Exchange RateThis is the rate at which the currency of onecountry would change hands with currency ofanother country.E.g. $1 = SLR 130Types of Exchange Rate1. Floating RateThis rate depends on a levels of theinternational trade of a country and it doesnot interfere with the government of thatcountry.
2. Fixed RateThis is the rate that the government of thecountry would set its own currency rate and itis not depending on the market rate.3. Dirty FloatThis is the rate that mixed between floatingrate and fixed rate system. This is where thegovernment would allow exchange rate tofloat between a particular two limits. If it goesoutside either of the limit, then thegovernment would take further action.
Forex Dealings1. Bid PriceThe price at which the currency is boughtby the dealer.2. Offer PriceThe price at which the currency is sold bythe dealer. When regarding the forex dealings,Offer Price > Bid Price
Example 01:David is a UK businessman. He needs $ 400,000to buy US equipment.Identify the amount of £ required to buy theDollars? ($/£ 1.75 - 1.77)Answer:The amount of £ required = $ 400,000$/£ 1.75= £ 228571.43
Example 02:James is a US businessman. He has just receiveda payment of £ 150,000 from his main customerin UK.Identify the amount of $ received by Jameswhen £ 150,000 are given? (£/$ 0.61 – 0.63)Answer:The amount of $ received = £ 150,000£/$ 0.63= $ 238095.24
Spot Rate and Forward RateSpot RateThis is the rate which is applicable for theimmediate delivery of currency as at now.Forward RateThis is a rate that set for the futuretransaction for a fixed amount of currency.The transaction would take place on thefuture date at this agreed rate by disregardingthe market rate.
Discounts & PremiumsDiscountsIf the forward rate which is quoted cheaper,then it is set to be quoted at a discount.E.g. $/£ current spot is 1.8500-1.8800 and theone month forward rate at 0.0008-0.0012 at adiscount.Answer:1.8500-1.8800+ 0.0008-0.0012= 1.8508-1.8812When quoted at a discount,their should be more Dollarsbeing received at a given Pound.So the discount factor have tobe added to the spot rate.
PremiumsIf the forward rate which is quoted moreexpensively, then it is set to be quoted at apremium.E.g. $/£ current spot is 1.9000-1.9300 and theone month forward rate at 0.0010-0.0007 at apremium.Answer:1.9000-1.9300- 0.0010-0.0007= 1.8990-1.9293When quoted at a premium,their should be less Dollars beingreceived at a given Pound becauseof the expensiveness of Dollars. Sothe premium factor have to bededucted from the spot rate.
Foreign Exchange Rate Risks1. Transaction RiskThis is the risk that adverse exchange ratemovement occurring in the cause of normalinternational trading transaction. This ariseswhen the prices of imports or exports arefixed in foreign currency terms and there is amovement in the exchange rate between thedate when the price is agreed and when thecash is paid or received.
2. Translation RiskThis is the risk that the organization willmade exchange losses when the accountingresults of its foreign branches or subsidiariestranslated into the local currency.3. Economic RiskThis is the risk that suppose to a effect ofexchange rate movements on theinternational competitiveness of thecompany.
4. Direct & Indirect Currency QuotesDirect Quote:This means the exchange rate is mentioned interms of the amount of domestic currencywhich needs to be given in returns for one unitof foreign currency.E.g. SLR 130 for $1Indirect Quote:This means the amount of foreign currencyunits that needs to be given to obtain one unitof domestic currency.E.g. $ 1/130 for SLR 1
Example 01ABC Ltd is a US company, buying goods fromSri Lanka which cost SLR 200,000. These goodsare resold in the US for $2000 at the time ofthe import purchased. The current spot rate is$1 = SLR 126-130.Calculate the expected profit of the resale interms of US Dollars using both direct & indirectquote methods.
Managing the Exchange Rate Risk1. Invoicing in domestic currencySince the exporter does not have to do anycurrency transaction in this method, the risk ofcurrency conversion is transferred to theimporter or vice versa.2. Money Market HedgingBecause of the close relationship betweenforward exchange rate and the interest rate intwo currencies, it is possible to calculate aforward rate by using the spot exchange rateand money market lending or borrowing whichis called as a money market hedge.
3. Entering into Forward Exchange Rate ContractsA person can enter into an agreement with abank to purchase the foreign currency on thefixed date at a fixed rate.4. Matching receipts & paymentsUnder this method a company can set off itspayments against its receipts in that particularcurrency.5. OptionsThese are similar to forward trade agreements,but the consumer can choose between thebank’s rate and the market rate.
Example 01A Sri Lankan company has to settle $800,000after three months time. The current spot rate is$1 = SLR 126-130. The foreign currency depositinginterest rate is 12%per annum and the borrowingrate in Sri Lanka is 8% per annum. The agreedexchange rate with the bank is $1 = SLR128.The company has identified to overcome theexchange rate under Money Market Hedging &Forward Exchange Rate Contract methods.Identify the cheapest method to overcome theexchange rate risk.
2.) Using Forward Exchange Rate Contract MethodTotal Cost (SLR) = $ 800,000*SLR128/$1= $102,400,000The best method is forward Exchange RateContract Method, because it gives the lowest totalcost when compare to Money Market HedgingMethod.
Reasons for Short Term Changes of Exchange Rate1. Investment FlowsIf a country does more investment to outsidecountries, then there would be a higherdemand for foreign currency. Therefore thedomestic will depreciated or vice versa.2. Trade FlowsIn a given time if a country has more importsand less exports, the domestic currency willdepreciated, because of the higher demand forthe foreign currency or vice versa.
3. Economic ProspectusIf a country has good economic policies andis showing shines of economic growth, itcould receive more investment andtherefore the domestic currency wouldappreciated.
Reasons for Long Term Changes of Exchange Rate1. Purchasing Power Parity TheoryThis theory describes how the differences ininflation rate among two countries would leadto changes in the exchange rates.Future Rate(A/B)=Spot Rate(A/B) * (1+ Inflation Rate of A)(1 +Inflation Rate of B)2. Interest Rate Parity TheoryThis theory links the future currency rates withdifferences in interest rate among twocountries.Future Rate(A/B)=Spot Rate(A/B) * (1+ Interest Rate of A)(1 +Interest Rate of B)
3. Monetarist TheoryThis theory identifies the relationship betweenexchange rate and the government moneysupply to an economy of one country.E.g. When the government released more moneyto their economy, individual would have moremoney. So they would purchased more, thedemand will increased & through that result inhigher prices & high inflation.This would lead to a high level of depreciationto the currency.
4. Keynesian ApproachThis theory says that an exchange rate may notchange in a balance and sometimes currencymay continuously appreciate or depreciatewithout reverse.E.g. There is a high taste & demand for importedproduct in one country while their exports arelosing its export position in other countries.Therefore, without any appreciation ofcurrency will continuously depreciate over along time period in that country.