Module : The Exchange Rate Risk Management

Strategy

Introduction:

Module Outcome:

Specific Learning Outcomes:

3.1
3.2
3.3
 Let’s get
ready to
ENGAGE!

Pre-Activity!

Philippine Peso Exchange Rates Table

Currency Peso to Currency Conversion Currency to Peso Conversion

US Dollar

Euro

British Pound

Indian Rupee

Australian Dollar

Canadian Dollar

Singapore Dollar

Swiss Franc

Malaysian Ringgit

Japanese Yen
 Let’s What Is Foreign Exchange (Forex)?

EXPLORE!

ual traders (mostly trading through brokers or banks).

How Does Foreign Exchange Work?

The market determines the value, also known as an exchange rate, of the majority of currencies. Foreign
exchange can be as simple as changing one currency for another at a local bank. It can also involve trading
currency on the foreign exchange market. For example, a trader is betting a central bank will ease or tight-
en monetary policy and that one currency will strengthen versus the other.

When trading currencies, they are listed in pairs, such as USD/CAD, EUR/USD, or USD/JPY. These
represent the U.S. dollar (USD) versus the Canadian dollar (CAD), the Euro (EUR) versus the USD and theUSD
versus the Japanese Yen (JPY).

There will also be a price associated with each pair, such as 1.2569. If this price was associated with the
USD/CAD pair it means that it costs 1.2569 CAD to buy one USD. If the price increases to 1.3336, then it now costs
1.3336 CAD to buy one USD. The USD has increased in value (CAD decrease) because it now costs more CAD
to buy one USD.

In the forex market currencies trade in lots, called micro, mini, and standard lots. A micro lot is 1000 worth
of a given currency, a mini lot is 10,000, and a standard lot is 100,000. This is different than when you go to a bank
and want $450 exchanged for your trip. When trading in the electronic forex market, trades take place in set
blocks of currency, but you can trade as many blocks as you like. For example, you can trade seven micro lots (7,000)
or three mini lots (30,000) or 75 standard lots (7,500,000), for example.

Factors that Affect Foreign Exchange Rates

Understanding Foreign Exchange Market

What Is the Foreign Exchange Market?

The foreign exchange market (also known as forex, FX, or the currency market) is an over-the- counter
(OTC) global marketplace that determines the exchange rate for currencies around the world. Participants are able to
buy, sell, exchange, and speculate on currencies.

Understanding the Foreign Exchange Market

The foreign exchange market—also called forex, FX, or currency market—was one of the original
financial markets formed to bring structure to the burgeoning global economy. In terms of trading volume,
it is, by far, the largest financial market in the world. Aside from providing a venue for the buying, selling,
exchanging, and speculation of currencies, the forex market also enables currency conversion for interna-
tional trade settlements and investments. According to the Bank for International Settlements (BIS), which
is owned by central banks, trading in foreign exchange markets averaged $6.6 trillion per day in April 2019.

Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative to
the value of the other. This determines how much of country A's currency country B can buy, and vice ver-
sa. Establishing this relationship (price) for the global markets is the main function of the foreign exchange
market. This also greatly enhances liquidity in all other financial markets, which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or "fixed float". Free-floating
currencies are those whose relative value is determined by free market forces, such as supply-demand rela-
tionships. A fixed float is where a country's governing body sets its currency's relative value to other cur-
rencies, often by pegging it to some standard. Free-floating currencies include the U.S. dollar, Japanese yen,
and British pound, while examples of fixed floating currencies include the Chinese Yuan and the Indian
Rupee.

One of the most unique features of the forex market is that it is comprised of a global network of fi-
nancial centers that transact 24 hours a day, closing only on the weekends. As one major forex hub closes,
another hub in a different part of the world remains open for business. This increases the liquidity available
in currency markets, which adds to its appeal as the largest asset class available to investors.

The most liquid trading pairs are, in descending order of liquidity:

1. EUR/USD 2. USD/JPY 3.GBP/USD

Benefits of Using the Forex Market

 There are fewer rules, which means investors aren't held to the strict standards or regulations found in
other markets.

 There are no clearing houses and no central bodies that oversee the forex market.

 Because the market is open 24 hours a day, you can trade at any time of day, which means there's no cut-
off time to be able to participate in the market.

Trading in the Foreign Exchange Market

The market is open 24 hours a day, five days a week across major financial centers across the globe. This
means that you can buy or sell currencies at any time during the day. The foreign exchange market isn't exactly
a one-stop shop. There are a whole variety of different avenues that an investor can go through in order to exe-
cute forex trades. You can go through different dealers or through different financial centers which use a host
of electronic networks. From a historical standpoint, foreign exchange was once a concept for governments,
large companies, and hedge funds. But in today's world, trading currencies is as easy as a click of a mouse—
accessibility is not an issue, which means anyone can do it. In fact, many investment firms offer the chance for
individuals to open accounts and to trade currencies however and whenever they choose.

When you're making trades in the forex market, you're basically buying or selling the currency of a par-
ticular country. But there's no physical exchange of money from one hand to another. That's contrary to what
happens at a foreign exchange kiosk—think of a tourist visiting Times Square in New York City from Japan.
He may be converting his (physical) yen to actual U.S. dollar cash (and may be charged a commission fee to do
so) so he can spend his money while he's traveling. But in the world of electronic markets, traders are usually
taking a position in a specific currency, with the hope that there will be some upward movement and strength
in the currency that they're buying (or weakness if they're selling) so they can make a profit.
 Differences in the Forex Markets

There are some fundamental differences between foreign exchange and other markets. First of all,
there are fewer rules, which means investors aren't held to as strict standards or regulations as those in
the stock, futures or options markets. That means there are no clearing houses and no central bod- ies
that oversee the forex market.

Second, since trades don't take place on a traditional exchange, you won't find the same fees
or commissions that you would on another market. Next, there's no cut-off as to when you can and can-
not trade. Because the market is open 24 hours a day, you can trade at any time of day. Finally, because
it's such a liquid market, you can get in and out whenever you want and you can buy as much currency
as you can afford.

The Spot Market- Spot for most currencies is two business days; the major exception is the U.S. dollar versus
the Canadian dollar, which settles on the next business day. Other pairs settle in two business days. During
periods that have multiple holidays, such as Easter or Christmas, spot transactions can take as long as six
days to settle. The price is established on the trade date, but money is exchanged on the value date. The
U.S. dollar is the most actively traded currency.3 The most common pairs are the USD versus the euro, Japanese
yen, British pound and Australian dollar.4 Trading pairs that do not include the dollar are referred to as crosses.
The most common crosses are the euro versus the pound and yen. The spot market can be very volatile.
Movement in the short term is dominated by technical trading, which focuses on direction and speed of
movement. People who focus on technical are often referred to as chartists. Long-term currency moves
are driven by fundamental factors such as relative interest rates and economic growth.

The Forward Market- A forward trade is any trade that settles further in the future than spot. The
forward price is a combination of the spot rate plus or minus forward points that represent the
interest rate differential between the two currencies. Most have a maturity less than a year in the fu- ture but
longer is possible. Like with a spot, the price is set on the transaction date, but money is ex- changed on the
maturity date. A forward contract is tailor-made to the requirements of the counterpar- ties. They can be
for any amount and settle on any date that is not a weekend or holiday in one of the countries.

The Futures Market- A futures transaction is similar to a forward in that it settles later than a spot deal,
but is for standard size and settlement date and is traded on a commodities market. The exchange acts as
the counterparty.

Example of Foreign Exchange

A trader thinks that the European Central Bank (ECB) will be easing its monetary policy in the coming
months as the Eurozone’s economy slows. As a result, the trader bets that the euro will fall against the U.S.
dollar and sells short €100,000 at an exchange rate of 1.15. Over the next several weeksthe ECB signals
that it may indeed ease its monetary policy. That causes the exchange rate for the euro to fall to 1.10 versus
the dollar. It creates a profit for the trader of $5,000. By shorting €100,000, the trader took in $115,000 for
the short-sale. When the euro fell, and the trader covered their short, it cost the trader only $110,000 to
repurchase the currency. The difference between the money received on the short-sale and the buy to cover
is the profit. Had the euro strengthened versus the dollar, it would have resulted in a loss.
 Let’s
Lesson 6:
EXPLAIN!
Analyzing Exchange Rate Forecasting

Exchange Rate Forecasting

3 Common Ways to Forecast Currency Exchange Rates

(1.) Purchasing Power Parity

The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in
most economic textbooks. The PPP forecasting approach is based on the theoretical law of one price, which
states that identical goods in different countries should have identical prices.

According to purchasing power parity, a pencil in Canada should be the same price as a pencil in the
United States after taking into account the exchange rate and excluding transaction and shipping costs. In
other words, there should be no arbitrage opportunity for someone to buy inexpensive pencils in one coun-
try and sell them in another for a profit.

The PPP approach forecasts that the exchange rate will change to offset price changes dueto
inflation based on this underlying principle. To use the above example, suppose that the prices of pencilsin
the U.S. are expected to increase by 4% over the next year while prices in Canada are expected to rise by
only 2%. The inflation differential between the two countries is:

4%−2%=2%

This means that prices of pencils in the U.S. are expected to rise faster relative to prices in Canada. In
this situation, the purchasing power parity approach would forecast that the U.S. dollar would have to de-
preciate by approximately 2% to keep pencil prices between both countries relatively equal. So, if the cur-
rent exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an exchange rate
of:

(1+0.02)×(US $0.90 per CA $1)=US $0.92 per CA $1

Meaning it would now take 92 cents U.S. to buy one Canadian dollar.

One of the most well-known applications of the PPP method is illustrated by the Big Mac Index,
compiled and published by The Economist. This lighthearted index attempts to measure whether a curren-
cy is undervalued or overvalued based on the price of Big Macs in various countries.
 (2.) Relative Economic Strength

As the name may suggest, the relative economic strength approach looks at the strength of economic growth
in different countries in order to forecast the direction of exchange rates. The rationale behind this approach is
based on the idea that a strong economic environment and potentially high growth are more like-ly to attract
investments from foreign investors. And, in order to purchase investments in the desired country, an investor
would have to purchase the country's currency—creating increased demand that should cause the currency to
appreciate.

This approach doesn't just look at the relative economic strength between countries. It takes a more general
view and looks at all investment flows. For instance, another factor that can draw investors to a cer- tain country
is interest rates. High interest rates will attract investors looking for the highest yield on their investments, causing
demand for the currency to increase, which again would result in an appreciation of the currency. Conversely, low
interest rates can also sometimes induce investors to avoid investing in a particular country or even borrow that
country's currency at low interest rates to fund other investments. Many inves-tors did this with the Japanese
yen when the interest rates in Japan were at extreme lows. This strategy is commonly known as the carry trade.

The relative economic strength method doesn't forecast what the exchange rate should be, unlike the
PPP approach. Rather, this approach gives the investor a general sense of whether a currency is going to ap-
preciate or depreciate and an overall feel for the strength of the movement. It is typically used in combination
with other forecasting methods to produce a complete result.

(3.) Econometric Models of Forecasting Exchange Rates

Another common method used to forecast exchange rates involves gathering factors that might affect
currency movements and creating a model that relates these variables to the exchange rate. The factors used
in econometric models are typically based on economic theory, but any variable can be added if it is believed
to significantly influence the exchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the
USD/CAD exchange rate over the next year. They believe an econometric model would be a good method to
use and has researched factors they think affect the exchange rate. From their research and analysis, they
conclude the factors that are most influential are: the interest rate differential between the U.S. and Canada
(INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two
countries. The econometric model they come up with is shown as:

USD/Cad(1 - Year)=z+a(INT)+b(GDP)+c(IGR)where:

z=Constant baseline exchange rate; a,b and c=Coefficients representing relativeweight of each factor;
INT=Difference in interest rates betweenU.S. and Canada; GDP=Difference in GDP growth rates;
IGR=Difference in income growth rates

After the model is created, the variables INT, GDP and IGR can be plugged in to generate a forecast.
The coefficients a, b, and c will determine how much a certain factor affects the exchange rate and direction of
the effect (whether it is positive or negative). This method is probably the most complex and time- consuming
approach, but once the model is built, new data can be easily acquired and plugged in to gener- ate quick
forecasts.
 Module 3 References and Additional Readings:

https: www tutorialspoint com international finance

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