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Section 2:
EXCHANGE RATE AND BALANCE OF
INTERNATIONAL PAYMENT

CHAPTER 3: EXCHANGE RATE

CHAPTER 4: BALANCE OF INTERNATIONAL PAYMENT

Chapter 3: EXCHANGE RATE

Main contents:
 Foreign Exchange rate
 Foreign Exchange quotation
 Cross exchange rate
 Exchange rate clarification
 The factors that affect exchange rate
 The methods of exchange rate adjustment
 Foreign Exchange market

EXCHANGE RATE
1. Definition:
- F. Mishkin: The price of one currency in terms of another is
called the E/R.
- Alan Shapiro: An exchange is, simply, the price of one nation’s
currency in terms of another.
- Dictionary of Banking Terms: E/R is conversion price for
exchanging one currency for another
- Financial institutions & markets: An exchange rate is the value of
one currency in terms of another.

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EXCHANGE RATE
1. Definition (cont):
- NguyenVan Tien (Int’l Finance): Exchange
rate is the price of
one currency expressed in terms of another currency.

- Ordinance on foreign exchange control 2005:

Vietnamese dong exchange rate means the price of one foreign currency
unit calculated in the Vietnamese currency.

2. Basis of exchange rate:

2.1. Prior to 1971:
each country’s monetary authority set the value of its
currency relative to an international standard such as gold
(the so-called “gold standard”) bản vị vàng

 There are three distinct types of "gold standards“:

 The gold specie standard (1875-1914)
 The gold exchange standard (1914- 1944) chế độ hối đoái vàng
 USD gold exchange standard system (1945-1971 )
35 USD = 1 ounce gold

hàm lượng vàng trên đồng tiền vàng, đồng tiền giấy, đồng dollar
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The gold specie standard (1875-1914)

How was E/R determined:

 1 GBP = 123, 274 grains (= 7,988g)
 1 USD = 23,22 grains (=1,50476g)
 GBP/USD = 123,274/23,22 = 5,3089
1 GBP = 5,3089 USD
Đồng tiền xấu sẽ đuổi những đồng tiền tốt ra khỏi lưu thông →

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Gold standard
 Under a gold standard, paper notes are convertible into pre-set, fixed
quantities of gold.

 No country currently uses the gold standard as the basis of its

monetary system.
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Under gold standard:

 exchange rates were fixed, the price levels around the world
to move together. Why?
 This co-movement occurred mainly through an automatic
balance-of-payments adjustment process called the price-
specie-flow mechanism.
 E/R is adjusted by gold-flow between 2 countries.

Under gold standard

 For example:
 6 GBP = 1 ounce of gold
 12 FRF = 12 ounce of gold
 GBP/FRF = 2
 If GBP/FRF = 1.8 => What would it happen?
1 GBP = 1.8 FRF → Vàng chuyển từ Anh sang Pháp, mang bảng Anh đến ngân hàng Anh để mua vàng,
mang vàng qua Pháp để đổi qua đồng FRF, đổi đồng FRF ra bảng Anh

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Exchange rate
2.2 After 1972:
 No country currently uses the gold standard as the basis of its
monetary system.
 No currency is convertible into precious metal
 There are some regimes of exchange rate:
 Freely floating rate
 Managed- floating rate
 Target zone
Expression “dirty float” ?

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Exchange rate
2.2 After 1972:
 What determines the exchange rate?
 Not relied on gold parity
 Is relied on PPP (Purchasing Power parity):

PPP: A unit of domestic currency should purchase the same

amount of goods in the home country as it would of identical
goods in a foreign country.

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Economic theories of exchange rate

determination
 The law of one price:
 in competitive markets free of transportation costs and barriers
to trade (such as tariffs), identical products sold in different
countries must sell for the same price when their prices is
expressed in terms of the same currency
 If the law of one price were true for all goods and services,
the purchasing power parity (PPP) exchange rate could be
found from any individual set of prices.

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PPP Example
 By comparing the prices of identical products in
different currencies, it would be possible to determine
the „real” or PPP exchange rate that would exists if
markets were efficient.

 A new ipad costs £460 in London and $700 in New York.

The exchange rate must reflect this price relationship:
 E (GBP/USD)= $700/£460 =$1.52 per £

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The price of a “basket of goods” should be roughly

equivalent in each country

Purchasing Power Parity

USD 3,000 = CHF 3,750
14  so USD|CHF should = 1.2500

Purchasing Power Parity

 Absolute form of PPP:
price of similar basket of goods to two countries should be
equal when measured in a common currency, not referred to
inflation.

 Relative form of PPP:

The strictest version of PPP is not supported empirically, but
changes in relative inflation rates are related to changes in
exchange rates.

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Purchasing Power Parity

 Absolute form of PPP:
price of similar basket of products to two countries should be
equal when measured in a common currency, not referred to
inflation.
 Pu: the USD price a basket of particular goods
 Pv: the VND price of the same basket of goods.
 The PPP theory predicts that the dollar/ yen exchange rate
should be equivalent to:

E(usd/vnd) = Pv/ Pu

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Relative PPP Example

 Relative form of PPP:
The strictest version of PPP is not supported empirically, but
changes in relative inflation rates are related to changes in
exchange rates => The exchange rate will change if relative prices
change.
Ex: Suppose the price ipad in London increases to £506 in
one year implying an inflation of 10%, while in the U.S.
the price of wine increases to $735 indicating an
inflation rate of 5%. The new exchange rate:
 GBP/USD = 735/506 = 1,4525

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Relative PPP Example

 Suppose the U.S. inflation rate is expected to be 3 percent
for the coming year, while the Britain's expected rate of
inflation is 5 percent.
 The current exchange rate is $1.50 per £. What should be the
£ spot rate in one year?

1.50 × 1.03/1.05 = $1.47 per £

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Relative form of PPP:

Rate of change in the prices of products should be similar
when measured in a common currency:
Pv+(Pv. ∆Pv)=(R+e. ∆e).(Pu+Pu. ∆Pu)

Pv = e. Pu, so that:
 (1+∆Pv) = (1+∆e). (1+∆Pu)
 (1+∆e) =(1+∆Pv)/(1+∆Pu)
 ∆e =[(1+∆Pv)/(1+∆Pu)]- 1
 ∆ e=(∆Pv-∆Pu)/(1+∆Pu)
 Approximately: %Δe0 = πd – πf

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Relative form of PPP:

 Approximately: %Δe0 = πd – πf
 Imagine there is no price inflation in the U.S, while prices in
VN are increasing by 10% a year. More precisely, by the end
of the year:
Eusd/vnd = Pvnd (1+ 10%)/Pusd

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PPP Implication
 According to PPP, the currency of countries with high
inflation rates should devalue relative to countries with low
inflations rates.
 Rationale:
if πd > πf, then:
 domestic imports increase; domestic exports decrease
 foreign imports decrease; foreign exports increase
 demand for FC increases; supply decreases
 demand for LC decreases; supply increases
 FC appreciates; LC depreciates

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Exchange Rate

 Comparative relations between two currencies:

 Ex 1 USD = 22.000 VND
 The gold standard:
 was a commitment by participating countries to fix the prices of
their domestic currencies in terms of a specified amount of gold.
 was also an international standard determining the value of a
country’s currency in terms of other countries’ currencies.
 Under a gold standard, paper notes are convertible into pre-set,
fixed quantities of gold.

 PPP: After Bretton Woods:

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Trade Tourism Investment Why Vietnam do not raise the exchange rate like China?
- Vietnam needs importing, while China can product on its own
- Trade balance of Vietnam: 90 import : 10 export → Low value-added → Supporting industry has not developed
18000 Import > Export Foreign tourism Invest in foreign countries
- Just only investment in short-term
USD / VND = 24000
30000 Export > Import Domestic tourism Attract domestic investment
→ Raise price in domestic product

3. Exchange rate quotations

III. Foreign Exchange Quotations
• Full statement
Exchange rate • Short statement
statement

• Ex. Rate: decimal

• Point
Exchange rate
interpretation • Figure

• As for domestic FX market

Exchange rate • As for int’l FX market
quotations

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3.1. Exchange rate statement

 In full statement:
Bid rate USD/VND= 23,000 or USD 1= VND23,000
Buying price
Bid rate USD/JPY = 90
Price that commercial bank are willing to
Ask rate USD/VND=23,500 or USD 1= VND23,500
Selling price
Ask rate USD/JPY = 92
 In short statement (abbreviation):
bid ask USD: Commodity/based currency → Unit of currency
USD/VND= 23,000/23,500 VND: Term currency/quoted currency
→ Giá USD tại VN
USD/JPY= 90/92
23000 là giá mua vào của NH, 23500 là giá bán ra của NH

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Profit: Spread between Bid rate and Ask rate

→ Market maker: Bank (Buy low sell high)
→ Price taker: Customer (Buy high sell low)

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In short statement (abbreviation):

Bank of Tokyo quotes exchange rate:
USD/JPY= 90/92

 First currency is Commodity currency (referring to currency being

traded or being valued)
 Second currency is term currency (referring to currency, in which
the commodity currency being expressed)

=> Commodity currency/Term currency = BID/ASK

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Bid & Ask Quotes

 Foreign currency dealers provide two quotes:

Bid Price: Price at which the dealer is willing to buy foreign
currency from you.
Ask Price: Price at which the dealer is willing to sell foreign
currency to you.
 It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread.

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Example

Bid Ask
£ /$ 1.4482 1.4484

Bid: Dealer buys £ for $ at the Bid =>

Client sells £ for $ (i.e., dealer will buy £1,000,000
for $1,448,200).

Ask: Dealer sells £ for $ at the Ask => Client buys

£ with $ (i.e., dealer will sell £1,000,000 for
$1,448,400).
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Discussion
In Tokyo:
 USD/JPY= 90/92
In Hanoi:
 VCB quoted on Oct 7, 2009:
USD/VND = 17,846/17,846
Case of Bid = Ask → Increase Bid or decrease Ask?

 Ordinary: BID < ASK

 ASK- BID = SPREAD (profit for market-marker)
 In the same quoted FX market, spread for USD is less than for AUD?

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VN has floating exchange rate having fix → Central exchange rate (+- x% band) → Policy to adjust band

3.2. Exchange rate interpretation

 If USD/CHF starts the day at S= 0,9300 and an hour later it
is at S =0,9301. How would we say about this change?
 A pip (or point) is the smallest quoted unit of the rate.
 1 USD = 1.3650 CHF
 1 GBP= 1.5174 USD
 1 USD = 92.35 JPY
 1 USD = 20,810 VND

A/B và B/A: tổng yết phải là 8 số sau dấu phẩy

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3.2. Exchange rate interpretation

 Where the 2 currencies have a similar value, their exchange
rate will be expressed to 4 decimal points (that is, rounded to
4 decimal places).
 Where they differ substantially in value, say the USD and the
JPY, the exchange will be quoted fewer decimal points (two
in the case of the USD/JPY).

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3.2. Exchange rate interpretation: Point, figure

 100 points (pips) = one “big figure”. The big figure often relates to (the
smallest quoted) currency unit of that currency.

 If EUR|USD S = 1.2500 and it rose three big figures, it

would go to S =1.2800. An FX market professional would
say, “Euro-Dollar is trading at one-twenty-eight ‘the
figure.’”

 With USD|JPY S = 111.00, what would an increase of

three big figures mean? This would mean that S now equals
114.00

 Remember, 100 pips is a big figure and a pip in USD|JPY

= .01).
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3.3. Foreign exchange rate quotation

 Direct quotation: Exchange rate is the price of one unit of
foreign currency in terms of units of domestic currency
 Indirect quotation: Exchange rate is the price of one unit of
domestic currency in terms of units of foreign currency:
GBP, AUD, NZD, EUR and SDR
 The US follows both direct and indirect quotation; USD is
terms currency in the relation to the group of the five
currencies.

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3. Foreign exchange rate quotation

Direct • Exchange rate is the price of one unit

of foreign currency in terms of units
quotation: of domestic currency
Vietnam, most countries → USD/VND

• Exchange rate is the price of one unit

Indirect of domestic currency in terms of
units of foreign currency: GBP, AUD,
quotation: NZD, EUR and SDR
UK, New Zealand, EU

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Mỹ áp dụng yết giá trực tiếp đối với đồng tiền của nước áp dụng yết giá gián tiếp và ngược lại

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Direct & Indirect Quotes

Direct Quote:
 In Tokyo: Home currency per unit of Foreign currency (FC) - e.g.
USD/JPY quote is 90.00/92.00
Indirect Quote:
 In Sydney: Foreign currency per unit of Home currency - e.g.
AUD/USD quote of 1.02661 – 1.0249
Note that in all cases, the reciprocal of a direct quote is an indirect
quote and
AUD 1

EUR EUR
34 AUD

Direct & Indirect Quotes

 Most countries quote price of foreign currency directly
 Countries that were part of the British Commonwealth
and Eurozone the customs is to express exchange rate
“indirectly” => GBP, AUD, NZD, EUR
 SDR is always commodity currency
 The US follows both direct and indirect quotations; USD
is term currency in the relation to the group of the five
currencies

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American terms vs European terms

 As for international market, an exchange rate can
be quoted in American terms or European terms.
 American terms (USD is the term currency in the rate):
 EUR/USD
 JPY/USD
 European terms (USD is the commodity
currency/underlying asset in the rate)
 USD/EUR
 USD/JPY

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Bid – Ask Spread

 Banks act as market makers and realise their profits from the
spread:
Bid-Ask Spread = (Ask-Bid)/Bid

 Consider the DIRECT quote of $ 1.4482 – 1.4484/£

% spread 
1.4484  1.4482  100  0.138%
1.4482

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Exercise

Exchange quotation Spread (%)

USD/JPY = 92.95/93.00
GBP/USD = 1.5120/1.5125
GBP/EUR= 1.1605/1.1611
EUR/USD =1.3030/1.3034
AUD/USD=1.0210/1.0214

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4. Cross Rate

 Narrow meaning: Cross Exchange Rate is defined as an exchange

rate between two currencies, neither of which is the USD; in other
words, the exchange rate of two currencies which is derived from their
rates against USD is called cross rate, where USD plays the role as the
intermediate currency

 Broad meaning: Many currency pairs are inactively traded, so

their exchange rate is determined through their relationship to a
widely traded third currency.

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Cross rates

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IV. Cross Rate

 Many currency pairs are inactively traded, so their exchange rate is

not quoted in the market.
 For example, an Australian importer needs Danish currency to pay
for purchase in Copenhagen.
 The Australian dollar (symbol AUD) is not widely quoted against
the Danish kroner (symbol DKK).
 However, both currencies are quoted against the U.S. dollar.
Assume the following quotes:
USD/AUD = 1.0806
USD/DKK =5.7210

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4.Cross Rates

 The Australian importer can buy one U.S. dollar for

AUD 1.0806 and with that dollar buy DKK 5.7210.
The cross-rate calculation would be:

DKK/AUD = 1.0806/5.7210 = 0.1888

 1 DKK = 0,1888

 However, calculating cross-rates is usually not as

easy as this!
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USD/VND = 23200/23400
JPY/VND = 223/227
→ Ask: USD/JPY = 23200/227
→ Bid: USD/JPY = 23400/223

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Exercise
Complete the following table of simple cross rate:

USD EUR JPY GBP CHF

USD 1.2500

EUR

JPY 110.00 96.00

GBP

CHF 2.4000

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Exercise
 Could the price of a U.S Dollar fall against the Swiss Franc
but rise against the Japanese Yen? If so, what must have
happened to the exchange rate between Swiss Franc and
Japanese Yen?
 More specifically, will CHF/JPY have gone up or gone down?

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Cases of cross rate:

Rates are usually quoted in pair: Bid and ask rate. So cross
rate have to be calculated in pair, too.
We have 3 cases of cross rate:
 Intermediate currency is term currency in two available rates.
 Intermediate currency is underlying asset (commodity currency)
in two available rates
 Intermediate currency is commodity in one rate and term
currency in the other rate.

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Cross rate
Case 1: Intermediate currency is term currency in two
available rates
Ex: In Hanoi, VCB quotes exchange rate:
USD/VND = 23,200/23,400
JPY/VND = 223/227
Ask (c) ) USD/JPY =?
Bid (c) USD/JPY =?

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4. Cross rate – Case 1

BID (c) USD/JPY =?

So, by the same way we have:

BID (c) USD/JPY = ASKUSD / VND

BIDJPY / VND
= 23,400/223
=

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4. Cross rate – Case 2

 In New York, rates are quoted:
 USD/JPY = 93.08/93.12 → 1/93.08 | 1/93.12 → JPY/USD = (1/93.12) / (1/93.08)

 USD/CAD = 1.22/1.24 → 1/1.22 | 1/1.24 → CAD/USD = (1/1.24) / (1/1.22)

Calculate the following rates: Ask < Bid [Customer]

Sell CAD = Buy USD Ask (c) CAD/JPY =?
Buy CAD = Sell USD Bid (c) CAD/JPY =? Ask USD

Customer buy USD by CAD → Bank sell USD: 1.24 Bid USD → 1 USD = 1.24 CAD
Ask CAD/JPY Customer sell USD to buy JPY → Bank buy USD: 93.08 Ask USD → 1 USD = 93.08 JPY
→ Ask CAD/JPY = 93.08/1.24 → 1.24 CAD = 93.08 JPY
Ask CAD/JPY → Buy high, Sell low →1/1.24 / 1/93.08

Bid CAD/JPY → Buy high, Sell low →1/1.22 / 1/93.12

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USD/VND = 23200/23400
JPY/VND = 223/227
→ Ask: USD/JPY = 23200/227
→ Bid: USD/JPY = 23400/223

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4. Cross rate – Case 2

BID (c) CAD/JPY = ASKUSD / JPY

BIDUSD / CAD
= 93.12/1.22 = 76.32

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1. A,B,C
Case: Receive 8.000.000 HKD, pay 500.000 JPY. Remaining convert to AUD, calculate maximum amount of AUD. - A/B = x1/x2
USD/JPY = 150,90/160,10 - C/B = y1/y2
USD/HKD = 7,8260/7,8270 B1: Bid JPY/HKD: 7,8270/150,90 = 0,052 → A/C (c) = x/y = x1/y2 < x2/y1 → Ask (c) < Bid (c)
AUD/USD = 0,65/0,70 B2: Remaining = 8.000.000 - 500.000*0,052 = 7.974.000 HKD
→ USD/AUD = (1/0,7) / (1/0,65) B3: Bid AUD/HKD: 7,8260/(1/0,70) = 5,4782 → AUD remaining = 1.455.587,60 AUD 2. A,B,C
- A/B = x1/x2
- A/C = y1/y2
→ B/C (c) = y/x = y1/x2 < y2/x1 → Ask(c) < Bid (c)

3. A,B,C
A/B = x1/x2
B/C = y1/y2
→ A/C (c) = x1y1 < x2y2 → Ask (c) < Bid (c)
4. Cross rate – Case 3 → C/A (c) = 1/x2y2 < 1/x1y1 → Ask (c) < Bid (c)

In New York, the rates are quoted:

 GBP/USD = 1.5245/1.5250 USD / GBP = (1/1.5250) / (1/1.5245)
 USD/JPY = 93.08/93.12

Calculate the following rates:

Ask (c) GBP/JPY = ?
Bid Ask (c) GBP/JPY = ?
Customer buy USD by GBP → Bank sell USD: 1/1.5245
Ask GBP/JPY
Customer sell USD to buy JPY → Bank buy USD: 93.08
C2: JPY/USD = (1/93.12) / (1/93.08) Bid GBP/JPY Customer buy USD by JPY → Bank sell USD: 93.12
Ask GBP/JPY = 1.5250/(1/93.12) Customer sell USD to buy GBP → Bank buy USD: 1/1.5250
Bid GBP/JPY = 1.5245/(1/93.08)

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5. Exchange rate classifications

Exchange rate can be classified into many categories.
5.1. Upon the bank transaction of foreign exchange
 Bid rate/Ask rate Spread: Difference between Bid & Ask
< Closing → Up-trend
 Opening rate/closing rate Opening Opening > Closing → Down-trend
Ty gia giao ngay Forward value date (FVD) = T + N
contract date & value date
 Spot rate/Derivative rates (Forward rate) - spot: within 2 days from contract date T: Time of contract concluded
Ty gia ky han/phai sinh N: Term of contract
- forward: more than 2 days from contract date
 Cash rate (bank note rate)/Transfer rate Note: the exchange rate is binding in the contract in expected value → Used for hedging, speculate
Cash rate: ty gia mua ban tien mat
Transfer rate: ty gia mua ban bang TTr (chuyen khoan)

Case VB: Tai sao yet gia Cash va Transfer (Cash< Transfer) trong Bid rate?
→ Bank encourage to we sell currency by transfer bid rate (Security, Convenience, Quality,…)
Tai sao Ask rate khong chia ra Cash va Transfer?
→ Usually transfer, if we ask cash bank will only respond to you

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5. Exchange rate classifications

Exchange rate can be classified into many categories.
5.2. Upon the instruments of international payment
 Telegraphic transfer rate (TT rate) Ty gia dien hoi
 Mail transfer rate (MT rate) Ty gia thu hoi
 Bank cheque (bank check) rate
In VN they are 1
as cheque has
only at sight
 At sight bank draft
 Time bank draft/ Usance bank draft

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a. Telegraphic transfer rate

most bank applied

 In short: TT rate
 the rate at which banks sold foreign currency to
their clients accompanying responsibilities to
transfer to the oversea beneficiaries by means of
electronic funds transfer.
 Basic rate that commonly used to refer to
 High speed of funds transfer
 High cost, but reduce FX risks

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a. Mail transfer rate

apply for cheque, sight draft

 In short: MT rate
 the rate at which banks sold foreign currency to
their clients accompanying responsibilities to
transfer to the oversea beneficiaries by post mail.
 Rarely used, low cost
 Low speed of funds transfer

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c. Bank’s Cheque Exchange Rate

 the rate at which banks sold foreign currency in cheque
form to their clients accompanying responsibilities to
transfer to the oversea beneficiaries.
 Lower than TT rate? Why?
→ as cheque is longer and bank hold you money → Cover the interest

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d. At sight Bank’s Draft Exchange Rate

 the rate at which banks sold foreign currency in at sight Bank’s Draft
form to their clients accompanying responsibilities to transfer to the
oversea beneficiaries. without
 Lower than TT rate?

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e. Usance Bank’s Draft Exchange Rate

 the rate at which banks sold foreign currency in usance

Bank’s Draft form to their clients accompanying without
responsibilities to transfer to the oversea beneficiaries.
 Lower than TT rate?
Usance < At sight bank draft < Bank cheque

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5. Exchange rate classifications

Exchange rate can be classified into many categories.
5.3. Upon the regime of foreign exchange
management
 Fixed / Freely floating/ Managed floating rate
published by financial institution
 Official rate/ Black market rate not published

 Popular rate /Preferential rate only for the economic sector that needed encouraging (e.g. export seafoods)

 Basic rate / Transaction rate

 Nominal exchange rate (NER)/Real exchange rate (RER)

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6. Factors affecting exchange rate

 Difference of inflation rates between two countries
 Difference of interest rates between two countries
 Foreign exchange demand and supply
 Other non-economic factors: government policy, war, people
habit, speculator expectation …

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6. Factors that affect exchange rate

6.1. Difference of inflation rates between 2 countries
 This factor is mentioned above (in the section of base of
exchange rate).
 Approximately: %Δe0 = πd – πf
 Imagine there is no price inflation in the U.S, while prices in
VN are increasing by 10% a year. More precisely, by the end
of the year:
 Eusd/vnd = Pvnd (1+ 10%)/Pusd

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6. Factors that affect exchange rate

2. Difference of interest rates between two countries
 In open market with no barrier for trade or capital flow, funds
would flow from countries with low expected real rates of interest
to countries with high expected real rates of interests.

Example:
 Ivnd goes up and higher than Iusd =>demand of VND rises
=>supply of USD goes up (inflow of USD) => S USD/VND
goes down => VND appreciates.
 If Ivnd goes down => demand of VND goes down => supply of
USD goes down = S USD/VND goes up => VND depreciates.
 But this situation is just right in short-term.

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6. Factors that affect exchange rate

6.2. Difference of interest rates between two countries
 According to interest rate parity, interest rates of two
countries should be matched to prevent interest arbitrage
opportunity.
 A theory in which the interest rate difference between two
countries is equal to the difference between the forward
exchange rate and the spot exchange rate.
Why Difference of interest rates between two countries affect the Difference of exchange rates between two countries?
→ Based on interest rate parity: no matter what currency you invest in, the result of investment is equal

The equation of interest rate parity: (1 + iUSD) = F/S (1 + iEUR)

In USA:
- If iUSD goes up → Demand of USD rises → Supply of Euro goes up (inflow of Euro) → S EUR/USD goes down
- If iUSD goes down → Demand of USD goes down → Supply of Euro goes down → S EUR/USD goes up

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Factors affect demand/supply of forex: turnover of export, government (controlled exchange rate), government debt (if VN attract foreign investment → increase supply of foreign currency)

6. Factors that affect exchange rate

6.3. The other factors
Besides 2 factors mentioned above, exchange rate can be affected by
balance of payment, people’s habit, war, trade barrier…
Factors affecting exchange rate: interest rate, inflation rate, non-economic factor

Factor Change in factor Response of the

exchange rate

Trade barriers

Import demand

Export demand

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7. Methods of exchange rate adjustment

Government adjust exchange rate of its currency by:
 Changing interest rates: When domestic interest rates rise
due to an expected increase in inflation, the domestic
currency depreciates .
 Changing money supply and demand:
A higher domestic money supply causes the domestic currency
to depreciate
A higher domestic money demand causes the domestic currency
to appreciate.

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7. Methods of exchange rate adjustment

 Direct tools: devaluation, revaluation, the Central Bank
operations in the foreign exchange markets, surrender,
restrictive regulation => directly affect exchange rate by
changing price of fore
 Indirect tools: rediscount rate, tariff, quotas, price
subsidies, required reserve adjustment on foreign currencies
=> affect the determinant of exchange rate such as interest
rate, trade barriers and the other non-economic policies.

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7. Methods of exchange rate adjustment

Devaluation:
 In the fixed exchange rate regime, a devaluation of a currency
refers to a drop in domestic currency’s value in comparison with
foreign currencies (made by the government).

 The signal of devaluation is that exchange rate adjusted to increase

compared to that the government committed to maintain.

 Exchange rate rises, leading to a decrease in domestic currency’s

value; therefore, it is called devaluation.

 Why does the government have to devalue domestic currency?

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7. Methods of exchange rate adjustment

Revaluation:
 In the fixed exchange rate regime, a revaluation is the activity
of the government to increase the domestic currency’s value
in comparison with foreign currencies.
 The signal of revaluation is exchange rate adjusted to
decrease compared to that the government makes a
commitment to maintain.
 Exchange rate falls, leading to a rise in the value of domestic
currency; therefore, it is called „revaluation”.
 Why does the government have to revalue domestic
currency?

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7. Methods of exchange rate adjustment

Open market operations:
 The Central Bank operations on the foreign exchange
markets are related to maintain fixed exchange rate (in the
fixed exchange rate regime) or affect exchange rate fluctuate
in the positive manner for the economy (in the managed
floating exchange rate regime).
 To make an intervention, the Central Bank is required to
have a specific amount of official foreign exchange reserves.

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7. Methods of exchange rate adjustment

Surrender (Remittance):
 The government sets regulations to force legal individuals
and entities who have foreign exchange income to sell a
specific part of their income in a specific period to those are
allowed to participate in foreign exchange trading.

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7. Methods of exchange rate adjustment

Restrictive regulation:
 A measure that regulates who are permitted to buy foreign
currencies, the purposes of foreign currency used, the
quantity of purchasable foreign currencies, and the time to
purchase foreign currencies

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7. Methods of exchange rate adjustment

Rediscount rate:
 Holding other things constant, when the Central Bank raises
rediscount rate, the average interest in the market would be
impacted to rise as an consequence. An increase in the
market interest will attract more foreign currency inflows,
leading to domestic currency appreciation.
 By contrast, a fall in discount rate would cause opposite
effects

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7. Methods of exchange rate adjustment

Tariff:
 The high level of tariff is one of contributors to penalize
import which in turn brings about a decrease in the demand
for foreign currency. As a result, domestic currency is
appreciated.
 Conversely, the low level of tariff will pose opposite effects

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7. Methods of exchange rate adjustment

Quotas:
 Like the high level of tariff, quotas put the same effect on
exchange rate and penalize import.
 Removing quotas will increase import, consequently
affecting exchange rate like the low level tariff.

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7. Methods of exchange rate adjustment

Price subsidies:
 Through the price system, the government can subsidize
strategic exports or exports in the first period of production.
Exports subsidies will encourage the quantity of exports and
increase the supply of foreign currency, leading to the
domestic currency revaluation.
 The government also can compensate price of essential
imports that could encourage imports. As a result, this could
lead to domestic currency’s value decreased.

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7. Methods of exchange rate adjustment

Required reserve adjustment on foreign currencies:
 When there is a shortage of foreign currency in the foreign
exchange market, the Central Bank can increase the required
reserve ratio on foreign currency deposits of commercial banks,
which helps increase the cost of using foreign currency capital.
 To gain profits, commercial banks are forced to lower interest rate
of foreign currency deposits; therefore, holding foreign currency
becomes less attractive than holding domestic currency, which
motivates foreign currency owners to sell foreign currency in
exchange for domestic currency. This leads to an increase in the
supply of foreign currency in the foreign exchange market

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8. Foreign exchange market

Definition:
The foreign exchange refers the organizational setting
within which individuals, businesses, governments, and
banks buy and sell foreign currencies and other debt
instruments.
Reason of FX market:
Money is not, properly speaking, one of the subjects of commerce;
but only the instrument which men have agreed upon to
facilitate the exchange of one commodity for another. It is
none of the wheels of trade: It is the oil which renders the
motion of the wheels more smooth and easy. (David Hume, Of
Money (1752))
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8. Foreign exchange market

 The foreign exchange refers the organizational setting within
which individuals, businesses, governments, and banks buy and sell
foreign currencies and other debt instruments.
 The foreign-exchange market is by far the largest and most liquid
market in the world.
 Unlike stock or commodity exchanges, the foreign-exchange
market is not an organized structure. It has no centralized meeting
place and no formal requirements for participation. Foreign-
exchange dealers are in constant telephone and computer contact,
the market is very competitive; in effect, it functions no
differently than if it were a centralized market.
 The foreign exchange market is a round-the-clock operation

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Functions of FX Market

The foreign exchange market is the mechanism by which

participants:
 transfer purchasing power between countries;

 obtain or provide credit for international trade transactions, and

 minimize exposure to the risks of exchange rate changes.

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Characteristics of FX Market

 Largest of all financial markets with average daily turnover

of over $2 trillion!
 66% of all foreign exchange transactions involve cross-
border counterparties.
 Only 11% of daily spot transactions involve non-financial
customers.
 London is the largest FX market.
 US dollar involved in 87% of all transactions.

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Market Activity – 24hrs

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Types of Transactions

FX
transaction

Basic Derivatives

Spot Forward Futures Options Swap

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Types of Transactions

A spot transaction is an agreement of purchase and sale of

foreign currency with delivery and payment to take place,
normally, not more than two business days after the date of
transaction.
The 2-day period is known as immediate delivery.
By convention, the settlement date is the second business day
after the date on which the transaction is agreed to by the
two traders.
The date of settlement is referred to as the value date.

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Types of Transactions

 A derivative is an instrument whose value depends on the values of

other more basic underlying variables
 A forward transaction is an agreement to buy or sell a specific
amount of the foreign exchange at a certain time in the future for a
certain price.
 The exchange rate is established at the time of the agreement, but
payment and delivery are not required until maturity.
 Buying Forward and Selling Forward describe the same transaction (the
only difference is the order in which currencies are referenced.
 Forward contracts are traded in the over-the-counter market

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Types of Transactions
 A futures contract is an agreement to buy or sell a specific
amount of the currency at a certain time in the future for a
certain price  forward contract
 By contrast futures are traded on the exchange.
 Terms of futures contract are standardized: contract size,
currency, date of maturity…

 EURO,GBP,JPY,AUD,CAD,CHF,NZD, MXN,RUB, NOK,

SEK…
 100,000CAD; 100,000AUD, 100.000NZD; 62.500GBP;
125.000EUR; 125.000CHF; 12.500.000JPY
 Month of maturity: Mar, Jun, Sep, Dec (third Wednesday)
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Types of Transactions
A swap transaction is the simultaneous purchase and sale of
a given amount of foreign exchange for two different
value dates.
Both purchase and sale are conducted with the same
counterparty.
Some different types of swaps are:
 spot against forward,
 forward-forward,
 nondeliverable forwards (NDF).

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Options
Two type of options:
 A call option is an option to buy a certain amount
of foreign exchange by a certain date for a certain
price (the strike price)
 A put option is an option to sell a a certain
amount of foreign exchange by a certain date for
a certain price (the strike price)

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