Pamra Ahmad BBFE-17-25 Foreign Currency Exchange THE EXCHANGE RATE IS DEFINED AS "THE RATE AT WHICH ONE COUNTRY'S CURRENCY MAY BE CONVERTED INTO ANOTHER." Introduction: Foreign exchange rates are an important way of measuring a country’s economic health, and a great way to assess the suitability of an economy for business expansion. This is why the exchange rate markets are so closely watched. But what influences movements in exchange rates? And more, what makes them ‘volatile’? That word gets thrown around a lot in the foreign exchange space, but what does it mean? Exchange rate volatility refers to the tendency for foreign currency to appreciate or depreciate in value and ultimately affects the profitability of a trade (or transfer) overseas. Factors Influencing Exchange Rate: 1: Inflation rate 2: Interest rate 3: Government debt 4: Terms of trade 5: Balance of payment 6: Speculation Other factors ° political stability ° tourism ° competitiveness etc. 1 : Inflation rate Inflation rates impact a country’s currency value. A low inflation rate typically exhibits a rising currency value, as its purchasing power increases relative to other currencies. Conversely, those with higher inflation typically see depreciation in their currencies compared to that of their trading partners, and it’s also typically accompanied by higher interest rates. Government debt also plays a part in inflation rates. A country with government debt (public or national debt owned by the central government) is less likely to acquire foreign capital, leading to inflation. 2: Interest rate Exchange rates, interest rates and inflation rates are all interconnected. An increase in interest rates cause a country’s currency to appreciate, as lenders are provided with higher rates and thereby attracting more foreign capital. This can cause a rise in the value of a currency and therefore the exchange rate. Cutting interest rates, on the other hand, can lead to a depreciation of the currency. Higher interest rates cause an appreciation. Cutting interest rates tends to cause a depreciation 3: Government debt Under some circumstances, the value of government debt can influence the exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds causing a fall in the value of the exchange rate. For example, if markets feared the US would default on its debt, foreign investors would sell their holdings of US bonds. This would cause a fall in the value of the dollar. 4: Terms of trade Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of exchange rate. 5: balance of payment A deficit on the current account means that the value of imports (of goods and services) is greater than the value of exports. If this is financed by a surplus on the financial/capital account, then this is OK. But a country which struggles to attract enough capital inflows to finance a current account deficit will see a depreciation in the currency. 6: speculation If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well. Other factors like: Tourism Political uncertainty Market competiveness etc. All of these factors determine the foreign exchange rate fluctuations to avoid any potential falls in currency exchange rates, opt for a locked-in exchange rate service, which will guarantee that your currency is exchanged at the same rate despite any factors that influence an unfavorable fluctuation. Anas Tayyab BBFE-17-10 Forward Rate. A forward rate is an interest rate applicable to a financial transaction that will take place in the future. The term may also refer to the rate fixed for a future financial obligation, such as the interest rate on a loan payment. A forward rate arises due to the forward contract. The commitment between two parties leads to the successful execution of a forward contract and it has been split into two legs, the first commitment is to deliver, sell, or take a short position on the asset and on another leg, to take delivery, buy, or take a long position on the asset. Importance of forward rate: The forward rate allows investors, firms, and individuals to avoid the uncertainty associated with changes in financial market prices. For example, the forward exchange rate market provides a way for exporters and importers to protect themselves against exchange rate risk. Formula to calculate Forward Rate: Formula to calculate Forward Rate: S1 = Spot rate until a further future date, S2 = Spot rate until a closer future date, n1 = No. of years until a further future date, n2 = No. of years until a closer future data Example. Let us take the example of a company PQR Ltd, which has issued bonds recently to raise money for its upcoming project to be completed in the next two years. The bonds issued with one-year maturity have offered a 6.5% return on investment, while the bonds with two years maturity have offered a 7.5% return on investment. Based on the given data, calculate the one-year rate one year from now. Given, The spot rate for two years, S1 = 7.5% The spot rate for one year, S2 = 6.5% No. years for 2nd bonds, n1 = 2 years No. years for 1st bonds, n2 = 1 year Cont. As per the above-given data, we will calculate a oneyear rate from now of company POR ltd. Therefore, the calculation of the one-year forward rate one year from now will be, = [(1 + 7.5%)2 / (1 + 6.5%)1]1/(2-1) – 1 = 8.51% Use of Forward Rate: Normally, the forward rates are used by the investors, who believe that they have a good understanding of market trends from immediate past to current market scenario relative to prices of specific item changes with respect to time. Merely, it is the belief of the potential investors that the real future rates will be always higher or lower than the present stated market rate. It could be a signal for potential investors and crack the opportunity. Use of Forward Rate: If we try to identify the situation on the basis of economic indicator, we can analyze the spot rate and the forward rate changes with respect to time, where a spot rate is used by the buyers and the sellers, who believe in immediate buy and sale and act as a starting point to any financial transaction. While a forward rate is merely a market’s expectations for future prices. It serves as an economic indicator, how may the market expect to perform in the future. Can forward rates be negative? The forward points reflect interest rate differentials between two currencies. They can be positive or negative depending on which currency has the lower or higher interest rate. How do you lock forward rate? To do a forward rate lock, you will need to execute a simple contract known as a forward rate agreement (FRA). Any FRA is simply a commitment to engage in a future transaction at a price stated and agreed upon today. Huzafa Tahir BBFE-17-33 Currency Future Market Currency futures are a exchange-traded futures contract that specify the price in one currency at which another currency can be bought or sold at a future date. Currency futures can be used to hedge other trades or currency risks, or to speculate on price movements in currencies. Currency futures contracts are legally binding and counterparties that are still holding the contracts on the expiration date must deliver the currency amount at the specified price on the specified delivery date. Use of Currency future market? Currency futures are futures contracts for currencies that specify the price of exchanging one currency for another at a future date. The rate for currency futures contracts is derived from spot rates of the currency pair. Currency futures are used to hedge the risk of receiving payments in a foreign currency. Basics of Currency Futures The first currency futures contract was created at the Chicago Mercantile Exchange in 1972 and it is the largest market for currency futures in the world today. Currency futures contracts are marked-to-market daily. This means traders are responsible for having enough capital in their account to cover margins and losses which result after taking the position. Futures traders can exit their obligation to buy or sell the currency prior to the contract's delivery date. This is done by closing out the position. It is important that the price of currency futures are determined when the trade is initiated. Example Buying a Euro FX future on the US exchange at 1.20 means the buyer is agreeing to buy euros at $1.20 US. If they let the contract expire, they are responsible for buying 125,000 euros at $1.20 USD. Each Euro FX future on the Chicago Mercantile Exchange (CME) is 125,000 euros, which is why the buyer would need to buy this much. On the flip side, the seller of the contract would need to deliver the euros and would receive US dollars. The daily loss or gain on a futures contract is reflected in the trading account. It is the difference between the entry price and the current futures price, multiplied by the contract unit. Example If the price is 125000$ and the contract drops to 1.19 or rises to 1.21, for example, that would represent a gain or loss of $1,250 on one contract, depending on which side of the trade the investor is on. Gul Hassan Bhutta BBFE-17-50 Currency Option Market A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates. Importance of Currency Option Market? Currency options give investors the right, but not the obligation, to buy or sell a particular currency at a prespecific exchange rate before the option expires. Currency options allow traders to hedge currency risk or to speculate on currency moves. Currency options come in two main varieties, so-called vanilla options and over-the-counter SPOT options. Basics of Currency option market: Investors can hedge against foreign currency risk by purchasing a currency put or call. Currency options are derivatives based on underlying currency pairs. Trading currency options involves a wide variety of strategies available for use in forex markets. The strategy a trader may employ depends largely on the kind of option they choose and the broker or platform through which it is offered. Vanilla Options Basics There are two main types of options, calls and puts. Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ''writing'' an option. Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. SPOT Options An exotic option used to trade currencies include single payment options trading (SPOT) contracts. Spot options have a higher premium cost compared to traditional options, but they are easier to set and execute. A currency trader buys a SPOT option by inputting a desired scenario (e.g. "I think EUR/USD will have an exchange rate above 1.5205 15 days from now") and is quoted a premium. If the buyer purchases this option, the SPOT will automatically pay out if the scenario occurs. Factors affecting currency option market. 1. exchange rate fluctuations. 2. More MNC 3. More initial investors. 4. More shirt term investors. 5. Trading amount of the related currencies. Aiman Fatima BBFE-17-02 Article. An analysis of the asymmetric impact of exchange rate changes on G.D.P. in Pakistan: application of non-linear A.R.D.L. Analysis. Sr. No. 1) First author Ibrar Hussain 2) Year of Publication 2019 3) Independent variable Exchange rate fluctuations 4) Dependent Variables GDP (Economic growth) 5) Methodology To test for the asymmetric impact of exchange rate change on GDP growth, recently developed technique of Non-linear A.R.D.L. by Shin, Yu, and Greenwood-Nimmo (2014) , has been applied. 6) References Adil, F. (2018, April 9). Asymmetric monetary policy response. Published in Dawn, The Business and Finance Weekly. Retrieved from https://www.dawn.com/news/1400467. [Google Scholar] Agenor, P. R., & Montiel, P. (1996). Development macroeconomics. New Jersey: Princeton University Press. [Google Scholar] Objective of the Endeavour: The objective of this endeavour is two pronged: firstly to investigate the asymmetric effect of E.R. appreciation and depreciation and secondly to apply more flexible and dynamic model of Shin et al. (2014) to test for short- and long-run asymmetry Exchange rate change impact: In South Asia, Pakistani currency has remained more volatile as compared to their counterparts with the same level of development. The response of G.D.P. to E.R. stems from the Aggregate Demand (A.D.) and Aggregate Supply (A.S.) model. The impact of E.R. depreciation can be expansionary or contractionary depending on the responses of net exports. In case of Pakistan, devaluation negatively affects G.D.P. and revaluation impacts it positively in Pakistan. Finding of the study: Weak currency hurts G.D.P. growth, while strong currency adds to growth. To achieve the objective of sustained growth and the ultimate objective of sustainable development, exchange rate management should focus to restore stability and go for more strong currency. Usama Malik BBFE-17-29
