FOREIGN EXCHANGE MARKET

RECENT HISTORICAL PERSPECTIVE OF EXCHANGE RATES

Fixed exchange rate system - Under this system, all countries were required to set a specific
parity rate for their currency vis-a-vis the United States dollar.

Devaluation - when a currency was made cheaper with respect to the dollar.
Upvaluation or revaluation - when a currency become more expensive with respect to the
dollar.

 A floating rate international currency system has been operating since 1973.

RECENT HISTORICAL PERSPECTIVE OF EXCHANGE RATES

The determination of exchange rates are influenced by such important factors as:
(a) the country's economic strengths,
(b) its level of exports and imports,
(c) the level of monetary activity, and
(d) the deficits or surpluses in its balance of payments.

THE FOREIGN CURRENCY EXCHANGE MARKET

 The forex market provides a service to individuals, businesses, and governments who need
to buy or sell currencies other than that used in their country.
 It is also a marketplace in which currencies are bought and sold purely to make profit via
speculation.
 The foreign exchange (or forex) market provides a mechanism for the transfer of purchasing
power from on currency to another.

EXCHANGE RATES - An exchange rate is simply the price of one country's currency
expressed in terms of another country's currency.

Why are exchange rates important?

Exchange rates are important because they affect the relative price of domestic and foreign
goods.

FACTORS INFLUENCING EXCHANGE RATES

(1) INFLATION - Inflation tends to deflate the value of a currency because holding the
currency results in reduced purchasing power.
(2) INTEREST RATES - If interest returns in a particular country are higher relative to other
countries, individuals and companies will be enticed to invest in that country.
(3) BALANCE OF PAYMENTS - Is used to refer to a system of accounts that catalogs the
flow of goods between the residents of two countries.
(4) GOVERNMENT INTERVENTION - Through intervention, the central bank of a country
may support or depress the value of its currency.
(5) OTHER FACTORS - Other factors that may affect exchange rates are political and
economic stability, extended stock market rallies and significant declines in the demand or major
exports.
INTERACTION IN FOREIGN CURRENCY MARKETS
 Exchange Rate Determination
Equilibrium exchange rate in floating markets are determined by the supply of and demand
for the currencies.
 Fixed Exchange Rate
 Managed Float
A manage float is the current method of exchange rate determination. During periods of
extreme fluctuation in the value of a nation's currency, intervention by governments or central
banks may occur to maintain fairly stable exchange rates.

THEORY OF PURCHASING POWER PARTY - It states that exchange rates between any
two currencies will adjust to reflect changes in the price levels of the two countries. The theory
of PPP is simply an application of the law of one price to national levels.

WHAT ARE THE FOREIGN CURRENCY EXCHANGE RATE TRANSACTIONS?

A. Spot Transactions - are those which involve immediate (two-day) exchange of bank deposits.
B. Forward Transactions - involve the exchange of bank deposits at some specified future date.

SPOT EXCHANGE RATES

 is the exchange rate for the spot transactions.
 a typical spot transaction may involve a Philippine firm buying foreign currency from its
bank and paying for it in Philippine pesos (or an American firm buying currency from its
bank and paying for it in US dollar).

DIRECT AND INDIRECT QUOTES

Direct quote - indicates the number of units of the home currency required to buy one unit of
the foreign currency.

Indirect quote - indicates the number of units of foreign currency that can be bought for one
unit of the home currency.
Indirect quote = 1/direct quote

CROSS RATES - is the indirect computation of the exchange rate of one currency from the
exchange rates of two other currencies.

ARBITRAGE - process of buying and selling in more than one market to make a riskless profit.

FORWARD RATES
 The forward rate for a currency is the exchange rate at which the currency for future
delivery is quoted.
 The trading of currencies for future delivery is called a forward market transaction.

FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN

(1) RELATIVE PRICE LEVELS - In the long run, a rise in a country's price level causes its
currency to depreciate, and a fall in the country's relative price level causes its currency to
depreciate.
(2) TRADE BARRIERS - Increasing trade barriers causes a country's currency to appreciate in
the long run.
(3) PREFERENCE FOR DOMESTIC VERSUS FOREIGN GOODS - Increased demand for
a country's export causes its currency to appreciate in the long run; conversely, increased
demand for imports causes the domestic currency to depreciate.
(4)PRODUCTIVITY - In the long run, as a country becomes more productive relative to other
countries, its currency appreciates.

AVOIDANCE OF EXCHANGE RATE RISK IN FOREIGN CURRENCY

1. The firm may hedge its risk by purchasing or selling forward exchange contracts.
2. The firm may choose to minimize receivables and liabilities denominated in foreign
currencies.
3. Maintaining a monetary balance between receivables and payables denominated in a
particular foreign currency avoid a net receivable or net liability position in that currency.
4. Another means of managing exchange rate risk is by the use of trigger pricing.
5. A firm may seek to minimize its exchange-rate risk by diversification.
6. A speculative forward contract does not hedge any exposure to foreign currency fluctuations,
it creates the exposure.