Foreign Exchange

1
Foreign Exchange

• Exchange rate is the price of a currency in terms
  of a foreign currency.

2
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.

3
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.

4
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.

5
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.

6
Foreign Exchange Market
New York
San Francisco
London
Hong Kong Singapore
Tokyo
7
Exchange Rate Systems Fixed exchange rates

• the exchange rates are determined by the
  government or the central bank of the country.

8
Exchange Rate Systems Floating exchange rates

• the truly flexible exchange rates are determined
  by the supply and demand in the market.

9
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.

10
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.

11
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 1HK14.55 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
  US1HK5.65. But in 1974, the Hong Kong dollar
  was allowed to float and the exchange control
  system was abolished.

12
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 Peoples
  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
  US1HK9.6.

13
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 US1HK7.8 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.

14
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
  US1HK7.80.

15
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.

16
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 HK0.20 per US1.

17
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.

18
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.

19
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.

20
Exchange rate quotations

• Suppose the exchange rate of US dollar to HK
  dollar is quoted as
• USD / HKD 7.7980 / 90 which stands for US1
  HK7.7980 / HK7.7990.
• The US dollar is the base currency and the HK
  dollar is the quoted currency.

21
Exchange rate quotations

• Bid Offer (Bank buy) (Bank sell)
• USD / HKD 7.7980 7.7990
•  
• The Bid rate means the bank buys US1 from a
  customer in return of HK7.7980 whereas the Offer
  rate means the bank sells US1 to a customer in
  return of HK7.7990.

22
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

23
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.

24
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.

25
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 ?

26
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
27
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 ?

28
Calculation of forward exchange rate
1 (0.055) (90 / 365)
7.8138
7.7960
1 (0.045) (90 / 360)
29
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.

30
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

31
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

32
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.

33
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.

34
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.

35
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.

36
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
  brokers commission.

37
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.

38
Tutorial

• If EUR / USD 1.0650 / 1.0660 andUSD / 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.