FOREIGN

EXCHANGE
MARKET
INTRODUCTION
Trade between countries involves the mutual
exchange of different currencies.
The trading of currency and
bank deposits denominated in
particular currencies takes place
in the foreign exchange market.
Transactions that are conducted determine
the rates at which currencies are exchanged,
in turn determine the cost of purchasing
foreign goods and financial assets.
The constant change in exchange
rates causes problems for financial
managers as the change in relative
purchasing power between
countries affects imports and
exports, interest rates and other
economic variables.
The relative strength of a particular currency
to other currencies changes many times over a
business cycle.

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HISTORICAL PERSPECTIVE OF
EXCHANGE RATES
At the end of WWII, the world was
on a fixed exchange rate system by
the IMF.
In this system, all countries were required to set a
specific parity rate for their currency. A country
could effect a major adjustment in the exchange rate
by changing the parity rate with respect to the dollar
and was made cheaper, as devaluation.
Upvaluation or revaluation aresulted
a when
a currency became more expensive with
respect to the dollar.
Floating rate international currency system has
been operating since 1973.
Factors of determination of exchange rates:
Country’s economic strength
Level of exports and imports
Level of monetary activity
Deficits or surpluses in its balance of payments
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FOREIGN CURRENCY EXCHANGE
MARKET
It provides a service to individuals, businesses
and governments who need to buy or sell
currencies other than theirs.
It is also a marketplace in which currencies are
bought and sold purely to make profit via
speculation.
When trading very large volumes of currency, even
small fluctuations in price can provide profits or
losses. It provides mechanism for the
transfer of purchasing power from
one currency to another.
This is where traders convert one
foreign currency into another and
is one of the largest financial
markets in the world.
Currency trading entails no specific physical
location, it is an over-the-counter market whose
main participants are commercial and investment
banks, and foreign exchange dealers and brokers
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around the world.
EXCHANGE RATES WHY EXCHANGE RATES ARE
It is simply the price of one country’s currency
IMPORTANT?
expressed in terms of another country’s currency. Exchange rates are important because they affect
the relative price of domestic and foreign goods.
Fixed rates are decided by central For example, the dollar price of French
banks of a country. goods to an American is determined by
Floating rates are decided by the the interaction of two factors, which are
mechanism of market demand and supply. the price of French goods in euros and the
For example, both the Euros, the Swiss France euro/dollar exchange rate.
and the Japanese Yen are traded with prices When a and
cheaper
cheaper country’s
and foreigncurrency
foreign goods
goods inappreciates
in that (rises
that country
country in
become
become
quoted in U.S. Dollar. value relative to more
other
morecurrencies),
expensive. the country’s
expensive.
good abroad become more expensive and foreign
Exchange rates are constantly goods in that country become cheaper (holding
changing. domestic prices constant in the two countries).
Foreign exchange rate quotations Conversely, when a country’s currency
can be found in The Wall Street depreciates, its goods abroad become more
Journal, or in other leading print expensive.
publications and on websites. Appreciation of a currency can make it harder
for domestic manufacturers to sell their goods
abroad and can increase competition at home
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from foreign goods because they cost less.

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FACTORS INFLUENCING
EXCHANGE RATES
Factors that tend to increase the supply or
decrease the demand schedule for a given
currency will bring down the value of that
currency.
Inflation – It tends to deflate the value of a
currency because holding the currency results in
reduced purchasing power.
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. As a result, there will be an
increased demand for the country’s currency.
Balance of Payments – It is used to refer to
a system of accounts that catalogs the flow
of goods between the residents of two
countries.
Governmental Intervention – Through
intervention, the central bank of a country may
support or depress the value of its currency.
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Other Factors - Political and economic stability,
extended stock market rallies and significant
declines in the demand for major exports.
HOW IS FOREIGN
EXCHANGE TRADED
Foreign exchange market is organized
as an over-the-counter market in
which several hundred dealers (mostly
banks) stand ready to buy and sell
deposits denominated in foreign
currencies.
An important point to note is that while banks,
companies, and governments talk about buying and
selling currencies in forex markets they do not take a
fistful of dollar bills and sell them for British pound
notes.
Most trades involve the buying and selling of bank
deposits denominated in different currencies.
When bank is buying dollars in the foreign
exchange market, the bank is buying deposits
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denominated in dollars.
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.
The equilibrium rate of Pe will prevail in the
market. No surplus (or deficit) occurs at Pe.
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Fixed Exchange Rate – An
exchange rate set too high tends to
create a deficit Philippine balance
payments.
This deficit must be financed by drawing down
foreign reserves of by borrowing from the central
banks of the foreign countries.
An exchange rate A, a greater quantity of peso is
supplied by Philippine interests than demanded by
foreign interests, called trade deficit.
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 Managed Float – It 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.
Floating rates permit adjustments to
eliminate balance of payments deficits or
surpluses.
For example, if the Philippine has a deficit in its
trade with Japan, the Philippine peso will
depreciate relative to Japan’s currency.
This adjustment should decrease imports from and
increase exports to Japan.
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THEORY OF PURCHASING
POWER PARITY
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 price levels.
The PPP conclusion that exchange rates are
determined solely by changes in relative price levels
rests on the assumption that all goods are identical
in both countries. When this assumption is true, the
law of one price states that the relative prices of all
these goods will determine the exchange rate.
Even though the prices of
these items might rise and lead
to a higher price level relative
to another country’s, there
would be little direct effect on
the exchange rate.
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WHAT ARE THE FOREIGN Direct and Indirect Quotes
Direct quotes indicate the number of units of the
CURRENCY EXCHANGE home currency required to buy one unit of the
foreign currency.
RATE TRANSACTIONS? Indirect quotes indicate the
Two Kinds of Foreign Exchange Rate
number of units of foreign
Determination
currency that can be bought for
1. Spot Transactions – those which involves one unit of the home currency.
immediate (two day) exchange of bank deposits. Its
exchange rate is spot exchange rate. ILLUSTRATIVE CASE
Currency Exchange as of August 27, 2019
2. Forward Transactions – involve US Dollar P52.3260
the exchange of bank deposits at Euro euros P58.1028
UK pounds P63.9424
some specified future date. Its
exchange rate is forward exchange  Indirect Quote =
rate.
 US Dollars = = 0.1911 (dollar/P1)
Spot Exchange Rates – it is for a currency is the
exchange rate at which the currency is traded for  EU Euros = = 0.1721 (euro/P1)
immediate delivery.
 UK Pounds = = 0.1564 (pound/P1)
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Sample Problem
1. A Filipino businessman wanted to remit 1,000 UK
pounds to London on August 27, 2019. How much in
pesos would have been required for this transaction?
P63.9424/pounds x 1,000 pounds = P63,942.40
2. A Filipino Businessman paid P112,148.20 to an
Italian supplier on August 27, 2019. How many euros
did the Italian supplier receive?
P112,148.20 x 0.1721 = € 1,930.07
Cross Rates – are the indirect computation of the
exchange rate of one currency from the exchange
rates of two other currencies.
For instance:
P63.9424 = £ 1
P58.1028 = € 1
Exchange rate euro/ pound
P63.9424/ P58.1028 = 1.01005 euro
per 1 pound
Exchange rate pound to euro
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P58.1028/ P63.9424 = 0.90867 pound per 1 euro
Arbitrage - The process of buying and selling in
more than one market to make a riskless profit. It can
occur when there is a mispricing.
Forward Rates – The exchange
rate at which the currency for future
delivery is quoted.
FACTORS THAT AFFECT
EXCHANGE RATE IN THE LONG
RUN
Relative Price Level – a rise in country’s price level
(relative to foreign price level) causes its currency to
depreciate.
Trade Barrier – increasing trade barrier causes a
country’s currency to appreciate in the long run.
Preferences for Domestic vs Foreign Goods –
increased demand for a country’s exports causes its
currency to appreciate in the long run.
Productivity – In the long run, as a country
becomes more productive relative to other
countries, its currency appreciates.
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EXCHANGE RATES IN THE AVOIDANCE OF EXCHANGE RATE
SHORT RUN RISK IN FOREIGN COUNTRY
The key to understand the
short-run behavior of
MARKETS 1. The firm may hedge its
risk by purchasing or
exchange rates is to selling forward contracts.
recognize that an exchange 2. The firm may choose to
rate is the price of domestic minimize receivables and
bank deposits in terms of liabilities denominated in
foreign bank deposits. foreign currencies.
The natural way to investigate the short-run 3. Maintaining a monetary balance between
determination of exchange rate is through an asset receivables and payables denominated in a
market approach that relies heavily on our analysis of particular foreign currency avoids a net receivable
the determinates of assets demand. or net liability position to that currency.
MANAGING FOREIGN 4. By using Trigger Pricing
EXCHANGE RATE 5. By diversification
Foreign exchange risk refers to the possibility of a
drop in revenue or an increase in cost in 6. A speculative forward contract does not hedge
international transaction due to exchange foreign any exposure to foreign currency fluctuations, it
rates. To deal with this foreign currency exposure creates exposure.
effectively, the financial manager must understand
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the foreign exchange rates and how they
determined.
THANK YOU!