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 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. 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 shortterm 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. An exchange rate A (PA foreign currency units per peso), a greater quantity of peso is supplied by Philippine interests than demanded by foreign interests (i.e., Philippine imports exceed exports). The result is a trade deficit. An exchange rate B, a smaller quantity of peso is supplied by Philippine interests than demanded by foreign interests (i.e., Philippine exports exceed imports). The result is a trade surplus. 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 Philippine 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 One of the most prominent theories of how exchange rates are determined is the theory of purchasing power parity (PPP). It states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. The theory of PPP is simply an application of the law of one price to national price levels. To illustrate, if the law of one price holds, a 10% rise in the yen price of Japanese steel results in a 10% appreciation of the dollar. Applying the law of one price to the price levels in the two countries produces the theory of purchasing power parity, which maintains that is the Japanese price level rises 10% relative to the U.S. price level, the dollar will appreciate by 10%. The theory of PPP suggests that if one country's price level rises relative to another's, its currency should depreciate (the other country's currency should appreciate). The PPP conclusion that exchange rates are determined solely by changes in relative price levels rests on the assumption that all goods are identical in both countries. When this assumption is true, the law of one price states that the relative prices of all these goods (that is, relative price level between the two countries) will determine the exchange rate. PPP theory furthermore does not take into account that many goods and services (whose prices are included in a measure of a country's price level) are not traded across borders. Housing, land, and services such as restaurant meals, haircuts, and golf lessons are not traded goods. So even though the prices of these items might rise and lead to a higher price level relative to another country's, there would be little direct effect on the exchange rate. WHAT AE THE FOREIGN CURRENCY EXCHANGE RATE TRANSACTIONS? The two kinds of Foreign Exchange Rate Transactions are: A. Spot Transactions B. Forward Transactions A. Spot transactions - Spot transactions are those which involve immediate (twoday) exchange of bank deposits. The spot exchange rate is the exchange rate for the spot transactions. B. 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 rate. 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 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, ask for US dollars. The banker will indicate the rate at which the US dollar is selling, say P52.60 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.
