Foreign Exchange

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					Foreign Exchange

Exchange rate is
 the price of a
 currency in
 terms of a
 foreign currency.
Foreign Exchange
The exchange rate of a country's currency is
  determined by the demand for and supply of
  the country's currency. There are three
  factors to consider, namely

 1. the balance of payment of the country,
 2. the economic performance of the country,
 and
 3. the interest rates and inflation rate in the
 country.
Foreign Exchange
For example, a favourable balance of payment is a
  surplus balance while an unfavourable balance of
  payment is a deficit balance. A long favourable
  balance results in the appreciation of the country's
  currency, i.e. the rise of the exchange rates of the
  country's currency to other currencies, such as the
  appreciation of Japanese Yen in 1990s. Whereas a
  long unfavourable balance results in the
  depreciation of the country's currency, i.e. the fall of
  the exchange rates of the country's currency to
  other currencies, such as the depreciation of
  Sterling Pound in 1990s.
Foreign Exchange Market
The foreign exchange market is actually a
  worldwide network of traders, connected by
  telephone lines and computer screens, and
  there is no central headquarters. There are
  three main centres of trading, which handle
  the majority of all foreign exchange
  transactions, namely United Kingdom,
  United States, and Japan.
The participants of the foreign exchange
  market are banks, finance companies,
  customers, brokers and central banks.
Foreign Exchange Market
Transactions in Singapore, Switzerland, Hong Kong,
  Germany, France and Australia account for most
  of the remaining transactions in the market.
  Trading goes on 24 hours a day: at 8 a.m. the
  exchange market is first opening in London, while
  the trading day is ending in Singapore and Hong
  Kong. At 1 p.m. in London, the New York market
  opens for business and later in the afternoon the
  traders in San Francisco can also conduct
  business. As the market closes in San Francisco,
  the Singapore and Hong Kong markets are
  starting their day.
Foreign Exchange Market

                  New York




                        San Francisco
    London
    Hong Kong
    Singapore
                Tokyo
Exchange Rate Systems : Fixed
exchange rates

   the exchange rates
    are determined by
    the government or
    the central bank of
    the country.
Exchange Rate Systems : Floating
exchange rates

   the truly flexible
    exchange rates are
    determined by the
    supply and
    demand in the
    market.
Exchange Rate Systems : Dirty floating
exchange rates

   the exchange rates
    are managed by
    the government or
    central bank of the
    country to float
    within an upper
    and a lower limits.
Exchange Rate Systems : Linked
exchange rate

   the exchange rate of
    the country's currency
    to a specific foreign
    currency is fixed, but
    the exchange rates of
    the country's currency
    to other currencies
    are not fixed.
Historical Development of Exchange
Rates System in Hong Kong

Before 1972, Hong Kong was a member of the
  sterling area.   The Hong Kong dollar was
  pegged to the pound sterling at £1=HK$14.55
  and there was an exchange control system. In
  1972, because of the depreciation of pound
  sterling, the government decided to have the
  Hong Kong dollar pegged to the United States
  dollar at US$1=HK$5.65. But in 1974, the Hong
  Kong dollar was allowed to float and the
  exchange control system was abolished.
Historical Development of Exchange
Rates System in Hong Kong

However, starting from 1982, there was a
 confidence     crisis    as  the    British
 government        negotiated   with     the
 government of the People’s Republic of
 China about the future of Hong Kong after
 1997.      Political uncertainty induced
 significant capital outflows and the
 exchange rate of Hong Kong dollar to US
 dollar dropped to US$1=HK$9.6.
Historical Development of Exchange
Rates System in Hong Kong

On 17 October 1983, the government adopted a
 new arrangement for issuing HK dollar notes,
 fixing the exchange rate at US$1=HK$7.8 and
 the removal of the 10% interest withholding
 tax on Hong Kong dollar deposits. The
 forces of competition and arbitrage would
 ensure that the market exchange rate to
 fluctuate around the level of 7.8.     Both
 measures restored confidence in the Hong
 Kong dollar.
The Mechanism of the Linked Exchange
Rate System

Prior to 17 October 1983, the Certificate of
  Indebtedness (CI) was issued and redeemed
  by the Exchange Fund against payments of
  Hong Kong dollars.      The Certificate of
  Indebtedness was hold by the note-issuing
  banks as cover for the issue of Hong Kong
  dollar notes. Under the Linked Exchange
  Rate System, the payment was to be made in
  US dollars at a fixed exchange rate of
  US$1=HK$7.80.
The Mechanism of the Linked Exchange
Rate System

The forces of competition and arbitrage
 between markets would ensure that the
 exchange rate would stabilize at a level
 close to the fixed rate with minimum
 intervention by the Exchange Fund.
The Mechanism of the Linked Exchange
Rate System

For example, if the Hong Kong dollar is traded
  in the market at a rate below 7.80, say 8.00,
  then banks will be encouraged to cash in
  their holding of Hong Kong dollar notes
  through the note-issuing banks for US dollar
  deposits. Then they can sell the US dollar
  deposits for Hong Kong dollar deposits at
  the market rate to make a profit of HK$0.20
  per US$1.
The Mechanism of the Linked Exchange
Rate System

As a result, in the open market, more banks
 will buy HK dollar notes and sell US dollar
 deposits. Following the redemption of the
 CIs, the HK dollar notes in circulation are
 reduced and the liquidity in the banking
 system is tightened. Interest rates in Hong
 Kong will rise until they are high enough to
 attract capital inflow. The arbitrage activity
 will boost the demand for HK dollar so that
 the exchange rate will rise to 7.80.
The Mechanism of the Linked Exchange
Rate System

Nevertheless, the mechanism assumes that the
 market obeys the laws of economics.
 Therefore,      political factors    might
 overshadow the laws of demand and supply.
 If    the capital outflow is serious, the
 government will have to spend a lot of the
 exchange fund to buy up Hong Kong dollars
 in the market in an effort to support the
 linked exchange rate.
The Mechanism of the Linked Exchange
Rate System

Moreover, only banks are capable of dealing
 with the Exchange Fund to make arbitrage,
 individuals and corporations are not allowed
 to do this with the Exchange Fund. In the
 normal course of business, banks must keep
 a certain liquidity level to meet customers’
 demand for money withdrawal. Therefore,
 banks’ ability to arbitrage is also limited.
Exchange rate quotations
Suppose the exchange rate of US dollar to
 HK dollar is quoted as
USD / HKD = 7.7980 / 90 which stands for
 US$1 = HK$7.7980 / HK$7.7990.
The US dollar is the base currency and the
 HK dollar is the quoted currency.
Exchange rate quotations
                  Bid          Offer
               (Bank buy)      (Bank sell)
USD / HKD       7.7980         7.7990

 The Bid rate means the bank buys US$1 from
 a customer in return of HK$7.7980 whereas
 the Offer rate means the bank sells US$1 to a
 customer in return of HK$7.7990.
Cross Rate Calculations
If GBP / USD = 1.4270 / 80 and
  USD / HKD = 7.7980 / 90,
 what are the exchange rates of GBP / HKD ?

         Bid : 1.4270  7.7980 =
 Offer : 1.4280  7.7990 =
Cross Rate Calculations
If USD / JPY = 115.50 / 70 and
 USD / HKD = 7.7980 / 90,
 what are the exchange rates of JPY / HKD ?
       Bid : (7.7980  115.70)  100 =
   Offer : (7.7990  115.50)  100 =
The exchange rates of Japanese Yen to HK
   Dollar are always quoted as JPY (100) /
   HKD.
Spot rate vs Forward rate
Spot rate is the exchange rate for a spot
  transaction in which there is a purchase or
  sale of a foreign currency with delivery
  (settlement) to be completed immediately
  between a bank and a customer or within two
  business days between two banks.
Forward rate is the exchange rate for a forward
  contract of a purchase or sale of a foreign
  currency with delivery to take place on a
  determined future date.
Calculation of forward exchange
rate

The forward rate is calculated from the spot
 rate and interest rates by the Interest
 Parity Theorem. Suppose the spot rate of
 USD / HKD is 7.7960, the 3-month deposit
 interest rate of USD is 7.25% and that of
 HKD is 6%, what is the 3-month forward
 rate of USD / HKD ?
Calculation of forward exchange
rate


           1 + (rHK) (n / 365)
Fn = S ×
           1 + (rUS) (n / 360)
                 1 + (0.06) (90 / 365)
   = 7.7960 ×
                 1 + (0.0725) (90 / 360)
   = 7.7707
Calculation of forward exchange
rate

The US dollar is at a discount whereas the
 HK dollar is at a premium. Therefore, HK
 dollar is more expensive in future than
 now in terms of US dollar.
But suppose the 3-month deposit interest
 rate of USD is 4.5% and that of HKD is
 5.5%, what will be the 3-month forward
 rate of USD / HKD ?
Calculation of forward exchange
rate

           1 + (0.055) (90 / 365)
7.7960 ×                            = 7.8138
           1 + (0.045) (90 / 360)
Calculation of forward exchange
rate

In this case, the US dollar is at a premium
   whereas the HK dollar is at a discount. In
   other words, HK dollar is cheaper in future
   than now in terms of US dollar.
If the spot rates of USD / HKD = 7.7960 / 70, the
   forward rates of USD / HKD will be quoted as
   250 / 240. Because the convention of the
   foreign exchange market is to quote the
   forward rates in terms of “points”.
Calculation of forward exchange
rate

The rule is that 250 / 240 indicates High /
 Low which means discount for US dollar
 or premium for HK dollar. Then

Spot rates               7.7960  7.7970
Premium of HKD          -0.0250 -0.0240
3-month Forward rates    7.7710  7.7730
Calculation of forward exchange
rate

On the other hand, if the 3-month forward rates of
 USD / HKD are quoted as 180 / 190 which
 indicates Low / High and means premium for US
 dollar or discount for HK dollar, then

Spot rates                   7.7960  7.7970
Discount of HKD             +0.0180 +0.0190
3-month Forward rates        7.8140  7.8160
Hedging
Hedging is the process of arranging a forward
 exchange contract by a merchant to meet a
 future requirement of foreign currency
 transaction and to reduce the risk of
 exchange rate fluctuation. For example, an
 importer needs Pound Sterling £125,000
 three months later to pay for a machine
 imported from England but worries that the
 exchange rate of Pound Sterling may rise.
 He can buy a 3-month GBP / USD forward
 exchange contract to fix the exchange rate.
Hedging
 For most importers and exporters, forward
    exchange contracts are a convenient and
    cheap means of avoiding or reducing the
    exchange risk in international trade. The
    other methods are :
 1. operating a foreign currencies account,
 2. invoicing in the domestic currency, or
 3.    buying a foreign currency futures
    contract or a foreign currency option.
Futures vs Option
Futures contracts are trade on futures
  exchanges. They are standardized contracts,
  the specifications are established by each
  futures exchange. A futures contract is a
  legally binding contract and can be bought
  or sold in that exchange in contract unit size.
  The buyer and seller only need to indicate
  the number of contracts, bought or sold, the
  trading price and month of delivery of the
  transaction, as well as the floor member with
  whom the trade was executed.
Futures vs Option
For example, the importer who needs GBP
   £125,000 in August can buy an August GBP
   futures contract in May at the trading price of
   GBP / USD 1.5860 through a broker.
 If an importer or exporter does not have the
   precise time for the need of a foreign
   currency transaction, an option contract can
   be used. An option contract sets a future
   period of time for the delivery (settlement) of
   an amount of foreign currency at a
   predetermined exchange rate.
Futures vs Option
An option is an agreement between a buyer and a seller
  by which the buyer has the right to exercise his option,
  i.e. to require the seller to perform certain obligations
  specified in the contract. The difference between a
  futures contract and an option is that in a futures
  contract, the seller is obligated to make a delivery
  when the contract falls due, while in an option, the
  seller is obligated to make a delivery at any time up to
  the expiry date if the buyer has opted to do so. The
  user of an option has to pay a premium but the buyer
  or seller of a futures contract do not need to pay any
  money at the time of entering the contract except the
  broker’s commission.
Futures vs Option
Premium is the price of an option. Strike price is
  the exchange rate of the foreign currency at
  which the option can be exercised. Expiry date
  is the last day on which the option can be
  exercised. A call option gives the buyer the right
  to purchase the currency at the stated strike
  price on or before the expiry date whereas a put
  option gives the buyer the right to sell.
Tutorial
   If EUR / USD = 1.0650 / 1.0660 and
    USD / HKD = 7.7980 / 90, calculate the
    exchange rates of EUR / HKD.
   Suppose the 3-month Savings Deposit Interest
    Rates are 0.0625% p.a. in Hong Kong and
    1.0625% p.a. for Euro Dollar. What are the
    forward exchange rates of EUR / HKD ?
   Distinguish between a foreign currency futures
    contract and a foreign currency option.

				
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