Exchange Rate

 After reading this chapter, you should be

able to:
 Understand the meaning and functions of
the foreign exchange market

Learning  Know what the spot, forward, cross, and

effective exchange rates are
Objectives
 Understand the meaning of foreign
exchange risks, hedging, speculation, and
interest arbitrage
  Functions of the Foreign Exchange Markets
1. By far the principal function of foreign exchange
markets is the transfer of funds or purchasing power
from one nation and currency to another
Introduction 2. Credit Function
3. Provides facilities for hedging and speculation
 Equilibrium
Foreign
Exchange Rates
  The exchange rate (R) between the
dollar and the euro is equal to the
number of dollars needed to
Equilibrium
purchase one euro. That is, R = $/€.
Foreign
Exchange Rates  For example, if R = $/€ = 1, this
means that one dollar is required to
purchase one euro.
  The U.S. demand for euros is negatively inclined,
indicating that the lower the exchange rate (R), the
greater the quantity of euros demanded by U.S.
Equilibrium residents.

Foreign  The U.S. supply of euros is usually positively inclined

(see Figure 14.1), indicating that the higher the
Exchange Rates exchange rate (R), the greater the quantity of euros
earned by U.S. residents and supplied to the United
States
  Depreciation - refers to an
increase in the domestic price of
the foreign currency.
Depreciation &
Appreciation  Appreciation - refers to a decline
in the domestic price of the foreign
currency.
  Once the exchange rate between each of
a pair of currencies with respect to the
Cross Exchange dollar is established, however, the
exchange rate between the two
Rate currencies themselves, or cross-exchange
rate, can easily be determined
  Example:
 If the exchange rate (R) were 2 between the U.S. dollar
and the British pound and 1.25 between the dollar and
the euro, then the exchange rate between the pound
Cross Exchange and the euro would be 1.60 (i.e., it takes ¤1.6 to
purchase 1£). Specifically,
Rate  R = € / £ = Value of £ / Value of €
= 2 / 1.25
= 1.60
  ERC - This is a weighted average
of the exchange rates between the
domestic currency and that of the
Effective nation’s most important trade
Exchange Rate partners, with weights given by the
relative importance of the nation’s
trade with each of these trade
partners
  This refers to the purchase of a
currency in the monetary center
where it is cheaper, for immediate
resale in the monetary center
Arbitrage
where it is more expensive, in order
to make a profit.
 This is only temporary
The Exchange
Rate and the
Balance of
Payments
  Spot
 The most common type of foreign exchange
transactions involves the payment and receipt
of the foreign exchange rate within two
Spot and Forward business days after the day the transaction
Rates, Currency agreed upon.
Swaps, Futures,  This type of transaction is called a spot
and Options transaction, and the exchange rate at which
the transaction takes place is called the spot
rate. The exchange rate R = $/€ = 1 in Figure
14.1 is a spot rate.
  Forward Rate
 Forward transaction involves an
Spot and Forward agreement today to buy or sell a
Rates, Currency specified amount of a foreign
Swaps, Futures, currency at a specified future date
and Options
at a rate agreed upon today (the
forward rate).
  If the forward rate is below the
present spot rate, the foreign
currency is said to be at a forward
discount with respect to the
domestic currency.
Forward Rate  However, if the forward rate is
above the present spot rate, the
foreign currency is said to be at a
forward premium.
  If the spot rate is $1=€1 and the three-
month forward rate is $0.99=€1, we say
that the euro is at a three-month forward
discount of 1 cent or 1 percent (or at a 4
percent forward discount per year) with
respect to the dollar.
Example of FD
 On the other hand, if the spot rate is still
and FP $1 = €1 but the three-month forward rate
is instead $1.01 = €1, the euro is said to
be at a forward premium of 1 cent or 1
percent for three months, or 4 percent per
year.
  Forward discounts (FD) or premiums (FP) are usually
expressed as percentages per year from the
corresponding spot rate and can be calculated formally
FD and FP with the following formula:
Formula FD or FP = FR – SR / SR x 4 x 100
  FD = $0.99−$1.00 / $1.00 ×4×100
= -$.01 / $1.00 x 4 x 100
= - 4%
 the same as found earlier without the
Computation of formula. Similarly, if SR = $1 and FR =
FD and FP $1.01:
 FP = $1.01−$1.00 / $1.00 ×4×100
= $.01 / $1.00 ×4×100
= +4%
  A foreign exchange swap refers to a
spot sale of a currency combined with
a forward repurchase of the same
currency—as part of a single
Foreign transaction
Exchange Swap  The swap rate (usually expressed on a
yearly basis) is the difference between
the spot and forward rates in the
currency swap.
  A foreign exchange futures is a
forward contract for standardized
currency amounts and selected
calendar dates traded on an
Foreign Exchange organized market (exchange).
Futures and  The currencies traded on the IMM
Options are the Japanese yen, the Canadian
dollar, the British pound, the Swiss
franc, the Australian dollar, the
Mexican peso, and the euro.
  The futures market differs from a forward market in that
in the
 futures market only a few currencies are traded;
 trades occur in standardized contracts only, for a few
specific delivery dates, and are subject to daily limits on
exchange rate fluctuations;
Future Market  and trading takes place only in a few geographical
Vs. Forward locations, such as Chicago, New York, London, Frankfurt,
and Singapore.
Market  Futures contracts are usually for smaller amounts than
forward contracts and thus are more useful to small firms
than to large ones but are somewhat more expensive.
 Futures contracts can also be sold at any time up until
maturity on an organized futures market, while forward
contracts cannot
  A foreign exchange option is a
contract giving the purchaser the
right, but not the obligation, to buy
(a call option) or to sell (a put
Foreign option) a standard amount of a
Exchange traded currency on a stated date
Options (the European option) or at any
time before a stated date (the
American option) and at a stated
price (the strike or exercise price
  In general, businesspeople are risk
averse and will want to avoid or insure
themselves against their foreign
exchange risk.

Foreign  (Note that arbitrage does not involve any

Exchange Risk exchange risk since the currency is
bought at the cheaper price in one
monetary center to be resold
immediately at the higher price in
another monetary center.)
  A foreign exchange risk arises not only from
transactions involving future payments and
receipts in a foreign currency (the
transaction exposure), but also from the need
to value inventories and assets held abroad in
Foreign terms of the domestic currency for inclusion
Exchange Risk in the firm’s consolidated balance sheet (the
translation or accounting exposure), and in
estimating the domestic currency value of the
future profitability of the firm (the economic
exposure)
  Hedging refers to the avoidance of
Hedging a foreign exchange risk, or the
covering of an open position
  Speculation is the opposite of hedging.
Whereas a hedger seeks to cover a
foreign exchange risk, a speculator
accepts and even seeks out a foreign
exchange risk, or an open position, in the
Speculation hope of making a profit.
 If the speculator correctly anticipates
future changes in spot rates, he or she
makes a profit; otherwise, he or she incurs
a loss
  Stabilizing speculation refers to the
purchase of a foreign currency when the
domestic price of the foreign currency (i.e.,
the exchange rate) falls or is low, in the
expectation that it will soon rise, thus leading
to a profit.
Stabilizing
 Or it refers to the sale of the foreign currency
Speculation when the exchange rate rises or is high, in the
expectation that it will soon fall. Stabilizing
speculation moderates fluctuations in
exchange rates over time and performs a
useful function.
  Destabilizing speculation refers to the sale
of a foreign currency when the exchange rate
falls or is low, in the expectation that it will fall
even lower in the future, or the purchase of a
foreign currency when the exchange rate is
Destabilizing rising or is high, in the expectation that it will
Speculation rise even higher in the future.
 Destabilizing speculation thus magnifies
exchange rate fluctuations over time and can
prove very disruptive to the international flow
of trade and investments
 PESOS PER US DOLLAR RATE *
1945-2017

% Appreciation(+)
Period Average Volatility 1 End-of-Period
/ Depreciation(-)

1945 2.0000 n.a. n.a. n.a.

Philippine Peso 1946

1947
2.0000
2.0000
0.00
0.00
n.a.
n.a.
n.a.
n.a.

Exchange Rate 1948

1949
2.0000
2.0000
0.00
0.00
n.a.
n.a.
n.a.
n.a.

Profile 1950
1951
2.0000
2.0000
0.00
0.00
n.a.
n.a.
n.a.
n.a.
1952 2.0000 0.00 n.a. n.a.
1953 2.0000 0.00 n.a. n.a.
1954 2.0000 0.00 n.a. n.a.
1955 2.0000 0.00 n.a. n.a.
1956 2.0000 0.00 n.a. n.a.
1957 2.0000 0.00 n.a. n.a.
1958 2.0000 0.00 n.a. n.a.
1959 2.0000 0.00 n.a. n.a.
 *
PESOS PER US DOLLAR RATE
1945-2017

% Appre ciation(+) 1
Pe riod Ave rage Volatility End-of-Pe riod
/ De pre ciation(-)
1960 2.7333 -26.83 n.a. n.a.
1961 3.0000 -8.89 n.a. n.a.
1962 3.6575 -17.98 n.a. n.a.
1963 3.8998 -6.21 n.a. n.a.

Philippine Peso
1964 3.8999 0.00 n.a. n.a.
1965 3.9010 -0.03 n.a. n.a.
1966 3.8955 0.14 n.a. n.a.

Exchange Rate 1967

1968
3.9152
3.9159
-0.50
-0.02
n.a.
n.a.
n.a.
n.a.

Profile 1969
1970
1971
3.9192
6.0246
6.4317
-0.08
-34.95
-6.33
n.a.
n.a.
n.a.
n.a.
6.4350
6.4350
1972 6.6749 -3.64 n.a. 6.7810
1973 6.7563 -1.21 n.a. 6.7300
1974 6.7887 -0.48 n.a. 7.0650
1975 7.2479 -6.33 n.a. 7.4980
1976 7.4403 -2.59 n.a. 7.4280
1977 7.4028 0.51 n.a. 7.3700
1978 7.3658 0.50 n.a. 7.3750
1979 7.3776 -0.16 n.a. 7.4150
1980 7.5114 -1.78 n.a. 7.6000
 PESOS PER US DOLLAR RATE *
1945-2017

% Appreciation(+)
Period Average Volatility 1 End-of-Period
/ Depreciation(-)
1981 7.8996 -4.91 n.a. 8.2000
1982 8.5400 -7.50 n.a. 9.1710
1983 11.1127 -23.15 n.a. 14.0020
1984 16.6987 -33.45 n.a. 19.7600

Philippine Peso 1985

1986
18.6074
20.3857
-10.26
-8.72
n.a.
n.a.
19.0320
20.5300

Exchange Rate 1987

1988
20.5677
21.0948
-0.88
-2.50
n.a.
n.a.
20.8000
21.3350

Profile 1989
1990
21.7367
24.3105
-2.95
-10.59
n.a.
1.9052
22.4400
28.0000
1991 27.4786 -11.53 0.5032 26.6500
1992 25.5125 7.71 0.7121 25.0960
1993 27.1199 -5.93 1.2818 27.6990
1994 26.4172 2.66 1.2187 24.4180
1995 25.7144 2.73 0.4627 26.2140
1996 26.2157 -1.91 0.0413 26.2880
1997 29.4707 -11.04 3.9235 39.9750
1998 40.8931 -27.93 1.9585 39.0590
1999 39.0890 4.62 1.0140 40.3130
 *
PESOS PER US DOLLAR RATE
1945-2017

% Appreciation(+) 1
Period Average Volatility End-of-Period
/ Depreciation(-)
2000 44.1938 -11.55 3.3627 49.9980
2001 50.9927 -13.33 1.5740 51.4040
2002 51.6036 -1.18 1.1291 53.0960
2003 54.2033 -4.80 0.9833 55.5690

Philippine Peso 2004

2005
56.0399
55.0855
-3.28
1.73
0.2801
0.8396
56.2670
53.0670

Exchange Rate
2006 51.3143 7.35 1.1536 49.1320
2007 46.1484 11.19 2.0991 41.4010
2008 44.4746 3.76 2.9141 47.4850

Profile 2009
2010
47.6372
45.1097
-6.64
5.60
0.7112
1.1125
46.3560
43.8850
2011 43.3131 4.15 0.5243 43.9280
2012 42.2288 2.57 0.8150 41.1920
2013 42.4462 -0.51 1.3701 44.4140
2014 44.3952 -4.39 0.5710 44.6170
2015 45.5028 -2.43 1.0807 47.1660
2016 47.4925 -4.19 1.1040 49.8130
2017 50.4037 -5.78 0.5867 49.9230