exchange rate determination

1. Designed and Prepared By: Malik Muhammad Mehran

2. Exchange rate Determination Designed and Prepared By: Malik Muhammad Mehran

3. Group Members: IrbazUmer ButtTanveer KashmiriMalik Muhammad Mehran (Group Leader) Designed and Prepared By: Malik Muhammad Mehran

4. Chapter Objectives This chapter will: A. Explain how exchange rate movements are measured B. Explain how the equilibrium exchange rate is determined C. Examine factors that determine the equilibrium exchange rate D. Explain the movement in cross exchange rates Designed and Prepared By: Malik Muhammad Mehran

5. Presenter: Malik Muhammad Mehran MS Business Administration Section “F” NCBA&E Multan Campus Designed and Prepared By: Malik Muhammad Mehran

6. Introduction Designed and Prepared By: Malik Muhammad Mehran

7. Exchange rate Definition: “The price of a nation’s currency in terms of another currency.” An exchange rate thus has two components, the domestic currency and a foreign currency. Designed and Prepared By: Malik Muhammad Mehran

8. FOREX Market Concept • Structure of FOREX Market: • OTC • Exchange Traded Market Designed and Prepared By: Malik Muhammad Mehran

9. FOREX Market Concept • Levels of FOREX Market: • Tier 1: Transaction between Central Bank and other Banks • Tier 2: Wholesale Market • Tier 3: Retail Market Designed and Prepared By: Malik Muhammad Mehran

10. FOREX Market Concept • Exchange Rate Systems: • Fixed Exchange Rate • Currency Pegging • Floating Exchange Rate • Clean Float • Dirty Float • Managed Exchange Rate Designed and Prepared By: Malik Muhammad Mehran

11. FOREX Market Concept • ‘FOREX Exposure’ Exchange rate sensitivity of the value of the firm to expected changes in the exchange rate. • Transaction Exposure • Economic Exposure • Accounting Exposure Designed and Prepared By: Malik Muhammad Mehran

12. FOREX Market Concept • 'Spot Rate’ The price quoted for immediate settlement on a commodity, a security or a currency. The spot rate, also called “spotprice”, Designed and Prepared By: Malik Muhammad Mehran

13. FOREX Market Concept • “Forward Exchange rate” A rate applicable to a financial transaction that will take place in the future. Forward rates are based on the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency, bond or commodity at some future time.  • T+2 Settlements Designed and Prepared By: Malik Muhammad Mehran

14. FOREX Market Concept • An exchange rate has a base currency and a counter currency. • Example: • $1 = £1.1050 • In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency. Designed and Prepared By: Malik Muhammad Mehran

15. FOREX Market Concept Currency Conversion: $/£ -> 1.7350 - If 500,000 base currency then “X” - If 500,000 price currency then “/” Designed and Prepared By: Malik Muhammad Mehran

16. FOREX Market Concept Example: US person decides to travel UK, JAPAN, CANADA He will spend £ 40,000 ¥ 600,000 CAD 75,000 if USD/GBP-> 1.6750 JPY/USD-> 130.30 CAD/USD-> 0.8750 Designed and Prepared By: Malik Muhammad Mehran

17. FOREX Market Concept Currency Conversion: A/B -> X/Y $/£ -> 1.6250/1.6280 Designed and Prepared By: Malik Muhammad Mehran

18. FOREX Market Concept • “Bid” The price a buyer is willing to pay for a security. • “Ask” The opposite of the bid is the ask price, which is the price a seller is looking to get for his or her shares. • Bid Can not be greater than Ask • “Bid-Ask Spread” The amount by which the ask price exceeds the bid. This is essentially the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell it. Designed and Prepared By: Malik Muhammad Mehran

19. FOREX Market Concept • “Bid-Ask Spread” • High Liquid Assets • Currency Pairs • Highly Traded Currencies • Less Traded Currencies • Major Markets Open (NY, LONDON) • Market Volatility • High- Spread high • Low- Spread low Designed and Prepared By: Malik Muhammad Mehran

20. FOREX Market Concept • “Cross Exchange Rate” The currency exchange rate between two currencies, both of which are not the official currencies of the country in which the exchange rate quote is given. • Example: • If an exchange rate between the Euro and the Japanese Yen was quoted in an American newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is the standard currency of the U.S. Designed and Prepared By: Malik Muhammad Mehran

21. FOREX Market Concept Question: What is Cross rate JPY/EUR? USD/EUR is 1.3649 / 1.3651 JPY/USD is 1.6789 / 1.6791 Solution: (JPY/EUR) = (JPY/USD) x (USD/ EUR) Designed and Prepared By: Malik Muhammad Mehran

22. FOREX Market Concept “Implied Rate” The rate that is determined by the difference between the spot rate and the forward rate. The degree of relative costliness of a future rate can be assessed by comparing the implied rate with the spot rate. Implied rate calculated as; “Implied rate = Forward Rate – Spot rate” Designed and Prepared By: Malik Muhammad Mehran

23. FOREX Market Concept Question: If the spot rate of LIBOR is 5% and the forward rate for LIBOR is 6%? Implied rate = Forward Rate – Spot rate Designed and Prepared By: Malik Muhammad Mehran

24. FOREX Market Concept • “Arbitrageur” A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits.ARBITRAGE Profits Designed and Prepared By: Malik Muhammad Mehran

25. FOREX Market Concept • “Arbitrageur” A type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other and capturing risk-free profits.ARBITRAGE Profits Designed and Prepared By: Malik Muhammad Mehran

26. Measuring Exchange Rate Movements Designed and Prepared By: Malik Muhammad Mehran Depreciation: decline in a currency’s value Appreciation: increase in a currency’s value Comparing foreign currency spot rates over two points in time, S and St-1

27. Presenter: Tanveer Kashmiri MS Business Administration Section “F” NCBA&E Multan Campus Designed and Prepared By: Malik Muhammad Mehran

28. Exchange Rate Equilibrium Designed and Prepared By: Malik Muhammad Mehran The exchange raterepresents the price of a currency, or the rate at which one currency can be exchanged for another. Demand for a currencyincreases when the value of the currency decreases, leading to a downward sloping demand schedule. Supply of a currencyincreases when the value of the currency increases, leading to an upward sloping supply schedule. In liquid spot markets, exchange rates are not highly sensitive to large currency transactions.

29. Exhibit 4.2 Demand Schedule for British Pounds Designed and Prepared By: Malik Muhammad Mehran 29

30. Exhibit 4.3 Supply Schedule of British Pounds for Sale Designed and Prepared By: Malik Muhammad Mehran 30

31. Exhibit 4.4 Equilibrium Exchange Rate Determination Designed and Prepared By: Malik Muhammad Mehran 31

32. Presenter: IrbazUmer Butt MS Business Administration Section “F” NCBA&E Multan Campus Designed and Prepared By: Malik Muhammad Mehran

33. Factors That Influence Exchange Rates Designed and Prepared By: Malik Muhammad Mehran

34. Factors That Influence Exchange Rates Designed and Prepared By: Malik Muhammad Mehran • Relative Inflation: Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency. • Relative Interest Rates: Increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar. • Fisher Effect:

35. Factors That Influence Exchange Rates Designed and Prepared By: Malik Muhammad Mehran • Relative Income Levels: Increase in U.S. income leads to increased in U.S. demand for foreign goods and increased demand for foreign currency relative to the dollar and an increase in the exchange rate for the foreign currency. • Government Controls via: • Imposing foreign exchange barriers • Imposing foreign trade barriers • Intervening in foreign exchange markets • Affecting macro variables such as inflation, interest rates, and income levels.

36. Factors That Influence Exchange Rates Designed and Prepared By: Malik Muhammad Mehran • Expectations: If investors expect interest rates in one country to rise, they may invest in that country leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency. • Impact of signals on currency speculation. Speculators may overreact to signals causing currency to be temporarily overvalued or undervalued.

37. Factors that Influence Exchange Rates Designed and Prepared By: Malik Muhammad Mehran Interaction of Factors: some factors place upward pressure while other factors place downward pressure. Influence of Factors across Multiple CurrencyMarkets: common for European currencies to move in the same direction against the dollar.

38. Movements in Cross Exchange Rates Designed and Prepared By: Malik Muhammad Mehran If currencies A and B move in same direction, there is no change in the cross exchange rate. When currency A appreciates against the dollar by a greater (smaller) degree than currency B, then currency A appreciates (depreciates) against B. When currency A appreciates (depreciates) against the dollar, while currency B is unchanged against the dollar, currency A appreciates (depreciates) against currency B by the same degree as it appreciates against the dollar.

39. Designed and Prepared By: Malik Muhammad Mehran