Chapter 8 – Foreign Exchange

8.1 An overview of the foreign exchange market

The foreign exchange market is a global venue for the trading of currencies, allowing participants to convert one type of currency into another. The primary purposes of the foreign exchange (FX) markets include enabling the settlement of cross-border transactions that stem from international trade activities, investment and financing operations, establishing the relative prices of different currencies, and providing a platform for market participants to hedge against potential losses due to currency value fluctuations.

These markets play a critical role in supporting international business by ensuring that entities can engage in financial transactions in the appropriate currency for their needs. Moreover, the FX markets contribute to the determination of exchange rates, which are vital economic indicators influencing global economic health. Investors and businesses utilize these markets to manage their exposure to foreign exchange risk, ensuring that currency volatility does not adversely impact their financial strategies and operations.

8.1.1 What is an exchange rate?

An exchange rate is the price at which one currency can be exchanged for another. It’s an expression of the value of one currency in terms of another. For instance, if the exchange rate between the US dollar (USD) and the euro (EUR) is 1.2, it means that one USD can be exchanged for 1.2 euros. Exchange rates can be influenced by a variety of factors, including economic indicators, market speculation, political stability, and interest rates. The US dollar plays a pivotal role in the world of exchange rates due to several factors:

Reserve Currency: The USD is widely held by governments and institutions as part of their foreign exchange reserves. This widespread use as a reserve currency underpins its significance in global trade and finance.

Benchmark Currency: Many commodities and goods traded on the global market are priced in USD, including oil, gold, and many other raw materials. This means that the dollar is a benchmark currency against which the value of other currencies is often measured.

Global Trade: The USD is the primary medium of exchange in international trade. For countries that do not have widely traded currencies, the USD serves as the intermediary, enabling easier trade between countries with different currencies.

Financial Markets: The United States hosts some of the world’s largest and most liquid financial markets. This makes the USD a dominant currency for international borrowing and investing.

In addition to the USD, The Trade Weighted Index (TWI) is a complex measure that evaluates the Australian Dollar (AUD) against a portfolio of various international currencies. These currencies are selected based on their significance in international trade with Australia. The TWI assigns different weights to each currency, reflecting the proportion of trade that Australia conducts with each respective currency’s country of origin.

8.1.2 Pegged versus floating exchange rates

In the aftermath of World War II, the Bretton Woods Agreement and System were established, shaping a new international monetary framework that spanned from the mid-1940s until the early 1970s. This system brought together 44 Allied nations in an unprecedented cooperative effort to manage currency exchange and foster financial stability across nations. At the heart of the Bretton Woods System was the requirement for other countries to peg their currencies to the value of the U.S. dollar. The U.S. dollar, in turn, was linked to gold at a fixed rate of 35 dollars per ounce. This gold standard for the dollar provided a sense of security and stability, as it guaranteed that the dollar’s value was backed by a tangible asset.

However, by 1971, it became evident that the United States did not possess sufficient gold reserves to support the burgeoning supply of dollars worldwide. This discrepancy led to a ‘run on the gold reserve’ as countries began to doubt the sustainability of the fixed exchange rate and sought to exchange their dollar holdings for gold. Developed countries started to shift from the Bretton Woods System and move towards a floating exchange rate system, where the value of a currency is allowed to fluctuate according to the foreign exchange market. In this new era, exchange rates were no longer fixed to a specific gold quantity or pegged to the dollar. Instead, they were determined by supply and demand dynamics, influenced by factors such as interest rates, economic performance, and geopolitical events.

This transition marked the beginning of modern foreign exchange markets  which is a complex global system where currency values are subject to rapid changes and are influenced by a multitude of economic conditions and policies. The shift to floating rates also reflected a broader trend towards liberalized trade and capital flows, setting the stage for the integrated global economy that continues to evolve in the present day.

In today’s global economy, most currencies are subject to floating exchange rates, where their values are determined by the forces of market supply and demand. This market-driven approach can lead to greater short-term fluctuations in currency values, as they respond to real-time economic events and sentiment. However, this system also tends to prevent the build-up of imbalances that require large, disruptive adjustments.

For instance, Australia made a significant shift in its monetary policy by allowing the Australian Dollar (AUD) to float on the 12th of December 1983. This transition from a fixed exchange rate meant that the AUD’s value was no longer tied to any specific foreign currency or set of currencies, and instead, its value could change from moment to moment based on trading in the foreign exchange market. This move was aimed at giving the Australian economy greater flexibility to absorb external shocks and to align more closely with the constantly changing conditions of the global economy.

In contrast, some developing countries employ a managed floating rate system. This hybrid approach allows a currency to float in the foreign exchange markets, but the central bank might intervene to stabilize or adjust the currency’s value in relation to other currencies. The Chinese Yuan (CNY), for instance, has been managed in such a way that it is loosely pegged to a basket of currencies, allowing the People’s Bank of China to guide its valuation while still letting market dynamics play a role.

8.1.3 The role of exchange rates in the economy

Exchange rates hold critical significance within an economy, as they are the determining prices at which a country values its international transactions. They directly affect the local cost of goods and services that are traded in foreign currencies, as well as the domestic valuation of foreign assets and liabilities held by investors within the country.

• Exporters: Companies based in Australia that manufacture goods or provide services domestically and then sell these to international customers are subject to exchange rate risk. A rise in the value of the Australian Dollar (AUD) against other currencies can make their products more expensive and less competitive in global markets. Exporters will favour a low exchange rate.
• Importers: Businesses that import goods and services to sell within Australia will benefit if AUD appreciates as the same AUD now buys more of the foreign goods. A weaker AUD on the other hand increases the cost of purchasing these foreign goods, affecting profitability.
• Investors: Australians investing in international markets, whether in stocks, bonds, or real estate, must consider the impact of exchange rate movements on their investments. If the AUD depreciates against the currency of the investment, the value of the investment in AUD terms increases, and vice versa.
• Borrowers: Entities or individuals that take out loans denominated in foreign currencies face risks if the AUD weakens against the currency they must repay their debt in. This could increase the cost of servicing the debt when converted back into AUD.

The influence of exchange rates extends beyond these groups to almost every sector that engages with the global economy, from tourism operators to multinational corporations. It affects decisions ranging from pricing strategies and budget forecasting to international expansions and hedging policies.

8.2. Quotes of foreign exchange

A direct quote in the context of foreign exchange (forex) is the price of one unit of a foreign currency expressed in terms of the local or domestic currency.

In Australia, the value of the Australian dollar is measured as the value of 1 AUD relative to the US Dollar, often abbreviated as AUD/USD. For example, if AUD/USD equals to 0.68, this means that 1 AUD can be exchanged for 0.66 USD or 66 US cents. An increase in this measure reflects an appreciation of the AUD, while a decrease in AUD/USD reflects the AUD has depreciated against the USD.

8.2.1. Cross rates

Cross rates are exchange rates between two currencies calculated from their common relationships with a third currency, often known as the intermediary currency.

Example: Imagine you are an investor or a traveller looking to exchange EUR for AUD, and there’s no direct EUR/AUD quote available. You can calculate the cross rate EUR/AUD using USD as the intermediary currency. EUR/USD = 1.15 (1EUR = 1.15 USD). AUD/USD = 0.77 (1 AUD= 0.77 USD).

EUR/AUD = EUR/USD * USD/AUD. You do not have USD/AUD, what you have is AUD/USD which is 0.77. Therefore, USD/AUD = 1/0.77 = 1.3. EUR/AUD = 1.15 * 1.3 = 1.495. So, 1EUR = 1.495 AUD.

8.2.2 Explaining exchange rate movement

Exchange rates movements are very difficult to predict. There are a number of factors that influence the fluctuations of exchange rates and these factors do not happen in isolation, they often interact with each other which makes exchange rate movements very difficult to predict.

1. Purchasing Power Parity: PPP is based on the law of one price which states that in the absence of transaction costs and other barriers to trade, the price of identical goods and services should equalize across different countries when prices are expressed in a common currency. This is because any significant price differences would be eliminated through arbitrage—the practice of buying goods in a cheaper market to sell them in a more expensive one. In practice, PPP does not hold because of transaction costs, tariffs and other trade barries exist and can prevent the prices of the same goods to be equal. In addition, PPP only applies to tradable goods and not to services such as haircuts.
2. Expected interest rate parity (EIRP): Interest rate parity suggests the difference in interest rates between two countries will be equal to the differential between the forward exchange rate and the spot exchange rate of their currencies. Carry trade is a strategy used by investors where they borrow money in a currency with a low-interest rate and invest it in a currency with a higher interest rate. The goal is to profit from the interest rate differential as long as the exchange rate between the two currencies does not offset the profit from the interest rates. Even though carry trades are based on exploiting the interest rate differentials, they are not reliable predictors of currency movements because currency values are influenced by many factors other than interest rates, including economic data, political events, and market sentiment. Central banks can change interest rates unexpectedly, affecting currency values and carry trade positions or high-interest rate currencies often come with higher risk, which can lead to sudden and sharp “unwinding” of carry trades if the market sentiment changes.
3. Expected interest rates: When a country is expected to raise its interest rates, it often leads to an inflow of foreign capital. Investors and international capital tend to seek the highest return, so if they expect a country’s interest rates to rise, they might start moving funds into that country’s assets in anticipation of higher returns. This increased demand for the country’s currency (needed to purchase the local assets) tends to drive up its value.
4. Terms of trade (ratio of export prices to import prices): The terms of trade measure the rate at which a country’s exports can be exchanged for imports. An improvement in the terms of trade (where export prices rise relative to import prices) typically generates more revenue from exports relative to the cost of imports. As international buyers purchase a country’s exports, they need to acquire the country’s currency to make payments, leading to increased demand for that currency on the foreign exchange market. As demand for the currency increases, its value will generally appreciate. If the terms of trade deteriorate (export prices fall or import prices rise), demand for the currency weakens, leading to depreciation. For a country like Australia, which is a major exporter of commodities such as iron ore, coal, and natural gas, the terms of trade are significantly influenced by global commodity prices. When commodity prices are high, Australia’s terms of trade improve, strengthening the AUD.
5. Current account balance: The current account includes the trade balance (exports and imports of goods and services), net income from abroad (like dividends and interest), and net current transfers (such as foreign aid, remittances). When a country’s exports exceed its imports, it has a trade surplus, and there is a higher demand for its currency. This is because foreign buyers need to exchange their currency for the exporting country’s currency to pay for the goods or services. This increased demand can cause the currency to appreciate. Conversely, if a country’s imports are greater than its exports, it has a trade deficit. This condition means that more of its currency is being used to purchase foreign goods and services than is being brought in by exports. This increased supply of the currency on the global market can lead to depreciation.
6. RBA intervention: Central banks may intervene in foreign exchange markets to influence the value of their currency. This is typically done to counteract excessive volatility or misalignments that are not consistent with the country’s economic fundamentals. If a central bank believes its currency is undervalued and has depreciated too much due to market overshooting or speculation, it may intervene by buying its own currency. This demand can prop up the currency’s value. Conversely, if the currency is deemed to be overvalued, the central bank may sell its own currency to push down its value, making exports more competitive. Interventions are generally large in scale to ensure they have the necessary impact on the market. However, they tend to be infrequent to maintain the market credibility of the central bank and avoid the expectation that the central bank will always act to correct movements in the exchange rate.
7. Speculation: Speculation in the context of foreign exchange (FX) refers to the act of trading currencies with the aim of making a profit from fluctuations in exchange rates. Speculators do not necessarily intend to take delivery of the currency; instead, they seek to predict and capitalize on market movements.

References:

International Financial Management by Jeff Madura, Ariful Hoque and Chandrasekhar Krishnamurti. End Asia Pacific Edition.