7-1

Chapter 4: The Foreign Exchange

Market
Course Teacher: Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
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The foreign exchange market is over the counter (OTC)

global marketplace that determines the exchange rate for
currencies around the world. This foreign exchange
market is also known as Forex, FX, or even the currency
market. The participants engaged in this market are able to
buy, sell, exchange, and speculate on the currencies.
These foreign exchange markets are consisting of
banks, forex dealers, commercial companies, central
banks, investment management firms, hedge funds, retail
forex dealers, and investors.
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Functions of Foreign Exchange Market

The foreign exchange market serves two

main functions.
(i) The first is to convert the currency of one
country into the currency of another.
(ii) The second is to provide some insurance
against foreign exchange risk i.e., the
adverse consequences of unpredictable
changes in exchange rates.
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Types of Foreign Exchange Rates

1. Spot exchange rate – when two parties agree to exchange
currency and execute the deal immediately, the transaction
is referred to as a spot exchange. Exchange rate governing
such “on the spot” trades are referred to as spot exchange
rate. Spot exchange rate is the rate at which a foreign
exchange dealer convert one currency into another
currency on a particular day.
2. Forward exchange rate – a forward exchange occurs when
two parties agree to exchange currency and execute the
deal at some specific date in the future. Exchange rate
governing such future transactions are referred to as
forward exchange rates. For major currencies, forward
exchange rates are quoted for 30 days, 90 days and 180
days into the future.
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Types of Foreign Exchange Rates

3. Currency swap – a currency swap is the simultaneous
purchase and sale of a given amount of foreign
exchange for two different value dates. Swaps are
transacted between international business and their
banks, between banks, and between government
when it is desirable to move out of one currency into
another for a limited period without incurring
foreign exchange risk. A common kind of swap is
spot against forward.
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The Nature of the Foreign Exchange Market

The foreign exchange market is not located in any one

place. It is a global network of banks, bankers and
foreign exchange dealers connected by electronic
communications systems. When companies wish to
convert currencies, they typically go through their
own banks rather than entering the market directly.
The foreign exchange market has been growing at
a rapid pace, reflecting a general growth in the
volume of cross-boarder trade and investment.
 7-7

Economic Theories: Rate Determination

At the most basic level, exchange rates are determined

by the demand and supply of one currency relative to
the demand and supply of another. For example, if
the demand for dollars outstrips the supply of them
and if the supply of Japanese yen is greater than the
demand for them, the dollar/yen exchange rate will
change. The dollar will appreciate against yen.
However, while differences in relative demand and
supply explain the determination of exchange rates,
they do so only in a superficial sense.
 7-8

Economic Theories: Rate Determination

Future exchange rate movements influence export

opportunities, the profitability of international trade
and investment deals and the price competitiveness
of foreign imports, this is valuable information for
an international business. Most economic theories of
exchange rate movements seem to agree that three
factors have an important impact on future exchange
rate movements in a country’s currency: the
country’s price inflation, interest rate and the market
psychology.
 7-9

Prices and Exchange Rates

i. The law of one price – the law of one price
states that in competitive markets free of
transportation costs and barriers to trade,
identical products sold in different countries
must sell for the same price when their price
is expressed in terms of same currency. For
example, if the exchange rate between the
British pound and the dollar is £1=$1.50, an
item that retails for $75 in New York should
sell for £50 in London.
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Prices and Exchange Rates

ii. Purchasing power parity – by comparing the
prices of identical products in different
currencies, it would be possible to determine
real or purchasing power parity exchange
rate that would exist if markets were
efficient. This theory states that given
relatively efficient markets, the price of a
basket of goods should be roughly equivalent
in each country. To express the PPP theory
in symbols, let P$ be the US dollar
 7-11

Prices and Exchange Rates

price of a basket of particular goods and P¥ be the price

of same basket of goods in Japanese yen. The PPP
theory predicts that the dollar/yen exchange rate,
E$/ ¥ should be equivalent to
E$/ ¥ = P$/P ¥
Thus, if a basket of goods costs $200 in US and ¥20000
in Japan, PPP theory predicts that the dollar/yen
exchange rate should be $200/ ¥20000 or $0.01per
Japanese yen.
 7-12

Measuring Exchange Rate Movements

An exchange rate measures the value of one currency in

units of another currency. As economic conditions
change, exchange rates can change substantially. A
decline in a currency’s is often referred to as
depreciation and the increase in a currency value is
often referred to as appreciation. When the spot
rates of two specific points in time are compared,
the spot rate as of the recent date is denoted by S
and the spot rate as of the earlier date is denoted as
St-1. The percentage change in value of a foreign
currency is computed as (S-St-1)/St-1.
 7-13

Determination of Equilibrium Exchange Rate

The exchange rate at a given point of time

represents a price of a currency. Like
any other products, the price of a
currency is determined by the demand
for that currency relative to supply. At
any point in time, a currency should
exhibit the price at which the demand
for that currency is equal to supply, and
this represents the equilibrium exchange
rate.
 7-14

Determination of Equilibrium Exchange Rate

For decreasing value of one currency in

terms of another quantity of demand is
increased and quantity of supply is
decreased. Thus equilibrium exchange
rate is determined at the point where
both demand curve for foreign currency
and supply curve of the same foreign
currency intersect each other.
 7-15

Determination of Equilibrium Exchange Rate

Value of BDT

Supply of $

$1=BDT118

Demand for $
Qd & Qs of $
Qd=Qs
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Currency Convertibility

A country’s currency is said to be freely convertible

when the country’s government allows both
residents and nonresidents to purchase
unlimited amounts of foreign currency with it.
A currency is said to be externally convertible
when only nonresidents may convert it into a
foreign currency without any limitations. A
currency is nonconvertible when neither
residents nor nonresidents are allowed to
convert it into a foreign currency.
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Currency Convertibility

Governments limit convertibility to preserve their

foreign exchange reserves. A country needs an
adequate supply of these reserves to service its
international debt commitments and to purchase
imports. Governments typically impose
convertibility restrictions on their currency when
they fear that free convertibility will lead t a run on
their foreign exchange reserves. This occurs when
residents and nonresidents rush to convert their
holdings of domestic currency into a foreign
currency that is referred to as capital flight.
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Foreign Exchange Exposures

1. Transaction exposure – it is the extent to which

fluctuations in foreign exchange values affect the
income from individual transactions. Such
exposure includes obligations for the purchase or
sale of goods and services at previously agreed
prices and the borrowing or lending of funds in
foreign currencies. It can be minimized by entering
into forward contract and currency swap.
2. Translation exposure – it is the impact of currency
exchange rate changes on the reported financial
statements of a company. It is concerned with the
present measurement of past events.
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Foreign Exchange Exposures

The resulting accounting gains or losses are said to be

unrealized – they are paper gains and losses – but
they are still important. It can be minimized by
entering into forward contract and currency swap.
3. Economic exposure – it is the extent to which a
firm’s future international earning power is affected
by changes in exchanges rates. It is concerned with
the long-run effect of changes in exchange rates on
future prices, sales and costs. It can be reduced by
distributing firm’s productive assets to various
locations.
 Motives for Using
Foreign Exchange Markets
 Investors invest in foreign markets:
 to take advantage of favorable economic conditions;
 when they expect foreign currencies to appreciate
against their own; and
 to reap the benefits of international diversification.

Problem # 1: An US MNC plans to invest $40 million to

a Singapore company when $1=S$22.50 @ 12% profit
rate for 4 months period. Expected exchange rate may
be $1=S$25.80 or $1=S$18.25. Calculte the gain or
loss from exchange rate movements.
 Motives for Using
Foreign Exchange Markets
 Creditors provide credit in foreign markets:
 to capitalize on higher foreign interest rates;
 when they expect foreign currencies to appreciate
against their own; and
 to reap the benefits of international diversification.

Problem # 2: An US MNC plans to lend $80 million to a

Bangladeshi company when $1=Tk.105.50 @ 10.55%
extra rate rate for 7 months period. Expected exchange
rate may be $1=Tk.115.80 or $1=Tk.101.25. Calculte
the gain or loss from exchange rate movements.
 Motives for Using
Foreign Exchange Markets
 Borrowers borrow in foreign markets:
 to capitalize on lower foreign interest rates; and
 when they expect foreign currencies to depreciate
against their own.
Problem # 3: A Bangladeshi MNC plans to borrow $95
million from US market when $1=Tk.107.50 @
9.55% extra rate for 9 months period. Expected
exchange rate may be $1=Tk.113.80 or
$1=Tk.103.25. Calculte the gain or loss from
exchange rate movements.
Foreign Exchange Transactions
 There is no specific building or location
where traders exchange currencies. Trading
also occurs around the clock.
 The market for immediate exchange is known
as the spot market.
 The forward market enables an MNC to lock
in the exchange rate at which it will buy or
sell a certain quantity of currency on a
specified future date.
Foreign Exchange Transactions
 The following attributes of banks are
important to foreign exchange customers:
 competitiveness of quote
 special relationship between the bank and its
customer
 speed of execution
 advice about current market conditions
 forecasting advice
 Foreign Exchange Transactions
 Banks provide foreign exchange services for a
fee: the bank’s bid (buy) quote for a foreign
currency will be less than its ask (sell) quote.
This is the bid/ask spread.
 bid/ask % spread = ask rate – bid rate
ask rate
 Example: Suppose bid price for £ = $1.52,
ask price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%
Factors that Influence Exchange Rates

Relative Inflation Rates

$/£
U.S. inflation 
S1   U.S. demand for
S0
r1 British goods, and
r0 hence £.
D1   British desire for U.S.
D0
goods, and hence the
Quantity of £ supply of £.
Factors that Influence Exchange Rates

Relative Interest Rates

$/£
U.S. interest rates 
S0   U.S. demand for
S1
r0 British bank deposits,
r1 and hence £.
D0   British desire for U.S.
D1
bank deposits, and
Quantity of £ hence the supply of £.
 Factors that Influence Exchange Rates

Relative Income Levels

$/£
U.S. income level 
  U.S. demand for
S0 ,S1
British goods, and
r1
r0 hence £.
D1  No expected change for
D0
the supply of £.
Quantity of £
Factors that Influence Exchange Rates

Government Controls
 Governments may influence the equilibrium
exchange rate by:
 imposing foreign exchange barriers,
 imposing foreign trade barriers,
 intervening in the foreign exchange market, and
 affecting macro variables such as inflation,
interest rates, and income levels.
 Factors that Influence Exchange Rates

Expectations
 Foreign exchange markets react to any news
that may have a future effect.
 Institutional investors often take currency
positions based on anticipated interest rate
movements in various countries.
 Because of speculative transactions, foreign
exchange rates can be very volatile.
Speculation: Chicago Bank expects the exchange rate of the
New Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.

Borrows at 7.20%
for 30 days
1. Borrows 4. Holds
$20 million $20,912,320
Returns $20,120,000
Profit of $792,320
Exchange at Exchange at
$0.50/NZ$ $0.52/NZ$
Lends at 6.48%
2. Holds for 30 days 3. Receives
NZ$40 million NZ$40,216,000
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of $0.50
to $0.48 in 30 days.

Borrows at 6.96%
for 30 days
1. Borrows 4. Holds
NZ$40 million NZ$41,900,000
Returns NZ$40,232,000
Profit of NZ$1,668,000
Exchange at or $800,640 Exchange at
$0.50/NZ$ $0.48/NZ$
Lends at 6.72%
2. Holds for 30 days 3. Receives
$20 million $20,112,000
Problem: Blue Demon Bank expects that the Chinese
currency (the yuan) will depreciate against the dollar
from its spot rate of $0.15 to $0.13 in 20 days. The
following interbank lending and borrowing rates exist:
Currency Lending rate Borrowing rate
U S dollar 8.20% 8.30%
Chinese yuan 8.40% 8.80%
 Assume that Blue Demon Bank has a borrowing
capacity of either $10 million or 70 million yuan
in the interbank market, depending on which
currency it wants to borrow.
(i) How could Blue Demon Bank attempt to
capitalize on its expectations without using
deposited funds? Estimate the profits that could
be generated from this strategy?
(ii) How could Blue Demon Bank attempt to
capitalize on its expectations without using
deposited funds if Chinese currency (the yuan)
will appreciate against the dollar from its spot
rate of $0.15 to $0.18 in 20 days.? Estimate the
profits that could be generated from this strategy?