An exchange rate (also known as Foreign-Exchange rate or Forex rate or FX rate) is the rate at which one currency can be exchanged for another. For example, the currency exchange rate for GBP-USD is 1.5393 or to quote it the other way around USD-GBP is 0.6502 (Bloomberg, 2010).
Reference: Wikipedia
Determinants of Exchange Rates
Exchange rates are volatile and are subject to rapid changes owing to the forces of supply and demand of the currencies in light which in turn are affected by a few other factor determinants. The changes could be a smooth line of inclination or declination as well as be an absolute anomaly which it usually is. The exchange rate can be fixed by the Central bank for one. The factors that put pressure on this fixed rate or alter the floating exchange rates include real variables like
Trade Balance
Balance of trade is one of the effective determinants of the exchange rates. A surplus in the balance would lead to a higher demand for the domestic currency (here the GBP) appreciating its value while a deficit in the trade account would affect otherwise.
Law of One Price
According to the law of one price, the price of single good should be the same worldwide if expressed in the same currency assuming that there are no other costs attached. Given that the exchange rates should fix accordingly to compensate for inflation differences in the two countries. Say the same good selling for 2 pounds cost $4.5 in US (The value are not real) . Here the exchange rate should reflect the inflation difference.
Besides the real variables the changes also often follow the Monetary and Financial variable such as
Interest Rates
Exchange rates and Interest rates go hand in hand. A change in interest rate stirs a change in the exchange rate and it goes the other way around as well. A higher interest rate attracts foreign investment into the country which fills the foreign reserve and lessens the relative demand for foreign currency. Consequently the appreciation in the domestic currency takes place and exchange rate change. Same would be the effect for an opposite change in the interest rates abroad. Similarly a decrease in domestic interest rates would call for depreciation in the currency. So an increase in the interest rates in Britain would lead to an appreciation of GP relative to the USD.
Inflation
Higher inflation often accompanies lower interest rate and thus depreciation in the currency or higher exchange rate (if quoted as GBP-USD) and vice versa. The change in the purchasing power between the two countries is reflected though the interest rate, however, its practical analysis would sometime project differently.
Political and Economic influence
Political instability and economic turmoil are two of the major pests of a country's economy. A country undergoing any of these two or both not only fails to attract foreign investment but also drives away the existing ones. This puts the whole economy in major chaos. The exchange rates for one rise drastically projecting high depreciation in the currency which not only summarizes the normal exchange rate fluctuation but shows the picture of major down falls of many of other economic and financial elements of the country like the interest rates, inflation etc. So a stable political situation and Economic growth would tend to do better for the country both in preservation sense and in the currency market.
Reference: http://www.economicswebinstitute.org/glossary/exchrate.htm#determinants
Empirical Evidence
The empirical evidence that supports the fund flow statement can be seen in the concept of long term and short term perspective of changes in the interest rates that in turn influence the flow of funds and thus affect the exchange rate accordingly. It can be better understood this way. Long term changes in the interest rate (say a hopeful increase) would induce the funds or foreign currency to flow in the long term and thus hold back in the short run. This would cause depreciation (a rise in exchange rate if its is quoted indirecty) in the currency in short run. On the other hand A short run increase in the interest rate would induce inflow of foreign currency and hence a domestic currency appreciation.
The Asset approach is evident in the exchange market of currency where they are sold and bought at specified rate (The Exchange Rate) assets. The law of one price holds here for if the exchange rate would differ between two places the arbitrage would push towards the one acceptable price as the exchange rate.
Foreign Exchange Quotation
An exchange system quotation is stated as the number of units of "quote currency or the foreign currency" that can be exchanged for one unit of "base currency or domestic currency".
For example, in a quotation that says the GBP/USD exchange rate is 1.5393 (1.5393 USD per GBP, the quote currency is USD and the base currency is GBP (Bloomberg, 2010).
There are two ways to quote an exchange rate,
Direct Quotation
From a country's perspective (say Britain or UK), quotes using a country's domestic currency as the 'quote currency' (e.g., GBP 0.6496 = USD 1.00) are known as direct quotation or price quotation from that country's perspective (Bloomberg, 2010).
Indirect Quote
From a country's perspective (say Britain or UK), quotes using a country's domestic currency as the 'base currency' (e.g., GBP 1 = USD 1.5393) are known as indirect quotation or quantity quotations from that country's perspective (Bloomberg, 2010).
Wikipedia
Spot and Forward Exchange Rates
Spot and forward exchange rate can be defined as follows
Spot Rate
The current exchange rate is mostly referred to as the 'Spot Rate'.
Forward Exchange Rate
An exchange rate that is quoted and traded on the current or present day however, delivered or paid for on specified date in the future is known as 'Forward Exchange Rate'
WIKIPEDIA
Calculating the Forward Exchange Rate
A forward exchange rate s calculated by using the following formula
Forward Exchange Rate = S [(1+rq)n / (1+rb)n]
Where S = Spot price (USD/GBP=0.6496)
rq = Interest rate in UK ( say 4.6%)
rb = Interest rate in US ( say 5.3%)
n = Time period (say number of time period is 1)
So
Forward Exchange rate = 0.6496 = 0.6496x 0.9934 = 0.6452
Thus forward rate 1 USD = 0.6452GBP
The spread can then be calculated by from spot rate
Time Series Plot
In 2009 the pound was seen to depreciate along the general trend till March where the exchange rate quoted indirectly was seen too peek. However the annual trend of British Pound was observed to have a general trend of falling exchange rate showing an appreciation against the US dollar in the year 2009 besides the random fluctuation along them monthly chart
Starting from an exchange rate USD/GBP of 0.68, or in GBP/USD terms 1.45, it was seen to rise as high as to around 0.73 in USD/GBP quotation or fall to GBP/USD quotation of 1.37, and then fell to close at USD/GBP of 0.63, or rose to GBP/USD of 1.60, by the year end.
The Exchange rate quoted above are mere approximations taken from the charts in the appendix but along the annual trend line the British Pound is seen to have appreciated and the exchange rate has fallen by 7.3% in direct quotations and in indirect terms the exchange rate has risen by 10.3% in the year 2009 according the charts provided in the Appendix taken from Yahoo, 2009.
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
Part B
Foreign Exchange Risk Exposure
Exchange Rate risk or Currency risk is the risk of incurring a loss at the hands of variation or movement in the exchange rates.
There are three types of risks that exchange rate are exposed to,
Transaction Risk Exposure
Translation Risk Exposure
Economic Risk Exposure
A Transaction Risk may be imposed in the course of a settlement of any foreign exchange transaction incurring a loss or a gain.
A Translation Risk may be imposed when changes in accounting income or balance sheet take place due to the change in the exchange rate.
An Economic Risk may be imposed if the value of a company alters following an unpredicted change in the exchange rate.
Our concern remains with the first type of risk exposure associated with the exchange rate variation, The Transaction Risk, given the situation of lending 10 million US dollars to a British Based firm assuming we are a US based firm.
http://www.cuckee.com/types-of-exchange-rate-risk-exposure-forex-and-finance/
Suppose having lent the British firm 10 million dollars, both the companies are exposed to risk of variation in the Exchange rate. If the British Pound appreciated against the dollar it would consequently induce a loss of value of the money lent to the British firm. And hence we would potentially be exposed to a risk of losing some worth of are invested money for the duration of lending period.
Our client on the other hand would be at a risk of losing value or incurring a loss if the Pound actually depreciated against dollar and they would have to pay back more in term of Pound since a dollar would be worth more pounds after the depreciation of Pound against a dollar during the lending period.
In order to cope with this risk exposure there are some financial market instruments that companies and individuals put to use to reduce their risk to minimum or hedge themselves against avoidable risks. The client and our firm can both use any of these contracts to avoid the exchange rate risk and to trade on specified price
These instruments are,
Forwards
Futures
Options
Swaps
Forwards
Forwards is one of the most common types of hedging tool which involves the buyer and the seller to agree on a future specific price of trade on a specified date to avoid the risk of potentially unfavourable variation in the exchange rate or price by negotiating on common grounds.
Futures
Futures not unlike forwards are contracts that involve the trade between buyer and the seller at a future specified date and exchange rate, however, the contract is much more standardized is not as much customizable in terms of date and amount as forwards.
Options
Options are contracts similar to Forwards ad futures that empower the buyer with the right to exercise the trade at a specified price before a given date on which the contract expires. However, the buyer is under no obligation if he does not wish to.
There are two types of Option contracts
Call Option
Put Option
Call Option is the right to purchase and Put Option is the right to sell.
http://idbdocs.iadb.org/wsdocs/getdocument.aspx?docnum=550616
Swaps
Swaps are contracts in which the involved parties exchange certain benefits or they agree to swap certain stream of cash flows over a period of time. There are four types of swaps based on the instruments that are being used. They are namely,
Interest Rate Swap
Currency Swap
Equity Swap
Commodity Swap
Interest Rate Swap Vs Currency Swap
Interest Rate Swaps
An exchange of fixed rate load for floating rate loan takes place within an Interes rate Swap and it applies the principle of comparative advantage.
Currency Swap
Currency Swap as the name implies is swap of one currency for another. The exchange of cash flow takes place so that one party pays in one currency and the other party pays in second.
http://www.investopedia.com/articles/optioninvestor/07/swaps.asp
The knowledge of currency swap would have been most beneficial to our client for hedging against the currency risk by simply agreeing to make imbursement in respective currencies. However, it would have worked flawlessly, to the extent that it does, if British firm was based in US and Us firm was based in UK.
Part C
Foreign currency options
A Foreign Currency Option or a Currency Option is a contact that provides the holder with the right, though not the obligation, to buy or sell the currency at a specified rate before a certain specified date that the contract expires on. A premium or fee is usually paid to the broker that depends upon how much contracts have been purchased. Currency Options stay as one of the best ways for many companies and corporations to hedge against the risk of adverse fluctuating movements in the exchange rates.
Investopedia.com
There are two common types of Currency Options.
Vanilla Option
SPOT Option
Vanilla Option
The form of Currency Option that resembles a stock or security option is the basic form of Currency Option also known as the Vanilla Option. The buyer has the right to purchase or sell the currency at a specified price called the strike price. A premium or fee is paid to the person who writes the option contract, usually the broker. The trader, however, has the freedom to choose the strike price and the date the contract expires on.
SPOT Option
A SPOT option or Single Payment Options Trading (SPOT) is also known as an exotic forex option. The premium is paid by the trader with a proposal of a specified situation. In the case of an event that the prediction comes true, trader gets a payoff that is actually the difference between the Strike Price that is quoted in the contract and the value of currency as predicted by the trader. In the event of prediction not coming true, the trader not only doesn't get the payoff but also loses the premium fee paid for the contract. A SPOT option also comes in more than one form such as,
Average Option
One-Touch Option
An Average SPOT Option is the kind in which the difference between the strike price and the average rate of exchange over time is taken as the pay-off.
A One-Touch SPOT Option is the kind in which the trader receives a payoff if the currency exchange rate is the same as the one predicted by the trader.
http://www.ehow.com/list_6108527_types-currency-options.html
Buying Call Option VS Writing A Put Option
Buying a Call Option
If the price of a stock or security or an exchange rate is rising or expected to rise too quickly in a given period of time then to minimize the possibility or risk of losing money in the given condition of buying the asset in the future, we buy a call option. However, in case an unexpected change we instead end up losing money.
Writing Put Option
If the price of a stock or security is falling or expected to fall too quickly in a given period of time then to minimize the possibility or risk of losing money in the given condition of selling the asset in the future, we write a Put Option, however, like in the case of buying Call option, if the changes in the price do not occur as predicted, we may actually end up losing the money rather than gaining from the contract.
Similar Contracts Traded on Different Premium
Risk is the probability of an event occurring differently than predicted. With respect to financial market risk is the possibility of losing money or not getting the expected return on any investment on stock, security or any other assets. In the event of such incident occurring, investor requires a collateral or security for his investments which is provided in the form of risk premium- a compensation for the risk attached to any investment.
So if two option contracts, similar in all respects but the expiration date, would have different lengths of time for risk exposure. Premium would be charged for compensating the risks that are attached to the factor of unpredictability that is associated with a longer period of time and the fact that if the event does not occur as predicted then we end up losing money. Hence with different levels of risk exposure owing to different durations of contracts would cause them to be traded in the market for different premiums.
Deep in the Money Option
An option that has a strike price too far above the market rate of an asset, in case of a call option, and in case of a put option, too far below the market price, is known as a Deep-in-the-money Option. The main factor determining the value of an option asset is the time it takes for the contract to mature. The potential for gaining profit is low besides the fact that these contracts are extremely expensive. Thus for the reason given that there is just too much risk attached to it and the possibility of getting higher return are too low, the Deep-in-the-money option would hardly be exercised by most of the investors and the very long maturity dates make the contracts unable to expire unexercised.
Call or Put
If the GBP were depreciate against the US dollar that would mean that every US dollar is worth more of Pounds in worth. Since the exporter receives payment in pounds that is worth less in dollars. The depreciation would cause them to spend more pounds to buy a dollar or receive fewer dollars for every pound. And hence they'd be worse off in that scenario.
To hedge themselves from the risk of pound depreciation, our client would be better off buying a call option that would reduce the risk of losing money if the pound depreciated since they could buy dollar at a specified rate within the specified time and then sell them at the current rate like an asset or rather shall we say invest without losing much money. However, if after buying the option contract pound actually appreciates, then our clients in UK would be worse off.
References
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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.
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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
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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
