CHAPTER 9 FOREIGN EXCHANGE MARKET - REVIEWER

United States - Dollars

France - Euro
Brazil - Real
India - Rupee

Foreign Exchange Market

● this is where the trading of currency and bank deposits denominated in particular
currencies takes place
● one of the largest financial markets in the world

1 Trillion
● worldwide averages of trading transactions

Exchange Rates
● the relationship among the values of currencies

HISTORICAL PERSPECTIVE OF EXCHANGE RATE

Fixed exchange rate system
● the exchange rate system from the end of World War II until 70's which is administered
by the International Monetary Fund or IMF
● under this system, all countries are required to set a specific parity rate for their currency

Devaluation
● the currency was made cheaper with respect to the dollar

Upvaluation or Revaluation
● a currency became more expensive with respect to the dollar

Floating Rate International Currency System

● it operates since 1973, major currencies are fluctuating freely depending on their values
as perceived by traders in the foreign exchange market

FACTORS THAT INFLUENCED THE DETERMINATION OF EXCHANGE RATES

1. Country's economic strengths
2. Level of Exports and Imports
3. Level of Monetary Activity
4. Deficits or Surpluses in the balance of payments

Forex Market
● it provides service to individuals, businesses and governments who are in need of
buying and selling 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
● provides a mechanism for the transfer of purchasing power from one currency to another
● over the counter market whose main participants are commercial, investment banks,
forex dealers and brokers

SOME COMMERCIAL CENTERS FOR FOREIGN EXCHANGE TRADING

1. New York
2. London
3. Zurich
4. Frankfurt
5. Hong Kong
6. Singapore
7. Tokyo, Japan

Exchange Rate
● The price of one country's currency expressed in terms of another country's currency
● they are important since they affect the relative price of domestic and foreign goods
● the price of one asset in terms of another
● the rate at which currency is converted into another

The Wall Street Journal

● this is where the foreign exchange rate quotations can be found

FACTORS INFLUENCING EXCHANGE RATES

1. Inflation - it tends to deflate the value of a currency because holding the currency results
in reduced purchasing power.
2. Interest Rates - the demand for country's currency is increasing if interest returns are
higher relative to other countries
3. Balance of payments - used to refer 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 - such as political and economic stability, extended stock market rallies

Trade Deficit
● the result when a greater quantity of peso is supplied by Philippine Interests than
demanded by foreign interests

Trade surplus
● the result when a lower or smaller quantity of peso is supplied by Philippine interests
than demanded by foreign interests

Managed Float
 ● the current method of exchange rate determination

Theory of Purchasing Power Parity

● one of the most prominent theories of how exchange rates are determined
● exchange rates between two currencies will adjust to reflect changes in the price levels
of the two countries
● application of the law of one price to national price levels
● it suggests that if one country's price level rises relative to another's, its currency should
depreciate which means that the other country's currency should appreciate

KINDS OF FOREIGN EXCHANGE RATE TRANSACTIONS

1. Spot Transactions - those which involve immediate (two-day) exchange of bank
deposits. The spot exchange rate - exchange rate for spot transactions
2. Forward Transactions - the exchange of bank deposits at some specified future date.
The forward exchange rate - exchange rate for forward transactions

Spot Rate
● The exchange rate at which the currency is traded for immediate delivery

Direct Quote
● the quoted exchange rate which 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

Cross Rate
● Indirect Computation of the exchange rate of one currency from the exchange rates of
two other currencies

Triangular Arbitrage
● the arbitrage condition for the cross rates

Arbitrageur
● an enterprising trader who makes profit by buying in the market where the currency was
cheaper and then selling it in the dearer if the exchange rate quotations between two
countries were out of line

Arbitrage
● the process of buying and selling in more than one market to make a riskless profit

Forward Rates
 ● exchange rate at which the currency for future delivery is quoted

Forward market transaction

● the trading of currencies for future delivery

FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN

1. Relative Price Levels - a rise in the country's price level causes its currency to
depreciate, and a fall in the country's relative price level causes its currency to
appreciste
2. Trade Barriers - increasing trade barriers causes a country's currency to appreciate in
the long run
3. Preferences for Domestic Vs. Foreign Goods - increased demand for a country's export
will appreciate its currency in the long run while the in increased demand for an imports
causes the domestic currency to depreciate
4. Productivity - a country becomes more productive relative to other countries will make its
currency appreciate

Asset Market Approach

● the method to investigate the short run determination of exchange rates

Foreign Exchange Risk

● possibility of a drop in revenue or an increase in cost in an international transactions due
to changes in foreign exchange rates

Monetary Items
● items with fixed cash flows

Trigger Pricing
● means of managing exchange rate risk
● foreign funds are supplied at an indexed price but with an option to convert to a
future-based fixed price

Diversification
● minimizing the exchange rate risk by diversification