FOREIGN EXCHANGE RATES

A. CONCEPT OF FOREIGN EXCHANGE RATE

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate,

FX rate or Agio) between two currencies is the rate at which one currency will
be exchanged for another. It is also regarded as the value of one country's currency in
terms of another currency foreign exchange rates. This rate depends on the
local demand for foreign currencies and their local supply, country's trade balance, strength of its
economy, and other such factors.

An exchange rate is how much it costs to exchange one currency for another. Exchange rates
fluctuate constantly throughout the week as currencies are actively traded. This pushes the
price up and down, similar to other assets such as gold or stocks.

If the USD/CAD exchange rate is 1.0950, that means it costs 1.0950 Canadian dollars for 1 U.S.
dollar. The first currency listed (USD) always stands for one unit of that currency; the exchange
rate shows how much of the second currency (CAD) is needed to purchase that one unit of the
first (USD).This rate tells you how much it costs to buy one U.S. dollar using Canadian dollars.
To find out how much it costs to buy one Canadian dollar using U.S. dollars use the following
formula: 1/exchange rate. In this case, 1 / 1.0950 = 0.9132. It costs 0.9132 U.S. dollars to buy
one Canadian dollar. This price would be reflected by the CAD/USD pair; notice the position of
the currencies has switched.

For example, an interbank exchange rate of 119 Japanese yen (JPY, ¥) to the United States

dollar (US$) means that ¥119 will be exchanged for each US$1 or that US$1 will be exchanged for
each ¥119. In this case it is said that the price of a dollar in terms of yen is ¥119, or equivalently that
the price of a yen in terms of dollars is $1/119.

B. Theoretical parts

1- Nominal exchange rate and real exchange rate. How are changes in the real exchange rate
and the nominal exchange rate related? Also produce the model to calculate eal exchange
rate.

The nominal exchange rate is the rate at which two currencies can be exchanged for each other in
the market.

The real exchange rate is the price of domestic goods relative to foreign goods.
 Changes in the real exchange rate are related to changes in the nominal exchange rate depending
on changes in the price levels of two countries:

 For example : if a bottle of US wine can be sold for $20, and the nominal exchange rate is 0.8
Euro per US dollar, then the bottle of US wine is worth 20 x 0.8 = 16 Euro. If a bottle of
European wine costs 15 Euro, then 16/15 = 1.07 bottles of European wine can be purchased
with the 16 Euro. Putting all of the pieces together, the bottle of US wine can be exchanged for
1.07 bottles of the European wine, and the real exchange rate is thus 1.07 bottles of
European wine per bottle of US wine.

Calculating the Real Exchange Rate

2- What are the two main types of exchange rate systems? Currently, which type of system
determines the values of the major currencies, such as the dollar, yen, and mark?

The two major types of exchange-rate systems are fixed exchange rates and flexible exchange
rates. In a fixed-exchange-rate system, exchange rates are set at officially determined levels. In a
flexible-exchange-rate system, exchange rates are determined by conditions of demand and supply
in the foreign exchange market.

Currently, the major currencies of the world are on a flexible-exchange-rate system.

3- Define purchasing power parity, or PPP. Does PPP work well empirically? Explain.

Purchasing power parity, PPP, is the idea that similar foreign and domestic goods, or baskets of
goods, should have the same price when priced in terms of the same currency. Purchasing power
parity does seem to explain exchange rates in the long run, but over shorter periods it doesn’t work
well because countries produce very different sets of goods, because some goods aren’t traded
internationally, and because there are transportation costs and legal barriers.

4- What is the fundamental value of a currency? What does saying that a currency is
overvalued mean? Why is an overvalued currency a problem? What can a country do about
an overvalued currency?

The fundamental value of a currency is the value of the exchange rate that would be determined by
free-market forces of demand and supply without government intervention. When the official
exchange rate is higher than its fundamental value, it is said to be overvalued. This is a problem,
because to maintain the official exchange rate, the central bank will have to buy the currency with
official reserve assets. To prevent having an overvalued currency, the country can change the
official exchange rate, restrict international transactions, or use contractionary monetary policy. 5-
Discuss the relative advantages and disadvantages of flexible exchange rates, fixed exchange rates,
and a currency union.

Flexible exchange rates have the advantage of allowing a country to use expansionary monetary
policy to combat recessions, but currency values fluctuate substantially, introducing uncertainty into
international transactions. Fixed exchange rates avoid this problem, but a country may have to give
up the independent use of monetary policy. This latter factor is a disadvantage when it comes to
combating recessions, but might be an advantage in helping keep inflation low. As long as countries
can coordinate on overall monetary policy, the fixed exchange rate system can be maintained. A
currency union is very similar to a system of fixed exchange rates, but has further advantages. Costs
of trading goods and assets across countries are even lower than under fixed exchange rates and
speculative attacks on the currency cannot occur. But a currency union requires an even greater
coordination of political and financial institutions than a fixed exchange rate system does.

5. Give a full definition of the market for foreign exchange.

Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing
power from one currency into another, bank deposits of foreign currency, the extension of credit
denominated in a foreign currency, foreign trade financing, and trading in foreign currency options
and futures contracts.

6. What is the difference between the retail or client market and the wholesale or interbank
market for foreign exchange?

The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesaleor
interbank market and the other tier is the retail or client market. International banks provide the core
of the FX market. They stand willing to buy or sell foreign currency for their own account. These
international banks serve their retail clients, corporations or individuals, in conducting foreign
commerce or making international investment in financial assets that requires foreign exchange.
Retail transactions account for only about 14 percent of FX trades. The other 86 percent is
interbank trades between international banks, or non-bank dealers large enough to transact in the
interbank market.

7. Who are the market participants in the foreign exchange market?

The market participants that comprise the FX market can be categorized into five groups:

international banks,

bank customers,

non-bank dealers,

FX brokers, and

central banks.
International banks provide the core of the FX market. Approximately 100 to 200 banks worldwide
make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their
own account. These international banks serve their retail clients, the bank customers, in
conducting foreign commerce or making international investment in financial assets that requires
foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment
banks, mutual funds, pension funds, and hedge funds, whose size and frequency of trades make it
cost- effective to establish their own dealing rooms to trade directly in the interbank market for their
foreign exchange needs. Most interbank trades are speculative or arbitrage transactions where
market participants attempt to correctly judge the future direction of price movements in one
currency versus another or attempt to profit from temporary price discrepancies in currencies
between competing dealers. FX brokers match dealer orders to buy and sell currencies for a fee,
but do not take a position themselves. Interbank traders use a broker primarily to disseminate as
quickly as possible a currency quote to many other dealers. Central banks sometimes intervene in
the foreign exchange market in an attempt to influence the price of its currency against that of a
major trading partner, or a country that it “fixes” or “pegs” its currency against. Intervention is the
process of using foreign currency reserves to buy one’s own currency in order to decrease its
supply and thus increase its value in the foreign exchange market, or alternatively, selling one’s own
currency for foreign currency in order to increase its supply and lower its price.

8. What is meant by a currency trading at a discount or at a premium in the forward market?

The forward market involves contracting today for the future purchase or sale of foreign exchange.
The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower
(at a discount) than the spot price.

9. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in
many instances for hedging purposes. How can the bank eliminate the currency exposure it
has created for itself by accommodating a client’s forward transaction?

Swap transactions provide a means for the bank to mitigate the currency exposure in a forward
trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a
forward purchase (or sale) of an approximately equal amount of the foreign currency.

To illustrate, suppose a bank customer wants to buy dollars three months forward against British
pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the
exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The
bank will lend the dollars for three months until they are needed to deliver against the dollars it has
sold forward. The British pounds received will be used to liquidate the sterling loan.

10. What is triangular arbitrage? What is a condition that will give rise to a triangular
arbitrage opportunity

Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then
trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an
arbitrage profit via trading from the second to the third currency when the direct exchange between
the two is not in alignment with the cross exchange rate. Most, but not all, currency transactions go
through the dollar. Certain banks specialize in making a direct market between non-dollar
currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the
implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their
direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is
possible.

11. Conversion Spreads

When you go to the bank to covert currencies, you most likely won't get the market price that
traders get. The bank or currency exchange house will markup the price so they make a profit,
as will credit cards and payment services providers such as PayPal when a currency conversion
occurs.

If the USD/CAD price is 1.0950, the market is saying it costs 1.0950 Canadian dollars to buy 1
U.S. dollar. At the bank though, it may cost 1.12 Canadian dollars. The difference between the
market exchange rate and the exchange rate they charge is their profit. To calculate the
percentage discrepancy, take the difference between the two exchange rates, and divide it by
the market exchange rate: 1.12 - 1.0950 = 0.025/1.0950 = 0.023. Multiply by 100 to get the
percentage markup: 0.023 x 100 = 2.23%..

A markup will also be present if converting U.S. dollars to Canadian dollars. If the
CAD/USD exchange rate is 0.9132 (see section above), then the bank may charge
0.9382. They are charging you more U.S. dollars than the market rate. 0.9382 - 0.9132
= 0.025/0.9132 = 0.027 x 100 = 2.7% markup.

C. Definitions and Formulae

 Forward Exchange Rate

Forward exchange rate is the exchange rate at which a party is willing to enter into a contract
to receive or deliver a currency at some future date. Forward rates can be calculated from
spot rates and interest rates using the formula 

Spot x (1+domestic interest rate)/(1+foreign interest rate),

where the 'Spot' is expressed as a direct rate (ie as the number of domestic currency

units one unit of the foreign currency can buy).

Using the relative purchasing power parity, forward exchange rate can be calculated using the following formula:

1 + Id n
f=s×   
1 + If
Where,

f is forward exchange rate in terms of units of domestic currency per unit of foreign currency;

s is spot exchange rate, in terms of units of domestic currency per unit of foreign currency;

Id domestic inflation rate;

If is foreign inflation rate; and

n is number of time period

Spot Exchange Rate

Spot exchange rate (or FX spot) is the current rate of exchange between two currencies. It is the rate at which the

currencies can be exchanged immediately.

According to the definition, delivery is theoretically immediate; however, conventions of currency markets allow for up

to two days for settlement of a transaction.

Spot exchange rates are presented either as a direct quote or as indirect quote.

Converting from Spot to Forward Rate

For simplicity, consider how to calculate the forward rates for zero-coupon bonds. A basic
formula for calculating forward rates looks like this:

Forward = (((1 + (spot rate for year "x")^"x") / ((1 + (spot rate for year "y")^"y")) - 1

In the formula, "x" is the end future date (say, 5 years), and "y" is the closer future date (3
years), based on the spot rate curve.
 D. PROBLEM PART

1. On January 1, 2000 Xerox Corporation signs a contract with Japanese government to

supply office machinery. The contract stipulates that Xerox will receive 500,000 Yen
on January 1, 2001. Xerox wishes to insure itself against exchange rate risk.
The yield on a one year US Treasury bill on January 1, 2000 is 5.73% and the yield on a
one year Japanese Treasury bond is 1.17%. The spot exchange rate on the same date
is 110 Yen per US dollar. Suppose that Xerox uses the forward market to insure itself
against exchange rate risk.
Compute the amount of dollars that Xerox will receive for sure.

SOL. Using Covered Interest rate parity, the implied forward exchange rate is

F = [(1+0.0117)/(1+0.0573)]* 110 = 105.26,

(Yen per dollar) hence the amount of dollars that Xerox will receive is
$500,000/105.26 = 4750.14.

2. PROBLEM 1 remains the same.

Suppose that there were no forward markets and that Xerox does not want any
exposure to exchange rate risk. The company can still eliminate all exchange rate
risk by borrowing in Yen and investing in US Treasury bonds.

a. Compute the magnitude of Yen borrowing that Xerox will have to conduct to
insure against exchange rate risk.

SOL. Xerox will borrow in yen the amount 500,000/(1+0.0117)=494217.65, that is the present
value of 500,000 yen. Then invest this amount, in dollars, in U.S. t-bills. The amount of USD
invested is 500,000/((1+0.0117)*110), and the amount of dollars received at the end of the year
is [500,000/((1+0.0117)*110)]*(1+0.0573).

b. Compute the amount of dollars that Xerox will receive.

SOL. As shown above the amount of dollars Xerox will receive is

[500,000/((1+0.0117)*110)]*(1+0.0573)=$4750.33

3. A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest
of the market is trading at CD1.3436-CD1.3441. What is implied about the trader’s
beliefs by his prices?

The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and
therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of
 U.S. dollars by standing willing to buy $ at only CD1.3435/$1.00 and offering to sell from
inventory at the slightly lower than market price of CD1.3440/$1.00.

4. Over the past six years, the exchange rate between Swiss franc and U.S. dollar, SFr/$,
has changed from about 1.30 to about 1.60. Would you agree that over this six-year
period, the Swiss goods have become cheaper for buyers in the United States?
(UPDATE? SF has gone from SF1.67/$ to SF1.04/$ over the last six years.)

The value of the dollar in Swiss francs has gone up from about 1.30 to about 1.60.
Therefore the dollar has appreciated relative to the Swiss franc, and the dollars needed
by Americans to purchase Swiss goods have decreased. Thus, the statement is correct.

5. The current spot exchange rate is $1.95/£ and the three-month forward rate is
$1.90/£. Based on your analysis of the exchange rate, you are pretty confident that
the spot exchange rate will be $1.92/£ in three months. Assume that you would
like to buy or sell £1,000,000.
a. What actions do you need to take to speculate in the forward market? What is
the expected dollar profit from speculation?
b. What would be your speculative profit in dollar terms if the spot exchange rate
actually turns out to be $1.86/£.

Solution:
a. If you believe the spot exchange rate will be $1.92/£ in three months, you should buy
£1,000,000 forward for $1.90/£. Your expected profit will be:
$20,000 = £1,000,000 x ($1.92 -$1.90).
b. If the spot exchange rate actually turns out to be $1.86/£ in three months, your loss
from the long position will be:
-$40,000 = £1,000,000 x ($1.86 -$1.90).

6. Exchange rate between US$ and British £ on 1 January 2012 was $1.55 per £. This
is our spot exchange rate. Inflation rate and interest rate in US were 2.1% and
3.5% respectively. Inflation rate and interest rate in UK were 2.8% and 3.3%.

Estimate the forward exchange rate between the countries in $/£.

Sol. Using relative purchasing power parity, forward exchange rate comes out to be $1.554/£

f = $1.5507/£ 1 + 3.3% n
    = $1.554/£
× 1 + 3.3%

Using the interest rate parity, forward exchange rate is

f = $1.5507/£ 1 + 2.1% n
    = $1.5401/£
× 1 + 2.8%
 Actual exchange rate was $1.6244/£. US$ has depreciated more than predicated by the relative

purchasing power parity and interest rate parity.

7. SPOT RATES

a. A US company is required to pay 20 billion Chinese Yuan (CNY) to a Chinese company today, 18

June 2013. How many USD the company has to convert in spot forex market to get the required

CNY. From XE.com, we get that 1 CNY = 0.163152 USD on 18 June 2013, at 23.33 UTC. The rate is

based on mid-market quotes.

Sol. Since 1 CNY = 0.163152 USD, 20 billion CNY must equal 3.26304 billion USD (0.163152 × 20

billion). The company must sell 3.26304 billion USD to get 20 billion CNY to pay to the Chinese

company.

b. In example 1, we used the mid-market quote to calculate the amount of US dollars needed. In

reality, exchange rates are quoted as a range, showing both bid and ask prices. Current live

CNY/USD bid-ask quote obtained are 0.1619 − 0.1623. How many USD the company has to

convert in spot forex market to get the required CNY.

Sol. The ask price is the price at which the dealer is willing to sell CNY in return of USD. The bid price is

the price at which the currency dealer is willing to buy CNY; in return of USD.

The US company has USD and it wants to buy CNY, so it must pay the ask price i.e. 0.1623. In order to

buy 20 billion CNY, it has to pay USD 3.246 billion.

8. Suppose a hypothetical two-year bond is yielding 10% while a one-year bond is

yielding 8%. The return produced from the two-year bond is the same as if an
investor receives 8% for the one-year bond and then uses a rollover to roll it over
into another one-year bond at a forward rate. Convert the spot rates intp a forward
rate of investment.

Sol. ( 1+.10) (1+.10)/1.08 – 1 =1 2.04%. That hypothetical 12.04% is the forward

rate of the investment.

9. Suppose the spot rate for the three-year bond is 7% and the four-year is 6%. Calculate forward
rate between years three and four.
Hints :

the equivalent rate required if the three-year bond is rolled over into a one-year bond

after it matures -- would be 3.06%.

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