Lecture International trade and investment (2/e): Chapter 9 - John Gionea

Chapter 9
The foreign exchange market

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–1


Lecture plan
• Determination of exchange rates
– supply of and demand for currencies.
• Functions of the foreign exchange market
– currency conversion
– reduction of foreign exchange risk (spot and
forward exchange rates; currency swaps.)
• Structure of Forex by type of transactions
• Economic theories of exchange rate determination
• Factors affecting the Australian dollar exchange
rate
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–2


Foreign exchange transactions

• The foreign
exchange rate =
the price of one
currency expressed
in terms of another
currency.
– appreciation
– depreciation

1A$ = US$0.75
1A$ = US$0.90
1$A = US$0.60

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–3


Determination of the exchange rates
Price
A$1
in

S

E

US$0.55

D
Quantity of A$
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–4


Floating currencies: demand for the
national currency
• Nation’s exporters paid in other hard currencies
• Foreign companies undertaking direct
and portfolio investment in the nation’s economy
• ‘Bull’ speculators in the nation’s currency
• Nation’s Central Bank (RBA) selling US$ and other
hard currencies for the nation’s currency
• Foreign tourists visiting your country

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–5

Floating currencies: supply of the
national currency
•
•
•
•
•

Nation’s importers paying in US$, Yen
Domestic firms investing abroad
‘Bear’ speculators in the national currency
Nation’s central bank buying US$, Yen
Individual residents travelling overseas

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–6


Impact of A$ depreciation
Commodity export price Commodity import price
(beef)
(computer)
US$1000 per tonne
US$1500 per unit
Exchange
rate for A$

Exporter
receives

Exchange
rate for A$

Importer
pays

US$0.75

A$1333

US$0.75

A$2000

US$0.60

A$1666

US$0.60

A$2500

E/R effect

+ A$333
(25%)

E/R effect

+ A$500
(25%)

Source: Table 9.1
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–7


Impact of A$ appreciation
Commodity export price Commodity import price
(beef)
(computer)
US$1000 per tonne
US$1500 per unit
Exchange
rate for A$

Exporter
receives

Exchange
rate for A$

Importer
pays

US$0.75

A$1333

US$0.75

A$2000

US$0.90

A$1111

US$0.90

A$1600

E/R effect

- A$333
(- 17%)

E/R effect

- A$500
(- 20%)

Source: Table 9.2

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–8


Geographical distribution of global
reported foreign exchange market
turnover, %, April 2004.
France
Australia
Hong Kong
Switzerland
Germany
Singapore
Japan
United States
United Kingdom

2.7
3.4
4.2
3.3
4.9
5.2
8.3

FOREX %

19.2
31.3

Source: adapted from Bank for International Settlements (BIS),
Press Release, 28 September 2004
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–9


Functions of the foreign exchange
market
• Currency conversion
• Reduction of foreign exchange risk

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–10


Australian importer purchase of
computers (purchase price: US$1400
FOB)

1A$ =
US$0.70
Customs value – FOB price
(US$1400)

1A$ =
US$0.63

A$2000

A$2200

Customs duty @ 5% x $2000

100

100

Int’l transport & insurance

100

100

2200

2200

220

220

Total costs (incl. other costs
@ A$30.00)

2450

2650

Net profit on A$2600 selling
price

150

-50

Value of taxable importation
(VoTI)
GST @ 10% x $2200

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–11


Reduction of FX risk
• Spot exchange rates

• Forward exchange rates
• Currency swaps

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–12


Spot transactions
• Spot transaction = the purchase of FX with
delivery and payment (referred to as
settlement on the following business day.
• Foreign exchange traders always quote a
bid (buy) and offer (sell) rate.
• The spread = difference between the bid
and offer rates and is the margin on which
the trader earns a profit.
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–13


Market quotations
• Dealers always ‘buy low’ and ‘sell high’.

• Selling rates and buying rates are always
from the perspective of the dealer/bank.

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–14


Forward transactions
• A forward rate = the price agreed on today
for purchase or sale of foreign exchange at
a future date.
• Usually agreed for less than 1 year.
• Premiums and discounts: forward
quotations are either at a
– premium: forward > spot
– discount: forward < spot
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–15


Australian exporter to receive
Euro 1 million in 6 months

• Spot rate on contract date:
A$1 = Euro 0.60): estimated income = A$1.67m
• Payment made after 6 months from delivery.
• If A$ appreciates by 10% over 6 months, the
exporter will receive 10% less: A$1.51 (loss
A$160,000).
• The exporter will take a forward contract in order to
protect the company income and ensure stable
planning of operations.

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–16


Speculative operations
• 1991: Clifford Hatch, finance director of
British food and drink company Allied Lyons
bet on a higher BP against the US$.
• Over the previous 3 years he had made
US$25 million for the company.
• Feb–April 1991 the BP depreciated from
US$2.00 to US$1.75.
• Allied Lyons lost US$269 m. (more than the
company was to earn from all of its food
and drink activities during 1991!).
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:

An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–17


Currency swaps
• Foreign exchange swaps commit two
counterparties (e.g. banks) to the exchange of two
cash flows and involve the sale of one currency for
another in the spot market with the simultaneous
repurchase of the first currency in the forward
market.
• The difference between the spot and the forward
rates, called the swap rate, is expressed in terms of
points and it is fixed.
• Peak of 54% of the total traditional FX market in
2001 (down to about 50% in 2004).
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–18


% share of ‘traditional’ foreign exchange
transactions in the total turnover, by type

% of total T/O

60
50
40

Spot

30

Outright forwards

20

FX Swaps

10
0
1992

1995

1998

2001

2004

Source: adapted from BIS, Press release, 28 September 2004
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:

An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–19


Economic theories of exchange rate
determination
• Prices and exchange rates
– the law of one price
– the Purchasing Power Parity (PPP)
• Money supply and price inflation
• Interest rates and exchange rates
• Investor psychology and band wagon
effects
Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–20


Factors affecting the Australian
dollar exchange rate
• Relative interest rates
• Commodity prices and terms of trade
• Relative inflation rates
• The external account

• The role of the Central Bank
– fall of the Baht

Copyright 2006 McGraw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment:
An Asia-Pacific Perspective 2e by Gionea. Slides prepared by John Gionea..

 

9–21