This document discusses exchange rate determination and concepts related to foreign exchange markets. It begins with objectives to explain how exchange rates are measured and determined, factors that influence exchange rates, and cross exchange rate movements. It then defines key terms related to foreign exchange markets, such as exchange rates, spot and forward rates, currency conversion, and cross rates. Subsequent sections examine how exchange rates reach equilibrium, factors that influence exchange rates like inflation and interest rates, and how movements in bilateral exchange rates impact cross exchange rates.

1. 1Designed and Prepared By: Malik Muhammad Mehran

2. Exchange rate DeterminationExchange rate Determination
2Designed and Prepared By: Malik Muhammad Mehran

3. Irbaz Umer ButtIrbaz Umer Butt
Tanveer KashmiriTanveer Kashmiri
Malik Muhammad Mehran (GroupMalik Muhammad Mehran (Group
Leader)Leader)
Group Members:Group Members:
3Designed and Prepared By: Malik Muhammad Mehran

4. 4
Chapter Objectives
This chapter will:
A. Explain how exchange rate movements are measured
B. Explain how the equilibrium exchange rate is determined
C. Examine factors that determine the equilibrium
exchange rate
D. Explain the movement in cross exchange rates
Designed and Prepared By: Malik Muhammad Mehran

5. Malik Muhammad MehranMalik Muhammad Mehran
MS Business Administration Section “F”MS Business Administration Section “F”
NCBA&E Multan CampusNCBA&E Multan Campus
5
PresenterPresenter::
Designed and Prepared By: Malik Muhammad Mehran

6. IntroductionIntroduction
6Designed and Prepared By: Malik Muhammad Mehran

7. 7
Definition:
“The price of a nation’s currency in terms of
another currency.”
An exchange rate thus has two components, the domestic
currency and a foreign currency.
Exchange rateExchange rate
Designed and Prepared By: Malik Muhammad Mehran

8. 8
Structure of FOREX Market:
-OTC
-Exchange Traded Market
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

9. 9
Levels of FOREX Market:
-Tier 1: Transaction between Central Bank and other Banks
-Tier 2: Wholesale Market
-Tier 3: Retail Market
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

10. 10
Exchange Rate Systems:
-Fixed Exchange Rate
• Currency Pegging
-Floating Exchange Rate
• Clean Float
• Dirty Float
-Managed Exchange Rate
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

11. 11
 ‘FOREX Exposure’ Exchange rate sensitivity of the
value of the firm to expected changes in the exchange
rate.
• Transaction Exposure
• Economic Exposure
• Accounting Exposure
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

12. 12
 'Spot Rate’ The price quoted for immediate settlement
on a commodity, a security or a currency. The spot
rate, also called “spot price”,
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

13. 13
 “Forward Exchange rate” A rate applicable to a financial
transaction that will take place in the future. Forward
rates are based on the spot rate, adjusted for the cost of
carry and refer to the rate that will be used to deliver a
currency, bond or commodity at some future time.
 T+2 Settlements
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

14. 14
 An exchange rate has a base currency and a counter
currency.
Example:
$1 = £1.1050
In a direct quotation, the foreign currency is the base
currency and the domestic currency is the counter
currency. In an indirect quotation, the domestic
currency is the base currency and the foreign currency
is the counter currency.
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

15. 15
Currency Conversion:
$/£ -> 1.7350
- If 500,000 base currency then “X”
- If 500,000 price currency then “/”
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

16. 16
Example:
US person decides to travel UK, JAPAN, CANADA
He will spend
£ 40,000
¥ 600,000
CAD 75,000
if
USD/GBP-> 1.6750
JPY/USD-> 130.30
CAD/USD-> 0.8750
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

17. 17
Currency Conversion:
A/B -> X/Y
$/£ -> 1.6250/1.6280
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

18. 18
 “Bid” The price a buyer is willing to pay for a security.
 “Ask” The opposite of the bid is the ask price, which is the
price a seller is looking to get for his or her shares.
Bid Can not be greater than Ask
 “Bid-Ask Spread” The amount by which the ask price
exceeds the bid. This is essentially the difference in price
between the highest price that a buyer is willing to pay for
an asset and the lowest price for which a seller is willing
to sell it.
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

19. 19
“Bid-Ask Spread”
- High Liquid Assets
- Currency Pairs
• Highly Traded Currencies
• Less Traded Currencies
- Major Markets Open (NY, LONDON)
- Market Volatility
• High- Spread high
• Low- Spread low
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

20. 20
 “Cross Exchange Rate” The currency exchange rate
between two currencies, both of which are not the official
currencies of the country in which the exchange rate
quote is given.
Example:
If an exchange rate between the Euro and the
Japanese Yen was quoted in an American newspaper, this
would be considered a cross rate in this context, because
neither the euro or the yen is the standard currency of the
U.S.
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

21. 21
Question: What is Cross rate JPY/EUR?
USD/EUR is 1.3649 / 1.3651
JPY/USD is 1.6789 / 1.6791
Solution:
(JPY/EUR) = (JPY/USD) x (USD/ EUR)
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

22. 22
“Implied Rate” The rate that is determined by the difference
between the spot rate and the forward rate. The degree of
relative costliness of a future rate can be assessed by
comparing the implied rate with the spot rate.
Implied rate calculated as;
“Implied rate = Forward Rate – Spot rate”
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

23. 23
Question: If the spot rate of LIBOR is 5% and the forward rate
for LIBOR is 6%?
Implied rate = Forward Rate – Spot rate
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

24. 24
 “Arbitrageur” A type of investor who attempts to profit
from price inefficiencies in the market by making
simultaneous trades that offset each other and capturing
risk-free profits.
ARBITRAGE PROFITS
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

25. 25
 “Arbitrageur” A type of investor who attempts to profit
from price inefficiencies in the market by making
simultaneous trades that offset each other and capturing
risk-free profits.
ARBITRAGE PROFITS
FOREX Market ConceptFOREX Market Concept
Designed and Prepared By: Malik Muhammad Mehran

26. ∗ Depreciation: decline in a currency’s value
∗ Appreciation: increase in a currency’s value
∗ Comparing foreign currency spot rates over two
points in time, S and St-1
26
Measuring Exchange RateMeasuring Exchange Rate
MovementsMovements
1
1
aluecurrency vforeigninPercent
−
−−
=∆
t
t
S
SS
Designed and Prepared By: Malik Muhammad Mehran

27. PresenterPresenter::
Tanveer KashmiriTanveer Kashmiri
MS Business Administration Section “F”MS Business Administration Section “F”
NCBA&E Multan CampusNCBA&E Multan Campus
27Designed and Prepared By: Malik Muhammad Mehran

28. ∗ The exchange rate represents the price of a currency, or
the rate at which one currency can be exchanged for
another.
∗ Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping
demand schedule.
∗ Supply of a currency increases when the value of the
currency increases, leading to an upward sloping supply
schedule.
∗ In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.
28
Exchange Rate EquilibriumExchange Rate Equilibrium
Designed and Prepared By: Malik Muhammad Mehran

29. 29
Exhibit 4.2 Demand Schedule for British PoundsExhibit 4.2 Demand Schedule for British Pounds
29
Designed and Prepared By: Malik Muhammad Mehran

30. 30
Exhibit 4.3 Supply Schedule of British Pounds for SaleExhibit 4.3 Supply Schedule of British Pounds for Sale
30
Designed and Prepared By: Malik Muhammad Mehran

31. 31
Exhibit 4.4 Equilibrium Exchange Rate DeterminationExhibit 4.4 Equilibrium Exchange Rate Determination
31
Designed and Prepared By: Malik Muhammad Mehran

32. Irbaz Umer ButtIrbaz Umer Butt
MS Business Administration Section “F”MS Business Administration Section “F”
NCBA&E Multan CampusNCBA&E Multan Campus
32
PresenterPresenter::
Designed and Prepared By: Malik Muhammad Mehran

33. Factors That Influence ExchangeFactors That Influence Exchange
RatesRates
33
ratesexchangefutureofnsexpectatioinchange
controlsgovernmentinchange
levelincomescountry'foreigntheand
levelincomeU.S.ebetween thaldifferentiin thechange
rateinterestscountry'foreigntheand
rateinterestU.S.ebetween thaldifferentiin thechange
inflationscountry'foreigntheand
inflationS.between U.aldifferentiin thechange
ratespotin thechangepercentage
where
),,,,(
=∆
=∆
=∆
=∆
=∆
=
∆∆∆∆∆=
EXP
GC
INC
INT
INF
e
EXPGCINCINTINFfe
Designed and Prepared By: Malik Muhammad Mehran

34. ∗ Relative Inflation: Increase in U.S. inflation leads to
increase in U.S. demand for foreign goods, an
increase in U.S. demand for foreign currency, and an
increase in the exchange rate for the foreign
currency.
∗ Relative Interest Rates: Increase in U.S. rates leads to
increase in demand for U.S. deposits and a decrease
in demand for foreign deposits, leading to a increase
in demand for dollars and an increased exchange
rate for the dollar.
∗ Fisher Effect:
34
Factors That Influence ExchangeFactors That Influence Exchange
RatesRates
rateInflationrateinterestNominalrateinterestReal −≅
Designed and Prepared By: Malik Muhammad Mehran

35. ∗ Relative Income Levels: Increase in U.S. income leads to
increased in U.S. demand for foreign goods and increased
demand for foreign currency relative to the dollar and an
increase in the exchange rate for the foreign currency.
∗ Government Controls via:
∗ Imposing foreign exchange barriers
∗ Imposing foreign trade barriers
∗ Intervening in foreign exchange markets
∗ Affecting macro variables such as inflation, interest rates, and
income levels.
35
Factors That Influence ExchangeFactors That Influence Exchange
RatesRates
Designed and Prepared By: Malik Muhammad Mehran

36. ∗ Expectations: If investors expect interest rates in one
country to rise, they may invest in that country
leading to a rise in the demand for foreign currency
and an increase in the exchange rate for foreign
currency.
∗ Impact of signals on currency speculation. Speculators
may overreact to signals causing currency to be
temporarily overvalued or undervalued.
36
Factors That Influence ExchangeFactors That Influence Exchange
RatesRates
Designed and Prepared By: Malik Muhammad Mehran

37. ∗ Interaction of Factors: some factors place upward
pressure while other factors place downward
pressure.
∗ Influence of Factors across Multiple Currency
Markets: common for European currencies to move in
the same direction against the dollar.
37
Factors that Influence ExchangeFactors that Influence Exchange
RatesRates
Designed and Prepared By: Malik Muhammad Mehran

38. ∗ If currencies A and B move in same direction, there is no
change in the cross exchange rate.
∗ When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then currency A
appreciates (depreciates) against B.
∗ When currency A appreciates (depreciates) against the
dollar, while currency B is unchanged against the dollar,
currency A appreciates (depreciates) against currency B by
the same degree as it appreciates against the dollar.
38
Movements in Cross Exchange RatesMovements in Cross Exchange Rates
Designed and Prepared By: Malik Muhammad Mehran

39. 39Designed and Prepared By: Malik Muhammad Mehran