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ExchangeRates
References Griffin and Pustay, Chapter 8; Rutledge, Chapter 8
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Fundamentalissues
» ExchangeratesandtheForExmarket
» Typesofexchangerateregime:‘Floating’and‘Fixed’
» Currencyappreciationsanddepreciations
» ProsandconsoftheUAE’sfixedexchangerate
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Money and Finance: Exchange Rates, MBA | 3
International Business Transactions
Oneimportantfactorwhichdistinguishesinternationalbusinessfromdomesticbusinessistheuseofmorethanonecurrencyincommercialtransactions
» Theforeignexchangemarketallowsbusinessestoconducttradeandinvestmentacrossnationalborders
» Mostinternationalbusinesstransactionsrequirestheconversionofcurrencies:thebuyingandsellingofcurrencies
Forexample:
» whenEtihadpurchasesaeroplanesfromAirbus,theyhavetoconvertdirhams(aed)intoeuros(€)tocompletetheorder
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Foreign Exchange Rates (slide 1 of 2)
Exchangerate– thecostofonecurrencypurchasedinanother
» Example:£1.00willbuy5.80aed|or|1.00aedwillbuy£0.17
» Directexchangerate– foreigncurrencypricedinhomecurrency
» Indirectexchangerate– homecurrencypricedinforeigncurrency
Country/region Direct exchangerate Indirectexchangerate
USA($,dollar) $1equals3.67AED 1AED equals$0.27
UK(£,pound) £1equals5.80AED 1AED equals£0.17
Eurozone(€,euro) €1equals5.03AED 1AED equals€0.19
Japan(¥,yen) ¥1equals0.04AED 1AED equals¥22.69
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Money and Finance: Exchange Rates, MBA | 5
Foreign Exchange Rates (slide 2 of 2)
» TheForeignExchangemarket(ForEx)comprisesbuyersandsellersofgloballytradedcurrencies
» Themajor‘financialhubs’forForExareLondon,NewYorkandTokyo
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Structure of the ForEx Market
» Banks(businessesorindividuals)buyandsellcurrenciesin:
» thewholesalemarket– forlargertransactions
» theretailmarket– forsmallertransactions
» Currenciescanbepurchasedatcurrentor‘predicted’futurerate:
» onthespotmarket,currenciesareboughtandsoldatthecurrentprice:thistellsushowmuchofonenation’scurrencymustbegivenupinimmediateexchangeforagivenamountofanothernation’scurrency
» ontheforwardmarket,afuturetradeofcurrenciesisagreedatanagreedexchangerate– speculatorscananddo‘bet’onthepredictedchangesinvalueofgloballytradedcurrencies
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Money and Finance: Exchange Rates, MBA | 7
What Determines the Rate of Exchange?
» Therearetwokeyfactors(1)the‘LawofSupplyandDemand’and(2)thetypeofexchangerateregimeagivencountryadopts:
» ‘Floating’exchangerateregime
thevalueofsuchcurrencieschangeconsiderableintheshortandlongtermastheyarefreelytradedandanygivenvaluationisdeterminedbysupplyanddemandintheForEx markets
Example:the$,£,and€ areallfloatingcurrencies
» ‘Fixed’exchangerateregime
thecentralbankbuysandsellsthecurrencyinordertokeepitsvaluefixedagainstaforeignanchorcurrency– itsvaluechangesmarginally
Example:theUAEdirhamisfixed againstUSdollar3.67AED/$1
1. Floating ex. rate
2. Fixed ex. rate
Money and Finance: Exchange Rates, MBA | 8
Demand for a Currency
» DemandforJapaneseyenisderivedfromforeigners’demandforJapanesegoods,services,assetsorforspeculation
» Demandforacurrencyiscalleda‘deriveddemand’
» Asthepriceofacurrencyfallsforeigners’increasetheirdemandforthecurrency
Quantity of yen demanded
Pri
ce o
f y
en (
in $
)
Foreigners’ demand for yen1. Floating ex. rates
1Yen=$0.016
1Yen=$0.012
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Money and Finance: Exchange Rates, MBA | 9
Factors that Increase Demand
Inthelongrundemandforacurrencywillincreaseif:
» Thecountrycanproducegoodsatrelativelylowerpricescomparedtoothercountries(meaningrelativelylowerinflationandbetterproductivity)
» Foreignershavemoreincomewithwhichtobuythatcountry’sgoods
» Foreignerspreferthatcountry’sgoodsrelativetoothers
» Tradebarriersareremovedorrelaxedallowingforeignerstopurchasemoreofthatcountry’sgoods
Intheshort‐run:
» Higherinterestrates/returnsondomesticassetsrelativetothoseintheforeigncountry.
1. Floating ex. rates
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Supply of a Currency
» SupplyforJapaneseyenisderivedfromJapanesedemandforforeigngoods,servicesandassetsorforspeculation
» Tobuyforeignproducts,Japaneseneedtoobtainforeigncurrencies,whichtheydobysellingyenandusingtheproceedstobuytheforeigncurrencies
» Sellingyenhastheeffectofsupplying yentotheForExmarket
Quantity of yen supplied
Pri
ce o
f y
en (
in $
)
Supply of yen
1Yen=$0.012
1Yen=$0.016
1. Floating ex. rates
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Equilibrium in the ForEx Market
» Attheequilibriumexchangerate,theforeignexchangemarket‘clears’…
…meaningthat:
» thequantityofthecurrencydemandedisexactlyequaltothequantitysupplied
Quantity of yen
Pri
ce o
f ye
n (
in $
)
1Yen=$0.014
1. Floating ex. rates
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The Impact of Exchange Rates on Businesses
‘STRONG’VS.‘WEAK’CURRENCIES
Ifacountryhasastrong currency,importsfromoverseaswillbecomparativelycheap,butthegoodsitexportswillbecomparativelyexpensiveforoverseasbuyers
Ifacountryhasaweak currency,importsfromoverseaswillbecomparativelyexpensive,butthegoodsitexportswillbecomparativelycheaperforoverseasbuyers
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Impact of Currency Appreciation
» Whenacountry’scurrencyappreciates,itsexportsbecomemoreexpensiveoverseas…foreignimportsarecomparativelycheaper
» Example:whenthe€ appreciatesagainstthe$,EuropeancarsbecomemoreexpensiveforAmericanstobuyand,atthesametime,AmericancarsbecomecheaperforEuropeanstoimportandpurchase:
» ∴ demandforEuropeancarsintheUSandEuropeanmarketsdeclines
Exchangerate€↔$ Appreciationofeuroagainst thedollar
2007 €1.00 equals $1.28 Thecost ofa€40,000carin$ 40,000x1.28=$51,200
2008 €1.00 equals $1.40 Thecost ofa€40,000carin$ 40,000x1.40=$56,000
1. Floating ex. rates
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Impact of Currency Depreciation
» Whenacountry’scurrencydepreciates,itsexportsbecomecheaperoverseas…foreignimportsbecomemoreexpensivetoimport
» Example:whenthe€ depreciatesagainstthe$,EuropeancarsbecomelessexpensiveforAmericanstobuy
demandforEuropeancarsintheUSmarketincreases
and
demandforAmericancarsintheEuropeanmarketdecreases– moreEuropeansbuyEuropeancarsinsteadofthemoreexpensiveUSones
1. Floating ex. rates
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Protecting against Foreign Exchange Risk
» ForeignExchangeRisk
» Overtime,thevalueofacurrencycouldchangebyalargeamount,thisrepresentsanexchangeraterisktobothexportersandimportersandcanthereforeaffectcompanyprofits…
» WhatisHedging?
» Aninvestmentmadeinordertoreducetheriskofadversechangesintheforeignexchangerate,hedginginstrumentscanbeboughtatacosttocompanies
» Bypurchasingaforwardcontractintheexchangeratemarketbusinessescanprotectthemselvesagainstpotentiallyadversechangesintheexchangerate
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Hedging: An Example
» AUScompanyagreestobuysteelfromaBritishcompanyforthenextyear,thepriceisfixedinthecontractat£1000perton.
» Atthebeginningofthecontract£1isworth$1.77thenthecompanypays$1,770pertonofsteel.
» Duringtheyearthepoundappreciatesto$2.07thenthepricepaidwillincreaseto$2,070perton.
» Thesteelimportercanhedgeitsexchangerateriskbybuyingaforwardcontractinwhichitagreestoanexchangerateforthenextmonth,oralongerperiod.
» Spotandforwardexchangeratesforpoundsterling:
Currency Spotprice 1month 3months` 1year
USdollar 1.7728 1.7721 1.7716 1.7747
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Fixed Exchange Rates (slide 1 of 3)
» alsoknownas‘pegged’or‘anchored’exchangerateregimes:
» thecentralbanksincountriesthatadoptfixedexchangerateregimes,interveneintheForExmarketsinordertostabiliseorfixthevalueoftheirnationalcurrencyagainstamajoranchorcurrency(i.e.$or€).
» Thevalueofthegivennationalcurrencyisfixed(‘pegged’)relativetothevalueofanexternalcurrency/orbasketofcurrencies
» Example:theUAEdirhamisfixedtoasingleanchorcurrency– theUSdollar
» Example:theKuwaitidinarisfixedtotrade‐weightedbasketofcurrencies– thebasketincludesthedollar,theeuro,theyenandtheUK’spoundsterling.
2. Fixed ex. rates
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Fixed Exchange Rates (slide 2 of 3)
» Inordertomaintainafixedexchangerate:
» Acentralbankmustbuyorsellforeign‐currencyreservestoinfluencethevalueofitsnation’scurrency.
» Inordertostrengthenthecurrencyitmustbuyitsowncurrency(increasedemand)andsellthecurrencywhichitisfixedto.
» Thismeansthatthecentralbankofanationfixingitscurrencymusthavelargeforeignreserves(e.g.USdollars)toprotectthecurrencypegandstopthemarketfromforcingitsvaluelower.
» Ifacountrydoesnothavesufficientforeignreservesthenitmaynotbeabletosustainitsexchangeratepegandcouldfaceacurrencycrisisandadepreciationofitscurrency.
2. Fixed ex. rates
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Fixed Exchange Rates (slide 3 of 3)
» MonetarypolicyintheUAEisinactive– interestrates‘must’followtheUSA’smonetarypolicydecisions...whicharebasedonconditionsintheUSeconomy
Source: DATASTREAM
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The Impact of Fixed Exchange Rates
Pros:
» Reducesforeignexchangeraterisk
» Removeshedgingcostsforbusinesses
» Reducesuncertaintyaboutthevalueofprofits,forbusinessesengagedininternationaltransactions
Cons:
» Exchangeratecannotactasa‘shockabsorber’– theex‐ratecan’tdepreciatetogivethecountry’sexportsacompetitiveboost
» MonetaryPolicyisinactiveandcannotbeusedtomanagethedomesticeconomy
» Fixedexchangerateregimesarevulnerabletospeculativeattacks