The foreign exchange market is actually a worldwide network of traders, connected by telephone lines and computer screens, and there is no central headquarters. There are three main centres of trading, which handle the majority of all foreign exchange transactions, namely United Kingdom, United States, and Japan. The participants of the foreign exchange market are banks, finance companies, customers, brokers and central banks.

Foreign Exchange Market Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day: at 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day.

Foreign Exchange Market New York San Francisco London Hong Kong Singapore Tokyo

Exchange Rate Systems : Fixed exchange rates the exchange rates are determined by the government or the central bank of the country.

Exchange Rate Systems : Floating exchange rates the truly flexible exchange rates are determined by the supply and demand in the market.

Exchange Rate Systems : Dirty floating exchange rates the exchange rates are managed by the government or central bank of the country to float within an upper and a lower limits.

Exchange Rate Systems : Linked exchange rate the exchange rate of the country's currency to a specific foreign currency is fixed, but the exchange rates of the country's currency to other currencies are not fixed.

Historical Development of Exchange Rates System in Hong Kong Before 1972, Hong Kong was a member of the sterling area. The Hong Kong dollar was pegged to the pound sterling at £1=HK$14.55 and there was an exchange control system. In 1972, because of the depreciation of pound sterling, the government decided to have the Hong Kong dollar pegged to the United States dollar at US$1=HK$5.65. But in 1974, the Hong Kong dollar was allowed to float and the exchange control system was abolished.

Historical Development of Exchange Rates System in Hong Kong However, starting from 1982, there was a confidence crisis as the British government negotiated with the government of the People’s Republic of China about the future of Hong Kong after 1997. Political uncertainty induced significant capital outflows and the exchange rate of Hong Kong dollar to US dollar dropped to US$1=HK$9.6.

Historical Development of Exchange Rates System in Hong Kong On 17 October 1983, the government adopted a new arrangement for issuing HK dollar notes, fixing the exchange rate at US$1=HK$7.8 and the removal of the 10% interest withholding tax on Hong Kong dollar deposits. The forces of competition and arbitrage would ensure that the market exchange rate to fluctuate around the level of 7.8. Both measures restored confidence in the Hong Kong dollar.

The Mechanism of the Linked Exchange Rate System Prior to 17 October 1983, the Certificate of Indebtedness (CI) was issued and redeemed by the Exchange Fund against payments of Hong Kong dollars. The Certificate of Indebtedness was hold by the note-issuing banks as cover for the issue of Hong Kong dollar notes. Under the Linked Exchange Rate System, the payment was to be made in US dollars at a fixed exchange rate of US$1=HK$7.80.

The Mechanism of the Linked Exchange Rate System The forces of competition and arbitrage between markets would ensure that the exchange rate would stabilize at a level close to the fixed rate with minimum intervention by the Exchange Fund.

The Mechanism of the Linked Exchange Rate System For example, if the Hong Kong dollar is traded in the market at a rate below 7.80, say 8.00, then banks will be encouraged to cash in their holding of Hong Kong dollar notes through the note-issuing banks for US dollar deposits. Then they can sell the US dollar deposits for Hong Kong dollar deposits at the market rate to make a profit of HK$0.20 per US$1.

The Mechanism of the Linked Exchange Rate System As a result, in the open market, more banks will buy HK dollar notes and sell US dollar deposits. Following the redemption of the CIs, the HK dollar notes in circulation are reduced and the liquidity in the banking system is tightened. Interest rates in Hong Kong will rise until they are high enough to attract capital inflow. The arbitrage activity will boost the demand for HK dollar so that the exchange rate will rise to 7.80.

The Mechanism of the Linked Exchange Rate System Nevertheless, the mechanism assumes that the market obeys the laws of economics. Therefore, political factors might overshadow the laws of demand and supply. If the capital outflow is serious, the government will have to spend a lot of the exchange fund to buy up Hong Kong dollars in the market in an effort to support the linked exchange rate.

The Mechanism of the Linked Exchange Rate System Moreover, only banks are capable of dealing with the Exchange Fund to make arbitrage, individuals and corporations are not allowed to do this with the Exchange Fund. In the normal course of business, banks must keep a certain liquidity level to meet customers’ demand for money withdrawal. Therefore, banks’ ability to arbitrage is also limited.

Exchange rate quotations Suppose the exchange rate of US dollar to HK dollar is quoted as USD / HKD = 7.7980 / 90 which stands for US$1 = HK$7.7980 / HK$7.7990. The US dollar is the base currency and the HK dollar is the quoted currency.

Exchange rate quotations Bid Offer (Bank buy) (Bank sell) USD / HKD 7.7980 7.7990   The Bid rate means the bank buys US$1 from a customer in return of HK$7.7980 whereas the Offer rate means the bank sells US$1 to a customer in return of HK$7.7990.

Cross Rate Calculations If GBP / USD = 1.4270 / 80 and USD / HKD = 7.7980 / 90, what are the exchange rates of GBP / HKD ?   Bid : 1.4270  7.7980 = Offer : 1.4280  7.7990 =

Cross Rate Calculations If USD / JPY = 115.50 / 70 and USD / HKD = 7.7980 / 90, what are the exchange rates of JPY / HKD ?   Bid : (7.7980  115.70)  100 = Offer : (7.7990  115.50)  100 = The exchange rates of Japanese Yen to HK Dollar are always quoted as JPY (100) / HKD.

Spot rate vs Forward rate Spot rate is the exchange rate for a spot transaction in which there is a purchase or sale of a foreign currency with delivery (settlement) to be completed immediately between a bank and a customer or within two business days between two banks. Forward rate is the exchange rate for a forward contract of a purchase or sale of a foreign currency with delivery to take place on a determined future date.

Calculation of forward exchange rate The forward rate is calculated from the spot rate and interest rates by the Interest Parity Theorem. Suppose the spot rate of USD / HKD is 7.7960, the 3-month deposit interest rate of USD is 7.25% and that of HKD is 6%, what is the 3-month forward rate of USD / HKD ?

Calculation of forward exchange rate 1 + (rHK) (n / 365) Fn = S × 1 + (rUS) (n / 360) 1 + (0.06) (90 / 365) = 7.7960 × 1 + (0.0725) (90 / 360) = 7.7707

Calculation of forward exchange rate The US dollar is at a discount whereas the HK dollar is at a premium. Therefore, HK dollar is more expensive in future than now in terms of US dollar. But suppose the 3-month deposit interest rate of USD is 4.5% and that of HKD is 5.5%, what will be the 3-month forward rate of USD / HKD ?

Calculation of forward exchange rate 1 + (0.055) (90 / 365) = 7.8138 7.7960 × 1 + (0.045) (90 / 360)

Calculation of forward exchange rate In this case, the US dollar is at a premium whereas the HK dollar is at a discount. In other words, HK dollar is cheaper in future than now in terms of US dollar. If the spot rates of USD / HKD = 7.7960 / 70, the forward rates of USD / HKD will be quoted as 250 / 240. Because the convention of the foreign exchange market is to quote the forward rates in terms of “points”.

Calculation of forward exchange rate The rule is that 250 / 240 indicates High / Low which means discount for US dollar or premium for HK dollar. Then Spot rates 7.7960 7.7970 Premium of HKD －0.0250 －0.0240 3-month Forward rates 7.7710 7.7730

Calculation of forward exchange rate On the other hand, if the 3-month forward rates of USD / HKD are quoted as 180 / 190 which indicates Low / High and means premium for US dollar or discount for HK dollar, then Spot rates 7.7960 7.7970 Discount of HKD ＋0.0180 ＋0.0190 3-month Forward rates 7.8140 7.8160

Hedging Hedging is the process of arranging a forward exchange contract by a merchant to meet a future requirement of foreign currency transaction and to reduce the risk of exchange rate fluctuation. For example, an importer needs Pound Sterling £125,000 three months later to pay for a machine imported from England but worries that the exchange rate of Pound Sterling may rise. He can buy a 3-month GBP / USD forward exchange contract to fix the exchange rate.

Hedging For most importers and exporters, forward exchange contracts are a convenient and cheap means of avoiding or reducing the exchange risk in international trade. The other methods are : 1.    operating a foreign currencies account, 2.    invoicing in the domestic currency, or 3.  buying a foreign currency futures contract or a foreign currency option.

Futures vs Option Futures contracts are trade on futures exchanges. They are standardized contracts, the specifications are established by each futures exchange. A futures contract is a legally binding contract and can be bought or sold in that exchange in contract unit size. The buyer and seller only need to indicate the number of contracts, bought or sold, the trading price and month of delivery of the transaction, as well as the floor member with whom the trade was executed.

Futures vs Option For example, the importer who needs GBP £125,000 in August can buy an August GBP futures contract in May at the trading price of GBP / USD 1.5860 through a broker.  If an importer or exporter does not have the precise time for the need of a foreign currency transaction, an option contract can be used. An option contract sets a future period of time for the delivery (settlement) of an amount of foreign currency at a predetermined exchange rate.

Futures vs Option An option is an agreement between a buyer and a seller by which the buyer has the right to exercise his option, i.e. to require the seller to perform certain obligations specified in the contract. The difference between a futures contract and an option is that in a futures contract, the seller is obligated to make a delivery when the contract falls due, while in an option, the seller is obligated to make a delivery at any time up to the expiry date if the buyer has opted to do so. The user of an option has to pay a premium but the buyer or seller of a futures contract do not need to pay any money at the time of entering the contract except the broker’s commission.

Futures vs Option Premium is the price of an option. Strike price is the exchange rate of the foreign currency at which the option can be exercised. Expiry date is the last day on which the option can be exercised. A call option gives the buyer the right to purchase the currency at the stated strike price on or before the expiry date whereas a put option gives the buyer the right to sell.

Tutorial If EUR / USD = 1.0650 / 1.0660 and USD / HKD = 7.7980 / 90, calculate the exchange rates of EUR / HKD. Suppose the 3-month Savings Deposit Interest Rates are 0.0625% p.a. in Hong Kong and 1.0625% p.a. for Euro Dollar. What are the forward exchange rates of EUR / HKD ? Distinguish between a foreign currency futures contract and a foreign currency option.