1. Slide 1.1 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Lecture 1 Introduction: Terminologies, Definition and FX Markets

2. Slide 1.2 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 2 TERMINOLOGIES Foreign Exchange rate Foreign exchange rate is the rate at which one currency is exchanged for other. It is the price of one currency in term of other The exchange rate between dollar and pound refers to numbers of dollars required to purchased one pound For example if $2.50=£1 It means that value of £0.40 pound =$1 2

3. Slide 1.3 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 3 Meaning of Exchange Rate Value of one currency in units of another currency A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

4. Slide 1.4 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Meaning of Exchange Rate (Cont.) (Bilateral) (spot) exchange rate, S, is (domestic currency) price of unit of foreign currency (FX), so rise (fall) in S is fall (rise) in value of domestic currency Cross exchange rate is bilateral exchange rate between two currencies other than dollar, $ (For Americans) Example: Cross exchange rate = ratio of two bilateral exchange rates against the $, since deviations create profit opportunities for traders Assume (unless stated otherwise) free capital movements i.e. currency fully convertible.

5. Slide 1.5 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 5 Foreign Exchange: The exchange rate of $2.50=£1 or £0.40=$1 will be eliminated in world market by arbitrage What is arbitrage: it refers to the purchase of foreign currency in one market where its price is low and sell it in another market where it price is high The effect of arbitrage is to remove differences in exchange rate, so that single exchange rate prevail in world market If exchange rate is $2.48 in London exchange market and $2.50 in new York exchange market

6. Slide 1.6 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 6 Foreign Exchange: Arbitrageurs will buy pounds in London and sell them in new York for earning profit As a result the price of pounds in term of dollars in London market rises and falls in the new York market This process will end the arbitrage practice

7. Slide 1.7 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Floating versus fixed exchange rate IMF Exchange Rate Regime Classifications: 8 Regimes (MSE,2009 p. 70-71) Pure float: exchange rate at any moment determined by net demand for currency Fixed exchange rate: monetary authority intervenes by (a) buying up excess supply of $ with £ (when £ strong, $ weak) or (b) satisfying excess demand for $ by selling $ for £ (when £ weak, $ strong), so as to prevent excess demand /supply affecting rate (a) adds $ to FX reserves, adds to £ in circulation (b) takes $ out of FX reserves, reduces £ in circulation.

8. Slide 1.8 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Foreign Exchange and Balance of payments 1. Current account: export receipts as credits, import payments as debits, net = current account balance (goods, services including financial services, interest and dividends, rent, tourism) 2. Capital account: net capital inflows = net purchases of £ by foreigners in order to acquire claims on UK residents less net sales of £ by UK residents in order to acquire claims on foreigners (long-term including securities – equities, bonds etc., real estate etc. + short-term including bank deposits, short-term securities) Total net underlying demand for £ = 1 + 2 (basic balance) is equated to zero by exchange rate movement, unless Government intervenes to fix exchange rate, in which case: 3. Reserve change = – (1 + 2) to prevent basic balance causing exchange rate to move.

9. Slide 1.9 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Table 1.3 UK balance of payments 2006 Source: National Statistics website: www.statistics.gov.uk. Crown copyright material is reproduced with the permission of the Controller Office of Public Sector Information (OPSI).

10. Slide 1.10 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 10 Determination of equilibrium exchange rate The exchange rate in a free market is determined by the demand and supply of foreign exchange Equilibrium exchange rate is a rate at which demand for foreign exchange is equal to supply of foreign exchange It is the rate which clears the foreign exchange market Two method for clearing the market A) Demand and supply of dollars with price of dollars in pounds B) Demand and supply of pounds with price of pounds in dollars…………both method yields same result

11. Slide 1.11 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 11 Determination of equilibrium exchange rate (cont…) 1) Demand for foreign exchange The demand for foreign exchange (pounds) is a derived from demand from pounds It arises from import of British goods and services into U.S and from capital movements from the U.S to Britain Demand for pounds implies supply of dollars When U.S businessmen buy British goods and services and make capital transfers to Britain they create demand for British pounds in exchange for U.S dollars

12. Slide 1.12 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 12 Determination of equilibrium exchange rate (cont…) Demand curve for pounds DD is sloping downward from left to right It means that lower the exchange rate on pounds( pounds became cheaper) (dollars price of pound) the larger will be demand for pounds in foreign market This means that British exports of goods and services cheaper in term of dollars The opposite happens if exchange rate on pounds (dollars price of pound) is higher It will make British goods and services dearer

13. Slide 1.13 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 13 Determination of equilibrium exchange rate (cont…) Supply of foreign exchange Supply of foreign exchange in our case is the supply of pounds It arises from U.S exports of goods and services to Britain and capital movement from U.S to Britain British holders of pounds wish to make payment in $, thus supply of pounds in market will increase Supply curve for pounds SS is an upward sloping curve The relation between exchange rate on pounds (dollar price of pounds) and supply of pounds is positive If exchange rate on pounds increases U.S goods and services become cheaper in Britain,they would purchase more and as a result supply of pounds in a market increase

14. Slide 1.14 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 14 Determination of equilibrium exchange rate (cont…) S S D pounds Exchange rate Dollar price of pounds R Q R2R2 R1R1 0

15. Slide 1.15 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 15 Determination of equilibrium exchange rate (cont…) Given the demand and supply curve for foreign exchange, the equilibrium exchange rate is determined where demand for pounds intersects supply of pounds Equilibrium exchange rate is “R” and OQ shows equilibrium demand and supply of foreign exchange rate If exchange rate is higher than equilibrium exchange rate it means that supply of pounds is greater than demand for pounds The price of pounds will fall and ultimately equilibrium exchange rate will reach and economy will come back to equilibrium point i.e point “E”

16. Slide 1.16 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 16 Determination of equilibrium exchange rate (cont…) An exchange rate lower than equilibrium rate mean demand for foreign exchange rate is greater than supply of foreign exchange rate This leads to increase the price of pounds in foreign exchange market so exchange rate will tends to increase and equilibrium rate will re- established in market Economy come back to equilibrium point i.e. point “E”

17. Slide 1.17 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 17 Meaning of Exchange Rate and Measuring Changes in Exchange Rates Value of one currency in units of another currency A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated

18. Slide 1.18 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 18 Appreciation/Depreciation Percentage change in value US $ New Value of Foreign Currency per unit of $- Old value of foreign currency per $ -------------------------------------------------- X 100 Old value of Foreign Currency per $ Percentage change in value of Foreign Currency New Value of $ per units of Foreign Currency - Old value of $ per unit of foreign currency -------------------------------------------------- X 100 Old value of $ per unit of Foreign Currency HW: Calculate the change in the value of your currency against both Euro and Dollar from September 2010 to September 2011.

19. Slide 1.19 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 19 Exchange Rate Equilibrium Forces of Demand and Supply Demand for foreign currency negatively related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate

20. Slide 1.20 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 20 Demand for Foreign Currency Price for Foreign Currency Units of Foreign Currency (£) $1.50 $2.00 D D 50m 75 m

21. Slide 1.21 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 21 Supply of Foreign Currency Supply for Foreign Currency Units of Foreign Currency (£) $1.50 $2.00 50 m75 m S S

22. Slide 1.22 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 22 Equilibrium Exchange Rate Exchange Rate Units of Foreign Currency(£) S S D D $1.6775

23. Slide 1.23 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 23 Factors that influence the Exchange Rate Expectations of the Market Political Events Relative Inflation Rates Relative Interest Rates Relative Income Levels Exchange rate is the results of an interaction of these factors

24. Slide 1.24 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 24 Market Expectations Expectations about future exchange rate changes on the basis of current and future political and economic conditions 1960s Strong $ Between 1960s and 1970s: weak $ Strong $ in 1999 – 2001 Weak Dollar today 2005 1995 European Exchange Rate Mechanism Devaluation of Asian Currencies

25. Slide 1.25 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 25 Political Events Fall of Berlin Wall and unification of East and West Germany Persian Gulf War September 11, 2001

26. Slide 1.26 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 26 Relative Inflation High inflation relative to a foreign country, decline in value of currency—Why? Low inflation relative to a foreign country, increase in value of currency—Why?

27. Slide 1.27 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 27 Relative Interest Rates High interest rates in home country relative to a foreign country may cause domestic currency to appreciate—Why?

28. Slide 1.28 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 28 Relative Income Levels Increase in domestic income relative to foreign income may lead to a decline in the value of domestic currency– Why?

29. Slide 1.29 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 29 Exchange Rate Determination An interaction of factors Is it possible for a country with high real returns to have a low currency value? Is it possible for a country with low real returns to have a high currency value?

30. Slide 1.30 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Exchange rates since 1945 Bretton Woods 1944–68 US $ fixed at 1 oz gold = $35, all other currencies fixed to $ with  1% fluctuation bands, devaluations to correct persistent deficits Breakdown 1968–73 as US printed excess $ causing worldwide inflation and flight into gold, other currencies (DM, Yen) Floating Era 1973 onward managed floats for most convertible currencies at first, but later experiments with limited fixed systems e.g. ERM in Europe, currency boards in Hong Kong, Argentina EMU 1998 onward response to failure of fixed exchange rates Increasing importance of Asian exchange rates 2000 onward especially RMB, Won, Rupee (varying degrees of flexibility/convertibility, increasingly linked to $/€/Yen currency basket).

31. Slide 1.31 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Figure 1.3 Exchange rates against the US dollar, 1975–2007 (1999 = 100)

32. Slide 1.32 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Figure 1.4 Effective exchange rates (trade-weighted), 1975–2006

33. Slide 1.33 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Figure 1.5 The pound (trade-weighted and bilateral), 1975–2006

34. Slide 1.34 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 Figure 1.6 The euro since 1999: currencies per € Note: each exchange rate is the daily closing mid-price of €1.00. For US$, the data are unscaled. The other five exchange rates are scaled so that 25/01/00 = 1.0, to match the $US, which actually stood at €1.00 = $1.0008 on that day

35. Slide 1.35 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010

36. Slide 1.36 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 36 The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency.

37. Slide 1.37 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 37 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET Participants at 2 Levels 1.Wholesale Level (95%) - major banks 2.Retail Level - business customers.

38. Slide 1.38 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 38 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET Two Types of Currency Markets 1.Spot Market: - immediate transaction - recorded by 2nd business day

39. Slide 1.39 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 39 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2.Forward Market: - transactions take place at a specified future date

40. Slide 1.40 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 40 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET Participants by Market 1. Spot Market a.commercial banks b.brokers c.customers of commercial and central banks

41. Slide 1.41 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 41 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2.Forward Market a.arbitrageurs b.traders c.hedgers d.speculators

42. Slide 1.42 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 42 PART III. THE SPOT MARKET I.SPOT QUOTATIONS A.Sources 1.All major newspapers 2.Major currencies have four different quotes: a.spot price b.30-day c.90-day d.180-day

43. Slide 1.43 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 43 THE SPOT MARKET B.Method of Quotation 1.For interbank dollar trades: a.American terms example: $0.5838/€ b.European terms example: €1.713/$

44. Slide 1.44 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 44 THE SPOT MARKET 2.For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. EXAMPLE:dm1.80/$

45. Slide 1.45 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 45 THE SPOT MARKET C.Transactions Costs 1. Bid-Ask Spread used to calculate the fee charged by the bank Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency

46. Slide 1.46 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 46 THE SPOT MARKET 4.Percent Spread Formula (PS):

47. Slide 1.47 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 47 THE SPOT MARKET D.Cross Rates 1.The exchange rate between 2 non - US$ currencies.

48. Slide 1.48 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 48 THE SPOT MARKET 2.Calculating Cross Rates When you want to know what the €/  cross rate is, and you know €2/US$ and .55/US$ then €/  = €2/US$  .55/US$ = €3.636/ 

49. Slide 1.49 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 49 THE SPOT MARKET E.Currency Arbitrage 1.If cross rates differ from one financial center to another, and profit opportunities exist.

50. Slide 1.50 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 50 THE SPOT MARKET 2.Buy cheap in one int’l market, sell at a higher price in another 3.Role of Available Information

51. Slide 1.51 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 51 THE SPOT MARKET F.Settlement Date Value Date: 1.Date monies are due 2.2nd Working day after date of original transaction.

52. Slide 1.52 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 52 PART III. THE FORWARD MARKET I.INTRODUCTION A. Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

53. Slide 1.53 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 53 THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk.

54. Slide 1.54 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 54 THE FORWARD MARKET B.Forward Rate Quotations 1. Two Methods: a.Outright Rate: quoted to commercial customers. b.Swap Rate: quoted in the interbank market as a discount or premium.

55. Slide 1.55 Copeland, Exchange Rates and International Finance, 5 th Edition, © Pearson Education Limited 2010 55 THE FORWARD MARKET C.Forward Contract Maturities 1. Contract Terms a.30-day b.90-day c.180-day d.360-day 2.Longer-term Contracts