LECTURER: (Elikplimi Komla Agbloyor, PhD DEPARTMENT: Department … · 2019. 2. 24. · Government Policy and Foreign Exchange Intervention •Govt. officials can intervene in the

College of Education

School of Continuing and Distance Education 2017/2018 – 2018/2019 ACADEMIC YEAR

LECTURER: (Elikplimi Komla Agbloyor, PhD ) DEPARTMENT: (Department of Finance, UGBS) (Contact Information: [email protected])

Course Information

Provide the following information:

Course Code:

Course Title:

Course Credit 3 Credit(s)

Session Number & Session Title:

11 –

Semester/Year: 2nd Semester - 2017/18Year

Teaching Assistant Francis K. A. Baidoo [email protected]

Slide 2

Session Overview

• The globalization and integrations of local financial markets has led

to the emergence of some financial concepts. In this session,

foreign exchange rates and markets will be discussed into details.

• Determinants of exchange rates, and exchange rate regimes and

systems will also be discussed.

• The session will conclude with functions of foreign exchange

market, and the levels of transactions within the foreign exchange

market with their associated problems.

Slide 3

Session Learning Outcomes

At the end of the session, the student will

1. Be able to explain transactions involving foreign exchanges and quotations

2. Be able to discuss factors that influence foreign exchange rates

3. Be able to explain foreign exchange regimes and systems

4. Be able to explain the operational transactions within the foreign exchange market

5. Be able to explain discuss problems associated with the foreign exchange trading

Slide 4

FOREIGN EXCHANGE MARKETS

Foreign Exchange Market

• The foreign exchange market allows currencies to be exchanged in order to facilitate international trade or financial transactions.

• Nominal exchange rate – the rate at which one can exchange the currency of one country for the currency of another country.

• Real exchange rate – the rate at which one can exchange the goods and services from one country for goods and services from another country.

– Real exchange rate = dollar price of domestics goods

dollar price of foreign goods

Foreign Rates in the Long-Run

• The Law of One Price is based on the concept of arbitrage

– dollar price of domestic goods = dollar price of foreign goods

• The Law of One Price fails almost all the time due to:

– Transport cost

– High tariffs

– Differences in technical specifications

– Differences in tastes

Foreign Rates in the Short-Run

• To explain the short-run changes in nominal exchange rates, we turn to an analysis of the supply of and demand for currencies.

• Equilibrium in the Market for Dollars.

• Shifts in the supply of and demand for dollars


• Increased supply leads to a fall in the value of the dollar. Increase in dollar supply is caused by:

– Increase in American preference for foreign goods

– Increase in US real GDP

– Increase in real interest rate on foreign bonds

– Increase in American wealth

– Reduction in riskiness of foreign investment

– Expected depreciation of the dollar


• Increased demand leads to a rise in the value of the dollar. Increase in dollar demand is caused by:

– Increase in foreign preference for American goods

– Increase in foreign real GDP

– Increase in real interest rate on US bonds

– Increase in foreign wealth

– Reduction in riskiness of US investment

– Expected future dollar appreciation

Government Policy and Foreign Exchange Intervention

• Govt. officials can intervene in the foreign exchange market in several ways:

– Adopt fixed exchange rate – maintain fixed exchange rate at all times.

– Foreign exchange intervention – buy and sell currency in an attempt to offset demand and supply.

Foreign Exchange Transactions

• There is no specific building or location where traders exchange currencies.

• Trading also occurs around the clock.

• The market for immediate exchange is known as the spot market.

• The forward market enables an MNC to lock in the exchange rate at which it will buy or sell a certain quantity of currency on a specified future date.

• Hundreds of banks facilitate foreign exchange transactions, though the top 20 handle about 50% of the transactions.

• At any point in time, arbitrage ensures that exchange rates are similar across banks.

• Trading between banks occurs in the interbank market. Within this market, foreign exchange brokerage firms sometimes act as middlemen.


• The following attributes of banks are important to foreign exchange customers:

– competitiveness of quote

– special relationship between the bank and its customer

– speed of execution

– advice about current market conditions

– forecasting advice


• Banks provide foreign exchange services for a fee: the bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote. This is the bid/ask spread.

• bid/ask % spread = ask rate – bid rate ask rate

• Example: Suppose bid price for £ = $1.52, ask price = $1.60.

bid/ask % spread = (1.60–1.52)/1.60 = 5%



• Assume you have $1,000 and plan to travel from the United States to the United Kingdom. The bank’s bid rate for the British pound is $1.52 and its ask rate is $1.60.

– How much pounds will your money convert into.

– Assume at the last minute you cancel your trip, how much in dollars will you have lost. What accounts for this loss?


• Bid = $1.52

• Ask = $ 1.60

• $1.60 = ₤1

• $1,000 = x

• X = $1000 * ₤1

$1.60

• X = ₤625


• $1.52 = ₤1

• X = ₤ 625

• X = ₤625 *$1.52

₤1

• X = $950

• You will have lost $50. This is due to the bank’s bid/ask spread (charge/profit).

• The bid/ask spread is normally larger for those currencies that are less frequently traded.

• The spread is also larger for “retail” transactions than for “wholesale” transactions between banks or large corporations.


Interpreting Foreign Exchange Quotations

• Exchange rate quotations for widely traded currencies are frequently listed in the news media on a daily basis.

• Forward rates may be quoted too.

• The quotations normally reflect the ask prices for large transactions.

• Direct quotations represent the value of a foreign currency in cedis

• Indirect quotations represent the number of units of a foreign currency per cedi.

• The same currency may also be used by more than one country.


• A cross exchange rate reflects the amount of one foreign currency per unit of another foreign currency.

• Value of 1 unit of currency A in units of currency B = value of currency A in $ value of currency B in $



Fixed Exchange-Rate Regimes

• The system for establishing exchange rates has evolved over time.

– From 1876 to 1913, each currency was convertible into gold at a specified rate, as dictated by the gold standard.

– This was followed by a period of instability, as World War I began and the Great Depression followed.

Exchange-Rate Pegs and the Bretton Woods System

– In 1944, a group of 44 countries agreed to form the Bretton Woods System

– The 1944 Bretton Woods Agreement called for fixed currency exchange rates.

– Each country pegged it’s exchange rate to the US dollar.

– By 1971, the U.S. dollar appeared to be overvalued. The Smithsonian Agreement devalued the U.S. dollar and widened the boundaries for exchange rate fluctuations from ±1% to ±2%.

Exchange-Rate Pegs and the Bretton Woods System

– Even then, governments still had difficulties maintaining exchange rates within the stated boundaries. In 1973, the official boundaries for the more widely traded currencies were eliminated and the floating exchange rate system came into effect.

Hard Pegs: Currency Boards and Dollarization

• Two important hard pegs include: – Currency boards – Dollarization


• Currency boards – The central bank commits to holding enough foreign

currency assets to back domestic currency liabilities at a fixed rate.

– Somewhere between 10 and 20 currency boards operate in the world.

– The best known one is the Hong Kong Monetary Authority – Argentina decided to adopt currency boards in 1991 to end

triple-digit inflation. After 3 years, inflation dropped to 4%; by 1998 it was nearly zero.


• One major problem with currency boards is that, by giving up the ability to control the size of its balance sheet, the central bank loses its role as the lender of last resort to the domestic banking system.


• Dollarization

– One country formally adopts the currency of another country for use in all its financial transactions, completely eliminating its own monetary policy.

– Need not be based on the dollar.

– Monaco adopted the French franc in 1865 and uses the euro today.

– Ecuador, El Salvador.

– Panama has been dollarized since 1904.


• Benefits of dollarization include: – With no exchange, there is no risk of an exchange rate

crises.

– Integration into the world markets – increasing trade and investment

– By rejecting the possibility of inflationary finance, a country can reduce the risk premium it must pay on loans and generally strengthen its financial institutions.

– The benefits of dollarization is balanced against the loss of revenue that comes from issuing currency • what is called seignorage.

– Dollarization is not the same as monetary union.

References

• Abor, Joshua Y. (2016), Financial Markets and Institutions: A Frontier Market Perspective, Digibooks.

• Madura, Jeff, Financial Markets and Institutions, South-Western College Publishing. • Fabozzi, Frank J., Modigliani Franco and Michael G. Ferri, Foundations of Financial Markets

and Institutions. • Thygerson, Kenneth J., Financial Markets and Institutions: A Managerial Approach, Harper

Collins College Publishers • Mishkin, Frederic S., and Stanley G. Eakins, Financial Markets and Institutions, published by

Addison-Wesley. • Cecchetti, Stephen G. Money, Banking, and Financial Markets, McGraw-Hill, Irwin • Mensah, Sam, Securities Markets and Investments: A Ghanaian Primer, Smartline. • Ghana Fixed Income Market Manual • Ghana Stock Exchange (GSE) 25th Anniversary Lecture • Prospectus for Edendale Bond Issue • Greenwood, R., & Scharfstein, D. S. (2012). How to Make Finance Work (Digest

Summary). Harvard Business Review, 90(3), 104-110. • Merton, R. (2009). Making the Financial Markets Safe. Harvard Business Review. • Campbell, J. Y., Jackson, H. E., Madrian, B. C., & Tufano, P. (2011). Making Financial Markets

Work for Consumers (Digest Summary). Harvard Business Review, 89(7/8), 47-54.

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Documents

LECTURER: (Elikplimi Komla Agbloyor, PhD DEPARTMENT: Department … · 2019. 2. 24. · Government Policy and Foreign Exchange Intervention •Govt. officials can intervene in the