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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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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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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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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

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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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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