4. foreign exchange

8/12/2019 4. Foreign Exchange

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Foreign Exchange

FINC 410-01

Hassan Abdalla


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Foreign Exchange

Definition:

! The transaction of purchasing one currency against the sale ofanother at an agreed date and a specific rate.

! It is an integral part of the world of financial systems

Main Reasons for FX:

! Trade! Investment - Movement of international capital seeking the

most profitable return


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Types of Foreign Exchange

" Banknotes" Transfers (between countries)

Differences:

# Insurance Expense# Transport Expense# Interest Expense# Handling Expense


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FX Market Participants

1. Central Banks

2. Banks

3. FX Brokers

4. Investment Funds5. Corporations

6. Speculators

7. Hedgers


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Factors influencing FX

1. Fundamental Factors$ Economic factors

2. Political3. Environment4. People5. Technical Factors


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1. Fundamental Factors

1. Purchasing Power Parity (PPP)2.

Real Interest Differentials

3. Balance of Payments4. Economic Growth Rate

Concerned with economic conditions such as inflation, recession,trade, GDP growth, etc.

Economic Factors include:


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PPP: The Theory

" Floating exchange rates should respond primarily to inflationdifferentials

" High inflation (caused by too generous a growth of moneysupply) would lead to the weakening of the currency to the

point where the rate is again the equilibrium rate, reflectingpurchasing power parity

" The equilibrium rate is the rate of exchange which wouldrender the prices of goods identical in the two countriesconcerned.


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Shortfalls of PPP Theory

1. Unavailability of price indices to measure purchasingpower.

2. International competitiveness is not a matter of price only,but also of quality and after-sale service.

3. The PPP does not take into consideration capitalmovements.


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Real Interest Differentials

" Real Interest Rate: " The rate of interest an investor expects to receive after subtracting inflation" Real Rate of Return = Interest Rate - Inflation Rate

Q// If we have 2 countries, Country A has a 30% interest rate and Country Bhas 10%, which one will you invest in?

Additional Information:

Country A has a 50% inflation rate

Country B has 5%,

Which Country would you invest in?


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Balance of Payments

" The trade balance is a fairly reliable barometer of internationalcompetitiveness of the economy concerned.

"It consists of Imports and Exports

" A surplus is when foreign exchange inflows from exports exceedoutflows from imports

"It affects exchange rates.

" If the demand increases on my products this will lead to an increasein the value of my currency


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Economic Growth Rate

" There are two types of indicators:o Lagging indicators: indicate what has already happenedo Leading indicators: indicate what will happen in the future.

" Inflation is measured by:o CPI: (Consumer Price Index) when I go to a consumer store, I know

whether prices went up or down

o WPI: (Whole price producer index) same as above but for wholesaleo PPI: (producer price index): Same as above but for producers.


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Unemployment

! A very important indicator compiled by the Labor Department! Usually released the 1stFriday of the month! The combination of the change in total employment and average

workweek data provide the first solid evidence for estimatingindustrial production for the month

! Employment data is more important than the unemployment rate! 2 methods for calculating the change in employment:

# Household Survey# Payroll data

! The payroll series is more reliable and is the one used inprojecting industrial production


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Index of Leading Indicators

! Compiled by the Commerce Department and released on thelast day of each month.

! Comprised of 12 component series, which combined, areexpected to forecast business conditions 3-6 months forward.

! Receives significant attention from the market because it hashistorically proven to be reasonably good in forecasting

recessions and recoveries

! Generally, the series must decline for 3 consecutive monthsbefore analysts begin to predict the onset of a recession.

! It must also rise for several months before they are willing topredict the end of a recession


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Index of Leading Indicators

Some of the components of the index are:

# Stock prices#

Money supply# Factory orders# Building permits# Growth in Inventories


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PPI: Producer Price Index

! A monthly inflation measure! Released by the Labor Department on the 2ndFriday of the month! The PPI usually has a greater market impact than the CPI because it

is more volatile and more difficult to predict.

# Food prices account for roughly 30% of the index#Non-food consumer goods account for another 30%


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CPI: Consumer Price Index

! Monthly inflation measure! Released by the Labor Department on the 22ndof each month! Measures prices at the retail level and is thus the most widely quoted

measure of inflation

! The PPI usually has a greater market impact than the CPI because itis more volatile and more difficult to predict.

# Food price account for around 20%# Housing and fuel account for around 40%# Consumer goods account for the remainder


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Housing Starts

! A Commerce Department series released around mid-month thatreports the number of housing units that were started during the

month

! It is expressed as a seasonally adjusted annual rate! Includes single-family and multi-family dwellings

# A reading above 2 Million units is very strong# A reading below 1.5 Million units is very soft

! During recessions this series often falls below 1 Million units! Data for housing permits are also included in this release! Permits provide some evidence as to the future pace of starts and are

also a component of the index of leading indicators


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Business Inventories

! Released around mid-month with a one-month lag! The market judges large increases in this series as a warning of

stronger demand for loans by corporations.

! Initially inventory accumulation is bearish for the market.


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Retail Sales

! Compiled by the Commerce Department and released around the10thof each month

! It is a highly erratic series that can be very difficult to forecast andquite misleading because it is revised at a later date

! However, consumer spending is very important, so the series alwayshas an impact on the market

! When the consensus forecast of the indicator is wrong, the marketmay react violently to this release.


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Consumer Credit

! Compiled by the Federal Reserve and released around mid-monthwith a one month delay

! Includes consumer borrowing, but not mortgage credit! It is used as a measure of consumer confidence


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Industrial Production

! Perhaps the best and most timely measure of business activity! Compiled by the Federal Reserve and released at 9:30 am on the 15 th

of each month.

! It measures the output of the manufacturing, mining and utilitysectors of the economy.

! The Fed would prefer a monthly increase of around 0.5%# 1.0% increase is very strong, suggesting real GNP growth of 6-8%# 0.2% increase is too weak, suggesting a slowdown in business activity

that may stimulate the lowering of interest rates.


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Personal Income

! Released around mid-month by the Commerce Department! Attempts to measure income gains each month and expresses

them as a seasonally adjusted annual rate

! This series is subject to considerable revision and is influencedby changes in taxes and benefits making it of limited value

# Gains above 1% are strong# Gains below 0.5% are weak# During recessions, gains average around 0.1-0.2%


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Real GNP

! Reported each month, but only the 1stmonth in the quarterrelease is important. Computed quarterly

! Measures total output of goods and services in the economyand is deflated

! Most comprehensive measure of economic activity! Recessions are defined as 2 consecutive quarters of falling

GNP

! THE GNP deflator is used to remove the impact of inflation. Itis a very good measure of inflation, yet is only calculated

quarterly.


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Durable Goods Orders

! Compiled by the Commerce Department and released aroundthe 23rdof each month

! Very volatile and unpredictable! Measures orders received by manufacturers of durable goods

such as cars, trucks, military hardware, etc.

! Military component is around 10%, yet is so volatile that itcauses the series to move several percentage points

! In theory, it is a leading indicator of production data


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What will be the effect of?

" CPI%" Durable Goods Orders %"

GNP&

" Housing Starts %" Industrial Production &" Inventories %

" Leading Indicators %" Oil Prices &"

Personal Income%

" Precious Metals Prices &" PPI%" Retail Sales %" Unemployment %


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2. Political Factors

! Elections!Nationalization! Parliament Composition


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3. Environmental Factors

" Violent Storms" Commodities"

Climate" Earthquakes" Harvest


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4. People

" Safe Haven: ex: Gold, Treasuries, etc." Mentality

" Religion" Saving


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5. Technical Factors

" Current prices are discounting all fundamental factors.

" One should be influenced more by the price fluctuations andprice trends.

" The past price trends are used to forecast future prices.

" Represented in the form of graphs or statistics (moving average)through which you can deduct future movements.

" Its based on trends, not where the real value is

" A stop-loss to prevent losses beyond a certain level isrecommended


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Technical Factors

Contd


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Technical Factors

Contd


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Technical Factors

Contd

Resistance (Sell)

Support (Buy)


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Technical Factors

Contd


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Types of Exchange Rate Exposure


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Types of Exchange Rate Exposure

1. Transaction exposure: it arises whenever the firm commits (or iscontractually obligated) to make or receive a payment at a future date

denominated in a foreign currency (e.g: accounts receivable and payable

arising from the conduct of business).

2. Translation exposure: a cross-border firm must periodically re-measure all ofits global operations into a single currency for reporting purposes. This

requires that the B/S and I/S of all affiliate operations worldwide be

translated and consolidated into the currency of the parent company.

3. Economic exposure: a firm is said to have economic exposure to exchangerates when unanticipated real exchange rate changes have a non-zero effect

on its expected future cash flows.


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FX Forecasting

Foreign exchange is the single most important price in anopen economy affecting:

1. Corporate Profits2. Market Shares3. Investment Decisions (Variability of Returns)4. Monetary & Fiscal Policies


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WRAP UP


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Monetary & Fiscal Policies

Alan Greenspan - Feb 1995

In the process of pursuing domestic objectives, centralbanks cannot be indifferent to the signals comingfrom international financial markets.

Although markets can be harsh teachers at times, the

constraints that they impose discipline our policychoices and remind us everyday of our longer-runresponsibilities.


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Getting the Currency Right

" Critical Objective of all market participants

" Difficult task on a consistent base

" Changes in macroeconomic variables take longer thanchanges in financial markets

" Short term distortions will occur

" Technical trading will dominate at times

" Numerous theories and models


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Composite Approach

" A composite approach that integrates both fundamentaland technical analysis should be used in the decision making process.

" Total reliance on one system can prove costly

" An integrated approach:" Long Term Structural" Medium Term Cyclical" Short Term Speculative


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An Integrated Approach

FIRST:

Analyze fundamental factors to determine equilibrium pathand assess currency medium to long term trend

SECOND:

Assess short term factors and whether they will be taking ratescloser to or further from the equilibrium path.

A currencys long term equilibrium path plays an importantrole by serving as a long run anchor or magnet ensuring thatFX rates would not wander aimlessly without limit, butinstead will gravitate toward the long run equilibrium path


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Long Term Structural

PPP:

Over time, exchange rates would move to offset differences innational inflation rates

External Balances:

Over time, exchange rates would adjust to ensure that abalanced current account is attained


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Medium Term Cyclical

Domestic Monetary Policy:

Affects inflation, currency substitution, real interest ratedifferentials and domestic economic activity

Central Banks Reserves

Domestic Fiscal Policy

Real Factors


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Technical Factors

Have a distinct advantage over fundamental based modelswhen exchange rates overshoot

since technical based models are not at all concerned withwhere values lie, but instead are concerned with where thetrend is heading.


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How Exchange Rates are Determined

Persistent Trendin CurrentAccount Balance

PPP

DomesticMonetary Policy

PortfolioDiversification

( CB Reserves)

Domestic FiscalPolicy

Real Factors

L-Term Structural Factors

FUNDAMENTAL FACTORS TECHNICAL FACTORS

Change in NetForeign Assets

(Liabilities)

RelativeInflation Rates

InflationaryExpectations

Currency

Substitution

DomesticEconomic Activity

Real Interest RateDifferentials

Risk Premium

Real Long RunEquilibrium

Exchange Rate

Capital Flows

Trade balance

S-Term Speculative Factors

Equilibrium

Exchange

Rate

S-Run

ExtrapolativeExchange Rate

Expectations

L-RunRegressive

Exchange Rate

Expectations

Central BankIntervention

TemporaryOvershoot ofEquilibrium

ExchangeRate

M-Term Cyclical Factors


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Model of Short, Medium and Long Term

Trend in a Domestic Currencys Value

Fundamentally Driven

Medium Term

Cyclical Path

Technically Driven

Short Term

Overshooting Path

Fundamentally DrivenLong Term

Equilibrium Path

TIME

DOMESTIC

CCY VALUE

Fundamental

Equilibrium

Path


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Integrating Fundamental &

Technical Analysis

in formulating urrency Investment Strategies

CURRENCY FUNDAMENTAL TECHNICAL STRATEGY

A

B

C

D

BULLISH

BULLISH

BEARISH

BEARISH

BULLISH

BEARISH

BEARISH

BULLISH

OVERWEIGHT

NEUTRAL

UNDERWEIGHT

NEUTRAL


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Analysis of Imminent economic

data/statistics

" Before an economic statistic is released, many economistsprovide a forecast indicating their expectations for it. A survey

of these forecasts is carried out, to establish a market consensus

for what is expected.

" After the release of the statistic, the market will moveaccording to how different the actual release is to the market

consensus

" Market reactions to a single economic release are generallyshort-lived


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FX Volatility

" FX prices move significantly over time" Movement of FX rates affect international businesses and

increase costs

USD/DM 3.50 1.348

USD/FRF 10.0 4.7

GBP/USD 1.0 2.02


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Exchange Risk

! Credit Risk (Settlement)! Speculation Risk

Control Measures:

" Position Limits" Overnight Limits" Stop Loss Limits


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USD: International Currency

! The USD was the only currency convertible into Gold in theBretton Woods Agreement, therefore it acts as a common

denominator

! Most currencies are quoted in relation to the USD (exceptionsare GBP, EUR and Australian $)

! Cross rates involve the buying/selling of currency A forDollars and the use of funds obtained to sell/buy currency B.


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Spreads

! Two-way prices involve:# Buying Rate (Bid)# Selling Rate (Offer)

! Spread is the difference between these two rates:USD/DEM 1.6300/1.6310 00/10

GBP/USD 1.5180/1.5190 80/90

USD/FRF 5.6850/5.6900 50/00

! Rate Inversion:# DEM/USD (1/1.6300) (1/1.6310)

0.6135 / 0.6131

O.6131 / 0.6135


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Cross Rates

" 1 Kilogram of Apples USD 2" 1 Kilogram of Apples DEM 4" USD/DEM 4/2 = 2

USD/DEM = 1.6300

USD/FRF = 5.6850

DEM/FRF = 5.6850 / 1.6300 = 3.4877

Rate in Dollars of Price CCY

Rate in Dollars of Reference CCY


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Crosses

DEM/FRF = 5.6900 / 1.6300

= 5.6850 / 1.6310

DEM/FRF = 3.4856 / 3.4907

GBP/DEM = 1.5190 * 1.6310

= 1.5180 * 1.6300

GBP/DEM = 2.4743 / 2.4775

4. foreign exchange

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