Tutorial topic – Chapter 10

Exchange Rate and Foreign Exchange Market

1. Concepts and definition
- Foreign Exchange Market: the market at which people buy and sell different currencies. One
international currency that is bought and sold popularly is the USD
- The rate at which two currencies can be exchanged for each other is called the Foreign Exchange
Rate (E).
Example: 1 USD = 23,000 VND or we write: EVND/USD = 23,000
In this example: VND is the “Base currency” and USD is the “Quote currency”
2. How to write the currency?
The first two letters are the country’s name. The third letter is the currency’s name.
Example: VND
Can you recognize these currencies?
THB, JPY, GBP, CNY, AUD, CAD.
- Some countries use symbols rather than letters: USD = $ ; GBP = £ ;
3. Direct Quote vs. Indirect Quote
- Direct Quote: the number of domestic currency units that are exchanged for one unit of foreign
currency.
Example: in Vietnam: 1 USD = 23,000 VND
in Japan : 1 USD = 110 JPY
- Indirect Quote: the number of foreign currency units that are exchanged for one unit of
domestic currency.
Example: in The UK : 1 GBP = 1.15 USD
in the US : 1 USD = 30 THB
4. Bid Rate vs. Offer Rate
- Bid Rate : buying rate
- Offer Rate: Selling rate
- At a bank:
Information
JPY: 100.0000 – 110.0000
THB: 30.0000 – 32.0000
GBP: 0.8900 - 0.9400
VND: 22,500.0000 – 23,000.0000
5. Cross – Rate
- Cross Rate: the rate of exchange between two non-USD currencies
- Example: use VND to buy THB
 The Cross Rate: E(VND/THB)
 Step 1: Use VND to buy USD
Step 2: Use USD to buy THB
VND/THB = VND*USD = VND*. 1 . = 23,000 *(1/30) = 767
USD THB USD (THB/USD)
E(VND/THB) = 767  1 THB = 767 VND
- Example 2: Calculate the Cross Rate: E(JPY/GBP) = 110/ 0.89 = 123.6
1 GBP = 123.6 JPY
6. Depreciation vs. Appreciation
- Because of changes in the foreign exchange market (changes in demand for or supply of the USD
in the market): 1 USD = 22,000 VND changes to 1 USD = 23,000 VND
- We say that: there is a depreciation of the VND or there is an appreciation of the USD.
- The VND is depreciated against the USD by (23000-22000)*100/22000 = 4.54%
- EX 1: The initial Exchange Rate: Eo: 1 USD = 22,000 VND ; Later on: E1: 1 USD = 21,000 USD
We say that the VND is appreciated against the USD by: (21,000 – 22,000)*100/22,000 = - 4.55%
7. Devaluating vs. Revaluating
- Under the central bank’s intervention into the market  1 USD = 22,000 VND changes to 1 USD
= 23,000 VND
- Vietnamese government has devaluated the VND
8. Bilateral Foreign Exchange Rate and Nominal Effective Exchange Rate (NEER)
- Bilateral Exchange Rate is the rate of Exchange of two currencies between the two countries.
EX: E(VND/GBP) = 32,000 or 1GBP = 32,000 VND
- Nominal Effective Exchange Rate (NEER): the sum of the trade shares multiplied by the exchange
rate changes for each country.
- The amount of international trade is the sum of Export value + Import value in a period of time
(normally a year).
EX: A Home country has 40% of international trade with country 1, 60% international trade is
with country 2. A Home’s currency appreciates 10% against country1’ currency but depreciates
30% against country 2’ currency. The Change in Nominal Effective Exchange rate will be:
= (-0.1*0.4) + (0.3*0.6) = +0.14 or 14%
-  Home’s Effective Exchange Rate has depreciated by 14% against the two countries 1 and 2.
9. Arbitrage
- Arbitrage: buying and selling of different currencies for profit.
- Example:
At the New York Money Center: 1 USD = 105 JPY
At the Tokyo Money Center: 1 GBP = 135 JPY
At the London Money Center: 1 GBP = 1.15 USD
You have 100,000 USD, how can you earn profit from this information?
 Use 100,000 USD to buy GBP: 100,000/1.15 = 86,956 GBP
 Use 86,956 GBP to buy JPY : 86,956*135 = 11,739,130 JPY
 Use 11,739,130 JPY to buy back USD: 11,739,130/105 = 111,801 USD
 Profit to the arbitrageur: 111,801 – 100,000 = 11,801 USD
- Example 2:
At the New York Money Center: 1 USD = 125 JPY
At the Tokyo Money Center: 1 GBP = 140 JPY
At the London Money Center: 1 GBP = 1.3 USD
You have 200,000 USD, how can you earn profit from this information?
 Use 200,000 USD to buy JPY: 200,000*125 = 25,000,000 JPY
 Use JPY to buy GBP: 25,000,000/140 = 178,571.43 GBP
 Use GBP to buy back USD: 178,571.43*1,3 = 232,142 USD
 Profit to the arbitrageur: 32,142 USD.
10. Foreign Exchange Risks:
- Foreign Exchange Risk: losses to exporters, importers, or investors which are caused by
fluctuation of the foreign exchange rates.
- Exporters sell their goods abroad and receive payments in terms of USD
- Importers buy foreign goods from abroad and make payments to foreign sellers in terms of USD
- Both of their performance is affected by the fluctuation of the USD.
a. Depreciation of the domestic currency causes risks to importers:
- Example: importing good X
- World price of X: Pw = 1 USD
- Domestic price of X: Pd= 24,000 VND
- Initial Exchange Rate: Eo(VND/USD) = 22,000
-  profit per one unit of X: πo = Pd – Pw*Eo = 24,000 – 1*22,000 = 2,000 VND/unit
- Suppose there is a depreciation of VND  E1: 1 USD = 23,000 VND
 new profit per unit: π1 = Pd – Pw*E1 = 24,000 – 1*23,000 VND = 1,000 VND/unit
- The Depreciation of VND (domestic currency) has reduced profit by 50%  risk to the importer.
b. Class Assignment
- Given the following data of an exporter:
Export the good X
Unit cost of production of X: AC = 18,000 VND
The world price of X: Pw = 1 USD
Initial Exchange Rate Eo(VND/USD) = 22,000 VND
- Prove for the statement: if the government devaluates the domestic currency from 1USD =
22,000 VND to 1 USD = 23,000 VND, it can encourage the country’s export.
11. Foreign Exchange Market for USD
- Suppliers of USD: the banks, the exporters, foreign visitors, arbitrageurs, foreign company’s
FDI,..
- Demand for USD: the banks, the importers, the citizens who abroad for visiting, studying,
arbitrageurs, …
- Price of USD: the Exchange Rate E
- If demand for USD increases  the price of USD ↑ or E ↑ and vice versa.
- If supply of USD increases  the price of USD ↓ or E ↓ and vice versa.
 - Factors that cause the foreign exchange rate E to change:
o The banks
o Export and Import values
o FDI flow into or out of the country
o Ect.
12. Foreign Exchange Regimes
a. Fixed Exchange Rate Regime (Pegging regime)
GDP = C + I + G + EX – IM
- If the exchange rate fluctuates, it negatively affects EX and IM  affect GDP
- Some countries don’t want it  they apply the Fixed Exchange Rate regime.
- The Central Bank keeps the exchange rate E fixed so that it does not affect EX and IM.
- If demand for USD increases, the price of USD ↑  E (VND/USD) ↑, the Central Bank will sell
out the USD into the market  supply of USD ↑  price of USD ↓  E ↓ back to the initial
value and vice versa.
- Advantage: the E does not negatively affect EX and IM activities.
- Disadvantage: when the Central Bank sells out the USD  the country’s Foreign Reserves ↓
the country becomes poorer.
- Note: Every country has its foreign reserves which consists of at least 3 sources: the USDs, gold,
and the IMF’s currency (or SDRs). These foreign reserves are kept at the Central Bank of the
country.
b. Floating Exchange Rate Regime:
- The Exchange Rate E fluctuates freely in the FOREX market without intervention of the Central
Bank.
- If demand for USD ↑  E ↑ and vice versa
- If supply of USD ↑  E ↓ and vice versa.
- Advantage: it does not cause reduction in the country’s Foreign Reserves
- Disadvantage: it may cause risks to IM and EX.
c. Manageable Floating Regime
- The Central Bank allows E to fluctuate freely within a frame of +/- a% specified by it.
- - a% E + a%

CB’s action

CB’s take action (sell out USD)

d. Crawling Peg Regime

- The Central Bank allows E to increase by less than a% every year. The a% is set by the Central
Bank.
- Applying when the country faces an increasing value of Import (IM) overtime.
e. Foreign Exchange Direct Control
- The Banking system announces the value of E every day. All the households and companies have
to follow.
- The Banking system controls the USDs. Companies and households are not allowed to buy and
sell USD directly.
- Problem: it leads to the establishment of two markets for USD: the official market for USD; the
Black Market for USD.
13. Measures to avoid or reduce the Foreign Exchange Risk
- From the example above: When E(VND/USD) = 22,000 , the profit to the importer is 2,000 VND
per unit; When E1(VND/USD) = 23,000, the profit to the importer is 1,000 VND per unit.

Now after 3 months

Eo: 1 USD = 22,000 VND E?

The importer receives goods from abroad

- If pay USD immediately (within 2 days) to the foreign seller: the importer goes to the bank to
buy USD. The bank sells USD to him at a Spot Rate Eo: 1USD = 22,000 VND. Not risk to the
importer.
- What happens if the importer makes payment after 3 months?  risk if E after 3 months is
1USD = 23,000 VND.
- To avoid the risk the importer uses Derivatives Instruments (công cụ phái sinh). There are 4
derivatives instruments:
o Forward contracts
o Options
o Futures
o SWAP
a. Forward Contracts: (hợp đồng giao USD sau)
- After receiving the foreign goods, the importer goes to his bank to sign a Forward Contract to
buy the USD today but he will receive USD after 3 months to make payment. The bank signs the
forward contract to sell USD to the importer with the Forward Rate Ew: 1 USD = 22,600 VND.
- After 3 months, the importer pays the bank to receive USD at the price: 1USD = 22,600 VND. He
does not care what happens to the USD price in the market after 3 months.
- Although after 3 months, if the exchange rate in the market is 1USD = 23,000 VND, the importer
pays only 22,600 VND to the bank to buy USDs.
- The importer pays extra 600 VND per 1 USD to transfer the risk to the bank. 600 VND per USD is
called “Hedging Cost”.
b. Options
- What happens if after 3 months the E reduces down to 1 USD = 21,000 VND? And the importer
has signed the Forward contract with the Forward Rate: 1USD = 22,600 VND.
- The importer can use Options to avoid the problem.
- Options = a Forward contract + the right not to exercise the forward contract in future.
- To buy Options the importer has to pay the bank additional cost beside the Hedging Cost.
c. Futures
- Futures are forward contracts which can be resold in the FOREX market to another importer.
- After signing the Forward contract, an importer can resell it to another importer in the FOREX
market if he thinks that he does not need these USDs in future.
- The importer can buy Futures contracts from the bank.
- Futures = the Forward Contracts which are made standardized in terms of the quantity of USD
and the time.
- Examples: the bank can offer to sell:
o A 200,000 USD- 3-month- forward contract
o A 500,000 USD – 3 month –forward contract
o A 300,000 USD- 6-month- forward contract
- Even if the importer needs only 189,000 USD to pay foreign sellers, he has to buy the
200,000USD-3 month forward contract.
d. SWAP
- Is applied when the importer has USDs today but he needs VNDs to operate his business.
However, he needs these USDs in future to pay the foreign sellers.
- SWAP: the importer signs a contract to sell USDs to the bank today and receives VNDs, and at
the same time, he signs a forward contract to buy back these USDs in future.
- The bank will use SWAP rate.
- Example: the importer has 100,000 USD today but he needs VNDs for his business operations.
He also knows that he has to use these 100,000 USD to pay the foreign sellers after 3 months.
The importer goes to his bank to do 2 actions for SWAP:
o Action 1: sells 100,000 USD today and receives VNDs for his business operations
o Action 2: at the same time, he signs a forward contract to buy back 100,000 USD after 3
months for paying the foreign seller.
o The Bank combines two actions into one transaction which is SWAP contract with the
SWAP rate.