This slides provides a detailed prespective of FOREX Markets.

1. Presentation on WasimYousuf, MIB 3rd Sem., Bangalore City College.

2. What is FOREX? The FOREX is the world’s biggest financial market. The FOREX or “FOReignEXchange” is the planets biggest most liquid financial marketplace hands down. “Foreign exchange” refers to money denominated in the currency of another nation or group of nations. Any person who exchanges money denominated in his own nation’s currency for money denominated in another nation’s currency acquires foreign exchange.

3. What is FOREX? (Contd.) Foreign exchange can be cash, funds available on credit cards and debit cards, traveler’s checks, bank deposits, or other short-term claims. It is still “foreign exchange” if it is a short-term negotiable financial claim denominated in a currency other than the U.S. dollar.” – Sam Cross – The Federal Reserve Bank The Foreign Exchange is made up of anyone who exchanges the currency of one country for that of another. The FOriegnEXchange does not have a centralized exchange like the stock market in New York or the commodities markets with centralized exchanges in cities like New York and Chicago.

4. Why do fluctuations occur in FOREX? There are many reasons but the most influential are: General condition of a country’s economy and economic influences like interest rates and inflation. Political Factors Trade Balance Purchase Power Parity Social Factors Government and central bank policies and policy changes

9. Nominal Vs. Real Exchange Rates Nominal Exchange Rates are value of one currency in terms of another. They do not, however, measure purchasing power, or Real Exchange Rate. Example: Suppose you can exchange $1 for 1818 Italian lira (L). Though L1818 seems a large number, but in Rome a hamburger may cost L4500. In other words, purchasing power of lira is very less as compared to that of dollar.

10. Nominal Vs. Real Exchange Rates (Contd.) Let a McDonald burger cost $2.56 in N.Y, U.S. and L4500 in Rome, Italy. $1 buys L1818 on foreign-exchange markets. We can find real exchange rate by comparing the cost of burgers in dollar terms. Let EX = nominal exchange rate in foreign currency per dollar. Pf = foreign currency price of goods in foreign country. P = domestic-currency price of domestic goods. EXr = real exchange rate.

11. Nominal Vs. Real Exchange Rates (Contd.) EXr = 1.03 Italian Thus, $2.56 will buy 1 McDonald burger in U.S. but 1.03 McDonald burger in Italy.

12. Nominal Vs. Real Exchange Rates (Contd.) Countries produce many different goods. Real Exchange Rate computed from price indexes, which compare price of basket of goods in one country with price of it in another. The relationship between nominal and real exchange rates depends on rates of inflation in two countries. We can calculate % change in real exchange rate as % change in numerator of previous equation minus the % change in denominator.

13. Nominal Vs. Real Exchange Rates (Contd.) The equation shows % change in nominal exchange rate has two parts: % change in real exchange rate. difference in foreign and domestic inflation rate. If exchange rate rises: rise in real exchange rate. or higher foreign inflation rate, or maybe both. If exchange rate falls: fall in real exchange rate. or higher domestic inflation rate, or maybe both.

14. Nominal Vs. Real Exchange Rates (Contd.) Suppose Peynolds and Barker are companies in two countries whose currencies are crown and royal. Peynolds makes ball pens sold at 2 crown each. Barker makes high-quality ink pens sold at 10 royals each. Real exchange rate between Peynolds and Barker pens is 10 ball pens per ink pen. What is the nominal Exchange rate?

16. International currencies are traded in foreign-exchange-markets around the world.

17. Market forces determine the exchange rate that prevails for consumers and investors.

18. Exchange rates affect the cost of acquiring foreign financial assets or foreign goods and services.

22. Investors sign a contract for a given quantity of currency and exchange rate.

24. Productivity differences.

25. Preference for domestic or foreign goods.

27. In such case where U.K. experiences higher inflation rate, pound is less useful as store of value than dollar.

28. All else being equal, relative increase in price levels lead to depreciation of domestic currency.

29. Example:

31. Higher productivity leads to cheaper production of domestic goods than foreign goods.

32. Hence domestic goods can be supplied at lower prices than foreign goods, leading to higher demand.

33. This higher demand for domestic goods leads to higher demand for domestic currency.

34. Thus higher productivity leads to appreciation of domestic currency.

35. Example:

37. Determining Long Run Exchange Rates: Trade Barriers Countries do not always allow goods to be traded freely with no market intervention. Example of trade barriers are quotas and tariffs. They increase demand for domestic currency, leading to higher exchange rates in the long run for the country imposing these barriers. Example: Suppose U.S. imposes tariff on U.K. leather goods, this will lead to higher price of the U.K. leather goods than U.S. made leather goods. There will be higher demand for domestic U.S. made leather goods leading to higher dollar demand.

39. Profit opportunities should ensure that its price is same.

40. Lets start with an example:

41. Suppose a yard of cloth produced by manufacturers in U.S. sells for $10

42. Same type of cloth produced by British manufacturers in U.K. sells for 5 pounds.

43. Law of one price says that exchange rate should be 5 pound per 10 dollar or 0.5 pound/dollar.

45. Law of One Price and The Purchasing Power Parity theory If current exchange rate is 0.75 pound /dollar. Then U.K. cloth will be cheaper as compared to the U.S. cloth. Consumers would demand dollars for purchasing U.K. cloth. This will lead to depreciation of dollar till exchange rate reaches 0.50 pound/dollar.

47. The Purchasing Power Parity (PPP) theory is based on the assumption that real exchange rates are fixed.

48. Thus it means that differences in the inflation rate in the two countries causes changes in nominal exchange rate between two countries.

51. You have choice between U.S. Treasury bill or a Japanese government bond.

52. U.S. instrument pays you interest and principal in dollars with nominal interest rate of 5% per year.

53. Japanese instrument pays you interest and principal in yen and carries nominal interest rate of 5% per year.

54. You should invest in one which will give you higher return.

56. Expected Returns on Domestic and Foreign Assets Suppose current nominal exchange rate is 100 yen/dollar. You expect the exchange rate will rise by 5% in the next year, thus the expected future nominal exchange rate EXe will be 100*1.05 = 105 yen/dollar. Now when you convert $1000 into yen you have an investment of 100000 yen. After receiving and interest rate of 5%, your investment is worth 105000 yen after a year. At that time expected exchange rate EXe is 105 yen/dollar.

57. Expected Returns on Domestic and Foreign Assets Thus the expected value of your investment in dollar terms will be 105000 yen/105 = $1000. !!! Hence even though Japanese bond pays you the same stated interest rate as the U.S. Treasury bill, but it carries a lower expected return: $0 instead of $50.

58. Expected Returns on Domestic and Foreign Assets

59. Expected Returns on Domestic and Foreign Assets

60. Expected Returns on Domestic and Foreign Assets

61. Interest Rate Parity Nominal Interest Rate Parity Condition: When domestic and foreign assets have identical risks, liquidity and information characteristics, their nominal returns (measured in same currency) must be identical. Thus any difference between the nominal interest rates on U.S. assets and Japanese assets reflect currency appreciation and depreciation. This condition states: i = if - ∆EXe/EX When domestic interest rate is higher than the foreign interest rate, the domestic currency depreciates.

62. THANK YOU! wasimyousuf