Int Business Chap 9.

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Chapter 9:

The Foreign Exchange Markets

Case: 1. The collapse of Thai Baht


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Functions of foreign exchange market:

Currency conversion: International business needs foreignexchange conversion on following reasons:

To make conversion of export receipts or any otherreceipts like profits or license fees.

To make payment for imports in course of business. To make short term investment to take advantages of

higher foreign interest rate than local interest rate. To borrow from foreign market to take advantage of lower

interest rate abroad. To make long term investment (a) to take advantage of

higher rate of return, (b) for international diversificationand (c) in anticipation of appreciation of foreign currency. To make currency speculations in anticipation of

appreciation of foreign exchange.


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Foreign exchange risk

Foreign exchange risk refers to thepossibility of making losses due to

change in the conversion rates during theperiod of settlement of payments.

Different kinds of exchange rates are

stated here:


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Ensuring against foreign exchange risk

Spot exchange rate: It is the exchange rate by what a foreign exchangedealer converts one currency into another currency on a particular day. Ittakes 48 hours to 72 hours to make the settlement of such dealings acrossthe world. The rate is determined by the interaction of demand and supplyfunctions of foreign exchange market. Demand comes from import andcapital outflow, and supply comes from export and capital inflow.

Forward exchange rate: If the contract is made now and the delivery ofcurrency will take place in future then the rate applicable is forward

exchange rate. It can be of 30/60 or 90 days period. Future exchange rate: It is similar to forward exchange rate except that thefuture dealings are standardized in terms of maturity and amount. There areonly 4 settlements dates in a year in USA (3rd Wednesdays of March, June,September. and December). The amount of the contract would be anymultiple of US, Canadian and Australian $100,000, UK Pound 62,500, Euro125,000, and so on. The future dealings are done not with banks but in

exchange markets. Option market: This gives a right to the holder to execute future dealings ata definite future date, at a definite rate and of a definite amount. An optioncan be a call (buy) or a put (sell) Option. The holder compares the spot rateat the time of execution and if that is favorable only then he executes it,otherwise he has the option not to execute it.

Currency swaps: Simultaneous buying and selling of 2 currencies, one spot

and another forward, to avoid foreign exchange risk.


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Contingency Graphs for Currency Call Options

+Tk.1

+Tk.2

-Tk.1

0

Tk.68 Tk.70 Tk.72

Net Profit

Future

Spot Rate

For Buyer of $ Call Option

Strike price = Tk.70Premium = Tk.1

+Tk.1

+Tk.2

-Tk.1

0

Tk.68 Tk.70 Tk.72

Net Profit

Future

Spot Rate

For Seller of $ Call Option

Strike price = Tk.70Premium = Tk.1


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Contingency Graphs for Currency Put Options

+Tk.1

Tk.2

-Tk.1

-Tk.2

0

Tk.68 Tk.70 Tk.72

Net Profit

Future SpotRate

For Seller of $ Put Option

Strike price = Tk.70

Premium = Tk.1.50

+Tk.1

-Tk.1

-Tk.2

0

Tk.68 Tk.70 Tk.72

Net Profit

Future SpotRate

For Buyer of $ Put Option

Strike price = Tk.70

Premium = Tk.1.5


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Economic Theories/factors of exchange ratedetermination:

1. Purchasing power parity theory: Swedish economist Gustav Casselintroduced this theory that says the exchange rate between 2countries would depend on the prices of different commodities atdifferent countries assuming there is no trade barriers and notransport cost. If the price of 1 kg rice in Dhaka is Tk.15 and in Delhiis Rs.10 then the conversion rate would be Tk.150=Rs.100. If not

then there would be arbitrage operation to ensure that. The threekinds of arbitrage operation are:

(i) Locational arbitrage: Locational arbitrage takes place when theselling rate of one bank is less than buying rate of another bank,

(ii) Triangular arbitrage: Triangular arbitrage is possible when the

exchange rates among 3 different currencies are not in conformitywith one another. and

(iii) interest coverage arbitrage: Interest coverage arbitrage takesplace when spot rate and forward rate are same but interest ratesbetween two currencies are different.


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Locational arbitrageis possible when a banks buying price (bidprice) is higher than another banks selling price (ask price) for

the same currency.

Example:

Sonali Bank Bid Ask IFIC Bank Bid Ask

$1= Tk.67 Tk.68 $1= Tk.68.50 Tk.70.00

Buy $ from Sonali Bank @ $1=Tk.68, and sell it to IFIC Bank

@ $1=Tk.68.50. Profit = Tk.0.50/Tk.68=0.74%.

Locational arbitrage


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Triangular arbitrageis possible when cross exchange rates arenot in consistence with one another.

Example: suppose, $1=Tk.70, $1=Rs.40, Tk.100=Rs.70

The lower loop is profitable @22.50%

Triangular arbitrage

Invest

Tk.700

Buy US$10.00

Selldollar forRs.400 Convert Rs.

into Tk.571

BuyRs.490

Buy$12.25by Rs.

Sell US $ forTk.857.50


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Interest coverage arbitrage

If spot rate and forward rates are same then interest ratesrelevant should be same. Otherwise, there will be interestcoverage arbitrage. For example, both spot and forward rate are$1=Tk.70. If interest rate in USA is 4% and in Bangladesh is 3%per quarter then there would be interest coverage arbitrage.

Step 1: Take a loan of Tk.700 from Sonali Bank at Dhaka for 3months at the interest rate of 3%.

Step 2: Buy $10, and put in US deposit for 3 months time @4%

Step 3: At the same time make a 3-month forward sell contract of

$10.04. Step 4: realize the forward sell after 3 months and get Tk.728.

Step 4: Return back Tk.721 to Sonali Bank loan, and make aprofit of 1%.


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Economic Theories/factors of exchange

rate determination (Contd..)2. Income and price inflation

3. Interest rate and exchange rates: Irvin Fisher introduced thetheory that nominal interest rate is equal to the aggregate of

real interest rate and the inflation rate. This suggestsincreased inflation rate related with nominal interest rate. Shortterm capital movement is guided by interest rate differences.Higher interest rate leads to high inflow of capital andincreased exchange rate.

4. Bandwagon Effect: When foreign exchange dealers followothers to deal in foreign exchange then exchange rate isaffected. (reference: George Soros case, p.318)


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Bangladesh inflation

Import demand for US goods, and hence

demand for US $ increases.

Factors that InfluenceExchange Rates

1. Relative Inflation Rates

US desire for Bdesh goods deceases, and

hence the supply of US $ decreases.

6


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Effect of inflation

Price of US $1 in taka

D1(M+O)

D2

S1(X+I)

S2

70

65

Quantity offoreign exchange

7


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Bdesh interest rates increases:

Bdesh demand for US bank deposits

decreases, and hence demand for US $

decreases.

Factors that Influence

Exchange Rates2. Relative Interest Rates

US desire for Bdesh deposits increases,and hence the supply of US $ increases.

8


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Effect of Higher Interest Rate

(in Bangladesh compared to USA) Price of US $1 in taka

D2

D1

S2

S1

70

65

9

Quantity of foreignexchange


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Relative Interest Rates

Factors that InfluenceExchange Rates

A relatively high interest rate may actually reflectexpectations of relatively high inflation, which

discourages foreign investment. It is thus useful to

considerreal in terest rates, which adjust the nominal

interest rates for inflation.

real interest rate

nominal interest rate inflation rate

This relationship is sometimes called the Fisher effect.

10


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If Bangladesh income level increases relative

to increase of US income:

Bdesh demand for US goods increases,

and hence demand for US $ increases.

Factors that Influence

Exchange Rates3. Relat ive Income Levels

No expected change for the supply of US$.

12


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Effect of increased local national

income Price of US $1 in taka

D1

D2

S1

68

65

Quantity offoreign exchange

13


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Asian Currency Crisis and

Collapse of Thai Baht Thailand experienced one of the highest growth rates in 1980s

and 1990s.

Inflation rate was only 5% (against 3.5% of USA)

Export growth was 16% from 1990 to 1996 Investment boom in commercial and residential building

To build infrastructure, factories, import from USA and developedcountries in the form of capital equipment and machineriesincreased

Since mid 1980s Thailand successfully maintained fixed rateexchange system with $1=Bt25

Interest rate of Thailand was higher than USA and most of thedeveloped countries


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Asian Currency Crisis andCollapse of Thai Baht (Contd..)

Thailand experienced 16% growth of export during 1990-1996. Thesystem of foreign exchange was fixed.

Thai banks started to borrow from outside and financed the property loans,which was profitable

Foreign investors were attracted to invest in Thailand

Overseas supply was more than the demand, and banks started to extendrisky loan as well Samprasong Land was the first victim when it failed to repay scheduled

interest of $3.1 million on $80 billion euro loan

Finance One, the largest financial institution of the country, failed to payinterest obligations to USA, and then turned bankrupt

Thai stock market started to decline by 45% as several propertycompanies might be forced to bankruptcy It was anticipated that Thailand will fail to maintain fixed rate


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Asian Currency Crisis andCollapse of Thai Baht (Contd..)

Speculative attacks typically involved traders selling baht short to profit a futuredecline in the value of baht against the dollar. For example, a trader might

borrow Bt 100 from a bank for 6 month, exchange that to $4 ($1=Bt25), and if

exchange rates subsequently declines to $1=Bt50, sell the $ to Bt200, return

back the money to bank after 6 month, and make a handsome gain.

In may 1997, government expended $5 billion foreign exchange reserves to buybaht. Foreign exchange reserve went down to $33 billion. George Sorrows hadbought the reserve by forward contract, that left only $1.14 billion left to central

bank. IMF extended conditional loan. IMF and other countries provided $16

billion loan.

Interest rate increased from 10% to 12.5% to make baht holding attractive.

July 2, 1997 bowed to the inevitable of floatation the Thai Baht. Baht depreciatedto $1=Bt55 by January 1998.

As overseas investment called back Thai Bank needed double the amount oforiginal loan. Bankruptcy was all around.

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