Foreign Exchange Markets
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Foreign Exchange Markets

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The ppt gives a description of how different theories define working of forex market. ?...

The ppt gives a description of how different theories define working of forex market. ?
when & where do these theories fail?
What is the impact of macro-economic factors like inflation, unemployment etc on forex exchange.?

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What are the different types of forex market?

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Foreign Exchange Markets Foreign Exchange Markets Presentation Transcript

  • FOREIGN EXCHANGE MARKET
    • The foreign exchange market is the "place" where currencies are traded.
    • Currencies need to be exchanged for conducting foreign trade and business.
    • Most liquid financial market in world.
    • No central marketplace for foreign exchange.
    • Currency trading conducted electronically over-the-counter (OTC).
    • Open 24 hours a day
  • TYPES OF MARKETS
  • EXCHANGE RATE REGIMES
  • Demand Supply Curve
  • Purchasing power parity
  • TERMINOLOGIES
  • The Law of One Price
    • A commodity will have the same price in terms of common currency in every country
      • In the absence of frictions (e.g. shipping costs, tariffs,..)
      • Example
        • Price of wheat in France (per bushel): P €
        • Price of wheat in U.S. (per bushel): P $
        • S €/$ = spot exchange rate
    P € = s €/$  P $
    • Example:
        • Price of wheat in France per bushel (p € ) = 3.45 €
        • Price of wheat in U.S. per bushel (p $ ) = $4.15
        • S €/$ = 0.83215 ( s $/€ = 1.2017)
    • Dollar equivalent price
    • of wheat in France = s $/€ x p €
        • = 1.2017 $/€ x 3.45 € = $4.15
    •  When law of one price does not hold, supply and demand forces help restore the equality
  • Absolute PPP
    • Extension of law of one price to a basket of goods
    • Absolute PPP examines price levels
      • Apply the law of one price to a basket of goods with price P € and P US (use upper-case P for the price of the basket):
      • where P € =  i (w FR, i  p €, i )
      • P US =  i (w US, i  p US, i )
    S €/$ = P € / P US
  • Absolute PPP
    • If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:
      • May 21 : s €/$ = P € / P US
      • = 1235.75 € / $1482.07 = 0.8338 €/$
      • May 24: s €/$ = 1235.75 € / $1485.01 = 0.83215 €/$
  • Relative PPP
    • Absolute PPP:
    • For PPP to hold in one year:
    • P € (1 + i € ) = E( s €/$ )  P $ (1 + i $ ),
    • or: P € (1 + i € ) = s €/$ [E( s €/$ )/ s €/$ )]  P $ (1 + i $ )
    • Relative PPP :
    • Main idea – The difference between (expected) inflation rates equals the (expected)
    • rate of change in exchange rates.
    P € = s €/$  P $ 1 + i € = E( s €/$ ) 1 + i $ s €/$
  • What is the evidence ?
    • The Law of One Price frequently does not hold.
    • Absolute PPP does not hold, at least in the short run.
      • See The Economist ’s Big McCurrencies
    • The data largely are consistent with Relative PPP, at least over longer periods.
  •  
  • Deviations from PPP
  • Interest rate parity
    • Main idea: There is no fundamental advantage to borrowing or lending in one currency over another
    • This establishes a relation between interest rates, spot exchange rates, and forward exchange rates
    FORWARD MARKET
  • Example of a forward market transaction
    • Suppose you will need 100,000 € in one year
    • Through a forward contract, you can commit to lock in the exchange rate
    • f $/€ : forward rate of exchange
      • Currently, f $/€ = 1.19854  1 € buys $1.19854
      •  1 $ buys 0.83435 €
    • At this forward rate, you need to provide $119,854 in 12 months.
  • Interest rate parity
    • (1 + r € )/ (1 + r $ ) = f €/$ / s €/$
    In the above figure, Point G indicates a situation of disequilibrium. Here, the interest differential is -3% while forward premium on home currency is only 2 %. The transfer of funds abroad with exchange risks covered will yield an additional 1% annually. At point H, the interest differential remains at -3% but forward premium increases to 4%. Now it becomes profitable to reverse the flow of funds. The 3% reduction in interest rates is more than made up for by the 4% gain on forward exchange transaction, leading to a 1% increase in the interest yield. This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates
  • Evidence on interest rate parity
    • Generally, it holds
    • Why would interest rate parity hold better than PPP?
  • The Fisher condition
    • Main idea: Market forces tend to allocate resources to their most productive uses
    • So all countries should have equal real rates of interest
    • Relation between real and nominal interest rates:
    • (1 + r Nominal ) = (1 + r Real )(1 + i )
    • (1 + r Real ) = (1 + r Nominal ) / (1 + i )
  • Example of capital market equilibriu m
    • Fisher condition in U.S. and France:
    • (1 + r $(Real) ) = (1 + r $ ) / (1 + i $ )
    • (1 + r €(Real) ) = (1 + r € ) / (1 + i € )
    • If real rates are equal, then the Fisher condition implies:
    • The difference in interest rates is equal to the expected difference in inflation rates
  • International Fisher Effect Expected change in home currency value of foreign currency(%) In the figure below, point E is a point of equilibrium because it lies on the parity line with 3% interest differential in favour of home country just offset by the anticipated 3% HC depreciation relative to foreign currency. Point F, however illustrates a situation of disequilibrium. If a 3% HC depreciation is anticipated but the interest differential is only 2% then funds would flow from home country to foreign country to take the advantage of the higher exchange adjusted return there. This capital out flow will continue until exchange adjusted returns are equal in both nations.
  • ECONOMIC FACTORS
  •  
  • NATURE OF FOREX MARKET
  • LIMITATIONS OF CURRENCY TRADING AS AN EXAMPLE OF A NEAR-PERFECTLY COMPETITIVE MARKET
  •   SHORT RUN EQUILIBRIUM FOR PERFECT COMPETITION
  • LONG-RUN EQUILIBRIUM
  • EFFECTS OF A CHANGE IN MARKET DEMAND
  •  
  •