Topic 8: Exchange rates

References 

EPS - Foreign Trade University

http://en.wikipedia.org/wiki/Exchange_rate

A. TERMS, THEORIES AND DEFINITIONS                             

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between twocurrencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.  For example,
an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. The actual rate quoted by money dealers in the retail market will usually be different for selling or buying currency, which will incorporate an allowance for the dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a “commission” or other fee.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

Quotations

A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.3533 means that 1 Euro is able to buy 1.3533 US dollar. In other words, this is the price of a unit of Euro in US dollar. Here, EUR is called the "Fixed currency"(price currency), while USD is called the "Variable currency"(base currency / unit currency).

Free or pegged

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the revaluation (usually devaluation) of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United States dollar at RMB 8.2768 to $1.

Purchasing power of currency

The real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country's currency necessary to buy a market basket of goods in the other country, after acquiring the other country's currency in the foreign exchange market, to the number of units of the given country's currency that would be necessary to buy that market basket directly in the given country . There are different kind of measurement for RER.

Thus the real exchange rate is the exchange rate times the relative prices of a market basket of goods in the two countries. For example, the purchasing power of the US dollar relative to that of the euro is the dollar price of a euro (dollars per euro) times the euro price of one unit of the market basket (euros/goods unit) divided by the dollar price of the market basket (dollars per goods unit), and hence is dimensionless. This is the exchange rate (expressed as dollars per euro) times the relative price of the two currencies in terms of their ability to purchase units of the market basket (euros per goods unit divided by dollars per goods unit). If all goods were freely tradable, and foreign and domestic residents purchased identical baskets of goods, purchasing power parity (PPP) would hold for the exchange rate andGDP deflators (price levels) of the two countries, and the real exchange rate would always equal 1.

Bilateral vs effective exchange rate

Bilateral exchange rate involves a currency pair, while an effective exchange rate is a weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness. A nominal effective exchange rate (NEER) is weighted with the inverse of the asymptotic trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued. that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable. (When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.)

B. VOCABULARY EXERCISES

Exercise 1. Match up the half – sentences below

1. To ‘peg’ a currency against something means to 2. A clean floating exchange rate 3. Exchange  controls used to limit 4. Speculators buy or sell currencies in order to 5. ‘Market forces’ means 6. ‘Hedge’ means

a, the amount of a country’s money that residents were able to change into foreign currencies. b, fix its value in relation to it. c, make a profit by making capital gains or by investing at higher interest rates. d, is determined by supply and demand. e, trying to insure against unfavorable price movements by way of futures contracts. f, the determination of price by supply and demand (the quantity available and the quantity bought and sold.

Exercise 2. Which six of these verbs are defined below?

abolish        adjust         appreciate        convert            diverge                  establish     fluctuate            peg           suspend         revalue

1. to make changes to something

2. to change something into something else

3. to end something permanently

4. to end something temporarily

5. to go up or down (in quantity, value, etc.)

6. to move away from what is consider normal

C. READING

Exchange rates

The Bretton Woods agreement of 1944 established fixed exchange rates, defined in terms of gold and the US dollar, i.e. their parities with the US dollar were fixed. In this period, a US dollar was a promissory note issued by the United States Treasury. If anybody requested it, the Treasury had to exchange the note for 1/35^th of an ounce of gold. Under this system, overvalued or undervalued currencies could only  be adjusted with the agreement of the International Moneytary Fund. Such adjustments are called devaluations and revaluations. The Bretton Woods system of gold convertibility and pegging against the dollar was abolished in 1971, because following inflation, the Federal Reserve did not have enough gold to guarantee the American currency.

Gold convertibility was replaced by a system of floating exchange rates. (Today, the US dollar – the unofficial world currency – is merely a piece of paper on which is written ‘In God We Trust’. God! Not Gold!). A freely (or clean) floating exchange rate is determined purely by supply and demand. Theoretically, in the absence of specualtion, exchange rates should reflect purchasing power parity – the cost of a given selection of goods and services in different countries. Proponents of floating exchange rates, such as Milton Friedman, argued that currencies would automatically established stable exchange rates which would reflect economic realities more precisely than calculations by central bank officials. Yet they underestimated the impact of speculation, and the fact that companies and investors frequently follow short – term money market trends even if these are contrary to their own long – term interests.

In the late 1970s and early 1980s, the American, British and other governments deregulated their financial systems, and abolished all exchange controls. Residents in these countries are now able to exchange any amount of their currency for any other convertible currency. This has led to the current situation in which 95% of the world’s currency transactions are unrelated to transactions in goods but are purely speculative. Enormous amounts of money move round the world, chasing high interest rates or capital gains, as investors – including rich individuals, companies and pension funds – seek to maximize the value of their assets. In London alone, in the late 1990s, over $300 billion worth of currency was traded on an average day – the equivalent of about 30% of the value of the goods Britain produces each year. Banks, of course, make a profit from the spread between a currency’s buying and selling prices.

Few governments, however, leave exchange rates wholly at the mercy of market forces. Most of them attempt to influence the level of their currency when necessary. Managed (or dirty) floating exchange rate are more common than freely floating ones. For example, in the 1980s, most Western European governements joint the EMS (European Moneytary System) which established parities between member currencies. There was also an Exchange Rate Mechanism (ERM): if the rate diverged by more than plus or minus 2,25 per cent from the central parity, central banks had to intervene in exchange market, buying and selling in order to increase or decrease the value of their currency.

Yet international speculators can be more powerful than governments. For example, on a single day in September 1992, the Bank of England lost five billion pounds in a hopeless attempt to support the pound sterling. For weeks, all the world’s financial institutions and rich individuals had been selling their pounds, as everyone except the British Government believed that the pound had been seriously overvalued ever since it belatedly joined the ERM in 1990. When the British central bank ran out of reserves and could no longer buy pounds, the currency was withdrawn from the ERM and allowed to float, instantly losing about 15% of its value against D – mark. The next year, speculators attacked five other currencies, and the European Moneytary System was suspended. It was later reintroduced in a looser form.

Many manufactures are in favor of fixed exchange rates, or a single currency. Although it is possible to some extent to hedge against currency fluctuations by way of futures contracts, forward planning is difficult when the price of raw materials bought from abroad, or the price of your products in export markets, can rise or fall by 50% in only a few months. (Since exchange controls were abolished, currencies including the US dollar and the pound sterling have in turn appreciated by up to 100% and then depreciated by more than 50% against the currencies of major trading partners).

Pressure from industrialists and government led to the introduction of the euro. Twelve countries fixed their exchange rates against the new currency, and beginning in 1999 the new currency was used as a mean of payment between conpanies and in foreign trade, and bonds were denominated in it. The euro came into existence as a real currency in 2002, when the old notes and coins in the twelve member countries were withdrawn.

Exercise 1. Are the following statements TRUE or FALSE?

1. Gold convertibility was abandoned because there was too much gold.

2. It is now impossible to exchange dollars for gold.

3. Only a pegged currency can be devalued or revalued.

4. A floating currency can either appreciate or be devalued.

5. Central banks sometimes attempt to decrease the value of their currencies.

6. The EMS was designed to stabilize exchange rates.

7. To speculate is to take risks, to hedge is to try to avoid risks.

8. Under the system of floating exchange rates, currencies can depreciate 100% in a short time.

C. FOLLOW – UP EXERCISES

Exercise 1. Add appropriate words to these sentences:

1. Another verb for fixing exchange rates against something else is to .............them.

2. Increasing the value of an otherwise fixed exchange rate is called..................

3. Gold ........................ended in the early 1970s.

4. The current system is one of ....................exchange rates.

5. A currency can appreciate if lots of .....................buy it.

6. In fact we have manged floating exchange rates, because governments and ................banks sometimes intervene on currency markets.

7. Bartering is based on the exchange of ..................for goods.

8. The Bretton Woods Agreement stipulated that all members would express their currencies in ....................

9. When central banks intervene in the foreign exchange markets at the intervention points, this is called the system of .....................exchange rates. The opposite is called the system of .....................exchange rates.

10. If dealers buy currency forward but do not sell forward simultaneously, their position is said to be....................

Exercise 2. Fill in the missing words. Then number these stages in order.

funds       identification          prevailing         sterling           tradable         working days

Making a priority payment from the UK

	If the payment is in a foreign currency, the bank carries out the currency exchange at the .........................rate.
	The payment is sent by SWIFT.
	Instruct your bank to make the payment. If transferring ...................to a bank account, quote the beneficiary’s IBAN (International Bank Account Number).
	The transfer usually takes three or four...............................
	The payment is credited to the beneficiary’s account, or can be collected by the beneficiary upon production of a suitable of..........................
	Decide if you want to send the payment in....................or in another ..................currency.

Exercise 3. Choose the best words.

1. When the government doesn’t control the exchange rate in any way, the currency is ....................

a. freely convertible           b. totally convertible         c. absolutely convertible

2. The Japanese yen is trading for less than its usual value. You can talk about...............

a. a small yen                    b. a bad yen                      c. a weak yen

3. The Mexican peso is trading for more than its usual value. You can talk about................

a. a big peso                      b. a good peso                   c. a strong peso

4. A sovereign is a coin made of 7.3 grams of gold, and is worth a lot of money. However, its ....................is just one pound.

5. Changes in the values of currencies are called............................

a. currency fluctuations     b. currency alterations      c. currency changes

6. An Internet site which does currency calculations based on the latest exchange rates called a...................

a. currency changer           b. currency converter        c. currency setter

7. When you change money, you usually have to pay a................

a. commision                     b. percentage                     c. fee

8. When changing money, banks tend to offer a ...................exchange rate than bureaus de change.

a. better                             b. nicer                              c. fatter

E. GUIDE

Vocabulary

Exercise 1.

1 – B, 2 – D, 3 – A, 4 – C, 5 – F, 6 – E

Exercise 2.

1 – adjust, 2 – convert, 3 – abolish, 4 – suspend, 5 – fluctuate, 6 – diverge

Reading

Exercise 1.

1 – F, 2 – T, 3 – T, 4 – F, 5 – T, 6 – T, 7 – T, 8 – T

Follow – up

Exercise 1 1. peg 2. revaluation 3. standard 4. floating 5. speculator 6. central 7. goods 8. gold 9. fixed, floating 10. long

Exercise 3 1 a 2 c 3 c 4 b 5 a 6 b 7 c 8 a

Exercise 2

3	If the payment is in a foreign currency, the bank carries out the currency exchange at the ...prevailing.......rate.
4	The payment is sent by SWIFT.
1	Instruct your bank to make the payment. If transferring ....funds.....to a bank account, quote the beneficiary’s IBAN (International Bank Account Number).
5	The transfer usually takes three or four...working days...
6	The payment is credited to the beneficiary’s account, or can be collected by the beneficiary upon production of a suitable means of..identification.......
2	Decide if you want to send the payment in...sterling..or in another ....tradable.....currency.