FOREIGN EXCHANGE MARKETS
AND EXCHANGE RATE SYSTEMS
Objectives
By
the end of this, you should be able to:
- To distinguish between nominal, effective, and real exchange rates.
- To explain the operation of the foreign exchange market.
- To outline the purchasing power parity theory of exchange rates.
- To compare and contrast different types of exchange rate system.
THE FOREIGN EXCHANGE MARKET
The
objectives of this topic are:-
(a)
Define and discuss the functions of
the foreign exchange markets.
(b)
To know how exchange rates are
quoted.
(c)
To understand the meanings of the
terms direct and indirect quotations, sport and forward rates, bid and offered
rates and cross rates.
(d)
To know the provisions of the
liberalized exchange rate management system.
Introduction
The
foreign exchange market is the organizational framework within individuals,
firms and banks to buy and sell foreign currencies or foreign exchange. The foreign exchange market for many currency
say the dollar, is composed of all locations, such as London, Zurich, Paris, as
well as New York, where dollars are bought and sold for other currencies. By far the principal function of the foreign
exchange market is the transfer of funds or purchasing power from one nation is
currency to another. Other functions are
to provide short-term credits to finance trade and other facilities for
avoiding foreign exchange risks or hedging.
Financial
markets all over the world have become active as never before. This is especially in the light of changes
that have occurred in the economic environment over the past few years. Technological developments in the field of
communication have made foreign exchange markets very active and
sensitive. As such fluctuations in
exchange rates are noticeable. The yen has emerged as a strong currency
while the dollar has seen many ups and downs.
Fluctuations
in exchange rates have made speculation rampant in the forex markets. Market players have been able to make
substantial profits through foreign exchange transactions. The globalisation process has led to establishment
of new centres all around the world.
With good communication facilities the markets are operational 24-hours
a day at all days of the year.
The
volume of foreign exchange traded has increased steadily and has even outshone
some of the busiest stock markets of the world.
With more nations changing their, economic policies, more foreign
exchange markets are likely to be created and more currencies are likely to be
traded.
Foreign Exchange Markets:-
Foreign
exchange markets have shot into prominence as a natural response to the growing
volume of international trade. These
markets facilitate the conversion of one currency to another for various
purposes like trade, payment for services, developmental projects, speculation
etc. Since the number of participants in
the markets have increased over the years, they have become highly competitive
and efficient. Estimates put the total
volume of trade done in a day to nearly over a trillion.
Besides
conversion of currencies, the foreign exchange markets provide services like
extension of credit and holding facilities.
Conversion of Currencies
The
primary function of a foreign exchange markets is to facilitate the conversion
of one currency to another. When trade
crosses national boundaries, payments become difficult. This because different countries have
different currencies. It is natural that
the person making an export would prefer to get the payments in his home currency
or may be stronger currency like the dollar.
In the absence of professional money converters it would be difficult
for importers to make payments for their imports in the currency of the
exporter’s choice. In such cases the
free flow of trade between countries becomes difficult. With the improvement in trade between countries,
there was a pressing need to have some mechanism to facilitate easy conversion
of currencies. This has been made
possible by the foreign exchange markets.
We also know that exchange rates are subject to wide
fluctuations. There is therefore, a constant
risk associated with exchange rates which cannot be avoided in the natural
course of business. Foreign exchange
markets cover the risk arising out of the fluctuations in exchange rates
through “Hedging”.
Constituents of the Foreign
Exchange markets:-
The
foreign exchange market is made up of the following:
The Market:-
The
foreign exchange market has no physical structure. This is because there is no common place
where people assemble to buy or sell currencies. Most of these transactions are done “over the
counter” (OTC).
It
simply means that transactions are executed via the telephone, telegraph or
cable. Electronic devices help to link
traders in different countries. More
specifically, trading is done through international branch banking and through
correspondent banking.
Since
the foreign exchange market is spread over the whole of the world, there is no
fixed trading time. Trading is done 24
hours a day at all days of the year. By
and large London, New York, Singapore and Tokyo are the largest foreign
exchange trading centres.
The Market Makers/Participants
Basically
the foreign exchange market markers/participants are the central banks and
major multinational commercial banks.
Recently several investment banking houses have started participating in
the foreign exchange markets.
Broadly
there are four distinctive categories of persons operating in the foreign
exchange markets:-
a)
Banks which are engaged in the
conversion of currencies on behalf of their customers.
b)
Non-banking establishments engaged
in exchanging currencies for specific purpose of hedging.
c)
Speculators who are engaged in
buying and selling currencies to take advantage of exchange rate fluctuations
(most of the activity in the foreign exchange market falls within the purview
of this category) and
d)
Arbitragers engaged in arbitrage
activities to take advantage of price differentials in different foreign
exchange markets.
Quotations:-
Banks
usually make two way quotations; one for purchase and the other for the sale of
the currency. Most of the currencies
have quotations against the US dollar.
Operations of Market Makers
Banks
operate at two levels. In the first i.e.
the retail level the banks deal with individuals and corporations. The transactions for purchase and sale of
currencies are between the banks and its customers. In the second level the transactions are
wholesale in nature.
The bank enters into purchase and sale
transaction amongst themselves in the interbank market. Most operations are done directly to
banks. However, at times the service of
foreign exchange brokers is taken.
Communication
Most
foreign exchange dealers have well established computer network capable of
handling several transactions at a time.
They enable effective communication that is vital for efficient and
profitable for trading.
Such networks facilitate not only conversion
of currencies but also speculation.
Sophisticated communication systems have enabled several active dealers
to make huge profits by taking appropriate dealing positions at the right time.
Transfer of funds:-
The
payment to complete a transaction is done through interbank clearing
systems. Most banks have international
correspondent relationships through which payments are settled. With the growing importance of banking. Most major banks have international branches
in major trading centres. Thus payment
is made easy.
Paper
based systems have become redundant considering the volume of forex
traded. Consequently electronic or
automated interbank fund transfer systems like the clearing House Interbank
payment system (CHIPS) and Clearing House Automated Payment System (CHAPS) have
come into existence.
Speed
is the prime importance in foreign exchange transactions. The society for Worldwide International
Financial Telecommunication (SWIFT) was established with the purpose of
providing a medium for swift and efficient transmission of information to
facilitate the clearing process and payment transfers.
THE FOREIGN EXCHANGE RATES:
The
foreign exchange rate is the domestic currency price of the foreign
currency. This exchange rate is kept the
same in all parts of the market by arbitrage. Foreign exchange arbitrage refers
to the purchasing of a foreign currency where its price is low and selling it
where the price is high. Arise in the
exchange rate refers to a depreciation or reduction in the value of the
domestic currency in relation to the foreign currency. Since a nation’s currency can depreciate
against some currencies and appreciate against others, an effective exchange
rate is usually calculated.
This is a weighted average of the nation’s
exchange rates. For example the exchange
rate between the dollar (the domestic currency) and the pound refers to the
number of dollars required to purchase one pound, or $/E.
If this rate is $1.99 in London and $2.01 in
New York, foreign exchange arbitrageurs will purchase pounds in London and
resell them in New York, making a profit of 2ct on each pound. As this occurs, the price of pounds in terms
of dollars rises in London and falls in New York until they are equal, say of
2.00, in both places. Then the
possibility of earning a profit disappears and arbitrage comes to an end. If through time, the exchange rate (R) rises
from $2.00 to $2.10 (in both New York and London), we say that the dollar has
depreciated with respect to the pound because we now need more dollars to
purchase each pound. On the other hand,
when R falls, the dollar appreciates. This
is equivalent to a depreciation of the pound.
Determination of Exchange Rates:-
Flexible
exchange rates are determined by demand and supply. The demand and supply curves for a currency
can be constructed from the country’s exports and imports respectively. The demand and supply situations, for
currencies do not necessarily take the same form as the demand and supply in
other markets.
The
demand curve for a currency always slopes downward. This is because when there is a fall in value
of a home currency with or without a corresponding increase in export price
expressed in terms of home currency there is an increase in quantity of
exports. Hence there is a consequent
increase in value of exports.
The
supply curve of a currency may slope downward or upward. The supply curve slopes downwards when demand
for imports are inelastic. When a
currency’s value decreases imports becomes costlier in terms of the home
currency, considering that the percentage reduction in quantity of imports is
not as much as the percentage increases in prices of imports.
The Equilibrium Foreign Exchange
Rate;
Therefore
the demand for any currency is derived from the demand of goods, services and
assets it exports to other countries. If
it exports more, its currency will have a high demand.
 |
R = $/f -
-
1.20
-
Sf
o -
2.0
-
-
1.90
-
1.80
-
Df
 |
0 1 2 3 4 5 6 7 8 9
Billion f/year
Exports
per year
Another
important demand for currency is the need for foreign governments to maintain
foreign exchange reserves, a form of official savings. These reserves are used to pay for official
transactions and intervene in foreign exchange markets to support the exchange
rate for their own currencies under a fixed or managed floating exchange rate
system natural that the value of imports increases. In such cases we have a downward sloping
supply curve for the currency. When the
demand for imports is elastic, we have an upward sloping supply curve. In such cases, the quantity of imports
increases by greater percentage as compared to the decline in price of imports.
Generally,
we study the effects of prices on the supply and demand of goods in the
market. The analogy is stretched in case
of currencies too, wherein the effects of exchange rate on the values of
exports and imports are used to construct the demand and supply curves.
Demand of Currency:
When
a country exports a commodity, a demand for the country’s currency is
created. This is because those countries
that have made purchases of the commodity require the exporting country’s
currency for making payments.
These
reserves normally consist of major foreign currencies used in international
trade and financial transactions.
Reserve currencies are often referred as “hard currencies” because they
are easily convertible into other currencies and relatively stable over time. They include US & Japanese yen, DM and
Sterling.
Whatever
the sources of demand for any currency, the basic law of demand will
apply. Other things being equal, the
higher the price of a currency, the lower will be the quantity demanded of that
currency and vice versa. Thus there is
an inverse relationship between the price and the quantity demanded of a
currency, this means the demand curve for currency is downward-sloping from
left to right, that is a negatively sloped curve when it is plotted against the
price of another currency.
The
demand for any currency will be generally determined by:-
a)
Its exchange rates
b)
The price of goods and services in
the country it represents,
c)
The prices of competing goods and
services produced by other countries.
d)
The income of consumers and in the
case of portfolio investment, relative interest rates and investors’
expectations about future developments, political reasons.
The Supply of a Currency:
The
sources of supply of a given currency are exactly the opposite of the demand
for another currency. Whenever a foreign
currency is demanded, domestic currency must be offered to pay for it.
The
supply of any currency will be generally be determined by the same factors as
those determining the demand for any currency.
Exchange Rate Systems:
An exchange rate system reflects the nature of the exchange rate
policy a country adopts in determining its currency’s exchange rate. At one extreme, the policy may allow market
forces to operate freely in determining exchange rates or at the other extreme,
the policy may be to intervene actively in foreign exchange markets to maintain
the exchange rate at a particular, desired level.
1.
Flexible
exchange rate systems:-
Under a flexible exchange rate system, the monetary authorities of a
country, represented by its central bank, allow market forces to determine the
exchange rate of their currency. In
other words the currency is allowed to float in order to find its own rate in
freely competitive foreign exchange market.
The alternative name for this system is floating exchange rate
system. The monetary authorities do not
intervene at all in order to influence the conditions of supply and demand.
2.
Fixed
exchange rate systems:-
Under
a fixed exchange rate system, the exchange rate can only fluctuate within
specified bands around an official par value.
In this case it is the responsibility of the country’s central bank to
beg the exchange rate to prevent unwanted and undesirable deviations from its
par value by intervening in the foreign exchange market.
3.
Managed
Exchange rate Systems:-
Managed exchange rate system is a compromise system attempting to
combine the best of the two extreme systems explained above and, at the same
time, avoiding their disadvantages. It
is basically a floating exchange rate system under which the central bank
intervenes in the foreign exchange market in anticipation of unwanted or
undesirable changes in the exchange rate.
If the country’s currency is weakening in the foreign exchange markets,
the central bank attempts to support the currency by buying the currency
(selling foreign currencies). If the
currency is strengthening, then the central bank sells the domestic currency
(buys foreign currencies). Thus the
central bank manages the supply of the domestic currency in such a way as to
stabilize the government’s overall economic policy.
HEDGING:-
Since
foreign exchange rates usually fluctuate through time, anyone who has to make
or receive a payment in a foreign currency at a future dates runs the risk of
having to pay more or receiving less in terms of domestic currency than
originally anticipated. These foreign
exchanging risks can be avoided or “covered” by hedging. This usually involves an arrangement day to buy or sell a certain amount of
foreign exchange at some future date (usually three months hence) at a rate
agreed upon today ( forward exchange rate).
For example, suppose that a U.S. firm owes f 1,000 to a British exporter
payable in three months. At today’s
exchange rate of sport rate of f2,00 = f1.00 the U.S. firm owes an equivalent of $2,100 or $200
more. But if the three-month forward
rate were $2.01 the U.S. could buy today f1000 at $2.01 per pound for delivery
in three months and avoid any further foreign exchange risk.
After
the three months, when the payment is due, the U.S. firm would get the f 1,000
it needs for $2,010, regardless of what the sport rate is at that time. Similarly, if a U.S. exporter is to receive
f1,000 in three months, he or she can sell this f 1,000 for delivery in three
months at today'’ three months forward rate, and avoid the risk that sport rate
in three months will be very much below today'’ spot rate.
SPECULATION
Speculation
is the opposite of hedging. While a
hedger seeks to avoid or cover a foreign exchange risk for fear of a loss, the
speculator accepts or even seeks foreign exchange risk or an open position in
the hope of making a profit. If the
speculator correctly predicts the market he or she makes a profit. Otherwise, the speculator incurs a loss.
Speculation
usually occurs in the forward exchange market.
For example, if the forward rate on pounds for delivery in three months
is f2.00 and a speculator believes that the spot rate of the pound in three
months will be f 2.10, he can enter today a forward contract to buy f 100 in
three months at $2.00 per pound. After
three months, he will pay $2,000 for Fl,000, and if at that time the spot rate
on the pound is indeed $2.10 (as he anticipated), he can resell the f1,000 in
the spot market from $2,100 and earn $100 on the transactions. If on the other hand, his expectations prove
to be wrong and the spot rate of the pound after three months is instead $1.95,
he will have to pay $2,00 for f 1,000 that he receives on the matured forward
transaction, but he can only resell this f1,000 for $ 1,950 in the spot
markets, thus losing $ 50 on the transactions.
INTER BANK DEAL:
Interbank deals are purchases and sales of foreign exchange between
banks. A cover deal is one where the
bank purchases or sells foreign exchange it requires or gets an account of its
dealings with customers. Cover deals
protect the bank from losses that might accrue as a result of adverse
fluctuations in foreign exchange rates.
When a bank enters into a similar transaction solely with the intention
of making gains on account of exchange rate fluctuations it is called trading.
Cover Deals:-
The
assumption is that the bank buys foreign exchange at the interbank selling
rate, so as to replenish whatever it has sold to a customer. Similarly in case of a purchase from a
customer the same is sole in the interbank market at the market buying rate.
The base rate for all cover deals is the interbank rate to which a margin is
added or deducted as the case may be.
The resulting rate is the quotation to the customer.
The Liberalized Exchange Rate
Management System:-
In
early 1990’s Kenya resorted to liberalization of its economy. Now it no longer regulates the exchange rate
of its currency. It adopted a
liberalized exchange rate management system (LERMS) came into existence. Many countries have made their currencies
fully convertible on the current account.
When a country adopts fully convertible on current account the following
rules will apply.
1.
Foreign exchange earned can be
exchanged at the market rate through authorized dealers.
2.
The market rate will be intimated
by the foreign exchange Dealers Association of Kenya on all working days. The central Bank of Kenya does not announce
the exchange rate of the rupee.
3.
Importers will have to acquire
foreign exchange at market determined rates.
4.
Payments against invisible account
transactions have to be made out of funds acquired at the foreign exchange
market rates.
5.
Recipients of foreign exchange can
retain 15% of receipts in hard currency account , the rest has to be
surrendered immediately. The retained
amount could be used for making payments for commissions to overseas agents and
meeting promotional expenditure.
6.
Receipts and payments on capital
account will be controlled.
7.
The central Bank of Kenya can
intervene to stabilize the market.
8.
Except for few items which are
banned, restricted or canalized, the rest come under the purview of the open
general license.
9.
Authorized dealers can release
foreign exchange for business medical treatment abroad.
10. Recipients
of foreign exchange can open Exchange Earners Foreign Currency (EEFC) accounts
in Kenya with most banks.
11. The
central Bank of Kenya can accept deposits of foreign currencies from authorized
dealers
12. Foreign
exchange with receipts duly surrendered can be retained by authorized dealers.
13. All
authorized dealers have to maintain a square or near square position in foreign
exchange
14. Recipients
of foreign exchange can also retain up to 15% of the receipts in Exchange
Earners’ Foreign Currency Account (EEFC).
The Purchasing power parity theory
of Exchange rates
The
traditional explanation of exchange rates is the theory of purchasing power
parity (PPP). It seeks to answer the
basic question, how much is a currency worth and determines, it’s worth? This is the sort of question a Kenyan going
abroad for holidays would be asking about the Kenyan shilling.
Theoretically, the PPP equalizes the
purchasing power of different currencies to their exchange rates. In reality however, the purchasing power of
different currencies is based on estimates of exchange rates which are used to
equate the prices of typical basket of goods and services in selected
countries. For example, the question
“how much is one pound sterling worth? could be answered by taking, say f100
and converting it at a PPP exchange rate into say, DM to buy the same basket of
goods and services in Germany. The
result would enable to compare living standards between the UK and Germany. This exercise would be repeated for a given number
of countries to obtain an international comparison of the PPP of each pound
sterling using a given amount of income.
Suppose the example above indicates the prices of some goods are
lower in Germany than in the UK. It
would be profitable for UK importers to import these goods from Germany where
they are cheaper and sell them in UK where they are relatively dearer
(disregarding transportation costs. This
practice known as “goods arbitrage”, brings about an equalization of prices in
both the UK and Germany and the result is “one price” with respect to each
other commodity in the basket. Once this
price equalization is complete, goods arbitrage will cease, as it would be
pointless to engage in importing goods whose prices are the same in both
countries.
The factors that influence exchange
rates:-
To cover all factors influencing exchange rates in detail would
require a separate study materials on economics. Instead I will look at the main influences to
give you a broad overview.
Fundamental issues:-
1. Balance of payments:- Generally a surplus leads to a stronger
currency, while a deficit weakens a currency.
2. Economic growth rate:- high growth leads to rise in imports and a
fall in the currency
3. Fiscal policy:-
an expansionary policy, e.g. lower taxes, can lead to higher economic growth
rate.
4. Monetary policy:-
the way a central bank attempts to influence and control interest rates and
money supply.
5. Interest rates:-
high interest rates tend to attract overseas capitals thus the currency
appreciates in the short term. In the
long term, however, high interest rates slow the economy down, thus weakening
the currency.
6. Political issues:- political stability is likely to lead to
economic stability, and hence a steady currency, while political instability
would have the opposite effect.
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