Exchange Rate Movements - Coursework Example

INTERNATIONAL MANAGEAMEANT: EXCHANGE RATES The exchange rate is defined as the rate at which one countrys currency can be traded for another countrys currency. The need for foreign exchange has emerged from the requirements of international traders who need to quote their prices in a vehicle currency such as the US dollar when they export, and to buy a foreign currency in order to purchase equipment and raw materials .Importers also require foreign exchange to pay as for foreign products they want to bring in. When tourists travel abroad they need to exchange their local currency to the currency of the country of their destination so that they can pay for goods and services. Also, international investors have to buy foreign exchange in order to take advantage of profitable opportunities abroad such as higher yields on bonds in another country. Owing to the use of foreign exchange in many transactions, businessmen have to hedge their exposures overseas, and to do this they would need to use currencies too to protect their assets or receivables that are denominated in foreign currencies. Others use foreign currencies to engage in speculation abroad, and many mutual funds and hedge funds engage in speculation for possible profit. Thus foreign currencies are necessary to make international trade and investments possible and to help smooth transactions in the tourism industry in many countries. Structure of the Foreign Exchange Markets Unlike the stock exchanges, there is no single formal foreign exchange market; it is in fact an over the counter market similar to the one for money market instruments. The main participants are the large multinational commercial banks and investment banking houses. They operate at two levels, the wholesale level where banks operate in the interbank market; and at the retail level, where they deal with individuals and corporations. However, many transactions are mediated by foreign exchange brokers in order to preserve the anonymity of the transacting parties (Kidwell et al 377). The other major participants are the central banks of many countries which may intervene in the market from time to time to modulate the fluctuations of their currencies. Other participants are individuals and non-financial businesses who enter the market for various reasons including speculation. The foreign exchange transactions Foreign exchange trading operates without fixed trading hours, round the clock, everyday of the year: When one market closes another elsewhere in the world opens. There are no written rules, and transactions are done according to some principles and code of ethics (Hill 322) There are two basic types of foreign exchange quotations – the spot land forward market. The spot market, with quotations by the the Asian Wall Street Journal and in other media, is one where foreign exchange is sold and purchased on the spot (or almost, as delivery has to be made within two business days) usually for retail customers. The forward market is where the participants agree to exchange a fixed amount of one currency for a fixed amount of a second currency, with actual delivery and exchange of the two currencies at some future date. Forwards are used by businessmen and individuals to hedge their positions when they have assets abroad. The total volume of foreign exchange transactions from London, New York, Tokyo, Singapore, and other major centers in the world, has been increasing rapidly, rreaching its peak in April 1998 of close to $1.5 trillion daily, falling off soon after the introduction of the Euro because of the fewer currencies traded (Hill 322). Macroeconomic Fundamentals What are the forces that determine a nations exchange rate? The determination of foreign exchange rates requires an analysis of supply and demand, the two central forces in economics. Exchange rate analysis can be broken down into fundamental analysis and short-run analysis (Colander 378). Fundamental analysis considers the forces that determine the supply of and demand for currencies, causing them to shift. These fundamental forces include a countrys income, price levels, and interest rates. Changes in a countrys income, its prices, and interest rates can affect the behavior of supply of and demand for its currency. For example, when a countrys income falls, demand for imports consequently falls, demand for currencies with which to buy imports will decline. In a recession, the supply of that countrys currency falls, which tends to push up the price of that currency relative to other currencies. On the other hand, if a country has more inflation relative to to other countries, foreign goods will become cheaper, domestic demand for foreign exchange will increase, and foreign demand for local currency will decrease. Thus the rise in inflation will tend to cause demand for the domestic currency to fall, and depreciation of the currency ensues. People with excess funds to invest will look for currencies that yield higher rates than their own. For example, if the United States increases its interest rates, countries with low interest rates will tend to acquire US financial assets, demand for the dollar increases, and the domestic supply for dollars drops as fewer Americans sell dollars to buy foreign assets. The US dollar will appreciate as a result of the higher interest yields on domestic assets. Colander (378) argues like many economists that the fundamental forces are not the only factors that move the exchange rates. Short-run analysis can show us that on a daily basis the supply and demand curves can move quite differently based on rumors and expectations. Expectations can become self-fulfilling prophecies, undermining the trust that the free market should determine changes in the exchange rates. The fluctuations have no logic or purpose and can make decision making difficult and risky for traders and investors/speculators alike. The 1997 Asian financial crisis may be cited as having been exacerbated by expectations of the fall of Asian currencies such as the Thai baht, the Malaysian ringgit, and others. The market reaction was fueled more by expectations of rapid and continuous fall of the Asian currencies that by the economic fundamentals. Government controls and interventions can also affect exchange rates. Madura (83) states the government may impose foreign exchange barriers and/or foreign trade barriers, affect macroeconomic economic variables by policies to control or manage inflation, interest rates, and income levels, and otherwise intervene directly in the market by buying and selling currencies to help stabilize the currency. Again, government actions and policies such as these can make business and investment decision making a difficult task. This and other the other forces mentioned above can interact in such a way forecasting exchange rate cannot be made accurate. A businessman or an individual looking for profitable opportunities must look closely at the economic fundamentals that seem to predict long-term exchange rate movements, such as the trend in a countrys money supply, the rate of inflation, nominal interest rates, income levels, the gross domestic product growth, as well as general expectations about a currencys movement. For example, where a country is known to have recently increased its money supply, a businessman should be cautious about investing in that country as inflation is likely to be high, which can lead to the depreciation of that countrys currency, thereby making an otherwise promising investment a disastrous one. Another element that he should examine is the exchange rate regime. Where there is a floating rate regime, the free market determines the rate of exchange of that countrys currency; even where a government intervenes occasionally via “dirty float” to manage domestic currency stability, or where currency is pegged to a basket of currencies, it is better than one where the government makes the currency unconvertible. Countertrade would seem to be the logical choice where this situation exists. For example, the businessman can export his product to that country and in return imports what he can sell elsewhere. Bid-Ask Quotes and Spreads In the foreign exchange market, there will generally be a quoted ask price and the quoted bid price for a currency pair, usually involving the US dollar. That difference is called the bid-ask spread (or bid-offer spread). Quotes may be expressed as actual prices, or yields, and measured in similar units. Bid-ask spreads are used as a measure of a markets liquidity, with narrow bid-ask spreads indicating greater liquidity and wider spreads signaling lack of liquidity. The average of the bid and ask prices is called the mid-offer price, around which most transactions are usually settled. The spread, is the best quote of the price at which participants in a market are willing to buy or sell foreign exchange. Specifically, the bid price is the price at which a party is willing to purchase, while the ask (or offer) price is the price at which the same person or another party is willing to sell. An example can be one where a participants in a market is willing to buy 0.8226 for the AUS/USD, and conversely willing to sell the same pair at 0.8229. This creates a spread which is 3 basis points wide. In the same manner, a dealer can quote an ask price in the UK£/USD of 1.7940, and offer to sell the pair at 1.7945, with a spread of 5 basis points. The bid-ask spread of the the UK/AUD pair can be similarly derived, with an ask quote of 2.185 and a bid quote of 2.178, for a 7 basis-point spread. The press and websites do not publish these data but these are available through the Reuter screens which update in time chunks of a few minutes. What determines the width of the spread? It is generally agreed that the spread is dictated by liquidity and transparency in the market. If there are more participants in the market, many buyers and sellers, the spreads can be quite narrow;and this is particularly true when market makers are able to access the same market-influencing information – when everyone has access to computer and Internet real-time information on fundamentals, news and recent pricing. In case of an illiquid market, particularly one where a currency is under attack, traders can be quite gun-shy, quoting very low bids and high ask quotes in order to avoid or minimize the risk of loss in a rapidly plummeting market. When the British pound was under attack in 1992, spreads were known to be quoted wide, for while a market maker can buy at the lower bid price, the next ask price might be lower than the price at which he bought a position, and he could incur a substantial loss in the transaction. Direct and Indirect Quote A direct quote is the number of units of a local currency which is exchangeable for one unit of a foreign currency. From the perspective of an U.S. national, the local currency would be the US dollar and the foreign currency would be, say, the the UK pound. From the viewpoint of an Australian participant, the local currency would be the Australian dollar and the foreign currency would be the US dollar. An indirect quote, however, is the number of units of a foreign currency that can be exchanged for one unit of a local currency. For an American national, an indirect quote would be the number of units of a foreign currency that can be exchanged for one US dollar. If one has a direct quote, it is simple to obtain an indirect quote by simply obtaining the reciprocal of the latter. For example, if one is given a direct quote of 0 .8228 US dollar for an Australian dollar, and its reciprocal is 1/0.8228 or $1.215, that is to say, $1 US dollar can be exchanged for $1.215 Australian dollar. The financial reports of the Wall Street Journal shows quotes both ways. For example, Australian dollar, the Euro, and the UK pound show a direct quote, while the rest, such as the Singapore dollar and the Mexican peso show indirect quotes. Table 1: Currencies showing both direct and indirect quotes (Source: Currencies Overview : http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3400) Although quotes can be either direct or indirect, a problem can arise in defining from whose perspective the quote is given. Given the importance of the US dollar as the dominant currency internationally, quotes have been standardized. so that all quotes are relative to the US dollar. Thus when dealers quote, they either give US dollars per unit of currency (direct quote from the US perspective), or the number of units of the foreign currency per US dollar (an indirect quote from the US perspective. Quoting in terms of US dollars per unit of foreign currency is called American terms, while quoting in terms of the number of units of the foreign currency per US dollar is called European terms. The Euro, UK pound, and the Australian dollar are quoted in American terms, while most of the other currencies are quoted by convention in European terms. Cross Rates A British traveler to Australia may find out that if the British currency is the only currency he has, that he needs to convert it into Australian dollars. At retail stores, he may find out that there are cross rates of different currencies, and he may not have to convert his money to US dollars first before buying the Australian dollar. But to check whether he is getting the correct exchange rate, it would be enough for him to know that the cross rate can be derived using the following: Quote in American terms of Currency X ------------------------------------------------= Quote in American terms of Currency Y If 1 UK pound is $1.7942 and the Australian dollar is 0.8228, then his currency can be converted as follows: $1.79242 ----------- = 2.181 UK pound/Australian dollar. A$0.8228 The converse result can be obtained by deriving the reciprocal of this cross rate – 1 divided by 2.18l results in the AUD 0.459 per UK pound (which compares with 0.4596 in the accompanying table below, the difference being due to rounding.) Another method of obtaining this results is by the formula: UK pounds US Dollars UK pound/Australian dollar ------------- x -------- US Dollars Aus. Dollars = UK pound per dollar x US dollars per Australian dollar = 1.79242 x 1.215 = 2.181 It is unusual for the theoretical cross rate to differ from the rates using the US dollar because of a discrepancy occurs, there arises what is called a riskless arbitrate opportunity. This is called a triangular arbitrage because it involves positions in 3 currencies - the US dollar and two other currencies. Because of this, the actual cross rates tend to be in line with the theoretical cross rates (Fabozzi et al. 622). Below is a table of cross rates of selected major currencies. (Source: http://uk.finance.yahoo.com/currency-converter?) Table 2: Cross Rates Exchange rate movements of USD, AUD and GBP, and forecasts It is recalled that certain fundamental forces influence the exchange rates. This writer obtained some basic information about the interest rates, income growth (GDP), and inflation rates in an attempt to predict the likely movement of the exchange rates of the US dollar, the Australian dollar, the British pound. While practically all authorities on the subject of exchange rate forecasting are unanimous in saying that forecasts are unreliable, with the possible exception of the forward rates, this attempt is hoped to improve understanding the the real forces at work in affecting exchange rates. a. Interest rates. Australian interest rates stood at 7.00 per cent as of July 30, 2008, which is higher than that of the UK which shows 5.00% and the US which is 2.00 per cent. Investors in the UK and the US may be enticed into investing in Australian securities, assuming that it has stable exchange rates and that no other significant costs are involved. This will tend to make the Australian currency appreciate relative to the two other currencies. In fact, forecasts on the spot rates show that the Australian dollar is slated to improve slightly while the US dollar and the UK pound are likely to decrease in value during the next 12 months. b. The Inflation Rate. The U.S inflation rate was a high 5.60 per cent during the same period, compared to 4.40 per cent in the UK and 4.50 per cent in Australia. High inflation rates cause the currency of a country to fall in value relative to the other countries. The depreciation of the US dollar is expected to continue, while those of Australia and the UK may hardly change at all, all other things being equal. c. The Gross Domestic Product (proxy for income level). The GDP of the US grew at 2.20 per cent coupled with a trade deficit of 56.77 billion; the UK GDP went up 1.40 per cent along with UK£4,414 million in deficit, whilst Australias GDP grew by 3.60 per cent along with A$411 billion trade surplus. In addition, unemployment in the US is 5.7 per cent, the UK 2.7 per cent, and in the Australia 4.3 per cent. Only Australia can expect to have its currency appreciate during the next 12 months on the basis of the above variables. To sum up, the UK is in the worst situation of all, followed by the US. The UK currency has already slid down from close to $2 early this year to $1.79 recently and it is bound to grow worse. The US dollar is slated to continue its drop unless government intervention and other extraordinary events can avert it. While these currencies are expected to drop, a falling currency can make exports and inward investments more attractive. WORKS CITED. Brigham, Eugene F. and Gapenski, Louis C. Intermediate Financial Management. 5th ed. Orlando, FL: Dryden Press, 1996 Case, Karl E. and Ray C. Fair. Principles of Macroeconomics. Upper Saddle River, NJ: Prentice Hall, 2002 Colander, David C. Macroeconomics. 4th ed. 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Accessed September 13, 2008, : http://online.wsj.com/mdc/public/page/mdc_currencies.html?mod=mdc_topnav_2_3400 Currency forecasts. Accessed September 13, 2008, http://www.forecasts.org/pound.htm Financial Forecast Center Home Page. The Financial Forecast CenterTM. Accessed September 13, 2008, http://www.forecasts.org/exchange-rate/british-pound-exchange-rate.htm CURRENCY CLOSING CROSS RATES. Accessed September 13, 2008, Source: http://online.wsj.com/mdc/public/page/2_3023-keyrates.html?mod=mdc_curr_pglnk Currency forecasts Australia. Accessed September 13, 2008, http://www.forecasts.org/exchange-rate/australia-dollar-exchange-rate.htm ECONOMIC OVERVIEW. Accessed September 13, 2008, http://www.tradingeconomics.com/Economics/Economic-Analysis-Summary.aspx?Symbol=GBP WORLD VALUE OF THE US DOLLAR. Accessed September 13, 2008, Source: http://online.wsj.com/mdc/public/page/2_3020-worlddollar.html?mod=mdc_curr_pglnk September 12, 2008 Read More