1. Foreign Exchange Lecture 18, 18 th February 2010 Dr Michael Wynn-Williams wm97@gre.ac.uk 1

2. 2  It affects the bottom line  Currency appreciation increases export prices, but reduces import prices  Depreciation reduces export prices but increases import prices  Invisibles, payments on account of services will increase  FDI, with devaluation, the ROCE will change as will the IRR  Commercial borrowing, devaluation will increase the cost of debt servicing  But  There are opportunities for arbitrage.  Companies can protect themselves through hedging,

3. 3  The exchange rate is the price at which the national currency is valued in relation to a foreign currency.  It also occupies a central position in monetary policy, where it may serve as a target, an instrument or simply an indicator-depending upon the chosen framework of monetary policy.  The exchange rate provides governments short term flexibility for their monetary policies – it acts as a pressure relief valve

4. 4  Only 2% of total transactions is trade related  BIS coordinated survey 2007 Daily forex turnover $ 3.99 trillion  US$ involved in 88% of trade volumes –has declined after the Euro  US$/GBP – 12%  US$/EURO – 27%  Main centres of trade  UK – 34.1%  US – 16.6%  Japan - 6.0%  France – 3.0%  Germany – 2.5%

5. 5  Classification of rates  Spot: delivery in two days  Forward contract: delivery at agreed price any day in the future  Future: standardised contract for amount and maturity, usually 3 months  Swap: currencies are exchanged for a period, then exchanged back. Comprises spot and forward rates

6. 6  Buying and selling : both from view point of the bank.  e:g £/$ buying rate = 1.75  £/$ selling rate = 1.65  Spread = 0.10 (this is where the bank makes profits)  Transaction types  Telegraphic Transfer TT – funds already with the bank  Bills for collection - funds reach the bank after a delay  Institutions  Commercial banks  Investment banks  Securities exchanges  Auctions  Company to company

7. 7 ActivityCustomerBankProfit Opportunity TT BuyingReceives money by wire Changes money on receipt BC BuyingReceives money on credit Changes money and issues bill TT SellingSends money by wire Changes money on receipt BC SellingSends money by wire Changes money and issues bill

8. 8  Purchasing power parity  Currency supply – import spending  Interest rates  Confidence in the government

9. 9  Purchasing power parity (PPP) compares the prices of identical goods in different markets  PPP shows how much can be bought assuming that the money spent is generated locally  This implies an exchange rate between countries  A basket of goods in the US costs $100, the same in the UK costs £50  The PPP exchange rate is £1 = $2 (direct), or $1 = £0.50  The “Law of One Price” suggests that prices will equalise in a free global market  The PPP exchange rate can indicate if the nominal exchange rate is sustainable  PPP exchange rate: £1 = $2  Nominal exchange rate: £1 = $1.50  Therefore current pound spot rate is undervalued by 25%

10. 10 Source: The Economist

11. 11  The demand for imports depends on  Income level  The relative prices of foreign and domestic products  The current exchange rate  If income levels rise…  Demand for imports (and domestic products) will rise  There is a greater need for foreign currency to pay for the imports  The local currency falls in value  If inflation is higher in one country, Year 1 to Year 2…  Local prices will rise relative to the foreign country  Local currency falls in value to account for the change  If there is a current account deficit…  There is an over-supply of domestic currency  The value of the currency will fall

12. 12  Investment funds will seek out the highest interest rates around the world  If the UK raises interest rates, foreign investors must buy sterling in order to make the investment  Raising interest rates, or the threat of it, will therefore boost the value of the currency  The currency would stop rising once it had eliminated the gains from transferring funds from the low interest rate region to the high interest rate region

13. 13  Influencing the exchange rate  Responsibility of the central bank  Uses money supply to regulate currency demand  Holds currency reserves as ballast Official Foreign Reserves Dec 2009 1. China $2,399.2 billion ( 10.4) 6. Korea $270.0 billion ( -0.9) 2. Japan $1,049.4 billion ( -24.3) 7. Hong Kong $255.8 billion ( -0.5) 3. Russia $439.0 billion ( -8.8) 8. Brazil $238.5 billion ( 1.8) 4. Taiwan $348.2 billion ( 1.0) 9. Germany $189.5 billion ( 12.5) 5. India $283.5 billion ( -4.6) 10. Singapore $187.8 billion ( -1.1)  Fixed/pegged exchange rate – eg. China  Open to black market exploitation  At the mercy of the partner currency  Often used to support export strategy, but restricts imports of foreign capital and technology Source: Bank of Korea

14. 14  Economic risk  High rates of inflation  Defaults on payments  Counter party risk – partner defaults  Interest rate changes  Transaction risk  US$ moves adversely against GBP£ for specific transaction  Translation risk  Accounting problems over the life of the investment

15. 15  Judgemental forecasts  Takes a sophisticated view, including politics, social trends and personal experience  Based on a “feel for the market”  Subjective  Technical forecasts  Based on trend analysis  Chartism – identifies patterns in the data  Relies on moving averages, filters and market momentum  Generally only valid in the short-run  Fundamental forecasts  Attempt to identify and quantify the underlying economic variables  Statistical basis  Generally valid only in the long-run

16. 16  Choose one of the following forecast methods  Judgement  Technical  Fundamental  Use the method to make a forecast for today’s US$/JPY spot rate

17. 17  Choose one of the following forecast methods  Judgement  Technical  Fundamental  Use the method to make a forecast for today’s US$/JPY spot rate

18. 18  The forex markets are like any other market-  determined by demand and supply  They have their own rules and peculiarities  A lot is based on convention and individual trust  Exchange rates can also be used as a instrument of monetary policy  They allow short term flexibility  Exchange rates will also reflect the confidence in the country  Stable vs volatile exchange rates

19. 19  Read the case on “Currency Crisis”  (uploaded on WebCT, Xtra resources for Tutorials)  Take a print out  You will be working in your groups to answer the question…  Which country is likely to devalue?

20. 20  Foreign exchange risk  Bank of International Settlements  BIS Triennial Review 2004-2007  Bank of Korea  Big Mac Index