Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Chapter 9:The Foreign Exchange Market

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Lecture Plan: Determination of exchange rates Foreign exchange quotations –Spot and forward rates Structure and size of the foreign exchange market Economic theories of exchange rate determination Case: The Fall of the Baht

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea FOREIGN EXCHANGE TRANSACTIONS the foreign exchange rate is the price of one currency expressed in terms of another currency! Appreciation Depreciation 1A$=US$ A$= US$ A$= US$ 0.50

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Determination of the exchange rates Price $A1S in $US 0.55 E D Quantity of $A

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Floating Currencies: Demand for the National Currency Nation’s exporters paid in other hard currencies Foreign companies undertaking direct and portfolio investment in the nation’s economy "Bull" speculators in the nation’s currency Nation’s Central Bank(RBA) selling US$ and other hard currencies for the nation’s currency Foreign tourists visiting your country.

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Floating Currencies:Supply of the National Currency Nation’s importers paying in US $, Yen etc. Domestic firms investing abroad "Bear" speculators in the national currency Nation’s central bank buying US $, Yen etc. Individual residents travelling overseas

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea The EURO Benefits: –significant savings for businesses and individuals –easier comparability of prices; more competition –boost to the development of a highly liquid pan- European capital market –more investment options Drawbacks: –national authorities lose control over monetary policy –EU is not an “optimal currency area”

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea SPOT TRANSACTIONS Spot transaction:is the purchase of FX with delivery and payment (referred to as settlement,on the following business day. The foreign exchange traders always quote: –a bid (buy) and offer (sell) rate The SPREAD is the difference between the bid and offer rates and is the margin on which the trader earns a profit

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Market Quotations Dealers always “buy low” and “sell high” Selling rates and Buying rates are always from the perspective of the dealer/bank

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea FORWARD TRANSACTIONS A FORWARD RATE is the price agreed on today for purchase or sale of foreign exchange at a future date. Usually agreed for less than 1 year Premiums and Discounts: Forward quotations are either at a –PREMIUM: forward >spot –DISCOUNT:forward< spot

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Structure of the FX Market Large commercial banks deal at two levels: –Retail:with bank customers –Interbank(wholesale):with other domestic and foreign banks –A third market, the FX futures/options market came into existence in the 1970’s with the inauguration of trading in foreign exchange futures and options by certain commodity and stock exchanges in the US,subsequently adopted by other financial centres

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Functions of the Foreign Exchange Market Currency conversion Reduction of foreign exchange risk

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Structure of the FX Market Large commercial banks deal at two levels: –Retail:with bank customers –Interbank(wholesale):with other domestic and foreign banks –A third market, the FX futures/options market came into existence in the 1970’s with the inauguration of trading in foreign exchange futures and options by certain commodity and stock exchanges in the US,subsequently adopted by other financial centres

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Geographical distribution of global reported foreign exchange market turnover, %

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Share of traditional foreign exchange transactions in the total turnover, %.

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Economic theories of exchange rate determination Prices and Exchange rates –The Law of one price –The Purchasing Power parity(PPP) Money supply and price inflation Interest rates and exchange rates Investor psychology and band wagon effects

Copyright ©2003 McGraw-Hill Australia Pty Ltd PPTs t/a International Trade and Investment by John Gionea Slides prepared by John Gionea Factors affecting the Australian dollar exchange rate Relative interest rates Commodity prices and terms of trade Relative inflation rates The external account The role of the Central Bank –The Fall of the Baht