CHAPTER 9: FOREIGN EXCHANGE MARKET

INTRODUCTION
Most countries of the world have their own currencies: The United States has its dollar;
France, the euro; Brazil, its real; India, its rupee and in the Philippines its peso. Trade
between countries involves the mutual exchange of different currencies (or, more
usually, bank deposits denominated in different currencies).
The trading of currency and bank deposits denominated in particular currencies takes
place in the foreign exchange market. The volume of these transactions worldwide
averages over P1 trillion daily. Transactions conducted in the foreign exchange market
determine the rates at which currencies are exchanged, which in turn determine the
cost of purchasing foreign goods and financial assets.
Firms that do business internationally must be concerned with exchange rates, which
are the relationships among the values of currencies. The constant change in exchange
rates causes problems for financial managers as the change in relative purchasing
power between countries affects imports and exports, interest rates and other economic
variables.

Exchange Rates
An exchange rate is simply the price of one country's currency expressed in terms of
another country's currency. For example, almost all trading of currencies takes place in
terms of the U.S. dollar. For example, both the Euro, the Swiss franc, and the Japanese
Yen are traded with prices quoted in U.S. dollars. Exchange rates are constantly
changing.
Foreign exchange rate quotations, can be found in The Wall Street Journal, in other
leading publications and on websites. A publication of the reference exchange rates
released by the Bangko Sentral ng Pilipinas as of August 27, 2019 is shown in Figure 9-
2 below.
Figure 9-2: Reference Exchange Rate Bulletin (August 27, 2019)
(Partial table content transcribed below):
COUNTRY UNIT SYMBO US DOLLAR PHIL PESO
L EQUIVALENT EQUIVALENT
UNITED STATES DOLLAR USD 1.000000 52.3260
JAPAN YEN JPY 0.009425 0.4931
UNITED KINGDOM POUND GBP 1.220200 63.8424
HONGKONG DOLLAR HKD 0.127476 6.6703
SWITZERLAND FRANC CHF 1.021764 53.4648
CANADA DOLLAR CAD 0.754546 39.4934
SINGAPORE DOLLAR SGD 0.720254 37.6880
AUSTRALIA DOLLAR AUD 0.677400 35.4458
BAHRAIN DINAR BHD 2.652520 138.7968
CHINA YUAN RMB NA NA
SAUDI ARABIA RIYAL SAR 0.266852 13.9626
BRUNEI DOLLAR BND 0.717691 37.5527
INDONESIA RUPIAH IDR 0.000070 0.0037
INDIA RUPEE INR 0.014203 0.7437
UAE DIRHAM AED 0.272079 14.2473
 EUROPEAN EURO EUR 1.110400 58.1028
MONETARY UNION
KOREA WON KRW 0.000825 0.0432
TURKEY LIRA TRY 0.176821 9.2561

Factors Influencing Exchange Rates

As with any other market, the exchange rate between two currencies is determined by
the supply and the demand for those currencies. The present international monetary
system consists of a mixture of "freely" floating exchange rates and fixed rates.
The major reasons for exchange rate movements which include inflation, interest
rates, balance of payments, government's policies or intervention and so forth are
discussed briefly in the following sections:
1. Inflation. Inflation tends to deflate the value of a currency because holding the
currency results in reduced purchasing power.
2. Interest rates. If interest returns in a particular country are higher relative to
other countries, individuals and companies will be enticed to invest in that
country. As a result, there will be an increased demand for the country's
currency.
3. Balance of payments. Balance of payments is used to refer to a system of
accounts that catalogs the flow of goods between the residents of two countries.
For instance, if Philippines is a net exporter of goods and therefore has a surplus
balance of trade, countries purchasing the goods must use the country's
currency. This increases the demand for the currency and its relative value.
Based on the image provided, here is the transcription of Page 146:

4. Government intervention. Through intervention (e.g., buying or selling the currency in the
foreign exchange markets), the central bank of a country may support or depress the value of its
currency.
5. Other factors. Other factors that may affect exchange rates are political and economic
stability, extended stock market rallies and significant declines in the demand for major exports.
HOW IS FOREIGN EXCHANGE TRADED
You cannot go to a centralized location to watch exchange rates being determined; currencies are
not traded on exchanges such as the New York Stock Exchange. Instead, the foreign exchange
market is organized as an over-the-counter market in which several hundred dealers (mostly
banks) stand ready to buy and sell deposits denominated in foreign currencies. Because these
dealers are in constant telephone and computer contact, the market [is] competitive; in effect it
functions no differently from a centralized market.
An important point to note is that while banks, companies, and governments talk about buying
and selling currencies in foreign exchange markets, they do not take a fistful of dollar bills and
sell them for British pound notes. Rather, most trades involve the buying and selling of bank
deposits denominated in different currencies. So when we say that a bank is buying dollars in the
foreign exchange market, what we actually mean is that the bank is buying deposits denominated
in dollars.
INTERACTION IN FOREIGN CURRENCY MARKETS
Exchange Rate Determination
Equilibrium exchange rate in floating markets are determined by the supply of and
demand for the currencies.

The diagram shows the interaction between the Supply (S) and Demand (D) for a currency.
The intersection of these two curves establishes the Equilibrium Price (Pe). As noted in the
text accompanying the original image, at this price level, there is no surplus or deficit of the
currency in the market.

Fixed Exchange Rate

An exchange rate set too high (in foreign currency units per peso) tends to create a deficit
Philippine balance of payments. This deficit must be financed by drawing down foreign reserves
or by borrowing from the central banks of the foreign countries. This effect is short-term because
at some time, the country will deplete its foreign reserves. A major reason for a country’s
devaluation is to improve its balance of payments. As an alternative to drawing down its
reserves, a country might change its trade policies or implement exchange controls or exchange
rationing. Many developing countries use currency exchange rationing to avoid a deficit balance
of payments.
An exchange rate set too low (in foreign currency units per peso) tends to create a surplus
Philippine balance of payments. In this case, surplus reserves build up. At some time, the country
will not want any greater reserve balances and will have to raise the value of its currency."
1. The Axes
 Vertical Axis (Y): Price ($P$)
This represents the Exchange Rate, expressed as foreign currency units per
Peso.
o PA: A price level set above the market equilibrium (Overvalued Peso).
o PE: The market equilibrium price where supply meets demand.
o PB: A price level set below the market equilibrium (Undervalued Peso).
 Horizontal Axis (X): Quantity (Q)
This represents the Quantity of Pesos being traded in the foreign exchange
market.
2. The Curves
 Demand Curve (D):
This downward-sloping curve represents the foreign demand for Pesos.
o Foreigners who want to buy Philippine exports or invest in the Philippines.
o As the Peso becomes cheaper (moves down the Y-axis), Philippine goods
become cheaper for foreigners, so they demand more Pesos to buy those
goods.
 Supply Curve (S):
This upward-sloping curve represents the domestic supply of Pesos.
o Filipinos (Philippine interests) who want to buy foreign imports or invest
abroad. To do this, they must "sell" or supply Pesos to get foreign
currency.
o As the Peso becomes stronger (moves up the Y-axis), foreign imports
become cheaper for Filipinos, so they supply more Pesos to buy those
imports.
3. Market Scenarios
At Pe (Equilibrium)
 Intersection: The point where the Supply curve (S) and Demand curve (D)
cross.
 Result: The quantity of pesos supplied equals the quantity demanded. There is
no trade deficit or surplus; the balance of payments is stable.
At PA (Price Set Too High)
 Situation: The exchange rate is fixed at a high level (e.g., the government
artificially keeps the Peso strong).
 Gap: Look at the horizontal distance between the curves at this level. The
Supply (S) is far to the right, while Demand (D) is to the left.
 Mechanism:
o Because the Peso is strong, imports are cheap, so Filipinos supply many
Pesos to buy foreign goods (S is high).
o Because the Peso is expensive, Philippine exports are costly for
foreigners, so they demand fewer Pesos (D is low).
 Result: Surplus of Pesos / Trade Deficit.
o The country is importing more than it is exporting. To maintain this rate,
the central bank must often intervene by selling foreign reserves to buy up
the excess Pesos.
At PB (Price Set Too Low)
 Situation: The exchange rate is fixed at a low level (e.g., the government
artificially keeps the Peso weak).
 Gap: The Demand (D) is far to the right, while Supply (S) is to the left.
 Mechanism:
o Because the Peso is cheap, Philippine exports are very attractive, so
foreigners demand many Pesos (D is high).
o Because the Peso is weak, imports are expensive, so Filipinos buy less
and supply fewer Pesos (S is low).

 Result: Shortage of Pesos / Trade Surplus.

o The country is exporting more than it is importing. This leads to an
accumulation of foreign reserves. The central bank would typically have to
issue more Pesos to meet the high demand.
Managed Float
A managed float is the current method of exchange rate determination. During periods
of extreme fluctuation in the value of a nation's currency, intervention by governments or
central banks may occur to maintain fairly stable exchange rates.
Floating rates permit adjustments to eliminate balance of payments deficits or
surpluses. For example, if the Philippines has a deficit in its trade with Japan, the
Philippine peso will depreciate relative to Japan’s currency. This adjustment should
decrease imports from and increase exports to Japan.

Theory of Purchasing Power Parity (PPP)

💰 Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is one of the major international parity conditions used to explain
or predict long-run exchange rates.
PPP holds that the prices of the same goods in different countries should be equal when
measured in terms of the same currency. The underlying concept is that, ideally, a product
should cost the same in every country, assuming a world with no shipping costs, trade barriers,
or restrictions.
The theory relies on the concept of arbitrage, which is the process of getting risk-free profits by
simultaneously buying and selling assets (or goods) at different prices. If the same product costs
significantly less in Country A than in Country B, traders would buy the product in Country A
and sell it in Country B until the price difference disappears, which would, in turn, adjust the
exchange rate.
PPP Formula
The PPP theory states that the exchange rate between two currencies should be equal to the ratio
of the two countries' price levels.
The relationship can be expressed by the following formula:

PPP Example: The Law of One Price

PPP is best understood through the "Law of One Price" applied to exchange rates.
The Purchasing Power Parity theory suggests that the price of the shoes in the Philippines, when
converted to US dollars, should equal the price of the shoes in the United States.
Variable Home Country (Philippines) Foreign Country (US)
Price of Shoes (P) PPh = ₱5,000 PUS= $100
Current Spot Rate ₱50/$1 ₱50/$1
(S_{current})

Goal: Determine the PPP Exchange Rate (SPPP) that makes the prices equal.
The PPP formula is: S = Ph/Pf
1. Calculate the PPP Exchange Rate (SPPP):
SPPP = PPh / PUS = ₱5,000 / $1
In this specific example, the current spot rate (₱50/$1) happens to equal the PPP exchange rate
(₱50/$1). This means the Peso is currently correctly valued according to the PPP theory for this
specific item.
What if the Spot Rate was Different?
Now, let's look at what would happen if the actual spot rate deviated from the PPP rate, which is
the scenario that drives arbitrage:
 Current
Scenario Spot Rate Implication for the Peso Arbitrage Action
()
The Peso is stronger than Traders would buy shoes in the US
A: Peso is ₱40/$1 PPP suggests (It takes ($100) and sell them in the Philippines
Overvalued fewer Pesos to buy one (₱5,000). The ₱5,000 is only 5000/40=
dollar). $125. The profit is $25.
The Peso is weaker than Traders would buy shoes in the
B: Peso is ₱60/$1 PPP suggests (It takes Philippines (₱5,000) and sell them in
Undervalued more Pesos to buy one the US ($100). The ₱5,000 costs
dollar). 5000/60 = 83.33. The profit is $16.67.
In both scenarios, the arbitrage activity would eventually increase the demand for the cheaper
currency and increase the supply of the more expensive currency, pushing the spot rate back
toward the ₱50/$1 PPP rate.
I'd be happy to transcribe Page 149, focusing on the section about Foreign Currency
Exchange Rate Transactions.

📝 Transcription: Page 149 - Foreign Currency

Exchange Rate Transactions
WHAT ARE THE FOREIGN CURRENCY EXCHANGE RATE TRANSACTIONS?
The two kinds of Foreign Exchange Rate Transactions are:
A. Spot Transactions
B. Forward Transactions
Spot Transactions
Spot transactions are those which involve immediate (two-day) exchange of bank
deposits. The spot exchange rate is the exchange rate for the spot transactions.
Forward Transactions
Forward transactions involve the exchange of bank deposits at some specified
future date. The forward exchange rate is the exchange rate for the forward
transaction.
In major financial newspaper (e.g., Wall Street Journal), two exchange rates for most
major currencies are published — the spot rate and the forward rate.
SPOT EXCHANGE RATES
If we are exchanging one currency for another immediately, we participate in a spot
transaction. A typical spot transaction may involve a Philippine firm buying foreign
currency from its bank and paying for it in Philippine pesos (or an American firm buying
currency from its bank and paying for it in US dollar).
The price of the foreign currency in terms of the domestic currency is the exchange rate
— in this instance, the Philippine peso. Another case of a spot transaction is when a
Philippine firm receives foreign currency from abroad. The firm would typically sell the
foreign currency to its bank for Philippine peso. These are both spot transactions, where
one currency is exchanged for another currency immediately. The actual exchange rate
quotes are expressed in several ways, as explained below.
The spot rate for a currency is the exchange rate at which the currency is traded for
immediate delivery. For example, if you walk into a local commercial bank and ask for
US dollars, the banker will indicate the rate at which the US dollar is selling, say ₱52.60
per US$1. If you like the rate, you buy what you need and walk out the door. This is a
spot market transaction at the retail level.

DIRECT AND INDIRECT QUOTES

In the spot exchange market, the quoted exchange rate is typically called a direct
quote. A direct quote indicates the number of units of the home currency required to
buy one unit of the foreign currency. Figure 9-1 shows the spot rates required to buy
one US dollar on August 27, 2019, and the direct exchange quotes to the
Philippine Daily Inquirer on August 27, 2019.

The table above shows that in order to buy one US dollar on August 27,
2019, ₱52.326 were needed. In order to buy one Japanese yen and one UK pound on
the same date, ₱.4931 and ₱63.9424 were needed, respectively. The quotes in the spot
market in New York are given in terms of US dollars and those in European Union in
terms of Euros.

An indirect quote indicates the number of units of foreign currency that can be bought
for one unit of the home currency. In summary, a direct quote is the peso / foreign
currency rate, and an indirect quote is the foreign currency / peso rate. Therefore, an
indirect quote is the reciprocal of a direct quote and vice versa.

(Source: Bangko Sentral ng Pilipinas Official Website ([Link]

ILLUSTRATIVE CASE
Compute the indirect quotes from the Philippine direct quotes of spot rates for US
dollars, UK pound, EU euros, and Japanese yen as of August 27, 2019 given in Figure
9-1. The related indirect quotes are computed as follows:

Currency Direct Quote Calculation (1 / Direct Indirect Quote

(₱/FC) Quote) (FC/₱1)
US Dollars ₱52.3260 $1 / 52.3260 .01911 (dollar/₱1)
UK ₱63.9424 $1 / 63.9424 .01564 (pound/₱1)
Pounds
EU euros ₱58.1028 $1 / 58.1028 .01721 (euro/₱1)
Japan Yen ₱0.4931 $1 / 0.4931 2.028 (yen/₱1)

The direct and indirect quotes are useful in computing foreign currency requirements.
Consider the following examples:
(a) A Filipino businessman wanted to remit 1,000 UK pounds to London on
August 27, 2019. How much in pesos would have been required for this
transaction?

P63.9424/pound x 1000 pounds = P63,942.40

(b) A Filipino businessman paid ₱112,148.20 to an Italian supplier on August 27,

2019. How many euros did the Italian supplier receive?

P112,148.20 x 0.1721 = 1,930.07 euros

CROSS RATES
Also important in understanding the spot-rate mechanism is the cross rate. A cross rate
is the indirect computation of the exchange rate of one currency from the
exchange rates of two other currencies.

For instance:

The peso/pound and the euro/peso rates are given in Figure 9-1. From this information,
we could determine the euro/pound and pound/euro exchange rates.

We see that:

₱63.9424 = £1

₱58.1028 = €1

₱63.9424 / ₱58.1028} = 1.1005 euro per 1 pound}

Thus, the pound/euro exchange rate is:

₱58.1028 / ₱63.9424} = .90867 pound per 1 euro

Cross rate computations make it possible to use quotations in New York to cross rate
exchange rates between pounds, euros, and so forth in other foreign exchange
markets. If the rate, say, pound per euro, quoted in London and Paris are different from
the computed cross rate, using quotes from New York, a trader could use three different
markets and make arbitrage profit. The arbitrage condition for the cross rate is
called triangular arbitrage.

ARBITRAGE

The foreign exchange quotes in two different countries must be in line with each other.
For example, the direct quote for US dollars to London is given in dollar/pound. Since
the foreign exchange markets are efficient, the direct quotes to the United States dollar
in London, on April 25, 2019, must be very close to the indirect rate of the US dollar per
pound prevailing in New York on that date.

If the exchange-rate quotations between the London and New York spot exchange
markets were out of line, then an enterprising trader could make a profit by buying in the
market where the currency was cheaper and selling it in the market where it was dearer.
Such a buy-and-sell strategy would involve an investment of funds for a very short time
and is not risky. The trader could make a sure profit. Such a person is called
an arbitrageur, and the process of buying and selling in more than one market to make
a riskless profit is called arbitrage. Spot exchange markets are efficient in the sense
that arbitrage opportunities do not last for any length of time. Thus, the exchange rates
between two different markets are quickly brought in line, or leveled, by the arbitrage
process.

Some people intentionally look for exchange rate mispricing by comparing direct quote
exchange rates between two currencies with cross rates determined though a third
currency. If direct quotes and cross rate differ, arbitrage - a form of buying low and
selling high is possible.

Because three exchange rates are necessary to profit from a mispricing, this process is
sometimes called triangular arbitrage and as previously mentioned, the person doing it
is called an arbitrageur.

FORWARD RATES
The forward rate for a currency is the exchange rate at which the currency for future
delivery is quoted. The trading of currencies for future delivery is called a forward
market transaction.
Suppose Sta. Lucia Corporation expects to pay US$1.0 million to a US supplier 30 days
from now. It is not certain, however, what these dollars will be worth in Philippine pesos
30 days from today. To eliminate this uncertainty, Sta. Lucia Corporation calls a bank
and offers to buy US$1.0 million to a US supplier 30 days from now. In their negotiation,
the two parties may agree on an exchange rate of ₱46 million to the bank and receives
$1 million.
The forward exchange rate could be slightly different from the spot rate prevailing at that
time. Since the forward rate deals with a future time, the expectations regarding the
future value of that currency are reflected in that forward rate. Forward rates may be
greater than the current spot rate (premium) or less than the current spot rate
(discount).
The discount or premium is usually expressed as an annualized percentage deviation
from the spot rate.
Normally, the forward premium or discount is between 0.1 percent and 5 percent. The
spot and forward transactions are said to occur in the over-the-counter market. Foreign
currency dealers (usually large commercial banks) and their customers (importers,
exporters, investors, multinational firms and so forth) negotiate the exchange rate, the
length of the forward contract and the commission in a mutually agreeable fashion.
Although the length of a typical forward contract may generally vary between one month
and six months, contracts for longer maturities are not common. The dealers, however,
may require higher returns for longer contracts.

FACTORS AFFECTING EXCHANGE RATES IN THE LONG RUN

The analysis indicates that relative price levels and additional factors affect the
exchange rate in the long run. These are four major factors: relative price levels, tariff
and quota, preferences for domestic versus foreign goods, and productivity.
 Relative Price Levels: If the country's price level (relative to the foreign price
level) causes its currency to depreciate and a fall in the country's relative price
causes its currency to appreciate.
 Trade Barriers: Increasing trade barriers causes a country's currency to
appreciate in the long run.
 Preference for Domestic Versus Foreign Goods: Increased demand for a
country's exports causes its currency to appreciate in the long run; conversely,
increased demand for imports causes the domestic currency to depreciate.
 Productivity: In the long run, as a country becomes more productive relative to
other countries, its currency appreciates.

EXCHANGE RATES IN THE SHORT RUN

The key to understanding the short-run determination of exchange rates is to recognize

that an exchange rate is the price of domestic bank deposits (those denominated in the
domestic currency) in terms of foreign bank deposits (those denominated in the foreign
currency). Because the exchange rate is the price of one asset in terms of another, the
natural way to investigate the short-run determination of exchange rates is through an
asset market approach that relies heavily on our analysis of the determinants of assets
demand.

Earlier approaches to exchange rate determination emphasized the role of import and
export demand. The more modern asset market approach used here does not
emphasize the flows of purchases of exports and imports over short periods because
these transactions are quite small relative to the amount of domestic and foreign bank
deposits at any given time. Thus, over short periods such as a year,
decisions to hold domestic or foreign assets play a much greater role in
exchange rate determination than the demand for exports and imports does.

MANAGING FOREIGN EXCHANGE RISK

Foreign exchange risk refers to the possibility of a drop in revenue or an
increase in cost in an international transaction due to a change in foreign
exchange rates. Importers, exporters, investors and multinational firms are
all exposed to this foreign exchange risk.
When the parties associated with a commercial transaction are located in the
same country, the transaction is denominated in a single currency.
International transactions inevitably involve more than one currency
(because the parties are residents of different countries). Since most foreign
currency values fluctuate from time to time, the monetary value of an
international transaction measured in either the seller's currency or the
buyer's currency is likely to change when payment is delayed. As a result,
the seller may receive less revenue than expected or the buyer may have to
pay more than the expected amount for the merchandise.
International business transactions are denominated in foreign currencies.
The rate at which one currency unit is converted into another is called the
exchange rate. In today's global monetary system, the exchange rates of
major currencies are fluctuating rather freely. These "freely" floating
exchange rates expose multinational business firms to foreign exchange risk.
To deal with this foreign currency exposure effectively, the financial manager
must understand foreign exchange rates and how they are determined.
Foreign exchange rates are influenced by differences in inflation
rates among countries, differences in interest rates, government
policies and the expectations of the participants in the foreign
exchange markets.

AVOIDANCE OF EXCHANGE RATE RISK IN FOREIGN CURRENCY

MARKETS
The international financial manager can reduce the firm's foreign currency
exposure by hedging in the forward exchange markets, money
markets and currency future markets.
1. The firm may hedge its risk by purchasing or selling forward
exchange contracts. A firm may buy or sell forward contracts to
cover liabilities or receivables, respectively, denominated in a foreign
currency. Any gain or loss on the foreign payables or receivables
because of changes in exchange rates is offset by the loss or gain on
the forward contract.
2. The firm may choose to minimize the receivables and liabilities
denominated in foreign currencies.
3. Maintaining a monetary balance between receivables and
payables denominated in a particular foreign currency avoids a
net receivable or net liability position in that currency.
Monetary items are those with fixed cash flows. A firm may attempt to
achieve a net monetary debtor (creditor) position in countries
with currencies expected to depreciate (appreciate). Large
multinational corporations have established multinational netting
centers as special departments to attempt to achieve balance between
foreign receivables and payables. They also enter into foreign
currency futures contracts when necessary to achieve balance.
4. Another means of managing exchange rate risk is by the use of
trigger pricing. Under trigger pricing, foreign funds are supplied at an
indexed price but with an option to convert to a future-based
fixed price when a specified basis differential exists between the two
prices.
5. A firm may seek to minimize its exchange-rate risk by diversification.
If it has transactions in both strong and weak currencies, the effects of
changes in rates may be offsetting.
6. A speculative forward contract does not hedge any exposure to
foreign currency fluctuations, it creates the exposure.