TOPIC 8

F O R E I G N E X C H A N G E M A R K E T
( C U R R E N C Y E X C H A N G E S )

20XX 1
 CURRENCY EXCHANGES

• An Overview

• Exchange Rates in the Long Run:

Theor y of Purchasing Power
Parity (PPP)

• Base and Quote Currency

• Direct and Indirect Quotes

Presentation title 2
An Overview

A n e x c h a n g e ra te b e t w e e n t w o c u r r e n c i e s i s a p r i c e – l i ke o t h e r p r i c e s – t h a t i s
i n fl u e n c e d b y d e m a n d a n d s u p p l y c o n d i t i o n .

A n i n c o r r e c t p r i c e w i l l d i s t o r t a p r o d u c t ’s d e m a n d o r s u p p l y e q u i l i b r i u m , a m i s a l i g n e d
e x c h a n g e ra t e , e sp e c i a l l y a g a i n s t c u r r e n c i e s o f k e y t ra d i n g p a r t n e r s , c o u l d i m p a c t a
n a t i o n’s c o m p e t i t i ve n e s s . I t i s b e c a u s e a n e x c h a n g e ra t e d i c t a t e s t h e t e r m s o f t ra d e
between any two countries.

A n u n d e r va l u e d / u n d e r p r i c e d e x c h a n g e ra t e i n c r e a s e s a n a t i o n’s c o m p e t i t i ve n e s s .

A n o ve r va l u e d / ove r p r i c e d e x c h a n g e ra t e r e d u c e s a n a t i o n’s c o m p e t i t i ve n e s s .

T h e c h a n g e o f c o m p e t i t i v e n e s s c o m e s i n h a n d - i n - h a n d w i t h o t h e r f a c to r s l i ke s p e c u l a t i ve
t ra d i n g o f c u r r e n c i e s b y d e l i b e ra t e l y u n d e r va l u i n g a c u r r e n c y.

T h i s m a y w o r k t e m p o ra r i l y b u t i n l o n g e r t e r m , s u c h u n d e r va l u a t i o n m ay c a u s e i m p o r t e d
i n fl a t i o n , p r ov i d e p e r ve r s e i n c e n t i ve s , a n d l e a d t o a m y r i a d o f o t h e r p r o b l e m s s u c h a s
d y s f u n c t i o n a l i n d u s t r y g r o w t h , w h i c h c o u l d d i s t r e s s t h e e c o n o m y.
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Factors that Infl uence Supply & Demand for a Currency

1. Relative Prices – If a nation’s goods are cheaper, demand for its goods and
currency will increase.
2. Barriers to Trade – Tariffs, taxes, quotas, and other restrictions affect demand
for goods and, consequently, currencies.
3. Resource Endowment – Availability of resources that determine the factors of
production affect demand for a nation’s goods and its currency price.
4. Tastes – Shifts in consumer preferences will influence demand for goods and
currency.
5. Productivity – Higher productivity  higher economic growth  greater demand
for goods and currency  higher exchange rate.

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Exchange Rates in the Long Run: Theor y of Purchasing Power Parity (PPP)

Purchasing power parity (PPP) is the theory Example:

explaining the change in foreign currency If a Big Mac hamburger costs $3 in
exchange rates as inflation rates in the countries the United States and ¥330 in Japan,
change. Exchange rates between two currencies PPP exists when the ¥/$ exchange
will adjust to reflect changes in price levels. rate was ¥110 for $1.
That is, a dollar should have the same
In their simplest form, PPPs are simply price purchasing power anywhere in the world.
relatives that show the ratio of the prices in However, market factors such as
national currencies of the same good or service in transportation costs, tariffs, or taxes could
different countries.  lead to the absolute PPP not holding.

PPP  Domestic price level  10%, domestic

currency  10%

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Factors that Infl uence Supply & Demand for a Currency

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Base and Quote Currency

It is important to note that currencies are traded and priced in pairs. From the
example, the Pound is the base currency while the second currency, which is the
US Dollar, is called the quote or counter currency. Either the pairs are being
quoted direct or i ndi rect, the currency pair is to be used to determine the val ue
of the base currency.
In all currency quote cases, the base currency i s wor th one unit. The quoted
currency i s the amount of currency that one unit of the base currency can buy. A
trader can make money in forex by appreciation i n the value of the quoted
currency or by a decrease i n val ue of the base currency.

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Direct and Indirect Quotes
Direct quote
A direct quote is a currency pair quote where the
foreign currency is expressed in per-unit terms of the
domestic currency.
• A direct quote gives you the quantity of local
currency needed to purchase one unit of foreign
currency.
• As the U.S. dollar (USD) is the dominant currency
in global foreign exchange markets, the convention
is to generally use direct quotes that have the U.S.
dollar as the base currency and other currencies
like the Canadian dollar (CAD), Japanese yen (JPY)
and Malaysian Ringgit as the counter (quote)
currency.
• Exceptions to this rule are the Euro Dollar and
Commonwealth currencies like the British pound
(GBP), Australian dollar (AUD) and New Zealand
dollar (NZD) which are typically quoted in indirect
form (for example GBP 1 = USD 1.30).
Indirect quote
• This can be contrasted with a 
direct quote. An indirect quote is also
known as a “quantity quotation,” since
it expresses the quantity of foreign
currency required to buy units of the
domestic currency. In other words, the
domestic currency is the base currency
while the foreign currency is the
counter(quote) currency.
• The exchange rate for the pound would
thus be quoted as $1.45 per £1,
regardless of whether this is considered
direct (in the United States) or indirect
(in the United Kingdom).
• Note that a quote involving two foreign
currencies (or one not involving USD) is
called a cross currency quote.
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 BUYING AND SELLING IN FOREX MARKET

• An Overview

• Buying & Selling Currency Pairs

• Buying & Selling of Foreign

Currencies

• Spot vs Forward Quotations

Presentation title 9
An Overview

B u y i n g a n d s e l l i n g i n fo r e x i s s p e c u l a t i n g o n
t h e u p w a r d a n d d o w n wa r d p r i c e m o ve m e n t s o f
a c u r r e n c y p a i r, w i t h t h e h o p e s o f m a k i n g a
p r o fi t . A l l fo r e x t ra d i n g i nvo l ve s b u y i n g o n e
c u r r e n c y a n d s e l l i n g a n o t h e r, w h i c h i s w h y i t i s
quoted in pairs.
Imagine each currency pair constantly in a “tug
o f wa r ” w i t h e a c h c u r r e n c y o n i t s o w n s i d e o f
t h e r o p e . S i n c e a n e x c h a n g e ra t e i s t h e r e l a t i v e
p r i c e o f t w o c u r r e n c i e s f r o m t w o d i ff e r e n t
c o u n t r i e s , m e a n i n g e x c h a n g e ra t e s fl u c t u a t e
based on which currency is stronger at present.
Yo u w o u l d b u y t h e p a i r i f yo u e x p e c t e d t h e b a s e
currency to strengthen against the quote
c u r r e n c y, a n d yo u w o u l d s e l l i f yo u e x p e c te d i t
to do the opposite. 10
Buying and Selling Currency Pairs

C u r r e n c i e s a r e t ra d e d t h r o u g h a “ fo r e x b r o k e r ” o r “ C F D p r ov i d e r ” a n d a r e t ra d e d i n p a i r s .
C u r r e n c i e s a r e q u o te d i n r e l a t i o n to a n o t h e r c u r r e n c y. W h e n yo u t ra d e i n t h e fo r e x
m a r k e t , yo u b u y o r s e l l i n c u r r e n c y p a i r s .

The term CFD stands for contract for difference which is a type of trading and a popular gateway for investors to enter
the financial markets. They are offered by brokers for common instruments like forex, commodities and spot metals. CFDs
are a form of derivative trading.

T h e p r i c e o f a fo r e x p a i r i s h o w m u c h o n e u n i t o f t h e b a s e c u r r e n c y i s w o r t h i n t h e q u o t e
c u r r e n c y. Fo r e x a m p l e , i f t h e p r i c e o f G B P / U S D i s 1 . 3 2 0 0 0 , i t m e a n s t h a t £ 1 c o s t s $ 1 . 3 2 .
M e a n i n g yo u a r e S E L L I N G D o l l a r a n d B U Y I N G Po u n d .

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 Buying and Selling of Foreign Currencies

S E L L ra t e – t h i s i s t h e ra t e a t w h i c h b a n k s e l l s fo r e i g n
c u r r e n c y i n e xc h a n g e fo r l o c a l c u r r e n c y. Fo r e x a m p l e ,
i f yo u w e r e h e a d i n g t o U K f r o m N e w Yo r k , yo u w o u l d
e x c h a n g e yo u r c u r r e n c y fo r Po u n d a t t h e S E L L ra t e .

B U Y ra t e   – t h i s i s t h e ra te a t w h i c h b a n k b u y s fo r e i g n
c u r r e n c y b a c k f r o m t rave l e r s t o e x c h a n g e i n to l o c a l
c u r r e n c y. Fo r e x a m p l e , i f yo u w e r e r e t u r n i n g f r o m U K ,
t h e b a n k / m o n e y c h a n g e r w o u l d e xc h a n g e yo u r Po u n d
Selling Buying
Pound and Pound and b a c k i n to D o l l a r s a t t h e B U Y ra te .
Buying US Selling US
Dollar Dollar
T h e r e i s a b u y i n g a n d a s e l l i n g ra t e fo r t ra d i n g o f
c u r r e n c y i n F O R E X m a r ke t . T h e F O R E X d e a l e r s m a k e
t h e i r p r o fi t b y b u y i n g fo r l e s s a n d s e l l i n g fo r h i g h . T h e
d i ff e r e n c e b e t w e e n t h e t w o ra te s i s c a l l e d S P R E A D .
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How a Trader Makes Money from Forex?

A n o t h e r p e r s p e c t i ve o n c u r r e n c y t ra d i n g c o m e s f r o m c o n s i d e r i n g t h e p o s i t i o n a n
i n ve st o r i s t a k i n g o n e a c h c u r r e n c y p a i r. T h e b a s e c u r r e n c y c a n b e t h o u g h t o f a s a s h o r t
p o s i t i o n b e c a u s e yo u a r e " s e l l i n g " t h e b a s e c u r r e n c y t o p u r c h a s e t h e q u o t e d c u r r e n c y.
I n t u r n , t h e q u o t e d c u r r e n c y c a n b e s e e n a s a l o n g p o s i t i o n o n t h e c u r r e n c y p a i r.

A s p e r e x a m p l e i n t h e e a r l i e r s l i d e , o n e Po u n d c a n p u r c h a s e $ 1 . 3 2 a n d v i c e ve r s a . To
b u y t h e Po u n d , a U S i nv e s t o r m u s t fi r s t g o s h o r t ( S E L L ) o n t h e U. S. d o l l a r to g o l o n g
( B U Y ) o n t h e Po u n d . To m a k e m o n e y o n t h i s i n ve s t m e n t , t h e U S i n ve s t o r w i l l h ave to s e l l
b a c k t h e Po u n d w h e n t h e i r va l u e a p p r e c i a te s r e l a t i ve t o t h e U. S. d o l l a r.

Fo r i n s t a n c e , l e t ' s a s s u m e t h e va l u e o f t h e Po u n d a p p r e c i a t e s to $ 1 . 3 4 . O n a l o t o f
1 0 0 , 0 0 0 Po u n d , t h e U S i n ve s to r w o u l d g a i n $ 2 , 0 0 0 ( $ 1 3 4 , 0 0 0 - $ 1 3 2 , 0 0 0 ) i f h e / s h e s o l d
t h e Po u n d a t t h i s e x c h a n g e ra t e . Co n ve r s e l y, i f t h e G B P / U S D e x c h a n g e ra t e fe l l f r o m
$ 1 . 3 2 t o $ 1 . 3 0 , t h e n t h e i n ve s t o r w o u l d l o s e $ 2 , 0 0 0 ( $ 1 3 0 , 0 0 0 - $ 1 3 2 , 0 0 0 ) .

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Spot and Forward Quotations

SPOT TRANSACTIONS FORWARD TRANSACTIONS

Trading currency for immediate delivery (within 2 Trading currency for future delivery – forward
business days)  spot market and spot rate. market and forward rate.

Spot Market Quotations Currency Forwards - do not trade on exchange.

Two-way quotations
The difference between the buy and sell
prices is the ‘spread’, represented in
percentage terms in the following equation
• Term tailored to business needs.
• Two-party agreement.
• Importers buy foreign currency forward to
hedge payables.
• Exporters sell foreign currency forward to
hedge receivables.

Transposing Spot Quotations

• Given a quotation of EUR/AUD 1.6155-
1.6165, the AUD/EUR can be determined by
transposing the quotation, by reverse and
invert.
• Reverse the bid and ask price: 1.6165-
1.6155. Then take the inverse (divide both
number into 1)
1/1.6165 1/1.6155
• AUD/EUR = 0.6186-0.6190 14
How a Financial Institution Makes Money from Forex?

A French importer buys goods from a US supplier and pays USD350,000. Meanwhile, a US
importer pays a French wine exporter USD350,000. All trade payments are made via BNP
Paribas Paris (“BNP”). Calculate the amount of profit the BNP is making from the FOREX
transactions, given below exchange rates:

Bank Buys Bank Sells

Note: This is an indirect
EUR/USD 1.21 1.20 quote

SPREAD

The French importer buys USD; BNP sells USD at $1.20: 350,000 ÷1.20 = 291,666.67
The French exporter sells USD; BNP buys USD at $1.21: 350,000 ÷ 1.21 = 289,256.20
Therefore, BNP is making: EUR2,410.47 (SPREAD)

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 EXCHANGE RATE RISKS

• Types of Risks

• Appreciation and Depreciation of

Currencies

• Changes in Revenue or
Receivables

• Changes in Costs or Payables

Presentation title 16
Types of Exchange Rate Risks
Translation Risk
• Arises from restating the
book value of assets of a
foreign operation (e.g.:
subsidiary in other country)
into home currency of
fi n a n c i a l p o s i t i o n d a t e .
• If there is an adverse
movement in the exchange
r a t e , t h e r e p o r t e d fi n a n c i a l
position of the foreign
operation in home currency
will not be as good as if the
case of otherwise.
Transaction Risk
• When the price of imports
o r e x p o r t s a r e fi xe d i n
fo r e i g n c u r r e n c y, a n d t h er e
i s a n a d v er s e m ov em en t i n
e xc h a n g e ra t e b e t w e e n t h e
d a t e o f c o n t ra c t a n d t h e
d a t e o f s et t l em e n t .
• The exporter may end up
r e c e i v i n g l es s e r a n d t h e
e x p o r t e r m a y en d u p p a y i n g
more in home currency than
originally expected.
Economic Risk
• T h e e ff e c t i n i n t e r n a t i o n a l
competitiveness of a company in
l o n g e r r u n d u e t o m o ve m e n t s i n
e x c h a n g e ra t e s .
• E . g . : a U K c o m p a n y i m p o r t s ra w
materials from USA which are
p r i c e d i n U S D. T h e e x p o r t s o f
fi n i s h e d g o o d s t o t h e o t h e r
European countries are in Euro.
• A depreciation in GBP against
USD or an appreciation of GBP
against Euro will erode the
c o m p e t i t i v e n e s s o f t h e c o m p a n y,
resulting in more spending of
the GBP for supplies or receiving
lesser GBP from exports.
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Exchange Rate Risk: Appreciation & Depreciation of Currencies

It is the rate at whi ch a countr y ’s currency can be exchanged for another

countr y ’s currency.
Example: If the USD/MYR exchange rate is MYR4.25, it means that one can buy
or sel l USD1 for MYR4.25.

Exchange rate can appreciate or depreciate over time, infl uenced by demand,
supply and other factors.
• If the demand for USD by Malaysians increases, then the USD will i ncrease
agai nst MYR. Hence, USD appreciates while MYR depreciates in value.
• If more Ringgit are required to purchase one Dollar, the Ringgit has
depreci ated rel ative to Doll ar.
Since an exchange rate is a quotation invol ving a pair of currencies, an
appreciation of one must mean a depreci ation of the other.
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How to Calculate the Percentage of Appreciation and Depreciation of a Currency?

On 25 December 2021, the exchange rate for MYR against USD is MYR4.25. On 31 December 2021, the rates
have changed between the two currencies whereby the MYR has become MYR4.00. Given the spot exchange
rates, determine which currency has depreciated and appreciated and their percentage, respectively.

25/12/2021: USD/MYR = RM4.25 31/12/2021: USD/MYR = MYR4.00

1. MYR appreciates while USD depreciates.

This is because the costs to buy a USD is less on 31/12/2021 (MYR4.00) compared to 25/12/2021, which is
MYR4.25.
2. Determining the % of:
(i) Depreciation of USD = x 100 (ii) Appreciation of MYR = x 100 OR x 100
= x 100 = x 100 OR
Answer: 5.88% = x 100

Answer: 6.25%

Where:
e0 is the exchange rate in the previous period
e1 is the exchange rate in the new period
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Exchange Rate Risk: Changes in Revenue or Receivables

Norman, a Malaysian exporter of sawn timber has just shipped 500 tonnes of timber to his Japanese customer.
He issued a 90 days invoice for JPY300 million at a spot rate of JPY10 per MYR. Determine the implied gain (or
loss) if on Day 90, the spot rate has changed to JPY12 per MYR and JPY8.5 per MYR, respectively.

Initial cost = = MYR30,000,000 Initial cost = = MYR30,000,000

Actual cost = = MYR25,000,000 Actual cost = = MYR35,290,000

Implied loss = Initial – Actual cost Implied gain = Initial cost – Actual cost
= MYR30,000,000 – MYR25,000,000 = MYR30,000,000 – MYR35,290,000
= (RM5,000,000) = MYR5,290,000

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 Exchange Rate Risk: Changes in Costs or Payables

A Malaysian distributor of electrical appliances had just confirmed the import of flat screen HDTVs from Samsung,
Korea. Samsung will invoice the amount of KRW 980 million for the goods. Payment will be due in 90 days. The
spot rate is MYR0.30 per KRW100. Determine the implied gain (or loss) if on Day 90, the spot rate has changed to
MYR0.33 per KRW100 and MYR0.26 per KRW100, respectively.

Initial cost = KRW980 million x = MYR2,940,000 Initial cost = KRW980 million x = MYR2,940,000
Actual cost = KRW980 million x = MYR3,234,000 Actual cost = KRW980 million x = MYR2,548,000

Implied loss = Initial cost – Actual cost Implied gain = Intial cost – Actual cost
= MYR2,940,000 - MYR3,234,000 = MYR2,940,000 – MYR2,548,000
= (MYR294,000) = MYR392,000

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Conclusion

FC Denominated Item Impact if FC Impact if FC

Appreciates Against HC Depreciates Against
HC
Exports Revenue Gain Loss
Imports Cost Loss Gain
Receivables Asset Gain Loss
Payables Liability Loss Gain

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Thank you

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