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International finance


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It BMS International Finance half theory part.

International finance

  1. 1. International Finance
  2. 2. Module No V(Balance of Payment) It is a systematic record of all economic transactions between the „residents of a given country and the residents of other countries-rest of the world-carried out in a specific period of time, usually a year.
  3. 3. Components of BOP Item/Year 2009-10 Credit Debit NetA. Current account1. Merchandise 182163 299491 -1173282. Invisibles (a+b+c) 161245 82328 78917a) Services 93791 59586 34205i) Travel 11859 9342 2517ii)Transportation 11147 11934 -787iii) Insurance 1600 1286 314iv) G.n.i.e. 440 526 -86v) Miscellaneous 68744 36499 32245of which: Software services 49705 1469 48236Business services 11645 18626 -6981Financial services 3736 4736 -1000Communication services 1229 1389 -160b) Transfers 54432 2318 52114i) Official 532 473 59ii) Private 53900 1845 52055c) Income 13021 20425 -7404i) Investment income 12107 18720 -6613ii) Compensation of employees 914 1705 -791Total Current account (1+2) 343408 381819 -38411
  4. 4. A) Current accountIt captures the effect of trade link between the economy and rest of the world.1) Merchandise Trade :It includes exports and Imports.2) InvisiblesGnie: Government not included elsewhere: It relates to receipt and payments on government account not included elsewhere as well as receipts and payment on account of maintenance of embassies and diplomatic missions and offices of international institutions such as UNO,WHO,etc.Credits includes allocation made for the embassy expenditure in India out of rupee proceeds of sales in India of US surplus agricultural commodities
  5. 5. A) Current account Transfers: It represent all receipts and payments without a quid pro quo. They include items like aid and grants received from /extended to foreign governments, migrants‟ transfer, repatriation of savings, remittances of family maintenance Contribution and donations to religious organizations and charitable institutions etc. Investment Income: Remittances, receipts, and payments on account of profits, dividends, interest and discounts including interest charges and commitment charges on foreign loans including those on purchase from the IMF
  6. 6. A) Current account Compensation of Employees: It covers wages, salaries and other benefits, in cash or in kind, and include those of border, seasonal and other nonresidents workers(e.g. local staff of embassies)
  7. 7. Item/Year 2009-10 Credit Debit NetB. Capital account1. Foreign investment (a+b) 198089 145964 52125a) Foreign direct investment (i+ii) 37920 18191 19729i) In India 37182 5500 31682Equity 27149 4242 22907Reinvested earnings 8080 0 8080Other Capital 1953 1258 695ii) Abroad 738 12691 -11953Equity 738 8057 -7319Reinvested earnings 0 1084 -1084Other capital 0 3550 -3550b) Portfolio investment 160169 127773 32396i) In India 159897 127521 32376of which: Flls 156570 127521 29049GDRs/ADRs 3328 0 3328ii) Abroad 272 252 202. Loans (a+b+c) 73204 60982 12222a) External assistance 4965 2917 2048i) By India 52 420 -368ii) To India 4913 2497 2416b) Commercial borrowings (MT & LT) 14674 12152 2522i) By India 974 1505 -531ii) To India 13700 10647 3053c) Short term to India 53565 45913 7652i) Suppliers Credit >180 days & Buyers Credit 48571 43914 4657ii) Suppliers credit up to 180 days 4994 1999 2995
  8. 8. Item/Year 2009-10 Credit Debit Net3. Banking capital (a+b) 61499 59415 2084a) Commercial Banks 60893 58966 1927i) Assets 17097 15259 1838ii) Liabilities 43796 43707 89of which: Non-resident deposits 41356 38432 2924b) Others 606 449 1574. Rupee debt service 0 97 -975. Other capital 11209 23941 -12732Total capital account (1 to 5) 344001 290399 53602C. Errors & omissions 0 1746 -1746D. Overall balance (A+B+C) 687407 673966 13441E. Monetary movements (i+ii) 0 13441 -13441i) I.M.F.ii) Foreign exchange reserves (Increase-/ 0 13441 -13441
  9. 9.  Banking capital: It is the changes in assets and liabilities of commercial banks, This includes government banks, private banks, co- operative banks. Assets are held by foreign branches of Indian banks. Liabilities are deposit balances held by foreign banks in India. So increase in asset is debit and increase in liabilities is credit. Decrease in asset is credit and decrease in liabilities is debit.
  10. 10.  Rupee Debt Service is the payment under rupee/rouble agreement with Russia.It is defined as the cost of meeting interest payments and regular contractual repayments of principal of a loan along with administration charges in rupees by India Errors and omissions: It indicates the value of discrepancies. Recording of transaction in the BOP statement is made according to the principle of double entry book system, certain discrepancies in estimating and timing may result in a situation where debits are not exactly equal to credits. Receipts are either overstated or
  11. 11. Monetary movements:a) India‟s transaction s with the IMFb) RBI‟s foreign currency reservesc) Drawings(essentially type of borrowing) from the IMF or drawing down of reserves credit items whereas repayments made to IMF or addition made to existing reserves are debit items.d) It measures the effect of transactions on current and capital account on the official reserves of the country
  12. 12.  IMF account: It contains purchase (credits) and re- purchases (debits) from IMF. SDR are a reserve account created by IMF and allocated from time to time to member countries. It can be used to settle international payments between monetary authorities of two different countries. An allocation is a credit and retirement is the debit. Foreign exchange reserves are in the form of balances with the foreign central banks and investment in foreign government securities.
  13. 13.  Changes in official reserves Official gold reserves (Monetary gold) Official foreign exchange holdings ( For e.g. Reserves) Reserve position in IMF and (IMF Quotas)
  14. 14. Overall Balance Balance on current accounti) Balance of Trade: Difference between value of exports and imports.ii) Balance of payment: Balance of trade + Invisibles. Balance on Capital account: It is the net inflows and outflows on capital transactions. It is more of private capital account becoz it excludes movement in official reserves.
  15. 15. BASIC BALANCE AND OVERALLBALANCE Basic Balance: This is the total of balance on current and long term items in capital account It is overall balance less short–term capital movements Overall balance: It is total of balance on current account and balance on capital account. It is also called as official settlements balance since it must be financed by official reserves or by other non-reserve transactions that are substituted for reserve transaction
  16. 16. Balance of payment always balances In accounting sense ,a BOP account always balances, because it is prepared on the principle of double entry of book-keeping. The total of the credit and debit entries must be equal to each other Balance in current A/C + Balance in capital A/C + Change in Movements = Zero The change in Monetary Movements reflects the overall BOP position.
  17. 17.  Increase in foreign exchange reserves indicates BOP Surplus Decrease in foreign exchange reserves indicates BOP deficit. No change indicates (Surplus/Deficit in Current A/C = Surplus/Deficit in Capital A/C)
  18. 18.  However , actual recording of entries can rarely be complete and accurate. Some transaction are bound to be left out (for e.g. illegal transactions like smuggling and havala do not appear in official records ) Some discrepancies is bound to persist in the totals of credit and debit entries. These discrepancies are more likely to arise in the short run, particularly because actual deals, shipment of goods, and the payments do not take place simultaneously. For this reason the balancing item E & O is inserted.
  19. 19. Concept of Autonomous andAccommodating Autonomous flows: This takes place in the ordinary course of foreign trade. These are “transaction above the line”. Accommodating flows (induced): These flows takes place to equalize the BOP. These are transactions above the line.
  20. 20. Credits Amt (Rs) Debits Amt (Rs)Current A/C Current A/CAutonomous 800 Autonomous 930Transactions TransactionsExport of 550 Imports of 500goods goodsExport of 150 Imports of 280services servicesUnrequited Unrequitedreceipts paymentsGifts 75 Gifts 20Indemnity 25 Remittances 60Capital A/C Capital A/CAccommodatin Accommodating transaction g transactionBorrowings 200 Loans 70
  21. 21. CAUSES OF DISEQUILIBRIUM IN BOP Change in foreign Demand: Inflationary or deflationary pressure: Inflation will increases the imports as the goods become relatively cheaper and vice-versa, making it favorable or unfavorable Development expenditure: Increase in cost structure of export sector: Higher wages, higher prices of raw materials, or higher rate of inflation.
  22. 22.  Decrease in supply: Agir.production falls due to the failure in monsoon, IND. Prod. Falls due to labour strike, shortage of raw materials. Appreciation of exchange rate: Increased debt Burden: Increase in capital inflows lead to debt servicing like interest. Demonstration Effect: Population Pressure: Political factors: political turmoil and instability majorly in African, Gulf countries, Afghanistan etc.
  23. 23. MEASURES TO CORRECT THEDISEQUILIBRIUM IN BOP Depreciation: Under flexible exchange rate ,changes in exchange rate will automatically adjust the BOP. Devaluation: It is used under the fixed exchange rate system, it means fall in the value of home currency. It is used to wipe out the deficit. If the elasticity is high then definitely the devaluation will work. Import control: By Imposing quotas and tariff.
  24. 24. MEASURES TO CORRECT THE DISEQUILIBRIUM IN BOP Export promotion: Reducing export duties , subsidies for exports, provision of market information, arranging exhibition, providing finance ,raw material at relatively less cost Exchange control: Buying and selling the foreign exchange through central Bank to restrict the foreign exchange. Production of Import substitutes: Monetary Policy: Tight monetary policy can be used to reduce expenditure to reduce deficit and vice-versa.
  25. 25. Foreign Exchange rate The foreign exchange rate is the rate at which the currency of a country is exchanged against the currency of another country.
  26. 26. Factors affecting Foreign Exchange Rates GDP: It is the primary indicator of the strength of the economic activity. The growth in GDP positively influences the foreign exchange prices of the currency and vice-versa. Trade Balance: A positive BOT (appreciation in the domestic currencies) and vice-versa. Inflation: It reduces the purchasing power of the currency which will lead to depreciation of the exchange rate. Employment levels: It reflect the development and stability in the economy. Increase in empt increases the consumption and savings which leads to increase in investment and leads to the appreciation of the domestic currency. Interest rate differential: Exchange rate policy: Political factors: These events may be anticipated or unforeseen. Some of the political developments are election, public announcements by central bank or government officials, military takeovers, political instability etc can affect the exchange rate. View of Speculators:
  27. 27. Concepts of Foreign exchangetransactions FIAT Currencies: Currency that a government has declared to be legal tender, despite the fact that it has no intrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. The term derives from the Latin fiat, meaning "let it be done" or "it shall be [money]", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.
  28. 28.  Foreign Currency: It is defined as, the legal tender applicable in a country outside the domestic area. Foreign Exchange means foreign currency and includes- Deposits, credits and balances payable in any foreign currency. Drafts, travellers cheque, letters of credit or bills of exchange expressed in Indian currency but payable in foreign currency and Drafts, travellers cheque, letters of credit or bills of exchange drawn by banks outside India but payable in Indian currency.
  29. 29.  Nostro Account – It is the overseas account which is held by the domestic bank in the foreign bank or with the own foreign branch of the bank. For example the account held by state bank of India with bank of America in New York is a Nostro account of the state bank of India. It is “our account with you”. Vostro Account – It is the account which is held by a foreign bank with a local bank, so if bank of America maintains an account with state bank of India it will be a vostro account for state bank of India. It is “your account with us” From the above one can see that the account which is Nostro for one bank is Vostro for another so when SBI opens a Nostro account with Bank of America, it is a Vostro account for them and vice versa.
  30. 30.  LORO Account: An account held by a domestic bank in itself on behalf of a foreign bank. The latter in turn would view this account as a Nostro account. A Loro is our account of their money, held by you. Loro account is a record of an account held by a second bank on behalf of a third party; i.e, my record of their account with you. In practice this is rarely used, the main exception being complex syndicated financing. Their account with them. Ex.: Just like State bank Of India maintaining an account with foreign correspondent say BTC, New York, Canara Bank may also maintain a Nostro Account with them. When SBI advises BTC New York for transfer of funds to Canara Bank Account with them, Canara Bank Account is titled as Loro Account "i.e. their account with you".
  31. 31.  Correspondent banks are used by domestic banks in order to service transactions originating in foreign countries, and act as a domestic banks agent abroad. This is done because the domestic bank may have limited access to foreign financial markets, and cannot service its client accounts without opening up a branch in another country. Maintaining the foreign currency a/c and receiving and making payments on behalf of the counterparty (principal) bank. Providing temporary overdrafts as and when necessary. Providing credit reports on companies located in the country of the correspondent bank. Assisting the principal bank in all agency functions such as presenting of documents, advising of LC , confirmation of LC etc.
  32. 32. Foreign Exchange Marketa) The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed .b) A foreign exchange transaction is an agreement between a buyer and seller that a fixed amount of one currency will be delivered for some other currency at a specified rate.c) Foreign exchange means the money of a foreign
  33. 33. FUNCTIONS Transfer function: It helps the transfer the purchasing power between the countries. It utilizes the instrument like bills of exchange, bank drafts, telegraphic transfers, etc. Credit functions: normally with maturity of 12 months. Hedging function: It is undertaken to avoid a risk with a change in exchange rate.
  34. 34. FUNCTIONS Speculating function: It is function which speculator undertakes and it is risky. Arbitrage function: It refers to the process by which an individual purchases foreign exchange in a low price market for a sale in a high price market for the purpose of making profit. It is the riskless profit.
  35. 35. FOREIGN EXCHANGE DEALERS Market Participants: Investment Bankers deals in inter bank Market. Commercial Bank: These are major players in the market who buy and sell the currencies. Exchange Brokers: This facilitates deals between the banks. Central Bank Investment Management Firms: An investment management firm with an international portfolio buys and sells the currencies
  36. 36. FOREIGN EXCHANGE DEALERS Hedge Funds Commercial companies: Often trades in the small amount Traders and Investors Money Changers: Are authorized by the RBIRestricted Money changers can only buy while others can buy as well as sell the currencies. for e.g. some hotels, firms have given the licenses by the RBI. Retail clients
  37. 37. Gold Standard This is the oldest system. This was in operation till first world war. It is based on value of gold There are three kinds of gold standard that have been adopted since 1700. The Gold specie Gold Exchange Gold bullion Standard
  38. 38. Gold Specie In this system actual gold coins or coins with content of gold were in circulation The unit of currency is linked with the gold coins Gold along with silver coins were also in use There were fix conversion ratio such as 5 silver coins = 1 gold coins Gold were used for trading of goods of services. Value of gold coin is same as the gold contents. Gold should be freely exported and imported. The supply of gold determine the liquidity and consequently its value. Some used only gold for conversion
  39. 39. Bimetallism: Before 1875 A “double standard” in the sense that both gold and silver were used as money. Some countries were on the gold standard, some on the silver standard, some on both. Both gold and silver were used as international means of payment and the exchange rates among currencies were determined by either their gold or silver contents. Gresham’s Law implied that it would be the least valuable metal that would tend to circulate. 2-39
  40. 40. Gold Specie Eastern roman empire made use of gold coin called Byzant. US dollar was minted as gold and silver coin till 1862 and continued along with paper notes till 1933. The four main basic unit was the cent, the dime, and an eagle Dime is 10 cents, a dollar is 10 dime, and an eagle is 10 dollars. The international gold standard was established by Britain in 1821, using the Gold Sovereign as their unit. By 1871 Germany established
  41. 41. Gold Specie The net trade imbalance between two countries would get settled through transfer of gold reserves. This would result in reduced in money supply and commodity prices in the deficit country and increased money supply and inflation in the surplus country. This would make commodities more attractive in the deficit country leading to a reversal in the trade imbalance and help to achieve equilibrium of trade. This in-built mechanism for balancing trade in the Gold Standard was called „Price Specie
  42. 42.  Gold Points was a term which referred to the rates of foreign exchange likely to cause movements of gold between countries adhering to the gold standard. Application In accordance with the law of supply and demand, the concept determined that the fluctuating limits of currency fixed the cost of money between the place where the bill was drawn and that in where it was payable. In the exchanges rates between gold- standard countries, these limits were known as the gold points, for the reason that, if the price of foreign bills rose above the upper limits determined by the exchange rate, countries would find it cheaper to export gold than to export bills for the purpose of settling international accounts. Conversely, if the exchange rate fell below the lower limit of the determined rate, countries would find it cheaper to import gold than to sell bills to foreign creditors.
  43. 43. Gold bullion Standard Gold Bullion Standard The reconstructed fixed exchange rate regime differed from the pre-war standard into two aspects. Gold coin no longer circulated as a currency and the inter- convertability of bank notes with gold coins were substituted by much more heavier minimum weight of gold bars. In gold Bullion standard, monetary authorities hold stock of Gold. Currency in circulation is a paper currency note. (or silver coin or low value metal coin). On these paper notes there is written promise that if you demand , on submission of this note, they would give you specified quantity of gold. Hence the paper currency is pegged with the gold and is unconditionally converted in to gold, on demand. The gold per note was fixed by the issuing authority (gold to bullion ratio).
  44. 44.  The USA introduced Gold Bullion paper currency notes in 1862 and they existed along with actual gold eagle coin dollars. Dollar coin or note was equivalent to 1.50 g (23.22 grains) of gold.
  45. 45. Mechanism of Exchange of Two currencies(Mint par of Exchange or Par value System) The mechanism of establishing exchange rates between currencies under the gold Standard was the Mint Par of Exchange. The exchange rate between two currencies was represented by the ratio of the official gold prices for the two currencies. Example If 1 ounce of gold in USA = USD 400 And 1 ounce of gold in Germany = DEM 600 „then 1 USD = = DEM 1.5000 Exchange rate established in this manner were called CENTRAL EXCHANGE RATES‟ or “MINT PARITIES. It is basically gold that was getting exchange, either actually or through promises. Hence in bullion standard, if one currency is worth
  46. 46.  In Gold exchange standard system, currency is exchanged for another currency at a specified ratio, as promised by the monetary authority. Another currency with which it is pegged is called as reserve currency. Reserve currency (Dollar and Pound) were in turn, convertible to real gold as these were in glld bullion standard.
  47. 47. The gold exchange standard (1870-1914) Towards the end of the 19th century, some of the remaining silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the USA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of 1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against the pound sterling with the silver Straits dollar being fixed at 2s 4d. At the turn of the century, the Philippines pegged the silver Peso/dollar to the US dollar at 50 cents. A similar pegging at 50 cents occurred at around the same time with the silver Peso of Mexico and the silver Yen of Japan. When Siam adopted a gold exchange standard in 1908, this left only China and Hong Kong on the silver standard.
  48. 48. Classical Gold Standard:1875-1914 Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.
  49. 49. Classical Gold Standard:1875-1914 There are shortcomings:  The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves.  Even if the world returned to a gold standard, any national government could abandon the standard.
  50. 50. Advantages Long-term price stability has been described as the great virtue of the gold standard. Under the gold standard, high levels of inflation are rare, and hyperinflation is impossible as the money supply can only grow at the rate that the gold supply increases. Economy-wide price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare, as gold supply for monetary use is limited by the available gold that can be minted into coin. High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available. In the U.S. one of those periods of warfare was the Civil War, which destroyed the economy of the South, while the California Gold Rush made large amounts of gold available for minting.
  51. 51.  The gold standard limits the power of governments to inflate prices through excessive issuance of paper currency. It provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade. Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the "price specie flow mechanism.“ The gold standard makes chronic deficit spending by governments more difficult, as it prevents governments from inflating away the real value of their debts. A central bank cannot be an unlimited buyer of last resort of government debt. A central bank could not create unlimited quantities of money at will, as there is
  52. 52. Disadvantages Deflation rewards savers and punishes debtors. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. Lenders become wealthier, but may choose to save some of their additional wealth rather than spending it all. The overall amount of expenditure is therefore likely to fall. Deflation also prevents a central bank of its ability to stimulate spending. However in practice it has always been possible for governments to control deflation by leaving the gold standard or by artificial expenditure. The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons. Assuming a gold price of US$1,000 per ounce, or $32,500 per kilogram, the total value of all the gold ever mined would be around $4.5 trillion. This is less than the value of circulating money in the U.S. alone, where more than $8.3 trillion is in circulation or in deposit (M2). Therefore, a return to the gold standard, if also combined with a mandated end to fractional reserve banking, would result in a significant increase in the current value of gold, which may limit its use in current applications. For example, instead of using the ratio of $1,000 per ounce, the ratio can be defined as $2,000 per ounce effectively raising the value of gold to $9 trillion. However, this is specifically a disadvantage of return to
  53. 53.  Many economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns. Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession. Such reason is often employed to partially blame the gold standard for the Great Depression, citing that the Federal Reserve couldnt expand credit enough to offset the deflationary forces at work in the market. Opponents of this viewpoint have argued that gold stocks were available to the Federal Reserve for credit expansion in the early 1930s, but Fed operatives failed to utilize them. Monetary policy would essentially be determined by the rate of gold production. Fluctuations in the amount of gold that is mined could cause inflation if there is an increase, or deflation if there is a decrease. Some hold the view that this contributed to the severity and length of the Great Depression as the gold standard forced the central banks to keep monetary policy too tight, creating deflation.[29][38] Milton Friedman however argued that the main cause of the severity of the Great Depression in the United States was the Federal Reserve, and not the gold standard, as they willfully kept monetary policy tighter than was required by the gold standard.
  54. 54.  Although the gold standard gives long-term price stability, it does in the short term bring high price volatility. In the United States from 1879 to 1913, the coefficient of variation of the annual change in price levels was 17.0, whereas from 1943 to 1990 it was only 0.88. It has been argued by among others Anna Schwartz that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt. Some have contended that the gold standard may be susceptible to speculative attacks when a governments financial position appears weak, although others contend that this very threat discourages governments engaging in risky policy (see Moral Hazard). For example, some believe the United States was forced to raise its interest rates in the middle of the Great Depression to defend the credibility of its currency after unusually easy credit policies in the 1920s. This disadvantage however is shared by all fixed exchange rate regimes and not just limited to gold money. All fixed currencies that appear weak are subject to speculative attack. If a country wanted to devalue its currency, it would generally produce sharper changes than the smooth declines seen in fiat currencies, depending on the method of devaluation.
  55. 55. SPOT AND FORWARD EXCHANGE RATE Spot Rate: it is the single outright transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value of delivery within two business days.For e.g. If AD quotes Rs 43.46-48/US$ This is the two way quotes of the spot rate. Trade date: The day the deal is struck Value date or settlement date: the day the exchange of currencies takes place is the value date.
  56. 56. THREE DIFFERENT SETTLEMENTMATURITIES  Ready Transactions or a cash transaction: Exchange of currency takes on the day itself.  Value TOM: Exchange of currency takes on the next business day.  Spot Transaction: Exchange of currency takes on the second business day.
  57. 57. BID and ASK Quotation Interbank quotations are given as a bid and ask (also referred to as offer). A bid is the price (i.e., exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i.e., exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices.
  58. 58. BID and ASK Quotation Bid and ask quotations in the foreign exchange markets are superficially complicated by the fact that the bid for one currency is also the offer for the opposite currency. A trader seeking to buy dollars with Swiss francs is simultaneously offering to sell Swiss francs for dollars. Assume a bank makes the quotations for the Japanese yen. The spot quotations on the first line indicate that the bank‟s foreign exchange trader will buy dollars (i.e., sell Japanese yen) at the bid price of ¥118.27 per dollar. The trader will sell dollars (i.e., buy Japanese
  59. 59. Direct quote and Indirect quote A direct quote is a home currency price of a unit of foreign currency. An example, using Mexico and the United States (home country) is: $0.1050/Peso. An indirect quote is a foreign currency price of a unit of home currency. An example, using Japan and China (home country) is: ¥14.75/Rmb.
  60. 60. European terms and American terms Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar. For example, the exchange rate between U.S. dollars and Swiss franc is normally stated SF1.6000/$, read as “1.6000 Swiss francs per dollar.” This method, called European terms, expresses the rate as the foreign currency price of one U.S. dollar. An alternative method is called American terms. The same exchange rate above expressed in American terms is $0.6250/SF, read as “0.6250 dollars per Swiss franc.” Under American terms, foreign exchange rates are stated as the U.S. dollar price of one unit of foreign currency.
  61. 61.  Reciprocals. Convert the following indirect quotes to direct quotes and direct quotes to indirect quotes:a. Euro: €1.02/$ (indirect quote); 1/1.02 = $0.98/i (direct)b. Russia: Rub 30/$ (indirect quote); 1/30 = $0.0333/Rub (direct)c. Canada: $0.63/C$ (direct quote); 1/0.63 = C$1.5873/$ (indirect)d. Denmark: $0.1300/DKr (direct quote); 1/0.1300 = DKr7.6923/$ (indirect)
  62. 62. FORWARD TRANSACTION It is also known as forward outright rate. The forward is the transaction involving the exchange of two currencies at a rate agreed on the date of the contract for a value or delivery at the same time in future (more than two days).
  63. 63. FORWARD TRANSACTION Transaction shows the forwarda) Suppose the trade date is April 1b) Value date is calculated one month after the spot date (i.e. April ) ,therefore the value is may 3. If May 3 is holiday then May 4.
  64. 64. OUTLINE Defining Exchange Rate Measuring Exchange Rate Movements  Appreciation/Depreciation of a currency Exchange Rate Equilibrium Factors that influence Exchange Rate Movements
  65. 65. MEANING OF EXCHANGE RATE ANDMEASURING CHANGES IN EXCHANGERATES Value of one currency in units of another currency A decline in a currency‟s value is referred to as depreciation and an increase in currency‟s value is called appreciation. If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated
  66. 66. APPRECIATION/DEPRECIATION Percentage change in value US $ - Old value of rupees per $New Value of rupees per unit of $--------------------------------------------------------- X 100 Old value of rupees per $ Percentage change in value of Rupees - Old value of $ per unit of RupeesNew Value of $ per units of Rupees-------------------------------------------------------------- X 100 Old value of $ per unit of Rupees
  67. 67. EXCHANGE RATEEQUILIBRIUM Forces of Demand and Supply Demand for foreign currency negatively related to the price of foreign currency Supply of foreign currency positively related to the price of foreign currency Forces of demand and supply together determine the exchange rate
  68. 68. DEMAND FOR ($) Price in ($) Exchange rate Demand for ($) 50 100 40 200 30 300 20 400 10 500
  69. 69. DEMAND FOR ($) 60 50 40Price of ($) EXchange rate 30 20 10 0 0 100 200 300 400 500 600 Demand for ($)
  70. 70. SUPPLY OF ($) Price in ($) Exchange rate Supply of ($) 50 500 40 400 30 300 20 200 10 100
  71. 71. SUPPLY OF ($) Price in ($) Exchange rate 60 50 40Price in ($) 30 20 10 0 0 100 200 300 400 500 600 Supply of ($)
  72. 72. EQUILIBRIUM EXCHANGERATE Price in ($)Exchange rate Demand for ($) Supply of ($) 50 100 500 40 200 400 30 300 300 20 400 200 10 500 100
  73. 73. EQUILIBRIUM EXCHANGERATE D S Excess Supply $1=30 Excess S Demand D 300 Units of Foreign Currency($)