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An exchange rate is an expression of national currency's quotation in terms of a foreign currency or vice versa. The GBP - USD exchange value is 1.5534 and USD - GBP exchange value is 0.6437 (Bloomberg, 2010).
Determinants of Exchange Rates
Exchange rate market is the largest financial market in terms of size and is irrespective of being absolutely an over the counter market. Under this hood comes the interbank market whose main purpose is to trade spot and forward contracts.
Following are some basic principles that determine exchange rates:
Interest rates and exchange rates are very much associated with each other and changing interest rates impact currency values directly. From a lenders perspective, a higher interest rate will offer a higher return as compared to other countries. Consequently, a higher interest rate attracts foreign investment and encourages the exchange rate to rise. Contrary to that, the decreasing interest rates will cause the exchange rates to lower as well (Tkac, 2004). If interest rates increase in the UK then it becomes relatively more attractive for investors to reduce its spending and save money in the British banks or through buying British bonds.
With the perspective of countries experiencing an economic downturn, traders tend to notice that the exchange rate is weakening. For traders in the currency markets, a slow growth is a sign of general economic weakness which in turn can cause the value of the currency to decrease due to loss of investor confidence.
Economies with import led scenarios may see their currency's value to fall. This may be because the financial markets get worried about the slow growth in the country or the obstinately elevated unemployment. Herd mentality kicks in at this point which explains the investors' persistent withdrawal of interest from the financial market.
Political Stability and Economic Performance
Foreign financiers predictably seek out to the countries with somewhat stable and strong financial and economic performance. With such positive attributes the financial markets will draw all the monetary attention to the country as compared to other countries perceived to have more political and economic risk. For example, politically unstable countries can face a loss of investor confidence in currency of a country. Hence, they'll move to the countries with more stable currency. As a recent shift from Pound sterling to Euro has been noticed all over Europe during the economic downturn.
With a basic economic principle of demand and supply, exchange rate is dependent on inflation rate as well. Generally, a country with steadily lower inflation rate shows a higher currency value and its exchange rate. This means that the currency's purchasing power increases as compared to other currencies. It is usually accompanied by higher interest rates.
With an inflation rate high, a country loses its competitiveness in the international markets. This causes the exports to fall and the imports to rise. In this scenario, a fall in the exchange rate may be needed to restore a country's competitiveness in overseas markets. Hence, inflation affects exchange rates adversely.
Balance of Payments
Exporting goods represent a demand of domestic currency like Pound Sterling from foreign importers. When American consumers buy British household electrical goods, they supply dollars as an exchange and this is sooner or later transformed into a demand for pounds.
Correspondingly, when British consumers buy imports, they give away British Pounds and eventually generate a demand for US Dollar. If a country is having a trade surplus there will be a large demand for its currency and if it's having a deficit, the currency will lose its exchange value.
There are two perspectives to the empirical evidence i.e. the long term aspect and the short term one. This evidence provides substantiation to the fact that short term interest rates can attract capital and temporarily raise currency values. With the commonality of investors, indications are found that the investor's anticipation of the interest rates going higher in the future, along with projections of reasonably low inflation in an economy can attract investment and increase demand for currency. Graphs in appendix show the trends followed by British pound and US Dollar during 2009. The trend is very mixed and fluctuating for total number of US Dollars required to buy a British pound and vice versa.
Contrarily, rising long term interest rates have been found out to be linked with declining currency exchange values. One reason to this could be the fact that long term interest rates substitute for inflation forecasts because an increase in long term interest rates result in losses to investor investing abroad. Modern-day trade flows also affect currency exchange values (Conway, 2008).
Law of one price is also commonly practiced in the financial markets because no trader will set its commodity price or exchange rate to an undesired level. Similarly, no currency can be bought or sold at a higher exchange price or at lower exchange price respectively.
Another significant inference is that the central banks and intermediaries can influence and control exchange rates with various determinants over short interims. However, longer term exchange rates are usually dependent on relative prices of real goods.
Foreign Exchange Quotation
Quote is basically the highest bid price or the lowest ask price available on a security at any given point in time.
Foreign exchange rates can be quoted in several ways. Some of them are mentioned below
A direct quote is a foreign currency exchange rate which is quoted as domestic currency per each unit of foreign currency. For example, in Britain, the direct quote for US Dollar will be GB£0.6437 = US$1. Conversely, in the US, the direct quote for British Pound will be US$1.5534 = GB£1.
An indirect quote is a foreign currency exchange rate which is quoted as foreign currency per each unit of domestic currency. For example, in Britain, the indirect quote for US Dollar will be US$1.5534 = GB£1. Contrariwise, in the US, the direct quote for British Pound will be GB£0.6437 = US$1.
SPOT and Forward Exchange Rates
Following are the details on spot and forward exchange rates (Eugene F. Brigham, 2004).
A spot rate is the effective exchange rate for a foreign currency in case of delivery on approximately the current day.
Forward Exchange Rate
A forward exchange rate is an already agree upon price at which two currencies will be exchanged at some future date.
Calculating the Forward Exchange Rate
Let's suppose that spot rate for USD/GBP = 0.6437 which means that 1 US$ is 0.6437£. Interest rate in UK is 3.5% and in the US it is 5.5%. Let's put these values in the following formula:
Forward exchange rates = =
= 0.6437 = 0.6437 = 0.6315
Thus the forward rate of 1 USD = 0.6315 GBP
Time Series Plot
Time series plot for both British Pound Sterling per US dollar and the US dollar per Pound Sterling can be viewed in the appendix.
Although the pound showed some signs of appreciation till the first quarter of 2009, it was already 20% lower than it was in August 2007. After that a constant decline was observed till the second quarter of 2009 when the value stabilized till the end of July. A steep fall and then recovery was observed in the August. This was due to the initiation of many rescue plans for banks (Avril Ormsby, 2009). Till the end of the year, the economy and the exchange rates kept fluctuating. Many reasons for Pound's depreciation include the low interest rates of 0.5% and the probability of interest rates to stay low was persistent for throughout the year. The bank of England was of the view that by keeping the Pound low will protect the interest rates.
Another ample reason according to BBC (2009) for the depreciation of Pound was the persistent current account deficit. BoE wanted Pound to fall to regain the trade balance. Ease in the rise in inflation also accelerated the process of Pound depreciation. Large government debt also acted as a key player in the whole process. This made the markets more panicky over Pound's future. The Pound has depreciated by around 12.34% in 2009 from January to December.
Foreign Exchange Risk Exposure
Assuming that we, a US based firm, have loaned out US$ 10 million to a British based firm. Even though the British firm borrows an amount denominated in US dollars, however, eventually they will have to convert the returns into Pounds. The movement in the exchange rate exposes both the borrower and the lender, Here the British firm as borrower and our firm as the lender, to a certain type of risk that is affiliated with the movement in the exchange rate. This is known as the exchange rate risk or Currency risk.
Since we have loaned out a dollar amount of 10 million, if during the period of loan, the price of pound falls against the US dollar, then we shall have a return on our dollar amount that is worth more Pounds then expected making us better off than our client. However, if the dollar price of Pound per Dollar should rise, than we shall have an amount that is worth less Pounds and we shall be worse off (BBC, 2009). This is only a matter of perception to us as we lent an amount in Dollars and we expect to receive the principal plus the interest in dollars, the foreign Exchange rate risk affects us to a minimal level. Our main focus should be on the interest rate that we lent on.
Our Client, on the other hand, incurs losses and gains on part of the exchange rate risk. So the rise in Pounds' price against Dollar would benefit our client putting them in less exchange rate risk exposure and vice versa. The exchange rate risk exposure depends, heavily, upon the volatility of the exchange rate and the factors affecting the exchange rate. And thus in turn predicts the exchange rate risk in a particular market transaction.
To provide our investments a shelter from certain types of market risks we use contracts such as Options, Futures, Forwards and Swaps that we shall discuss below (Jones, 2007).
Options is a contract that gives the holder the right to buy or sell a fixed number of shares of security at a fixed or given price before a certain date that the contract expires on. Option contracts are classified into two types
A right given to the holder of the contract to buy a fixed number of shares of a stock before a certain expiration date at a fixed or agreed price is known as a Call Option. For example, for a British individual holding currency as an asset according to an asset approach. If the currency is to appreciate in the near future say GBP with respect to USD, he or she would go for a call option to hedge from the appreciated exchange rate and gain profits through hedging.
A right given to the holder of the contract to sell a fixed number of shares of a stock before a certain expiration date at a fixed or agreed price is known as a Put Option. Like before for Call option if the individual wished to hedge himself from depreciating currency (GBP) in the future. He would go for a put option and hedge himself from the risk of losing money from selling at depreciated rate of exchange.
A contact that commits the involved parties today to make a transaction in the future at a fixed price that is specified on the current date is known as a Forward Contract or Forward. Forward contracts involve liquidity risk given the difficulty of getting out of the contract and a credit risk i.e. the involved parties can default on their obligation (G.A. Larsen, 2000). However the most attractive feature of this contract stays to be that it is customizable to the needs of the parties involved unlike the Future Contracts.
A Future contract is a 'standardized transferable agreement' that allows for a transaction in the future of a particular asset at a currently specified price. The future contracts do not involve credit risk; however, they are not customizable to the needs of the involved parties either and are thus called Standardized agreements.
The parties that are exposed to risk of price changes i.e. risk due to volatility in price fluctuations, hedge themselves against such risks by going under future contracts. The parties hedging themselves against risks are called hedgers and they hedge themselves using Future contracts. In this way they reduce the risk of adverse fluctuations in prices (Raimond Maurer, 2007).
Investors can take two kinds of positions as hedgers.
In Short Hedge, the transaction that takes place involves selling the future contract while holding the asset.
In Long Hedge, the transaction that takes place involves purchasing the future contract to lock the current price while not holding the asset.
Swaps are agreements to exchange a series of cash flows on periodic settlement dates over a certain period of time. Typical swaps include quarterly payments over a year's time. Difference between interest rate and currency swaps is mentioned below.
Interest Rate Swaps
An interest rate swap takes place with an exchange of a fixed rate loan to a floating rate loan. The principle of comparative advantage actively takes place in this type of swaps.
In a currency swap, one individual makes the imbursement in one currency while the other individual make the payment in a secondary currency.
Given the circumstances we can minimize our risks by using one the above mentioned contracts to hedge ourselves from possibility of incurring real losses in future. These contracts provide a cushion against the risk exposure and project positive expectation of the return. By using options we can hold on to the right to sell or buy at the fixed exchange rate to cushion from probable depreciation of our domestic currency against the pounds, that will make every dollar worth less in pounds and make us worse off.
Similarly with forward and future contracts we see that we can customize according to our needs in the former one to specify a fixed price or exchange rate while standardization n low credit risk are part of the latter. However with option we do have the options of not exercising our right of making transactions in case of appreciation of dollar and rather facing an unexpected gain. Similarly our client can also use these instruments to hedge itself from depreciation of his own currency which means appreciation of dollar and hence meaning that he may have to pay more in pounds now.
Foreign currency options
A foreign currency option is an opportunity that provides the owner with the right to buy or sell the desired amount of foreign currency at specific price on or before a specified date. In terms of trading volumes, currency option market is among the largest of the option markets. Majority of trading in currency options is done in the private interbank markets (Wiley, 2007).
Following are some common types of foreign currency options.
Vanilla option is another name of standard or basic form of currency option. These resemble the options contracts for securities like stocks etc. in this, the buyer has a right to buy or sell a currency at a price that is ensured until the contract for options expire. The price is called strike price. The trader is at liberty to opt for a strike price and an expiry date. A premium is charged to the trader by the broker, usually the option writer (Coulling, 2010).
SPOT is actually an acronym for Single Payment Options Trading. The working mechanism is simple; the trader predicts a specific scenario and pays a premium amount. If the predicted event occurs, the trader gets a payoff amount. This payoff amount is actually the difference between the strike price pre-mentioned in the SPOT option as well as in the proposition offered by the trader in the beginning. If the event does not occur, then the trader simply loses the premium (Coulling, 2010). An example of a SPOT option is the If-touch option. If the currency exchange rate touches the predefined value before the option expires, the trader gets a payoff amount.
Use of Options
Some of the elementary trading approaches for options are mentioned below.
Buying Call Option
We buy a call option if we expect the price of a stock or any security to rise quickly during a period in time. This doesn't mean that we'd stay profitable all the time. If the underlying price of security rises not as expected, we lose money.
Writing Put Option
We write a put option when we expect that the price of a stock or a security will not fall too much or too quickly. This is done in order to enter a stock at a real bargain. Again, this doesn't always pay off; that is when the stock crashes, we're left with a loss (Matras, 2009).
Expiration - Premium Relationship
Two option contracts similar in all respects but with different expiration dates are bound not to be traded at the same premium. The reason for this or should we say a hidden dissimilarity is that that risk premium is a compensation for the risk involved in any investment that is a factor of the return on that particular investment.
Since an option contract that has different expiration dates are being exposed to different duration. And given unequal lengths of time periods, there is an inequitable chance of volatility for both options while one may have more and the other may be exposed to less. In this case, different level of changes may take place on price charts, provided the difference in the time duration of expiration to allow for volatility. Hence there is a different level of risk attached to each option contract with different expiration dates even though they stand similar in all other respects. And thus the reason why these two option contracts would not trade on the same premium.
Deep in the Money Option
A Deep in the money option is an option which has the strike or an exercise price considerably below or above, for call and put respectively, the market price for an asset. The time to maturity is undoubtedly the major determinant of the value of any option. Most investors should usually avoid deep in-the-money options because they are expensive and their profit potential is very limited as compared to others. Same goes for deep out-of-the-money options. The premium on these options is low and so is the chance of large return on them. Most investors would probably be better off with trivially involved in out-of-the-money or in-the-money options or more preferably the ones that are at-the-money.
Since our client is an exporter, it would benefit him to sell his merchandise to US importer, assuming we are the importers based in the US and we would pay for the exports in pounds sterling, when GBP appreciates because the appreciation of British pound against dollar would mean that every pound that our client receives is worth more of US Dollar. Similarly if GBP depreciates, as the question requires of the situation, it would not be in our clients benefit to receive a payment that is worth less in dollars.
The reason is that after depreciation every pound would be worth less in dollar amount. Thus our common business instinct would make sense to buy at a low price and sell at a higher price. In the case of exchange rate involvement it would be wise to buy where domestic currency appreciates and sell when it depreciates against some foreign currency.
Since pound is depreciating against dollar, this would mean a high time to hedge against the climbing exchange rate and go for call option and thus our client would be much better off with a call option. However, a more precise decision would come easy with a more detailed given scenario.
List of References
Avril Ormsby, J. J. (2009, January 19). TIMELINE-British actions to deal with financial crisis. Retrieved August 25, 2010, from Reuters: http://uk.reuters.com/article/idUKTRE50I2B720090119
BBC. (2009). Global recession timeline . Retrieved August 24, 2010, from BBC News: http://news.bbc.co.uk/2/hi/business/8242825.stm
BBC. (2009, August 7). Timeline: Credit crunch to downturn. Retrieved August 25, 2010, from BBC News: http://news.bbc.co.uk/2/hi/business/7521250.stm
Bloomberg. (2010, August 22). Currency . Retrieved August 22, 2010, from http://www.bloomberg.com/markets/currencies/
Conway, E. (2008, June 28). British household debt is highest in history. Retrieved August 25, 2010, from Telegraph website: http://www.telegraph.co.uk/finance/2792372/British-household-debt-is-highest-in-history.html
Coulling, A. (2010). Currency Options Market. Retrieved August 25, 2010, from http://www.currency-options-trading.com/currency-options-market/
Eugene F. Brigham, J. F. (2004). Fundamentals of Financial Management 10th Edition. Ohio: Thomson South Western.
G.A. Larsen, B. R. (2000). the optimal construction of internationally diversified equity portfolio hedged against exchange rate uncertainty. European Financial Management, Vol. 6, pp. 479-519.
Jones, C. P. (2007). Investments: Analysis and Management. 10th Edition. New Jersey: Wiley Inc.
Matras, K. (2009, May 22). Put Option Writing - How It Works. Retrieved August 25, 2010, from http://www.dailymarkets.com/options/2009/05/22/put-option-writing-how-it-works/
Raimond Maurer, S. V. (2007). Hedging the exchange rate risk in international portfolio diversification: Currency forwards versus currency options. Managerial Finance, Vol. 33 Iss: 9, pp.667 - 692.
Tkac, P. A. (2004). Economic Review. Retrieved August 22, 2010, from Federal Reserve Bank of Atlanta: http://www.frbatlanta.org/filelegacydocs/erq404_tkac.pdf
Wiley. (2007). Retrieved August 25, 2010, from http://media.wiley.com/product_data/excerpt/15/04713164/0471316415.pdf
Yahoo. (2009). Finance. Retrieved August 25, 2010, from Yahoo Inc.: http://finance.yahoo.com/echarts?s=GBPUSD=X#symbol=GBPUSD=X;range=1d;compare=
Yahoo. (2009). Finance. Retrieved August 25, 2010, from Yahoo Inc.: http://finance.yahoo.com/echarts?s=USDGBP%3Dx#chart2:symbol=usdgbp=x;range=20090105,20100104;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=off