IP - Chapter1 - Foreign Exchange and Currency Risk Management - Student

FOREIGN EXCHANGE RATE: LEARNING AGENDA
September 30, 2020

CHAPTER 2: EXCHANGE RATE AND
September 30, 2020

CURRENCY RISK MANAGEMENT o Foreign Exchange
Exchange Rate
Foreign Trade University, HCM city campus

o

o Exchange Rate Quotation
o Cross Exchange Rate
o Determinants of Exchange Rate Fluctuations
o Types of Foreign Exchange Rates
1
o Methods of Exchange Rate Adjustment
Lecturer: Vũ Thị Đan Trà (PhD) o Foreign Exchange Market 2
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1. FOREIGN EXCHANGE FOREIGN EXCHANGE

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 Foreign Exchange (FX) includes all payment means that are  In the Decree providing regulations for implementation of
used in international settlements. They are considered as Ordinance on foreign exchange control:
financial assets.
Foreign exchange comprises:

 The FX comprises:
• Foreign currency;
• Foreign currencies
• Foreign currency payment instruments
• Financial instruments denominated in foreign currencies
• Valuable papers denominated in foreign currencies
• Standard Gold
• The domestic currency held by non-residents

• Gold;
• The currency of the Socialist Republic of Vietnam.
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ORDINANCE ON FOREIGN EXCHANGE CONTROL ORDINANCE ON FOREIGN EXCHANGE CONTROL

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ARTICLE 4 ARTICLE 4
Foreign exchanges comprises: Foreign currency is used in international and regional payments
 (a) Currencies of other nations or the common European currency and
other common currencies used in international and regional payments
(hereinafter referred to as foreign currency);  currencies of other nations or

 (b) Foreign currency payment instruments, cheques, credit cards, bills
of exchange, promissory notes and other payment instruments;  the common European currency
 (c) All types of valuable papers denominated in foreign currencies  and other common currencies
including Government bonds, corporate bonds, term bonds, shares and
other valuable papers;
 (d) Gold belonging to the foreign exchange reserves of the State, gold
in overseas’ accounts of residents, and gold in the form of bullion,
bars, granules and plate which is brought into or taken out of the
territory of Vietnam;
 (dd) The currency of the Socialist Republic of Vietnam in cases where
it is remitted into or out of the territory of Vietnam or used as an 5 6
instrument for international payments.
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ARTICLE 4 ARTICLE 4
Foreign currency payment instruments: All types of valuable papers denominated in foreign currencies:
 cheques, credit cards,  Government bonds,

 bills of exchange,  corporate bonds, term bonds,
 promissory notes  shares
 other payment instruments;  other valuable papers;
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7 8

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ARTICLE 4 ARTICLE 4
 gold belonging to the foreign exchange reserves of the State, The currency of the Socialist Republic of Vietnam in cases where
 gold in overseas’ accounts of residents, it is:

 gold in the form of bullion, bars, granules and plate which is  remitted into or out of the territory of Vietnam
brought into or taken out of the territory of Vietnam;  or used as an instrument for international payments.
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TRAVELERS CHEQUE /CHECK

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USD = United States

Dollar
GBP = Great Britain
Pound (UK Pound
Sterling)
EUR = Euro
CHF= Swiss Franc

JPY = Japanese Yen (Confederation
Helvetica)
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CROSS CHECK
2. FOREIGN EXCHANGE RATE: DEFINITION
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 Exchange rate is conversion price for exchange one currency for

another (Dictionary of Banking Terms, Barrons)
 Rate of Exchange or Exchange Rate is price at which one

currency is exchanged for another (Dictionary of Banking and
Finance, Peter Collin)
 The Exchange Rate is simply the price of one currency in terms
of another (Keith Pibean, International Finance)
 Exchange Rate is the price of one country’s currency in units of
another currency or commodity (typically gold or silver) (David
K. Eiteman, Multinational Business Finance)
 The price of one currency in terms of another is called the
exchange rate (Federic S. Minskin, The Economics of Money,
Banking and Financial Markets) 14
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EXCHANGE RATE: DEFINITION FOREIGN EXCHANGE RATE (CONT.)
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15
• F. Mishkin: The price of one currency in terms of another is  The nature of exchange rate is the correlation of purchasing power
between currencies and is price in which currencies can exchange of
called the E/R.

the others. (Financing Academy, International Finance)
• Alan Shapiro: An exchange is, simply, the price of one nation’s  Exchange Rate of VND is price of one unit of foreign currency in
currency in terms of another. units of VND (Law of the State Bank of Vietnam, 2010)
• Dictionary of Banking Terms: E/R is conversion price for  Exchange Rate of the price of one unit of foreign currency in terms of
units in domestic currency, i.e. foreign currency is commodity
exchanging one currency for another
currency and domestic currency in terms currency. In other words,
• Financial institutions & markets: An exchange rate is the value exchange rate is the number of units of domestic currency in terms of
of one currency in terms of another. one unit of foreign currency 16
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EXCHANGE RATE: HISTORY AND ITS FOUNDATION 18
THREE TYPES OF "GOLD STANDARDS“:
Prior to 1971:  The gold specie standard (1875-1914) :
each country’s monetary authority set the value of its currency relative
to an international standard such as gold (the so-called “gold - a system in which the monetary unit is associated with
standards”) the value of circulating gold coins.
- is known as the classic gold standard.
 There are three stages of "gold standards“:
 The gold specie standard (1875-1914): The classical gold standard - was also a period of unprecedented economic growth
 The gold exchange standard (1914- 944): The collapse of the gold standard with relatively free trade in goods, labor, and capital.
 USD gold exchange standard system (1945-1971): The Bretton Woods System
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The common point of the three types of gold standards:
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THREE TYPES OF "GOLD STANDARDS“: 20
 The gold exchange standard (1914- 1944) :  The gold standard:

 the government guarantees a fixed exchange rate with another country  was a commitment by participating countries to fix the
that does use the gold standard (specie or bullion).
prices of their domestic currencies in terms of a specified
amount of gold.
 USD gold exchange standard system (1945-1971):  was also an international standard determining the value of
 was further modification of the gold standard, a country’s currency in terms of other countries’ currencies.
 most European currencies were pegged to US dollars, USD was
pegged to gold at rate of USD 35 per ounces.
 countries settled their international balances in U.S. dollars.
 on August 15, 1971, President Richard M. Nixon announced that the
United States would no longer redeem currency for gold => was the
final step in abandoning the gold standard..
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21
THE GOLD SPECIE STANDARD (1875-1914) 22
GOLD STANDARD
How was E/R determined:  Under a gold standard, paper notes are convertible into pre-set, fixed
quantities of gold.
 1 GBP = 123, 274 grains (= 7,988g)
 1 USD = 23,22 grains (=1,50476g)
 GBP/USD = 123,274/23,22 = 5,3089
1 GBP = 5,3089 USD
=> the value of a country’s currency in terms of other countries’
currencies is determined by comparing the certain amounts of
gold in each currencies (GOLD PARITY).
 No country currently uses the gold standard as the basis of its monetary
system.
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UNDER GOLD STANDARD

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UNDER GOLD STANDARD: 24
 exchange rates were fixed, the price levels around the world to  For example:
move together. Why?  6 GBP = 1 ounce of gold
 This co-movement occurred mainly through an automatic  12 FRF = 12 ounce of gold
balance-of-payments adjustment process called the price-specie-  GBP/FRF = 2
flow mechanism.  If GBP/FRF = 1.8 => What would it happen?
 E/R is adjusted by gold-flow between 2 countries.
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EXCHANGE RATE: HISTORY AND ITS FOUNDATION (CONT.)
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EXCHANGE RATE: HISTORY AND ITS FOUNDATION (CONT.) 26
After 1972: After 1972:

 No country currently uses the gold standard as the basis of its  No country currently uses the gold standard as the basis of its
monetary system. monetary system.
 No currency is convertible into precious metal  No currency is convertible into precious metal
 There are some regime of exchange rate:  There are some regimes of exchange rate:
 Freely floating rate  Freely floating rate
 Managed- floating rate  Managed- floating rate
 Target zone  Target zone
Expression “dirty float” ? Expression “dirty float” means:
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EXCHANGE RATE: HISTORY AND ITS FOUNDATION (CONT.) ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION
27 28
After 1972:  The law of one price:

 What determines the exchange rate?  in competitive markets free of transportation costs and barriers to
 Not relied on gold parity trade (such as tariffs), identical products sold in different countries
 Is relied on PPP (Purchasing Power parity): must sell for the same price when their prices is expressed in terms of
the same currency
PPP: A unit of domestic currency should purchase the same amount of

 If the law of one price were true for all goods and services, the
goods in the home country as it would of identical goods in a foreign purchasing power parity (PPP) exchange rate could be found
country. from any individual set of prices.
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THE PRICE OF A “BASKET OF GOODS” SHOULD BE

ROUGHLY EQUIVALENT IN EACH COUNTRY
PPP EXAMPLE
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 By comparing the prices of identical products in

different currencies, it would be possible to determine
the „real” or PPP exchange rate that would exists if
markets were efficient.
 A new ipad wine costs £460 in London and $700 in

New York. The exchange rate must reflect this price
relationship: Purchasing Power Parity
USD 3,000 = CHF 3,750
 E (GBP/USD)= $700/£460 =$1.52 per £  so USD|CHF should = 1.2500
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PURCHASING POWER PARITY 32
PURCHASING POWER PARITY
 Absolute form of PPP:  Absolute form of PPP:
price of similar basket of goods to two countries should be equal price of similar basket of products to two countries should be
when measured in a common currency, not referred to inflation. equal when measured in a common currency, not referred to
inflation.
 Relative form of PPP:  Pu: the USD price a basket of particular goods
 Pv: the VND price of the same basket of goods.

The strictest version of PPP is not supported empirically, but
 The PPP theory predicts that the dollar/ yen exchange rate
changes in relative inflation rates are related to changes in
exchange rates. should be equivalent to:
E(usd/vnd) = Pv/ Pu
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RELATIVE PPP EXAMPLE RELATIVE PPP EXAMPLE
 Relative form of PPP:  Suppose the U.S. inflation rate is expected to be 3 percent for the
coming year, while the Britain's expected rate of inflation is 5
The strictest version of PPP is not supported empirically, but
percent.
changes in relative inflation rates are related to changes in
 The current exchange rate is $1.50 per £. What should be the £
exchange rates => The exchange rate will change if relative
prices change. spot rate in one year?
Ex: Suppose the price ipad in London increases to £506 in one
year implying an inflation of 10%, while in the U.S. the price of 1.50 × 1.03/1.05 = $1.47 per £
wine increases to $735 indicating an inflation rate of 5%. The
new exchange rate:
 GBP/USD = 735/506 = 1,4525
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RELATIVE FORM OF PPP: RELATIVE FORM OF PPP:
36
Rate of change in the prices of products should be similar when  Approximately: %Δe0 = πd – πf
measured in a common currency:  Imagine there is no price inflation in the U.S, while prices in VN
Pv+(Pv. ∆Pv)=(R+e. ∆e).(Pu+Pu. ∆Pu) are increasing by 10% a year. More precisely, by the end of the
year:
Pv = e. Pu, so that: Eusd/vnd = Pvnd (1+ 10%)/Pusd
 (1+∆Pv) = (1+∆e). (1+∆Pu)
 (1+∆e) =(1+∆Pv)/(1+∆Pu)
 ∆e =[(1+∆Pv)/(1+∆Pu)]- 1
 ∆ e=(∆Pv-∆Pu)/(1+∆Pu)
 Approximately: %Δe0 = πd – πf
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3. EXCHANGE RATE QUATATIONS
PPP IMPLICATION ANGE QUOTATIONS
 According to PPP, the currency of countries with high • Full statement
inflation rates should devalue relative to countries with low Exchange rate • Short statement
inflations rates. statement
 Rationale:
• Ex. Rate: decimal
if πd > πf, then:
• Point
 domestic imports increase; domestic exports decrease Exchange rate
• Figure
interpretation
 foreign imports decrease; foreign exports increase
 demand for FC increases; supply decreases
 demand for LC decreases; supply increases • As for domestic FX market
 FC appreciates; LC depreciates Exchange rate • As for int’l FX market
quotations
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EXCHANGE RATE STATEMENT IN SHORT STATEMENT (ABBREVIATION)

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 In full statement: Bank of Tokyo quotes exchange rate:

Bid rate USD/VND= 20,810 or USD 1= VND20,810 USD/JPY= 90/92
Ask rate USD/VND=20,820 or USD 1= VND20,820

 First currency is Commodity currency (referring to currency being
 In short statement (abbreviation): traded or being valued)
USD/VND= 20,010/20,820  Second currency is term currency (referring to currency, in which
the commodity currency being expressed)
USD/VND= 20,010/20
USD/VND= 10/20 => Commodity currency/Term currency = BID/ASK
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BID & ASK QUOTES EXAMPLE

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 Foreign currency dealers provide two quotes: Bid Ask

Bid Price: Price at which the dealer is willing to buy
foreign currency from you. £ /$ 1.4482 1.4484
Ask Price: Price at which the dealer is willing to sell Bid: Dealer buys £ for $ at the Bid =>
foreign currency to you. Client sells £ for $ (i.e., dealer will buy
£1,000,000 for $1,448,200).
 It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread. Ask: Dealer sells £ for $ at the Ask => Client
buys £ with $ (i.e., dealer will sell £1,000,000
for $1,448,400).
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DISCUSSION
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EXCHANGE RATE INTERPRETATION
In Tokyo:  If USD/CHF starts the day at S= 0,9300 and an hour later it is at
 USD/JPY= 90/92 S =0,9301. How would we say about this change?
 A pip (or point) is the smallest quoted unit of the rate.
In Hanoi:
 1 USD = 1.3650 CHF
 VCB quoted on Oct 7, 20xx:  1 GBP= 1.5174 USD
USD/VND = 17,846/17,846  1 USD = 92.35 JPY
 1 USD = 20,810 VND

 Ordinary: BID < ASK
 ASK- BID = SPREAD (profit for market-marker)
 In the same quoted FX market, spread for USD is less than for AUD?
 The less traded and more volatile a currency, the greater is
the spread
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EXCHANGE RATE INTERPRETATION: POINT, FIGURE

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EXCHANGE RATE INTERPRETATION 46
 100 points (pips) = one “big figure”. The big figure often
 Where the 2 currencies have a similar value, their exchange rate relates to (the smallest quoted) currency unit of that currency.
will be expressed to 4 decimal points (that is, rounded to 4
decimal places).  If EUR|USD S = 1.2500 and it rose three big figures, it would
 Where they differ substantially in value, say the USD and the go to S =1.2800. An FX market professional would say, “Euro-
JPY, the exchange will be quoted fewer decimal points (two in Dollar is trading at one-twenty-eight ‘the figure.’”
the case of the USD/JPY).
 With USD|JPY S = 111.00, what would an increase of three big
figures mean? This would mean that S now equals 114.00
 Remember, 100 pips is a big figure and a pip in USD|JPY =

.01).
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N47ICKNAMES 48
NICKNAMES
 USD - Dollar
GBP|USD: “Cable”; GBP - Sterling

JPY - Yen  USD/CAD: is known as "Dollar Canada",
 USD|CHF “Swissy”; CHF - Swiss(y)
AUD - Aussie  USD/JPY is known as "Dollar Yen",
 AUD|USD is “Aussie”;
NZD - Kiwi  AUD/USD is known as "Aussie Dollar".
 NZD|USD is “Kiwi”; SEK - Stocky (named after
Stockholm)  GBP/USD, which is known as "Cable", which stems
DKK - Copey (named after
 Some of the old euro legacy Copenhagen but no longer used) from the days when a cable under the Atlantic Ocean
currencies were known as: NOK - Nocky (simply named
after its ISO currency code)
was used to synchronize the GBP/USD rate between
DEM - Mark
FRF - Paris
SGD - Sing the London market and the New York market.
HKD - Honky
ITL - Lira MXN - Mex  Before IEP (Irish Pound) became a denomination of the
PTE – Scud ZAR - Rand
HUF - Huff (simply named after euro, IEP/USD was sometimes known as "Wire",
its ISO currency code) particularly in the forward market.
ARS - Argie
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FOREIGN EXCHANGE RATE QUOTATION 50
FOREIGN EXCHANGE RATE QUOTATION
 Direct quotation: Exchange rate is the price of one unit of
foreign currency in terms of units of domestic currency
 Indirect quotation: Exchange rate is the price of one unit of
Direct • Exchange rate is the price of one
unit of foreign currency in terms of
domestic currency in terms of units of foreign currency: GBP, quotation: units of domestic currency
AUD, NZD, EUR and SDR
 The US follows both direct and indirect quotation; USD is terms
currency in the relation to the group of the five currencies.
• Exchange rate is the price of one
Indirect unit of domestic currency in terms
quotation: of units of foreign currency: GBP,
AUD, NZD, EUR and SDR
49 50
DIRECT & INDIRECT QUOTES

51 52
Direct Quote:
 Most countries quote price of foreign currency directly
 In Tokyo: Home currency per unit of foreign currency (FC)
- e.g. USD/JPY quote is 90.00/92.00  Countries that were part of the British Commonwealth
Indirect Quote: and Eurozone the customs is to express exchange rate
“indirectly” => GBP, AUD, NZD, EUR
 In Sydney: Foreign currency per unit of home currency -
e.g. AUD/USD quote of 1.02661 – 1.0249  SDR is always commodity currency
 The US follows both direct and indirect quotations;
Note that in all cases, the reciprocal of a direct quote is an
indirect quote and USD is term currency in the relation to the group of the
five currencies
AUD 1

EUR EUR
AUD
51 52

53 54
AMERICAN TERMS OR EUROPEAN TERMS
 Because of difference of quotation, be careful when saying about
appreciation or depreciation of one currency’s value.  As for international market, an exchange rate can be quoted in
In Tokyo: USD/JPY = 90 In NY: USD/JPY =90 American terms or European terms.
 Day 1: 90  American terms (USD is the term currency in the rate):
 Day 2: 92  EUR/USD
 JPY/USD
Appreciation of commodity currency is shown by an increase in the  European terms (USD is the commodity currency/underlying asset in
exchange rate.
the rate)
Depreciation of commodity currency is shown by a fall in the exchange
rate.  USD/EUR
 USD/JPY
53 54
BID – ASK SPREAD
55  Banks act as market makers and realise their profits 56
EXERCISE
from the spread:
Bid-Ask Spread = (Ask-Bid)/Bid Exchange quotation Spread (%)
USD/JPY = 92.95/93.00
 Consider the DIRECT quote of $ 1.4482 – 1.4484/£ GBP/USD = 1.5120/1.5125
GBP/EUR= 1.1605/1.1611
EUR/USD =1.3030/1.3034
% spread 
1.4484  1.4482  100  0.138%
AUD/USD=1.0210/1.0214
1.4482
55 56
FORWARD QUOTES
EXERCISE
57 58  Forward rates can be quoted as either as an outright quote,
 Barclay Bank, UK quotes mean rate of exchange: GBP/USD = points or as an annualised % forward premium or discount.
1.5124 with transaction fee: 0.3%. Broker fee: 0.1% per total
value.
 Citibank, NY quotes mean rate of exchange: GBP/USD =
1.5129 with transaction fee: 0.2%. Broker fee: 0.08% per total
value.
 Which bank should you sell USD to in your favor?
57 58
FORWARD QUOTES – POINTS

4. CROSS RATE
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 A forward quotation expressed in points is not a foreign  Narrow meaning: Cross Exchange Rate is defined as an
exchange rate as such. It is the difference between the exchange rate between two currencies, neither of which is the
forward rate and the spot rate. USD; in other words, the exchange rate of two currencies
which is derived from their rates against USD is called cross
rate, where USD plays the role as the intermediate currency
 When the Bid Points > Ask Points, you subtract the
points from the spot rate to get the outright forward  Broad meaning: Many currency pairs are inactively
quote. traded, so their exchange rate is determined through their
 If the Bid Points < Ask Points, you add the points to relationship to a widely traded third currency.
the spot rate to get the outright forward quote
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CROSS RATES 62
CROSS RATE
 Many currency pairs are inactively traded, so their exchange
rate is not quoted in the market.
 For example, an Australian importer needs Danish currency
to pay for purchase in Copenhagen.
 The Australian dollar (symbol AUD) is not widely quoted
against the Danish kroner (symbol DKK).
 However, both currencies are quoted against the U.S. dollar.
Assume the following quotes:
USD/AUD = 1.0806
USD/DKK =5.7210
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63
CROSS RATE 64
EXERCISE
 The Australian importer can buy one U.S. dollar for Complete the following table of simple cross rate:
AUD 1.0806 and with that dollar buy DKK 5.7210.
The cross-rate calculation would be: USD EUR JPY GBP CHF
USD 1.2500
DKK/AUD = 1.0806/5.7210 = 0.1888 EUR
 1 DKK = 0,1888
JPY 110.00 96.00
GBP
 However, calculating cross-rates is usually CHF 2.4000

not as easy as this!
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65
EXERCISE 66
EXERCISE
Complete the following table of simple cross rate:  Could the price of a U.S Dollar fall against the Swiss Franc but
rise against the Japanese Yen? If so, what must have happened to
USD EUR JPY GBP CHF the exchange rate between Swiss Franc and Japanese Yen?
 More specifically, will CHF/JPY have gone up or gone down?
USD 1.2500
EUR
JPY 110.00 96.00
GBP
CHF 2.4000
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CASES OF CROSS RATE: 68
CROSS RATE
Case 1: Intermediate currency is term currency in two available
 Rates are usually quoted in pair: Bid and ask rates
rate. So cross rate have to be calculated in Ex: In Hanoi, VCB quotes exchange rate:
pair, too. USD/VND = 20,800/20,900
We have 3 cases of cross rate: JPY/VND = 223/227
 Ask (c) ) USD/JPY =?
 Intermediate currency is term currency in two available rates.
 Bid (c) USD/JPY =?
 Intermediate currency is underlying asset (commodity currency)
in two available rates
 Intermediate currency is commodity in one rate and term
currency in the other rate.
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CROSS RATE- CASE 1 ROSS RATE CROSS RATE – CASE 1
 Ask (c) USD/JPY =?
 This is the rate at which a client should sell USD getting JPY=>
ask rate from client’s perspective The cross-rate calculation would be:
 The client sell USD at the bid rate quoted by bank
BIDUSD / VND
Bid: USD/VND = 20,800 ASK(c) USD/JPY = ASKJPY / VND
 Using that VND to buy JPY at ask rate of bank
Ask JPY/VND = 227

= 20,800/227
= 91,6299
The cross-rate calculation would be:
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CROSS RATE – CASE 1 CROSS RATE – CASE 2

71 72
BID (c) USD/JPY =?  In New York, rates are quoted:

So, by the same way we have:  USD/JPY = 93.08/93.12
 USD/CAD = 1.22/1.24
BID (c) USD/JPY = ASKUSD / VND

Calculate the following rates:
BIDJPY / VND Ask (c) CAD/JPY =?
= 20,900/223 Bid (c) CAD/JPY =?
= 93,7219
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CROSS RATES – CASE 2
CROSS RATE – CASE 2
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How do I get Ask (c) CAD/JPY from the two rates?

First: Use (sell) CAD to buy USD at ask rate quoted by bank BID (c) CAD/JPY = ASKUSD / JPY

Ask USD/CAD = 1.24
BIDUSD / CAD
Second: With that USD buy to buy JPY  I sell USD buy JPY = 93.12/1.22 = 76.32
Bid USD/JPY = 93.08
Third: I have: 1USD = 1.24 CAD
1USD= 93.08 JPY
So 1.24 CAD = 93.08 JPY
Therefore, Ask (c) CAD/JPY = 93.08/ 1.24 =75.06

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CROSS RATE – CASE 3 CROSS RATES – TIPS
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In New York, the rates are quoted:  As you do more cross rate questions you will start to see
GBP/USD = 1.5245/1.5250 patterns emerging.

For example if both rates are something per USD or USD per


 USD/JPY = 93.08/93.12
something then you will have to divide the rates somehow and
you will be matching bids with asks.
Calculate the following rates:  Or if the rates are in different forms (USD is in different
Ask (c) GBP/JPY = ? places) then you will be multiplying and you will match bid
with bid and ask with ask.
Ask (c) GBP/JPY = ?
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5. EXCHANGE RATE CLASSIFICATIONS 78
EXCHANGE RATE CLASSIFICATIONS
Exchange rate can be classified into many categories. Exchange rate can be classified into many categories.
 Upon the bank transaction of foreign exchange Upon the instruments of international payment
• Bid rate/Ask rate • Telegraphic transfer rate (TT rate)
• Opening rate/closing rate • Mail transfer rate (MT rate)
• Spot rate/Derivative rates (Forward rate) • Bank cheque (bank check) rate
• Cash rate (bank note rate)/Transfer rate • At sight bank draft
• Time bank draft/ Usance bank draft
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EXCHANGE RATE CLASSIFICATIONS 80
6. FACTORS THAT AFFECT EXCHANGE RATE
Exchange rate can be classified into many categories. • Difference of inflation rates between two countries
Upon the regime of foreign exchange management • Difference of interest rates between two countries
• Fixed / Freely floating/ Managed floating rate • Foreign exchange demand and supply
• Official rate/ Black market rate • Other non-economic factors: government policy, war, people
• Popular rate /Preferential rate habit, speculator expectation …
• Basic rate / Transaction rate
• Nominal exchange rate (NER)/Real exchange rate (RER)
79 80
DIFFERENCE OF INFLATION RATES BETWEEN 2

81
FACTORS THAT AFFECT EXCHANGE RATE COUNTRIES
Difference of inflation rates between 2 countries  The currency of countries with high inflation rates should
 This factor is mentioned above (in the section of base of devalue relative to countries with low inflations rates.
exchange rate).  Rationale:
 Approximately: %Δe0 = πd – πf  if πd > πf, then:
 Imagine there is no price inflation in the U.S, while prices in VN  domestic imports increase; domestic exports decrease
are increasing by 10% a year. More precisely, by the end of the  foreign imports decrease; foreign exports increase
year:  demand for FC increases; supply decreases
 Eusd/vnd = Pvnd (1+ 10%)/Pusd  demand for LC decreases; supply increases
 FC appreciates; LC depreciates
September 30, 2020
81 82
FACTORS THAT AFFECT EXCHANGE RATE

83 84
FACTORS THAT AFFECT EXCHANGE RATE
Difference of interest rates between two countries Difference of interest rates between two countries
 In open market with no barrier for trade or capital flow, funds
 According to interest rate parity, interest rates of two countries
would flow from countries with low expected real rates of
interest to countries with high expected real rates of interests. should be matched to prevent interest arbitrage opportunity.
 A theory in which the interest rate difference between two
Example: countries is equal to the difference between the forward
 Ivnd goes up and higher than Iusd =>demand of VND rises exchange rate and the spot exchange rate.
=>supply of USD goes up (inflow of USD) => S USD/VND
goes down => VND appreciates.
 If Ivnd goes down => demand of VND goes down => supply of
USD goes down = S USD/VND goes up => VND depreciates.
 But this situation is just right in short-term.
83 84
85
INTEREST RATE PARITY 86
INTEREST RATE PARITY
The equation of interest rate parity
 (1+ Iusd) = F/S x (1+ Ieuro)
In long term:
 Real rates of interest are equalized across countries
through arbitrage.
 A long-run tendency for interest rates differentials
to offset exchange rate changes has been
demonstrated empirically.
 Currencies with low interest rates would appreciate
with respect to currencies with high interest rates.
September 30, 2020
Why? September 30, 2020
85 86
87
INTEREST RATE PARITY 88
INTEREST RATE PARITY
The equation of interest rate parity
 (1+ Iusd) = F/S x (1+ Ieuro)
 Example: Interest rate in U.S. is 4%, while interest In USA:
rate in Switzerland is 10%. If the current SF spot rate  If Iusd goes up=> demand of USD rises =>supply of Euro goes
is $0.80, what should be the SF spot rate one year up (inflow of Euro) => S EUR/USD goes down
from now?
 If Iusd goes down => demand of USD goes down => supply of
 $0.80 × 1.04/1.10 = $0.7564 per SF EURO goes down = S eur/usd goes up.
 Or SF depreciates about 5.5%
87 88
FACTORS THAT AFFECT EXCHANGE RATE FACTORS THAT AFFECT EXCHANGE RATE
89 90
The other factors: Besides 2 factors mentioned above, exchange The other factors: Besides 2 factors mentioned above, exchange
rate can be affected by balance of payment, people’s habit, rate can be affected by balance of payment, people’s habit,
war, trade barrier… war, trade barrier…
Factor Change in factor Response of the Factor Change in factor Response of the
exchange rate exchange rate
Trade barriers Trade barriers
Import demand Import demand
Export demand Export demand
89 90
91
7. METHODS OF EXCHANGE RATE ADJUSTMENT 92
METHODS OF EXCHANGE RATE ADJUSTMENT
Government adjust exchange rate of its currency by:  Direct tools: devaluation, revaluation, the Central Bank
 Changing interest rates: When domestic interest rates rise due to operations in the foreign exchange markets, surrender, restrictive
an expected increase in inflation, the domestic currency regulation => directly affect exchange rate by changing price of
depreciates . fore
 Changing money supply and demand:  Indirect tools: rediscount rate, tariff, quotas, price subsidies,
 A higher domestic money supply causes the domestic currency to required reserve adjustment on foreign currencies => affect the
depreciate determinant of exchange rate such as interest rate, trade barriers
 A higher domestic money demand causes the domestic currency to and the other non-economic policies.
appreciate.
91 92
93
METHODS OF EXCHANGE RATE ADJUSTMENT 94
Devaluation: Revaluation:
 In the fixed exchange rate regime, a devaluation of a currency
refers to a drop in domestic currency’s value in comparison with  In the fixed exchange rate regime, a revaluation is the activity of
foreign currencies (made by the government). the government to increase the domestic currency’s value in
comparison with foreign currencies.
 The signal of devaluation is that exchange rate adjusted to  The signal of revaluation is exchange rate adjusted to decrease
increase compared to that the government committed to compared to that the government makes a commitment to
maintain.
maintain.
 Exchange rate rises, leading to a decrease in domestic currency’s  Exchange rate falls, leading to a rise in the value of domestic
value; therefore, it is called devaluation. currency; therefore, it is called „revaluation”.
 Why does the government have to revalue domestic currency?
 Why does the government have to devalue domestic currency?
93 94
95
Open market operations: Surrender (Remittance):
 The Central Bank operations on the foreign exchange markets  The government sets regulations to force legal individuals and
are related to maintain fixed exchange rate (in the fixed entities who have foreign exchange income to sell a specific part
exchange rate regime) or affect exchange rate fluctuate in the of their income in a specific period to those are allowed to
positive manner for the economy (in the managed floating participate in foreign exchange trading.
exchange rate regime).
 To make an intervention, the Central Bank is required to have a
specific amount of official foreign exchange reserves.
95 96
97
Restrictive regulation: Rediscount rate:
 A measure that regulates who are permitted to buy foreign  Holding other things constant, when the Central Bank raises
currencies, the purposes of foreign currency used, the quantity of rediscount rate, the average interest in the market would be
purchasable foreign currencies, and the time to purchase foreign impacted to rise as a consequence. An increase in the market
currencies interest will attract more foreign currency inflows, leading to
domestic currency appreciation.
 By contrast, a fall in discount rate would cause opposite effects
97 98
99
Tariff: Quotas:
 The high level of tariff is one of contributors to penalize import  Like the high level of tariff, quotas put the same effect on
which in turn brings about a decrease in the demand for foreign exchange rate and penalize import.
currency. As a result, domestic currency is appreciated.  Removing quotas will increase import, consequently affecting
 Conversely, the low level of tariff will pose opposite effects exchange rate like the low-level tariff.
99 100
101
Price subsidies: Required reserve adjustment on foreign currencies:
 Through the price system, the government can subsidize  When there is a shortage of foreign currency in the foreign
strategic exports or exports in the first period of production. exchange market, the Central Bank can increase the required
Exports subsidies will encourage the quantity of exports and reserve ratio on foreign currency deposits of commercial banks,
increase the supply of foreign currency, leading to the domestic which helps increase the cost of using foreign currency capital.
currency revaluation.  To gain profits, commercial banks are forced to lower interest
 The government also can compensate price of essential imports rate of foreign currency deposits; therefore, holding foreign
that could encourage imports. As a result, this could lead to currency becomes less attractive than holding domestic currency,
domestic currency’s value decreased. which motivates foreign currency owners to sell foreign
currency in exchange for domestic currency. This leads to an
increase in the supply of foreign currency in the foreign
exchange market
101 102
103
8. FOREIGN EXCHANGE MARKET 104
FOREIGN EXCHANGE MARKET
 Definition:  The foreign exchange refers the organizational setting within
The foreign exchange refers the organizational setting within which individuals, businesses, governments, and banks buy and
which individuals, businesses, governments, and banks buy sell foreign currencies and other debt instruments.
and sell foreign currencies and other debt instruments.  The foreign-exchange market is by far the largest and most
 Reason of FX market: liquid market in the world.
Money is not, properly speaking, one of the subjects of  Unlike stock or commodity exchanges, the foreign-exchange
commerce; but only the instrument which men have agreed market is not an organized structure. It has no centralized
upon to facilitate the exchange of one commodity for meeting place and no formal requirements for participation.
another. It is none of the wheels of trade: It is the oil which Foreign-exchange dealers are in constant telephone and
renders the motion of the wheels smoother and easier. computer contact, the market is very competitive; in effect, it
(David Hume, Of Money (1752)) functions no differently than if it were a centralized market.
 The foreign exchange market is a round-the-clock operation
103 104
CHARACTERISTICS OF FX MARKET
FUNCTIONS OF FX MARKET
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CHARACTERISTICS OF FX MARKET
105
 The foreign exchange market is the mechanism by  Largest of all financial markets with average daily
which participants: turnover of over $2 trillion!
 transfer purchasing power between countries;  66% of all foreign exchange transactions involve
 obtain or provide credit for international trade transactions, and cross-border counterparties.
 minimize exposure to the risks of exchange rate changes.  Only 11% of daily spot transactions involve non-
financial customers.
 London is the largest FX market.
 US dollar involved in 87% of all transactions.
106
September 30, 2020
105 106
MARKET ACTIVITY – 24HRS

INCREASING TURNOVER
September 30, 2020
108
Daily foreign exchange market turnover in billions of US dollars

107 (Bank for International Settlements Triennial Central Bank Survey 2004)
September 30, 2020
107 108
IMPORTANT CURRENCIES TYPES OF TRANSACTIONS
109 110
 A Spot transaction in the interbank market is the purchase of

foreign exchange, with delivery and payment between banks to
take place, normally, on the second following business day.
 The date of settlement is referred to as the value date.
109 110
TYPES OF TRANSACTIONS
111 112
 An outright forward transaction (usually called just “forward”)  A swap transaction in the interbank market is the
requires delivery at a future value date of a specified amount of
one currency for a specified amount of another currency. simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
 The exchange rate is established at the time of the agreement,
but payment and delivery are not required until maturity.  Both purchase and sale are conducted with the same
 Forward exchange rates are usually quoted for value dates of counterparty.
one, two, three, six and twelve months.
 Some different types of swaps are:
 Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which currencies  spot against forward,
are referenced.)
 forward-forward,
 nondeliverable forwards (NDF).
111 112
MARKET PARTICIPANTS
September 30, 2020
114
 The foreign exchange market consists of two tiers:

 the interbank or wholesale market (multiples of $1M US or
equivalent in transaction size), and
 the client or retail market (specific, smaller amounts).
 Five broad categories of participants operate within

these two tiers: bank and nonbank foreign exchange
dealers, individuals and firms, speculators and
arbitragers, central banks and treasuries, and foreign
exchange brokers.
113
September 30, 2020
113 114
MARKET PARTICIPANTS
115
MARKET PARTICIPANTS 116
 Banks and a few nonbank foreign exchange dealers  Individuals (such as tourists) and firms (such as
operate in both the interbank and client markets. importers, exporters and MNEs) conduct commercial
 They profit from buying foreign exchange at a “bid” and investment transactions in the foreign exchange
price and reselling it at a slightly higher “offer” or market.
“ask” price.
 Their use of the foreign exchange market is necessary
 Dealers in the foreign exchange department of large but nevertheless incidental to their underlying
international banks often function as “market makers.” commercial or investment purpose.
 These dealers stand willing at all times to buy and sell  Some of the participants use the market to “hedge”
those currencies in which they specialize and thus their foreign exchange risk.
maintain an “inventory” position in those currencies.
115 116
September 30, 2020
MARKET PARTICIPANTS
118
MARKET PARTICIPANTS
 Speculators and arbitragers seek to profit from trading  Central banks and treasuries use the market to acquire or
spend their country’s foreign exchange reserves as well as to
in the market itself. influence the price at which their own currency is traded.
 They operate in their own interest, without a need or  They may act to support the value of their own currency
because of policies adopted at the national level or because of
obligation to serve clients or ensure a continuous commitments entered into through membership in joint
market. agreements such as the European Monetary System.
 The motive is not to earn a profit as such, but rather to
 While dealers seek the bid/ask spread, speculators seek influence the foreign exchange value of their currency in a
all the profit from exchange rate changes and manner that will benefit the interests of their citizens.
arbitragers try to profit from simultaneous exchange  As willing loss takers, central banks and treasuries differ in
rate differences in different markets. motive from all other market participants.
117
September 30, 2020
117 118
COVERED ARBITRAGE DEMAND FOR THE DOLLAR ($)

1. Borrow $1,000,000 in US @ 4% per year or 2% for half year.  Investment Currency
Loan plus Interest to be paid in 180 days = $1,020,000
 Reserve Currency
2. Convert $ to SF at the spot rate:  Transaction Currency
$1,000,000/0.80 = SF 1,250,000
 Invoice Currency
3. Invest SF 1,250,000 @ 10% for 180 days:  Intervention Currency

Will receive SF 1,250,000 × (1+10%/2) = SF 1,312,500 in 180 days
4. Sell SF 1,312,500 in forward market @180 forward rate $0.78/SF

Will receive 1,312,500 × $0.78/SF = $1,023,750 in 180 days
5. After 180 days receive $1,023,750 from forward contract, and pay-off loan
Net profit form arbitrage: $1,023,750 -1,020,000 = $3,750
119 120
FOREIGN EXCHANGE DEFINITIONS FOREIGN EXCHANGE DEFINITIONS
 Convertibility – the degree that one currency can be exchanged (CONTINUED)
for another one without difficulty
 Hard Currency – is a currency that is convertible and is supported  Value date – is the date of settlement for the foreign exchange
by a strong economy transactions
 Spot Rate – an exchange rate quoted for immediate delivery or  Bid price – the price the dealer is willing to buy a currency at
within 2 business days  Offer price/ ask price – is the price the dealer sells currency for
 Forward Rate – an exchange rate quoted for today that is intended  Spread – is the difference between the buy and sell price from the
for use in the future. It is a verbal agreement or a binding contract dealer’s point of view.
121 122
FOREIGN EXCHANGE DEFINITIONS

CONTINUED BALANCE OF PAYMENTS
 Direct Quote – the number of units of a domestic B of P – is a record of the value of all economic
currency for one unit of foreign currency transactions between residents of a country
 Indirect Quote – the number of units of a foreign
currency for one unit of a domestic currency Consists of the following accounts:
 Spread (forward) – is either a discount or a premium
- when the forward rate is higher than the spot rate Merchandise Trade Balance
selling at a premium Services
- when the forward rate is lower than the spot rate Unilateral Transfers +
selling at a discount
Current Accounts
123 124
TYPES OF ACTIVITIES
125
DISCUSSION 126
 High inflation relative to a foreign country, decline in value of  Speculation

currency—Why?  An activity that leaves one open to exchange rate
 Low inflation relative to a foreign country, increase in value of
fluctuations where one aims to make a profit.
currency—Why?  Hedging
 High interest rates in home country relative to a foreign country
 Allows the firm to transfer exchange rate risk inherent
in foreign currency transactions or positions.
may cause domestic currency to appreciate—Why?
 Arbitrage – take advantage of inconsistent prices to
 Increase in domestic income relative to foreign income may lead make risk-free profits. These profits are unlikely to
to a decline in the value of domestic currency– Why? last long.
 Spatial (or Locational) Arbitrage
 Triangular Arbitrage
 Covered Interest Arbitrage – Lecture 3
125 126
$ DEPRECIATION, A$ APPRECIATION NOT EQUAL
127
 In general, the percentage appreciation in one currency

is not equal to the percentage depreciation in the other
currency. Instead…
1
________________________
1 + RA$ = (1 + RUS$)
September 30, 2020
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FOREIGN EXCHANGE RATE: LEARNING AGENDA

September 30, 2020

September 30, 2020

Foreign Trade University, HCM city campus

Foreign Trade University, HCM city campus

1. FOREIGN EXCHANGE FOREIGN EXCHANGE

Foreign exchange comprises:

• The domestic currency held by non-residents

September 30, 2020

ORDINANCE ON FOREIGN EXCHANGE CONTROL ORDINANCE ON FOREIGN EXCHANGE CONTROL

September 30, 2020

Foreign Trade University, HCM city campus

(hereinafter referred to as foreign currency);  currencies of other nations or

September 30, 2020

September 30, 2020

Foreign Trade University, HCM city campus

Foreign Trade University, HCM city campus

 promissory notes  shares

 other payment instruments;  other valuable papers;

ORDINANCE ON FOREIGN EXCHANGE CONTROL ORDINANCE ON FOREIGN EXCHANGE CONTROL

September 30, 2020

Foreign Trade University, HCM city campus

TRAVELERS CHEQUE /CHECK

USD = United States

CHF= Swiss Franc

September 30, 2020

 Exchange rate is conversion price for exchange one currency for

Foreign Trade University, HCM city campus

EXCHANGE RATE: DEFINITION FOREIGN EXCHANGE RATE (CONT.)

September 30, 2020

Foreign Trade University, HCM city campus

September 30, 2020

September 30, 2020 September 30, 2020

 The gold exchange standard (1914- 1944) :  The gold standard:

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UNDER GOLD STANDARD

September 30, 2020 September 30, 2020

After 1972: After 1972:

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After 1972:  The law of one price:

PPP: A unit of domestic currency should purchase the same amount of

September 30, 2020 September 30, 2020

THE PRICE OF A “BASKET OF GOODS” SHOULD BE

 By comparing the prices of identical products in

 A new ipad wine costs £460 in London and $700 in

 Pv: the VND price of the same basket of goods.

September 30, 2020 September 30, 2020

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 (1+∆Pv) = (1+∆e). (1+∆Pu)

September 30, 2020 September 30, 2020

EXCHANGE RATE STATEMENT IN SHORT STATEMENT (ABBREVIATION)

 In full statement: Bank of Tokyo quotes exchange rate:

Ask rate USD/VND=20,820 or USD 1= VND20,820

September 30, 2020 September 30, 2020

BID & ASK QUOTES EXAMPLE

 Foreign currency dealers provide two quotes: Bid Ask

 1 USD = 20,810 VND

September 30, 2020 September 30, 2020

EXCHANGE RATE INTERPRETATION: POINT, FIGURE

 Remember, 100 pips is a big figure and a pip in USD|JPY =

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September 30, 2020

September 30, 2020 September 30, 2020