Global Finance Lesson 8

Global Finance Lesson 8
This Weeks’ Time Table: (October 12-October 16, 2020)

For this week, the following shall be your guide for the different lessons and tasks that you need
to accomplish. Be patient, read them carefully before proceeding to the tasks expected of you.
HAVE A FRUITFUL LEARNING EXPERIENCE 😊

Date Topics Activities or Tasks
Exchange Rates
- Definition
- Products of FOREX market
October 12- Read Lessons
16 - Types

- Exchange rate movement
- Factors affecting exchange
rate
October 16
(12:00 noon) Online Quiz Actual quiz through the LMS

Lesson 8: Exchange Rates

Topic: - Definition
- Products of FOREX market
- Types
- Exchange rate movement
- Factors affecting exchange rate
Learning Outcomes:
At the end of this module, you are expected to:

1. Know how to convert local currency to a foreign currency and vice versa
2. Discuss the importance of foreign currency in a country
3. Calculate cross rates of currencies
4. Explain the impact of exchange rates to prices and quantities
Lesson Proper:
Exchange Rates Defined
 Exchange rate is the price of one currency expressed in terms of another currency.
Therefore, in every exchange rate quotation, there are always two currencies involved.
 It is also known as foreign exchange rate, FOREX rate or FX rate.
 It specifies how much one currency is worth in terms of the other.
 It is the value of a foreign nation’s currency in terms of the home nation’s currency
 Traditionally, in the Philippines, the exchange rate is expressed as the value of one US
dollar in terms of the peso.

Types of Exchange Rates
FIXED EXCHANGE RATE
A fixed exchange rate, also known as the pegged exchange rate, is “pegged” or linked to
another currency or asset (often gold) to derive its value. Such an exchange rate mechanism
ensures the stability of the exchange rates by linking it to a stable currency itself. Also, a fixed
currency system is relatively well protected against the rapid fluctuations in inflation. Some
countries following a fixed rate system include Denmark, Hong Kong, Bahamas & Saudi Arabia.
Advantage: A country with a fixed exchange rate system is attractive to foreign investors who
are lured to invest in that country due to the stability it offers.
Disadvantage: The government of a country following such a system has to maintain a huge
amount of foreign exchange or gold reserves to maintain its value. This system thus proves to be
an expensive one.

FLEXIBLE EXCHANGE RATE
Flexible or Floating exchange rate systems are ones whereby the rate of a currency is
determined by the market forces of demand and supply. Unlike the fixed exchange rate they do
not derive their value from any underlying. Some economists argue that a floating system is
more preferable since it absorbs the shocks of a global crisis and automatically adjusts to arrive
at an equilibrium.
The central bank of the country may interfere in economically extreme situations such as the
recession or boom to stabilize the currency. They may buy or sell an amount of the currency to
prevent the rates from going haywire. This phenomenon is known as the managed float.
Advantage: The rates under this system are determined by a self-sufficient mechanism.
Therefore, the dependence on government or international monetary organizations is minimum.
Also, the determination of rate by the market forces of demand and supply promote efficiency
and robustness of operations.
Disadvantage: Floating rate systems are prone to greater volatility since they are determined by
the market forces. The increased volatility increases the risk quotient in such markets
consequently making it a relatively expensive place for the foreign investors.

FORWARD RATE
A forward rate is a one that is determined as per the terms of a forward contract. It
stipulates the purchase or sale of a foreign currency at a predetermined rate at some date in the
future. A forward contract is generally entered into by exporters and importers who are exposed
to Forex fluctuations. The forward rate is quoted at a premium or discount to the spot price.
Advantage: A forward contract freezes the rate of exchange for both the parties and thus
eliminates the element of uncertainty. Therefore, it provides a complete hedge against all unruly
movements in the market.
Disadvantage: A forward contract is not backed by any exchange. Therefore the possibility of
default is quite high. Also freezing the rates may prove to be a loss-making decision in some
situations. For example, a long forward in a bearish market or a short forward in a bullish market
are instances of the forward backfiring.

SPOT RATE
The spot rate is the current exchange rate for any currency. It is the rate at which your
currency shall be converted if you decided to execute a foreign transaction “right now”. They
represent the day-to-day exchange rate and vary by a few basis points every day.
Advantage: Trading at a spot rate does not require deep mathematical or statistical analysis. It is
what it is. It is a straightforward rate without any ambiguity.
Disadvantage: Spot rates can be a misleading indicator in times of economic crisis,

unreasonable demand or supply patterns or temporary transitional phases in an economy.

DUAL EXCHANGE RATE
In this type of system, the
currency rate is maintained separately
by two values-one rates applicable for
the foreign transactions and another for
the domestic transactions. Such systems
are normally adopted by countries who
are transitioning from one system to
another. This ensures a smooth
changeover without causing much
disruption to the economy.
Advantage: Countries enforcing a dual
exchange rate can enforce separate rates
for capital and current account
transactions. Therefore a significant
amount of control is with the
government whereby it can influence
revenues from capital or current sources
depending upon the need of the hour. It
also becomes easier to regulate
international trade and at the same time
protect the domestic markets.
Disadvantage: A dual exchange rate system may cause mis-fixing of the exchange rate and
consequent misallocation of resources in various industries. Because of these several economic
anomalies such as black markets, arbitrage opportunities and inflation may emerge.
INTERPRETING CURRENCY EXCHANGE QUOTES

DIRECT & INDIRECT QUOTES
A direct currency quote uses the domestic or home currency as the base. Exchange rates are
quoted in terms of the number of units of domestic currency per unit of foreign currency. For
example, for a Filipino national, the direct currency quote to obtain US dollars will look like $1=
P45.
An indirect currency quote denotes the domestic currency as the quoted currency. Or in
simpler terms exchange rates are quoted in terms of the number of foreign currency units per unit
of domestic currency. For example, P1= $.0222
BID & ASK PRICE
In the practical life, currency quotes are always quoted as USD/EUR 1.1681-1.1685.That is,
using the direct quote.
The former part of the quote USD/EUR 1.1681 is known as the bid rate. Bid rate is the rate at
which the bank will pay you should you go to it to buy Euros against USD. It is nothing but
the buying rate for the bank.
The latter part of the quote USD/EUR 1.1685 is known as the ask rate. Ask rate is the rate which
the bank “asks” from you to obtain a unit of Euro against value in dollar. It is nothing but
the selling rate for the bank.
It is important to know that the ask rate will always exceed the bid rate. The bank will always
buy at a lower rate and sell at a higher rate. The simple reason for it being that the difference is
the margin that the bank earns for facilitating such currency exchange.
CROSS CURRENCY RATE
Reserve currency or an anchor currency is essentially the one in terms of which most other
currencies are expressed. Such currency is held in large amounts by governments as Forex
reserves. The US Dollar is currently the most widely held reserve currency followed by the Euro.
Consequently, a currency quote not expressed in terms of USD is known as a cross rate. All
dominant and frequently traded currencies are translated in terms of USD. However, certain
transactions may be such that they do not contain the dollar component at all. In such cases, the
currency quotes are required to be expressed at a rate relative to one another to facilitate that
exchange.
The following example shall clear the concept.
A manufacturer in Germany wants to obtain certain automobile parts from a supplier in
Australia. The supplier only accepts payment in Australian Dollars (AUD). Therefore, the
German manufacturer will be compulsorily required to convert EUR to AUD to close the
contract. The amount payable to the Australian Supplier is AUD 350,000.
The following quotes are quoted by the exchange.
EUR/USD 1.1670-1.1674
USD/AUD 1.3561-1.3570
The quote relevant to the German manufacturer is EUR/AUD
Therefore, the same is obtained by carrying out the simple working mentioned below
The simple multiplication of (bid*bid)-(ask*ask) gives the required cross rate.
= (1.1670*1.3561) -(1.1674-1.3570)
=1.5826-1.5841
Therefore, the amount payable to the bank to obtain AUD 350,000 is (350,000/1.5841) EUR
220,945
Other examples:
Determine the cross rate between francs and pound if F1= $0.12855 and £1= $1.4463
ANSWER: £1= F11.2506
SOLUTION: 1.4463
0.12855
= 11.25
OR $1= F7.7789 and £1=$1.4463 therefore F7.7789 x $1.4463= F11.2506/£

Determine the cost of £1 in DM if £1= $1.5578 and DM1= $0.6760

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Global Finance Lesson 8

This Weeks’ Time Table: (October 12-October 16, 2020)

Date Topics Activities or Tasks

Lesson 8: Exchange Rates

Disadvantage: Spot rates can be a misleading indicator in times of economic crisis,

INTERPRETING CURRENCY EXCHANGE QUOTES

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