Foreign exchange

The FX market

The foreign exchange market allows for the exchange of one currency for another.

International Finance (ECON 3231)

Large commercial banks serve this market by holding inventories of each currency.

The exchange rate is the rate at which one currency can be exchanged for another, for
example, one dollar can be exchanged for Rs 36.

FX transaction
Spot Market. The most common type of foreign exchange transaction is for immediate
exchange at the so-called spot rate.

Forward Market. Forward exchange involves a contractual arrangement to exchange

currencies at an agreed exchange rate on a stated date in the future. The forward market
plays an important role in avoiding foreign exchange risk (hedging) and in choosing to take
risk (speculating).

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FX quotations

Bid-ask spread

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Commercial banks charge fees for conducting foreign exchange transactions.

At any given point in time, a bank’s bid (buy) quote for a foreign currency will be less than
its ask (sell) quote.

The bid/ask spread represents the differential between the bid and ask quotes and is
intended to cover the costs involved in accommodating requests to exchange currencies.

The bid/ask spread is normally expressed as a percentage of the ask quote.

Example. Assume you have Rs 110,000 and plan to travel from to the United Kingdom.
Assume further that the bank’s bid rate for the British pound is Rs 55 and its ask rate is Rs
54. Before leaving on your trip, you go to this bank to exchange rupees for pounds.

The Rs 110, 000 will be converted to 2,000 pounds at the bank’s bid price.

Suppose now, due to some emergency, you cancel the trip and convert the money back to 2
rupee. So your 2,000 pounds will now exchange to Rs 108,000.

Due to the bid-ask spread, you lost Rs 2,000.

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FX quotations

Bid-ask spread (continued)

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The bid/ask spread can be computed in percentage terms follows:

𝐴𝑠𝑘 𝑝𝑟𝑖𝑐𝑒 − 𝐵𝑖𝑑 𝑝𝑟𝑖𝑐𝑒

𝐴𝑠𝑘 𝑝𝑟𝑖𝑐𝑒

Factors affecting bid-ask spread:

• Order costs. Order costs are the costs of processing orders, including clearing costs
and the costs of recording transactions.

• Inventory costs. Inventory costs are the costs of maintaining an inventory of a particular
currency. Holding an inventory involves an opportunity cost because the funds could
have been used for some other purpose. If interest rates are relatively high, the
opportunity cost of holding an inventory should be relatively high. The higher the
inventory costs, the larger the spread that will be established to cover these costs.

• Competition. The more intense the competition, the smaller the spread quoted by
intermediaries. 3

• Volume. More liquid currencies are less likely to experience a sudden change in price.
Currencies that have a large trading volume are more liquid because there are
 Foreign exchange

FX quotations

Bid-ask spread (continued)

International Finance (ECON 3231)

• Currency risk. Some currencies exhibit more volatility than others because of economic
or political conditions that cause the demand for and supply of the currency to change
abruptly. Emerging currencies tend to have wider bid-ask spread due to elevated
volatility.

Direct vs indirect quotations

Quotations that represent the value of a foreign currency in dollars (number of dollars per
currency) are referred to as direct quotations. For example, $1 = Rs36.

Conversely, quotations that represent the number of units of a foreign currency per dollar
are referred to as indirect quotations. For example: $1/Rs = 0.0278

The indirect quotation is the reciprocal of the corresponding direct quotation, i.e,
Direct quotation = 1 / Indirect quotation
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FX quotations

Cross exchange rate

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• A cross-exchange rate is an exchange rate between two currencies, A and B, neither of
which is the US dollar. It can be calculated as the ratio of the exchange rate of A to the
dollar, divided by the exchange rate of B to the dollar.

• For example, the USD = MUR 36.5 and USD = INR 66, the cross MUR-INR is…?

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Determination of foreign exchange

Exchange rate movements affect an international companies, investors etc.. because they
can affect the value of cash flows.

International Finance (ECON 3231)

A decline in a currency’s value is often referred to as depreciation, for example, if the MUR
depreciates against the U.S. dollar, it implies that the U.S. dollar is strengthening relative
to the MUR. Conversely, the increase in a currency value is often referred to as
appreciation.

When a foreign currency’s spot rates at two specific points in time are compared, the spot
rate at the more recent date is denoted as S and the spot rate at the earlier date is
denoted as St-1. The percentage change in the value of the foreign currency is computed
as follows:

𝑆 − 𝑆𝑡−1
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝑣𝑎𝑙𝑢𝑒 =
𝑆𝑡−1

A positive percentage change indicates that the currency has appreciated, while a
negative percentage change indicates that it has depreciated.
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Determination of foreign exchange (cont ‘d)

Equilibrium exchange rate

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To explain the variations in exchange rates, one should understand the concept of
equilibrium exchange rate. Just like for products, the exchange rate is determined by the
combined forces of demand and supply under a flexible exchange rate system.

The demand schedule for the exchange rate is downward sloping, meaning that more or
of a currency is demanded at a lower than at a higher rate. For example, Mauritian
shoppers might be more willing to buy goods from EBay when the USD lower rate.
Demand for U.S. dollars (or foreign currencies in general) is derived from imports as a
current transaction and the outflow of funds as a capital transaction,

The US citizens also buy products / services from Mauritius, for example, hotel and
leisure. They need to sell the USD and buy the MUR for this purpose. This is the supply-
side of the USD. Hence, the supply of dollars comes from exports as a current transaction
and the inflow of funds as a capital transaction.

The equilibrium exchange rate between the MUR and the USD will then be at the
intersection between the demand and supply schedules. 7
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Determination of foreign exchange (cont ‘d)

Factors influencing the exchange rate

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1. Relative inflation rates. Changes in relative inflation rates can affect international trade
activity, which influences the demand for and supply of currencies and therefore
influences exchange rates. Suppose inflation increases in Mauritius while remain the
same in the US. Other things being equal, there will be higher demand for US goods
and consequently, higher demand for the USD and increased supply of the MUR. This
will result in an appreciation of the USD against the MUR.

2. Relative interest rates. Changes in relative interest rates affect investment in foreign
securities, which influences the demand for and supply of currencies and therefore
influences exchange rates. Assume that interest rates fall in the US and remain
unchanged in Mauritius. Other things being equal, there will be capital flow in
Mauritius, raising demand for the MUR and increasing the supply of the USD,
ultimately leading to a depreciation of the USD against the MUR. However, higher
interest rates might reflect higher inflation rates such that it is more practical to
consider real interest rates (= interest rates – inflation rates).

3. Relative income levels. Income can affect the amount of imports demanded and 8
hence, the exchange rates. Assume income levels rise in Mauritius while remaining
the same in the US. This situation can lead to higher demand for imports from
Mauritians, and raise demand for the USD, other things being equal. Consequently,
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Determination of foreign exchange (cont ‘d)

Factors influencing the exchange rate (cont ‘d)

International Finance (ECON 3231)

4. Government controls. The governments of foreign countries can influence the
equilibrium exchange rate in many ways, including (a) imposing foreign exchange
barriers by limiting the amount of a foreign currency a trader can exchange, (b)
imposing foreign trade barriers which involve additional costs, for example, tariffs,
quotas etc.. (c) intervening (buying and selling currencies) in the foreign exchange
markets, and (d) affecting macro variables such as inflation, interest rates, and income
levels.

5. Expectations. Like other financial markets, foreign exchange markets react to any
news that may have a future effect. Expectations of a rise in real interest rates in the
US may cause currency traders to buy dollars, anticipating a future rise in the dollar’s
value. This response places immediate upward pressure on the dollar. Many
institutional investors (such as commercial banks and insurance companies) take
currency positions based on anticipated interest rate movements in various countries.

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International Monetary Systems

There have been many systems for determining exchange rates over time.

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1. Gold standard - From 1876 to 1913, exchange rates were determined by the gold
standard. Each currency was convertible into gold at a specified rate. The exchange
rate between two currencies was determined by their relative convertibility rates per
ounce of gold. A country that uses the gold standard sets a fixed price for gold and
buys and sells gold at that price. That fixed price is used to determine the value of the
currency. For example, if the U.S. sets the price of gold at $30 an ounce, the value of
the dollar would be 1/30th of an ounce of gold.

2. Bretton woods - In 1944, an international agreement (known as the Bretton Woods

Agreement) called for fixed exchange rates between currencies. During this period,
governments would intervene to prevent exchange rates from moving more than 1
percent above or below their initially established levels.

• The Bretton Woods system worked on a principle known as the Gold Exchange
Standard, which amounted to a kind of 19th-century Gold Standard by proxy.
Under this arrangement the USA operated a fully fledged Gold Standard – in other
words, it pledged to keep the dollar price of gold fixed (at the price of $35 per 10
ounce), by standing ready to exchange gold for US currency on demand via the
so-called Gold Window.
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International Monetary Systems (Cont ‘d)

• Note that the requirements for fixing the dollar price of gold are similar to those for

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fixing the dollar price of foreign currency.

• Other countries then fixed their currencies in terms of dollars, devaluing or

revaluing as necessary in order to counteract disequilibrium.

• In other words, the USA anchored the system as a whole, by virtue of the fixed
dollar price of gold. Other countries then had to accommodate themselves by
changing their exchange rates when required.

3. Floating exchange rate – Under this system, the traded currencies were allowed to
fluctuate in accordance with market forces and the official boundaries were eliminated.

4. Managed floating exchange rate - The managed exchange rates strike a medium
between fixed and floating systems. In this case, the government maintains exchange
rates within some acceptable range.
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International Monetary Systems (Cont ‘d)

European Monetary System (EMS)

In 1979, the member countries of the EU (with the exception of the UK) fixed the values of

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their currencies against each other in a so-called parity grid, specifying central rates for
each exchange rate, along with maximum ranges of fluctuation. The aim was to maintain
stable exchange rates by preventing exchange rate fluctuations of more than 2.25%.

European Monetary Union

One of the reasons for the collapse of the EMS was that, in a world of free capital
movements and electronic trading systems, fixed exchange rate regimes were bound to
fail.

Rather than adopting a floating system, EU policymakers opted for a full monetary union
with a single currency for all member countries. The details were finalized at the
Maastricht Conference of December 1991, which set a start date of 1 January 1999

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