1. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–19–1 Chapter 9 The foreign exchange market

2. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–29–2 Foreign exchange transactions The foreign exchange rate = the price of one currency expressed in terms of another currency. – appreciation – depreciation 1A$ = US$0.75 1A$ = US$0.90 1$A = US$0.60

3. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–39–3 Determination of the exchange rates Price A$1 S in US$0.55 E D Quantity of A$

4. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–49–4 Floating currencies: demand for the national currency Nation’s exporters paid in other hard currencies Foreign companies undertaking direct and portfolio investment in the nation’s economy ‘Bull’ speculators in the nation’s currency Nation’s Central Bank selling US$ and other hard currencies for the nation’s currency Foreign tourists visiting your country

5. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–59–5 Floating currencies: supply of the national currency Nation’s importers paying in US$, Yen Domestic firms investing abroad ‘Bear’ speculators in the national currency Nation’s central bank buying US$, Yen Individual residents travelling overseas

6. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–69–6 Impact of A$ depreciation Commodity export price (beef) US$1000 per tonne Commodity import price (computer) US$1500 per unit Exchange rate for A$ Exporter receives Exchange rate for A$ Importer pays US$0.75A$1333US$0.75A$2000 US$0.60A$1666US$0.60A$2500 E/R effect + A$333 (25%) E/R effect + A$500 (25%) Source: Table 9.1

7. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–79–7 Impact of A$ appreciation Commodity export price (beef) US$1000 per tonne Commodity import price (computer) US$1500 per unit Exchange rate for A$ Exporter receives Exchange rate for A$ Importer pays US$0.75A$1333US$0.75 A$2000 US$0.90A$1111US$0.90A$1600 E/R effect - A$333 (- 17%) E/R effect - A$500 (- 20%) Source: Table 9.2

8. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–89–8 Functions of the foreign exchange market Currency conversion Reduction of foreign exchange risk

9. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–99–9 Australian importer purchase of computers (purchase price: US$1400 FOB) 1A$ = US$0.70 1A$ = US$0.63 Customs value – FOB price (US$1400) A$2000A$2200 Customs duty @ 5% x $2000100 Int ’ l transport & insurance100 Value of taxable importation (VoTI) 2200 GST @ 10% x $2200220 Total costs (incl. other costs @ A$30.00) 24502650 Net profit on A$2600 selling price 150-50

10. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–10 Reduction of FX risk Spot exchange rates Forward exchange rates Currency swaps

11. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–11 Spot transactions Spot transaction = the purchase of FX with delivery and payment (referred to as settlement on the following business day. Foreign exchange traders always quote a bid (buy) and offer (sell) rate. The spread = difference between the bid and offer rates and is the margin on which the trader earns a profit.

12. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–12 Market quotations Dealers always ‘buy low’ and ‘sell high’. Selling rates and buying rates are always from the perspective of the dealer/bank.

13. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–13 Forward transactions A forward rate = the price agreed on today for purchase or sale of foreign exchange at a future date. Usually agreed for less than 1 year. Premiums and discounts: forward quotations are either at a –premium: forward > spot –discount: forward < spot

14. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–14 Australian exporter to receive Euro 1 million in 6 months Spot rate on contract date: A$1 = Euro 0.60): estimated income = A$1.67m Payment made after 6 months from delivery. If A$ appreciates by 10% over 6 months, the exporter will receive 10% less: A$1.51 (loss A$160,000). The exporter will take a forward contract in order to protect the company income and ensure stable planning of operations.

15. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–15 Speculative operations 1991: Clifford Hatch, finance director of British food and drink company Allied Lyons bet on a higher BP against the US$. Over the previous 3 years he had made US$25 million for the company. Feb–April 1991 the BP depreciated from US$2.00 to US$1.75. Allied Lyons lost US$269 m. (more than the company was to earn from all of its food and drink activities during 1991!).

16. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–16 Currency swaps Foreign exchange swaps commit two counterparties (e.g. banks) to the exchange of two cash flows and involve the sale of one currency for another in the spot market with the simultaneous repurchase of the first currency in the forward market. The difference between the spot and the forward rates, called the swap rate, is expressed in terms of points and it is fixed.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–17 Economic theories of exchange rate determination Prices and exchange rates –the law of one price –the Purchasing Power Parity (PPP) Money supply and price inflation Interest rates and exchange rates Investor psychology and bandwagon effects

18. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–18 The Law of One Price It states that in competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price(when their price is expressed in terms of the same currency). An example is a highly traded good like wheat.

19. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–19 The Purchasing Power Parity (PPP) PPP exchange rate shows what the exchange rate would be if the law of one price held. Example: In German, 1 box of Chocolate = € 165 IN USA, 1 box of Chocolate = $150 Exchange rate at that time is €1.00 = $0.909 End of the year: In German = €198, In USA=$150 PPP theory predicts exchange rate should be then €1.00 = $0.7575 (Euro depreciated against dollar)

20. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–20 Money Supply and Price Inflation Positive Relationship between the inflation rate and the level of the money supply

21. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–21 Interest Rates and Exchange Rates (International Fisher Effect) An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Calculated as: Where: "E" represents the % change in the exchange rate "i 1 " represents country A's interest rate "i 2 " represents country B's interest rate For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency. The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.

22. Copyright  2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea.. 9–22 Investor Psychology and Bandwagon Effects Example of George Soros: “Anti-Pound Scheme”  Sell massively British Pound in 1990  Devaluation of British Pound  Short term exchange rate movements