UNIT 6 Theories of Foreign Exchange PDF

UNIT:-06 Theories of Foreign Exchange Every country has a currency different from others. There is no common medium of exchange. It is this feature that distinguishes international trade from domestic. Suppose the imports and exports of a country are equal, the demand for foreign cu...

UNIT:-06 Theories of Foreign Exchange Every country has a currency different from others. There is no common medium of exchange. It is this feature that distinguishes international trade from domestic. Suppose the imports and exports of a country are equal, the demand for foreign currency and its supply conversely, the supply of home currency and the demand for it will be equal. The exchange will be at par. If the supply of foreign money is greater than the demand it will fall below par and the home currency will appreciate. On the other hand, when the home currency is in great supply, there will be more demand for the foreign currency. This will appreciate in value and rise above par. Economists have propounded the following theories in connection with determination of rate of exchange (Theories of Foreign Exchange). 1. Mint Par Theory Mint par indicates the parity of mints or coins. It means that the rate of exchange depends upon the quality of the contents of currencies. It is the exact equivalent of the standard coins of one country expressed in terms of standard coins of another country having the same metallic standards the equivalent being determined by a comparison of the quantity and fineness of the metal contained in standard coins as fixed by law. A nation’s currency is said to be fully on the gold standard if the Government: 1. Buys and sells gold in unlimited quantity at an official fixed price. 2. Permits unrestricted gold movements into and out of the country. In short, an individual who holds domestic currency knows in advance how much gold he can obtain in exchange for it and how much foreign currency this gold will buy when exported to another country. Under this circumstances, the foreign exchange rate between two gold standard countries’ currencies will fluctuate within the narrow limits around the fixed mint par. But mint par is meant that the exchange rate is determined on the weight-to-weight bases of the metallic contents of the two currency units, allowance being given to the purity of the metallic content. The mint parity theory of foreign exchange rate is applicable only when the countries are on the same metallic standards. So, there is no fixed mint par between gold and silver standard country. 2. Purchasing Power Parity Theory This theory was developed after the break down of the gold standard post World War I. The equilibrium rate of foreign exchange between two inconvertible currencies in determined by the ratio between their purchasing powers. Before the first World War, all the major countries of Europe were on the gold standard. The rate of exchange used to be governed by gold points. But after the I World War, all the countries abandoned the gold standard and adopted inconvertible paper currency standards in its place. The rate of foreign exchange tends to be stabilized at a point at which there is equality between the respective purchasing powers of the 2 countries. For eg; say America and England where the goods purchased for 500 $ in America is equal to 100 pounds in England. In such a situation, the purchasing power of 500 US $ is equal to that of 100 English pounds which is another way of saying that US $500 = 100, or US $5=1 pound. If and when the rate of foreign exchange deviates from this nor, economic forces of equilibrium will come into operation and will bring the exchange rate to this norm. The price level in countries remain unchanged but when foreign exchange rate moves to 1=$5.5, it means that the purchasing power of the pound sterling in terms of the American dollars has risen. People owing Pounds will convert them into dollars at this rate of exchange, purchase goods in America for 5$ which in England cost 1 pound sterling and earn half dollar more. This tendency on the part of British people so to convert their pound sterling into dollars will increase, the demand for dollar in England, while the supply of dollar in England will decrease because British exports to America will fall consequently the sterling price of dollar will increase until it reaches the purchasing power par, i.e. 1=US $5. On the other hand, of the prices in England rose by 100 percent those on America remaining unaltered, the dollar value of the English currency will be halved and consequently one sterling would be equal to 2.5 $. This is because 2 unite of English currency will purchase the same amount of commodities in England, as did one unit before. If on the other hand, the prices doubled in both the countries, there would be no exchange in the purchasing power parity rate of foreign exchange, this , in brief is the purchasing power parity theory of foreign exchange rate determination. The change in the purchasing power of currency will be reflected in the exchange rate. Equilibrium Exchange Rate (ER) =Er * ( Pd / Pf) Where;  ER = Equilibrium Exchange Rate  Er = Exchange Rate in the Reference period  Pd = Domestic Price Index  Pf = Foreign currencies price index. Read More:  Purchasing Power Parity (PPP) Theory of Exchange Rate  Determination of Exchange Rates 3. Balance of Payments Theory According to this approach, foreign exchange rate is determined by independent factors no related to international price levels, and the quantity of money has asserted by the purchasing power parity theory. According to this theory, an adverse balance of payment, lead to the fall or depreciation of the rate of foreign exchange while a favorable balance of payments, by strengthening the foreign exchange, causes an appreciation of the rate of foreign exchange. When the balance of payments is adverse, it indicates a situation in which a demand for foreign exchange exceeds its supply at a given rate of exchange consequently, its price in terms of domestic currency must rise i.e., the external value of the domestic currency must depreciate. Conversely, if the balance of payment is favorable it means that there is a greater demand for domestic currency in the foreign exchange market that can be met by the available supply at any given rate of foreign exchange. Consequently, the price of domestic currency in terms of foreign currency rises i.e., the rate of exchange moves in favor of home currency, a unit of home currency begins to command larger units of the foreign currency than before. Balance of Payment theory, also known as the Demand and Supply theory, holds that the foreign exchange rate, under free market conditions is determined by the conditions of demand and supply in the foreign exchange market. According to this theory, the price of a commodity that is , exchange rate is determined just like the price of any commodity is determined by the free play of the force of demand and supply. “When the Balance of Payment is equilibrium, the demand and supply for the currency are equal. But when there is a deficit in the balance of payments, supply of the currency exceeds its demand and causes a fall in the external value of the currency. When there is a surplus, demand exceeds supply and causes a rise in the external value of the currency.” FOREX CURRENCY CODE, QUOTATION AND NAMING CONVENTIONS The forex market, much like any other financial market, has its nicknames and slang terms for currencies and exchange rates, known as currency codes. Some of them even have colorful histories behind them. Furthermore, a number of code, quotation and naming conventions have arisen over the years that are now in popular use among forex traders. THE ISO 4217 STANDARD For standardization purposes, each world currency is designated by a particular three letter currency code assigned to it by the International Organization for Standardization or ISO. This set of currency codes is referred to as the ISO 4217 Standard. In most cases, the ISO 4217 Standard code for a currency will consist of the country’s two character ISO 3166 country code (also sometimes called the Internet country code), in addition to an extra letter referring to the name of the currency unit. For example, US is the ISO 3166 country code for the United States and D stands for Dollar, so the ISO 4217 code for the U.S. Dollar is USD. Similarly, JP is the ISO 3166 country code for Japan and Y represents the unit of currency, the Yen, so the ISO 4217 code for the Japanese Yen is JPY. CURRENCY CODES AND SYMBOLS FOR MAJOR AND MINOR CURRENCIES In addition to three-letter currency codes assigned by the ISO, many countries also have a special character or other brief symbol for their money. What follow in the table below are the ISO 4217 codes for major and minor currencies, as well as their commonly used symbols, when applicable. Major Currencies  European Union Euro EUR €  United States Dollar USD $   United Kingdom Pound Sterling GBP £  Japan Yen JPY ¥  Switzerland Swiss Franc CHF Sfr. Minor Currencies  Australia Australian Dollar AUD A$  Canada Canadian Dollar CAD C$  New Zealand New Zealand Dollar NZD NZ$ The reason that the Swiss Franc’s CHF symbol is not as obvious as the other currencies is due to the fact that the first letters of the old Roman name of the country – Confederation Helvetia – is used for Switzerland’s country code. CURRENCY PAIR QUOTATION CONVENTIONS The base currency in a particular currency pair are often determined by their importance in relation to other currencies. For example, the Euro is generally considered the most dominant base currency, followed by the Pound Sterling, the Australian Dollar and the New Zealand Dollar. All of these serve as the base currency in their currency pairs involving the U.S. Dollar, and they would be written in currency codes like this: EUR/USD. The U.S. Dollar then dominates as the base currency in virtually all other currency pairs, including against the Japanese Yen, the Canadian Dollar, and the Swiss Franc, as well as in currency pairs against the exotic currencies. These currency pairs would generally be written like this: USD/JPY. What is Foreign Exchange Market? The foreign exchange market is the marketplace in which participants are able to sell, purchase, exchange and theorize on currencies. Foreign exchange markets are made up of investment management firms, banks, central banks, hedge funds, commercial companies and investors and retail forex brokers. The major participants involved in the foreign exchange market are forex brokers, commercial banks, and other legitimized dealers and monetary authorities. It is important to note that although participants may possess their own trading centres, the market in itself is spread worldwide. There is close and continuous contact between the trading centres, and there is more than one market where the participants can deal. Demand for Foreign Exchange People demand foreign exchange because, they want to buy commodities and services from other nations; they want to send presents abroad and they want to buy financial assets of a particular nation. Supply of Foreign Exchange Foreign currency flows into the host nation due to the following reasons:  Exports by a nation lead to the buy its domestic commodities and services by the foreigners send presents or make transfers  The assets of a host nation are bought by the foreigners What is Foreign Exchange Rate? Forex rate or foreign exchange rate is the cost price of one currency in terms of another currency. The currencies from the other nations are linked and associated, which enables the comparison of international costs and prices. Hedging Foreign Exchange Risk For every article lauding the benefits of currency hedging, there are just as many that criticize the practice. The multitude of opinions on foreign exchange risk management is often driven by the increasing number of businesses that regularly conduct international transactions. Even small and newer companies maintain a level of foreign exchange rate risk through common activities like buying overseas supplies, selling products in another country and outsourcing tasks to foreign staff. Generally, anyone who makes non-local payments can be vulnerable to shifts in currency exchange rates. Despite owing a set amount each month to an international partner, the actual cost can fluctuate and depending on the severity, can affect a business’s bottom line. What is Currency Risk? Currency risk or hedging refers to the unpredictable nature of exchange rates between two different currencies. The aim of hedging is to manage the risk of exposure, or financial loss, when the exchange rate fluctuates unfavorably. Businesses can opt for a set exchange rate in order to help avoid volatility and accurately manage profits. The Argument Against Hedging While the goal of hedging is protection, not everyone is a fan. Businesses with irregular or small international payments may not necessarily be a candidate for the practice. Additionally, some market watchers fear missing out on a better spot rate, should they commit to a fixed one. While it’s true that some months a spot rate may be more favorable, there may also be months where having a fixed rate can save the business from taking a financial hit. The Benefits of Hedging Protecting profit margins is often a key goal for companies. One advantage of hedging is security: a CFO can accurately plan a fiscal budget and the pricing of products and services can be maintained, as the cost would be static. Foreign exchange rates can be unpredictable and even traditionally stable currencies can be susceptible to movement based on market events or unforeseen circumstances. Misconceptions about Currency Hedging 1. Speculation: While hedging is a risk management strategy, some actually consider the practice a form of speculation. Opponents argue that deciding on a fixed exchange rate is itself a gamble as the forex market is unpredictable and choosing to hedge does not guarantee the most favorable rate. While it’s true that hedging may not secure the most optimal rate, primary objectives are to allow predictability and manage unexpected losses. 2. Unnecessary in times of low volatility: There are periods in the market where major currencies are relatively stable and do not experience steep dips and rises for months at a time. During these cycles, critics of hedging often suggest that it’s pointless to bother hedging. However, it’s important to note that these phases rarely seem to last. It is nearly impossible to predict shifts in the forex market and businesses with concerns about their exposure may be better off hedging from the start, rather than waiting until after an unfavorable move. 3. Flexible pricing: Some companies choose to adjust the pricing of their goods and services based on the shift in currency. While a number of businesses have this freedom, an unexpected dip could mean that customers may be subject to an increase in cost, which could lead them to turn to a competitor. Forward Contracts A forward contract is a derivatives contract that derives its value from an underlying asset. It is a contract between two parties to buy or sell an asset at a predetermined price on a future date. A forward contract is physically settled, which means it is considered to be fulfilled when the goods are exchanged. Forward contract example  Forward contracts were first used by farmers. Let’s understand how a forward contract works with the help of an example of a rice farmer Mr Iyer who is based out of Madurai. Now, cultivation of crops is not an easy job. A farmer needs to plough the fields, sow the seeds, use fertilisers, ensure adequate irrigation etc. Also, he ends up investing a substantial amount of time, energy and resources. But the farmer earns money or returns on his produce only after selling the rice. His entire income is dependent on the produce. So, let’s assume that currently rice is being sold at ₹20 per kg. If the price of the rice goes down, he will make losses. And if the price goes up, he stands to gain. Hence, Mr Iyer would like to eradicate this uncertainty. So, he enters into an agreement with Mr. Raj, who is a wholesaler in Kolkata. The agreement states that Mr Raj will buy 500 kgs of rice at the price of ₹20 per kg, two months from now from Mr Iyer. This quantity of rice will be delivered to Mr Raj’s warehouse through trucks and the cost of transportation will be borne by Mr. Raj. It means, in this scenario, Mr Iyer is the seller and Mr Raj is the buyer of this forward contract. The predetermined quantity of rice to be sold is 500 kgs and the price at which the rice will be sold is ₹20 per kg. Hence, the price of forward contract is ₹10,000 (500 * 20), which derives its value from the underlying – rice. The contract will be fulfilled on a future date – two months from now. This is when the rice will be delivered to Mr Raj’s warehouse and Mr Iyer will receive ₹10,000. As this a customisable derivative contract terms such as delivering of rice to the warehouse and footing the transport costs can be incorporated into the contract. Also, both the parties in this transaction must agree on these terms. Advantages of forward contracts:  High degree of customisation: Forward contracts can be customised to suit the requirements of the parties involved.  No margin requirement: While trading in forward contracts, no prerequisite margin is required. Risks involved in forward contracts:  Counterparty risk: If either of the parties involved decline to honour the contract, the deal will not be completed. This is known as the counterparty risk.  No regulator: This is an over-the-counter (OTC) agreement, and there is no third-party regulator involved. Simply put, there is no one to hold both the parties accountable. In order to overcome the risk associated with forward contracts, future contracts were introduced. Future contract A future contract is a standardised derivatives contract that derives its value from the underlying asset. It is a contract between two parties to buy or sell an asset at a predetermined price and quantity on a specified date in the future. Future contracts are standardised in terms of quality and quantity to facilitate trading on a futures exchange. Here, exchanges act as a regulator to eradicate the risk of a default. In order to trade in futures, both the buyer and the seller need to keep a margin. A margin refers to the minimum amount that needs to be in your account before you take a position (trade) in the market. A mark-to-market (daily settlement of profit and loss) margin should be maintained in the account at all times. A future contract can be physically settled (i.e. it is considered to be fulfilled when the goods are exchanged) or cash settled. Types Of Futures Contract #1 – Commodity Futures It stipulates the commodity‘s price time and volume in the contract for both parties. The contract is generally cash settled. The three basic components of commodity futures are metal, food, and energy. For example, it can be gold, silver, crude oil, etc. For commodities, it is essential because it reduces the risk faced by the buyers due to the probability of prices increasing in the future. Such contracts are sold on exchanges ensuring a safer trade. Companies use futures contracts to obtain a fixed price for commodities they buy from commodity producers. #2 – Currency Futures In these contracts, the underlying assets are currency exchange rate; the rate defines the exchange between any two currencies, for example, the US Dollar to the Euro exchange rate, the Indian Rupee to the English Pound rate, or the English Pound to the US Dollar rate. In essence, it is the contract to exchange one currency for the other. The currency futures remain constant as in all other futures and are traded similarly. Such currencies are traded via currency brokers in exchanges like Chicago Mercantile Exchange. #3 – Interest Rate Futures These contracts concern interest-bearing financial instruments or debt instruments. They are used for hedging and speculative purposes. An example of the underlying instrument is treasury bills and treasury bonds. These futures are settled either way by cash or by physical delivery. #4 – Stock Market Index Futures These contracts are in context to the stock index, so the underlying asset is linked to a stock index. Future brokers trade these primarily for hedging, spread trading, speculating, etc. It is also a part of technical indicators denoting market emotion and sentiment. Example Let’s understand it with a simple futures contract example: Luther started a company that consistently requires silver, and his company is already in conversation with a company supplying silver. The silver provider uses a futures contract to bind Luther and his company, promising to sell a fixed quantity of silver at a pre-determined price and the time the delivery will be executed. Luther agrees to the contract. Now both of them are obligated to trade the silver in the future at a set price.