FINANCIAL MARKETS AND INSTITUTIONS

ULAB SCHOOL OF BUSINESS

University of Liberal Arts Bangladesh

Foreign Exchange Markets

University of Liberal Arts Bangladesh 2

 Foreign Exchange Market

• The foreign exchange market is a market for converting the

currency of one country into that of another country. In other
words, it is the market where foreign currencies are traded.
People need to exchange currencies for various reasons (such
as paying import bill, paying medical bill in a foreign hospital,
paying tuition fees in a foreign university, during traveling etc.)
• The exchange rate is the rate at which one currency is
converted into another. It is synonymous to the price of a
foreign currency.
 Characteristics of FOREX Market

– A global network of banks, brokers and foreign exchange

dealers connected by electronic communications systems.
– It is a global market in the sense that currency
transactions require only a few seconds to execute and
the market never sleeps (operating 24 hours per day).
– The exchange rates quoted worldwide are basically the
same. For example, Dollar/Euro exchange rate today is
same all over the world although very small differences
may happen among small dealers in case of low volume
transactions.

4-4
Exchange
Rates
1990–2010
 Direct Quote Vs. Indirect Quote
• Direct quote expresses the amount of domestic* currency required to
buy/sell one unit of the foreign currency. This is the quote that we observe
in Banks and Money Exchanges.
– Example: USD1 = BDT 84
• Indirect quote expresses the amount of foreign currency required to
buy/sell one unit of the domestic* currency.
– Example: BDT 1 = USD 0.0119 ;
BDT 1 = JPY 1.30

*: Here, from our perspective, Bangladesh is the domestic country.

Currency Depreciation Vs. Currency Appreciation
• Currency depreciation occurs when a country’s currency
falls in value relative to other currencies.
– Example: From USD1 = BDT 78 to USD1 = BDT 84. BDT has depreciated,
because now more BDT is needed to buy 1 USD. In this situation:
- domestic goods become cheaper for foreign buyers
- foreign goods become more expensive for domestic buyers

• Currency appreciation occurs when a country’s currency

rises in value relative to other currencies.
– Example: USD1 = BDT 84 to USD1 = BDT 74
 Factors that cause currency depreciation/appreciation
• Inflation:
• Low inflation –> cheaper price of domestic goods –> higher
demand for domestic goods –> more competitive exports and
less competitive imports –> higher demand for domestic
currency and lower demand for foreign currency = currency
appreciation
• Monetary Policy (interest rates: effect 1)
• Expansionary monetary policy –> interest rate decreases –>
inflation increases –> currency depreciation
 Factors that cause currency depreciation/appreciation

• Interest rates: effect 2

• High interest rates –> more attractive to deposit money in
domestic FI –> more demand for domestic currency (hot
money flows) = currency appreciation
• Government debt
• Increase in government debt –> higher default risk might be
perceived among foreign investors –> decrease in foreign
investment –> decrease in the demand for domestic currency
= currency depreciation
 Factors that cause currency depreciation/appreciation

• Trade balance (= Export – Import)

• Trade deficit –> higher demand for foreign currency and lower
demand for domestic currency –> currency depreciation
• Speculation
• If speculators believe that the price of a certain currency will rise in
the future, they will demand more now to be able to make a profit. This
increase in demand will cause the value to rise.
• Therefore, movements in the exchange rate do not always reflect
economic fundamentals, but they are often driven by the sentiments
and speculations in the financial markets.
 Factors that cause currency depreciation/appreciation
• Demand for Currency
• When a country’s currency is in demand, the currency stays strong. One of the ways
a currency remains in demand is if the exporter demands payment in his domestic
currency.
• While the U.S. does not export more than it imports, it has found another way to
create an artificially high global demand for U.S. dollars. The U.S. dollar is what is
known as a reserve currency. Reserve currencies are used by nations across the
world to purchase desired commodities, such as oil and gold. When sellers of these
commodities demand payment in reserve currency, an artificial demand for that
currency is created, keeping it stronger than it might otherwise have been.
• In the United States, there are fears that China’s growing interest in attaining
reserve currency status for the yuan will reduce demand for the U.S. dollars. Similar
concerns surround the idea that oil producing nations will no longer demand
payment in U.S. dollars. Reduction in the artificial demand for U.S. dollars is likely to
depreciate the dollar.
 Spot Rate Vs. Forward Rate
– Spot exchange rates: The rate at which a foreign exchange dealer
converts one currency into another currency on any particular day.
– Forward exchange rates: When two parties agree to exchange
currency and execute the deal at some specific date in the future.
– 1-month, 2-months, 3-months, 4-months, 6-months forward rates
are common
– The next slide shows a formula to calculate forward rate (based on
spot rate and interest rates of respective countries).
Forward Exchange Calculation Example
 Law of One Price
• The law of one price says that the same good in different
markets must sell for the same price (when transportation
costs and barriers between markets are not important).
– Suppose the price of pizza at one restaurant is $20, while the
price of the same pizza at a similar restaurant across the street is
$40.
– What do you predict to happen?
– Many people would buy the $20 pizza, few would buy the $40.
 Law of One Price (cont.)
– Due to the increased demand, the price of the $20 pizza would tend to
increase.
– Due to the decreased demand, the price of the $40 pizza would tend to
decrease.
– People would have an incentive to adjust their behavior and prices would
tend to adjust to reflect this changed behavior until one price is achieved
across markets.
– However, ‘law of one price’ is mostly a theoretical concept and do not
always exist in the real market. If two vendors, side by side, are selling the
same quality rice and buyers are absolutely free to choose, only then
probably the law of one price will be effective.
 From Law of One Price to Exchange Rate
• Consider two pizza restaurants: one in Seattle, the other in
Vancouver.
• The law of one price says that the price of the same pizza (using a
common currency to measure the price) in the two cities must be the
same if barriers between markets and transportation costs are not
important:
PpizzaUS = (EUS$/Canada$) x (PpizzaCanada)
PpizzaUS = price of pizza in Seattle
PpizzaCanada = price of pizza in Vancouver
EUS$/Canada$ = exchange rate between US dollar and Canadian dollar
 Purchasing Power Parity
• Purchasing power parity is the application of the law of
one price across countries for all goods and services, or for
representative groups (“baskets”) of goods and services.
PUS = (EUS$/Canada$) x (PCanada)
PUS = price level of goods and services in the US
PCanada = price level of goods and services in Canada
EUS$/Canada$ = US dollar/Canadian dollar exchange rate
 Purchasing Power Parity (cont.)
• Purchasing power parity implies that
EUS$/Canada$ = PUS/PCanada
– The price levels adjust to determine the exchange rate.
– If the price level in the US is US$200 per basket, while the price level in
Canada is C$400 per basket, PPP implies that the US$/C$ exchange rate
should be US$200/C$400 or, US$ 1= CAD$2
– Purchasing power parity says that each country’s currency has the same
purchasing power: 2 Canadian dollars buy the same amount of goods and
services as does 1 US dollar, since prices in Canada are twice as high.
 Exchange Rate Regimes
• What is an exchange rate regime?
• The exchange rate regime is the way a country manages its
currency in respect to foreign currencies and the foreign exchange
market.
• What are the most common types of exchange rate regimes?
• Fixed Exchange Rate
• Floating Exchange Rate
 Fixed, or Pegged, Exchange Rate
• A country's exchange rate regime under which the government or central
bank ties the official exchange rate to another country's currency.
• Fixed rates provide greater certainty for exporters and importers. This
also helps the government maintain low inflation, which in the long run
should keep interest rates down and stimulate increased trade and
investment.
• Typically, a country will "peg" its currency to a major currency such
as the U.S. dollar.
• The choice of the currency is affected by the currencies in which the
country's external debt is denominated and the extent to which the
country's trade is concentrated with particular trading partners.
• Typically, with a pegged exchange rate, an initial target exchange
rate is set and the actual exchange rate will be allowed to fluctuate
in a range around that initial target rate.
• Advantages of pegged exchange rates include a reduction in the
volatility of the exchange rate.
• The next slide presents some of the common currencies that have
adopted fixed exchange regime.
 Country Region Ccy Name Code Peg Rate Peg Ccy Rate Since
Bermuda North America Bermuda Dollar BMD 1 USD 1972
Brunei Asia Brunei Dollar BND 1 SNG 1967
Cameroon Africa Central African CFA Franc XAF 655.957 EUR 1999
Chad Africa Central African CFA Franc XAF 655.957 EUR 1999
Dijibouti Africa Franc DJF 177.721 USD 1973
Eritrea Africa Nakfa ERN 15 USD 2005
Ivory Coast Africa West African CFA Franc XOF 655.957 EUR 1999
Mali Africa West African CFA Franc XOF 655.957 EUR 1999
Namibia Africa Dollar NAD 1 ZAR 1993
Niger Africa West African CFA Franc XOF 655.957 EUR 1999
Senegal Africa West African CFA Franc XOF 655.957 EUR 1999
Swaziland Africa Lilangeni SZL 1 ZAR 1974
Togo Africa West African CFA Franc XOF 655.957 EUR 1999
Hong Kong Asia Dollar HKD 7.75-7.85 USD 1998
Nepal Asia Rupee NPR 1.6 INR 1993
Cuba Central America Convertible Peso CUC 1 USD 2011
Panama Central America Balboa PAB 1 USD 1904
Bulgaria Europe Lev BGN 1.95583 EUR 2002
Denmark Europe Krone DKK 7.46038 EUR 1999
Latvia Europe Lats LVL 0.702804 EUR 2004
Lithuania Europe Litas LTL 3.4528 EUR 2005
Bahrain Middle East Dollar BHD 0.376 USD 2001
Jordan Middle East Dinar JOD 0.709 USD 1995
Lebanon Middle East Pound LBP 1507.5 USD 1997
Oman Middle East Rial OMR 0.3845 USD 1986
Qatar Middle East Riyal QAR 3.64 USD 2001
Saudi Arabia Middle East Riyal SAR 3.75 USD 2003
Venezuela South America Bolivar VEB 6.3 USD 2013
 Floating Exchange Rate
• A country's exchange rate regime where its currency is set by the foreign-
exchange market through supply and demand for that particular currency
relative to other currencies. Thus, floating exchange rates change freely
and are determined by trading in the FOREX market.
• Therefore trade and capital flows play a big role in determining the
currency’s value.
• In some instances, if a currency value moves in any one direction at a
rapid and sustained rate, central banks intervene by buying and selling its
own currency reserves (i.e. Federal Reserve in the U.S.) in the foreign-
exchange market in order to stabilize the local currency. However, central
banks are reluctant to intervene, unless absolutely necessary, in a floating
regime.