Chapter 9 The foreign exchange market Copyright 2006

Chapter 9 The foreign exchange market Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 2

Foreign exchange transactions • The foreign exchange rate = the price of one currency expressed in terms of another currency. – appreciation – depreciation 1 A$ = US$0. 75 1 A$ = US$0. 90 1$A = US$0. 60 Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 3

Determination of the exchange rates Price A$1 in US$0. 55 S E D Quantity of A$ Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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%) Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 7 Source: Table 9. 1

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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 8

Geographical distribution of global reported foreign exchange market turnover, %, April 2004. Source: adapted from Bank for International Settlements (BIS), Press Release, 28 September 2004 Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 9

Functions of the foreign exchange market • Currency conversion • Reduction of foreign exchange risk Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 10

Australian importer purchase of computers (purchase price: US$1400 FOB) 1 A$ = US$0. 70 Customs value – FOB price (US$1400) 1 A$ = US$0. 63 A$2000 A$2200 Customs duty @ 5% x $2000 100 Int’l transport & insurance 100 2200 220 Total costs (incl. other costs @ A$30. 00) 2450 2650 Net profit on A$2600 selling price 150 -50 Value of taxable importation (Vo. TI) GST @ 10% x $2200 Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 11

Reduction of FX risk • Spot exchange rates • Forward exchange rates • Currency swaps Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 15

Australian exporter to receive Euro 1 million in 6 months • Spot rate on contract date: A$1 = Euro 0. 60): estimated income = A$1. 67 m • Payment made after 6 months from delivery. • If A$ 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 18

% share of ‘traditional’ foreign exchange transactions in the total turnover, by type Source: adapted from BIS, Press release, 28 September 2004 Copyright 2006 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 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 Mc. Graw-Hill Australia Pty Ltd. PPTs t/a International Trade and Investment: An Asia-Pacific Perspective 2 e by Gionea. Slides prepared by John Gionea. . 21