01/08/2020

Ton Duc Thang University

Finance and Banking Faculty
Banking Department

INTERNATIONAL PAYMENT

CHAPTER 2:
EXCHANGE RATE
Course Code: B01031

Prepared by: Banking Department

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

Chapter 2: Exchange Rate

Chapter Objectives
Describe the background and corporate use of the
following knowlegde: Forign exchange marketreign
- Exchange rate
- What foreign exchange (FX) market is and
participants on FX market.
- Tools to limit the exchange rate risks

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

1
 01/08/2020

Chapter 2: Exchange Rate

Contents

2.1. Exchange Rate and Foreign exchange market

2.2. Tools to limit the Exchange Rate Risk

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

Chapter 2: Exchange Rate

2.1. Exchange rate and Foreign exchange market

2.1.1. Exchange rate
2.1.2. Foreign exchange market

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

2
 01/08/2020

2.1.1. EXCHANGE RATE

Exchange rate specifies the rate at which one

currency can be exchanged for another.
v History of Foreign Exchange
1. Gold Standard (1876 – 1913)
Each currency was convertible into gold at a specified rate. When
World War I began in 1914, the gold standard was suspended.
2. Agreements on Fixed Exchange Rates
a. Bretton Woods Agreement 1944 - 1971
b. Smithsonian Agreement 1971 - 1973

3. Floating Exchange Rate System

Widely traded currencies were allowed to fluctuate in accordance
with market forces
Chapter 2: Exchange Rate
Chapter 2_ The Exchange Rate

Exchange rate quotation

Spot exchange rate

x/ y
commodity/base currency term/quote currency

1
x/y = y/x
Reciprocate rate
Chapter 2: Exchange Rate

3
 01/08/2020

Methods of quotation

v Direct/ indirect quotation

§ Direct quotation: shows how many units of
home currency per one unit of foreign currency.
§ Indirect quotation: shows how many units of
foreign currency per one unit of home currency.

Chapter 2: Exchange Rate

Buying – selling price

Ò Selling price (Ask exchange 23000 USD/VND

rate): the price at which
quoting bank commits to sell
base currency.
Spread
Ò Buying price (Bid exchange
rate) : the price at which
quoting bank commits to buy 22500 USD/VND
base currency.

Chapter 2: Exchange Rate

4
 01/08/2020

Spread

§ Spread is the difference between bid and ask

prices.
§ The bid/ask spread covers the bank’s cost of
conducting foreign exchange transactions
§ Calculating spread:
ü In absolute number: Spread = Ask Rate – Bid Rate

ü In percentage number
Askrate - Bidrate
Spread (%) = *100%
Askrate
Chapter 2: Exchange Rate

Spread (cont)
v Factors That Affect the Spread
1. Order costs: Costs of processing orders, including
clearing costs and the costs of recording transactions.
2. Inventory costs: Costs of maintaining an inventory of a
particular currency.
3. Competition: The more intense the competition, the
smaller the spread quoted by intermediaries.
4. Volume: Currencies that have a large trading volume are
more liquid because there are numerous buyers and
sellers at any given time.
5. Currency risk: Economic or political conditions that
cause the demand for and supply of the currency to
change abruptly.
Chapter 2: Exchange Rate
Chapter 2_ The Exchange Rate

5
 01/08/2020

Point/Pip

Ò A point is the minimum change of exchange rate.

Ò Point is calculated in term of term currency.

GBP/USD 1,9537 – 1,9540 0,0001

USD/CHF 1,2201 – 1,2204 0,0001
EUR/USD 1,3103 – 1,3105 0,0001
USD/JPY 119,79 – 119,82 0,01
USD/VND 22873 – 23160 1

à A point is the last digit of quotation

Chapter 2: Exchange Rate

Reading exchange rate

Big figure figure point

EUR/USD = 1 30 50

One Third-ty fifty

Chapter 2: Exchange Rate

6
 01/08/2020

Writing exchange rate

§ Full writing: USD/JPY 119,79 – 119,82

§ Short writing: USD/JPY 119,79/82
§ Professional writing: USD/JPY 79/82

Chapter 2: Exchange Rate

Cross exchange rate

§ Cross exchange rate is the exchange rate calculated

from the exchange rates quoting its relevant
currencies against another currency (third currency).
§ The currency exchange rate between two currencies,
both of which are not the official currencies of the
country in which the exchange rate quote is given in
É SGD/USD
É CAD/USD
è SGD/CAD
§ USD is the third currency when calculating cross
exchange rate.
Chapter 2: Exchange Rate

7
 01/08/2020

Main determinants of exchange rate

Natural
Inlation
calamity
Interest rate Fundamental Environmental
GDP growth… economic
factors
factors
Exchange
rate
Psychology
Act of
Wars.. speculators
Terrorism… Human
Political beings
factors
Chapter 2: Exchange Rate

2.1.2. FOREIGN EXCHANGE MARKET

§ Foreign exchange market is the market where

currencies are exchanged.
§ FX market concerns only about bank deposits
(not including bank notes)

Chapter 2: Exchange Rate

8
 01/08/2020

Characteristics of FX market

— It’s a twenty-four-hour market

— The market is made up of an international network
of dealers
— The market’s most widely traded currency is USD
— It’s the most perfect market.
— It’s the most effective market.
— It is an over-the-counter market with an exchange-
traded segment.
— Dealers trade by telephone, fax and electronic
trading system.
Chapter 2: Exchange Rate

Function of FX market

— Transfer purchasing power from one currency into

another
— Specify external value of a currency (exchange rate)
— Provide hedging instruments against exchange rate
risk

Chapter 2: Exchange Rate

9
 01/08/2020

Main participants in FX market

By purpose
earn profit by taking earn profit by buying
advantages from the Arbitragers and selling the same
difference in exchange currencies at different
rate quotation time
between markets.

Hedgers Speculators

protect themselves against foreign exchange rate risk

by using foreign exchange derivatives (instruments to
hedge against foreign exchange risk)
Chapter 2: Exchange Rate

Main participants in FX market

By organization

Commercial
Central banks
banks

Financial
and non-
Brokers
financial
customers

Chapter 2: Exchange Rate

10
 01/08/2020

Main participants in FX market

By function
— Elementary market makers.
— Secondary market makers.
— Price takers.
— Brokers.
— Speculators.
— Policy makers.

Chapter 2: Exchange Rate

Main transactions on FX market

Chapter 2: Exchange Rate

11
 01/08/2020

Spot FX market
§ A foreign exchange transaction for immediate
exchange is said to trade in the spot FX market.
§ Basic transaction in FX trading.
§ The exchange rate in the spot market is the spot
exchange rate.

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

Spot FX market (cont)

§ The U.S. Dollar is the commonly accepted medium of
exchange in the spot FX market.
§ Spot FX market time zones - Foreign exchange
trading is conducted only during normal business hours
in a given location. Thus, at any given time on a
weekday, somewhere around the world a bank is open
and ready to accommodate foreign exchange requests.
The standard settlement timeframe for FX spot
transaction is within 2 days from the date of trade
execution.
§ Spot FX market liquidity: More buyers and sellers
means more liquidity.
Chapter 2: Exchange Rate
Chapter 2_ The Exchange Rate

12
 01/08/2020

2.2. TOOLS TO LIMIT THE EXCHANGE

RATE RISK

2.2.1. Forex Outright Forward Transaction

2.2.2. Forex Swaps Transaction
2.2.3. Currency Futures Transaction
2.2.4. Currency Options Transaction

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

2.2.1. Forex Outright Forward Transaction

— An outright forward transaction is contracted by two

parties to agree today upon the price, quantity and
term of trading and commit to make settlement on
agreed date.
Ex: Company M&M sell forward 1 month 2ml USD to HSBC
Singapore at forward rate of 1,4450 USD/SGD
— Characteristics:
- Tailored contract
- Binding contract
- Non-negotiable contract

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

13
 01/08/2020

2.2.1. Forex Outright Forward Transaction

v Application of outright forward contract

— To hedge against foreign exchange risk in cases of:

¡ Payables of importers.

¡ Receivable of exporters.

Chapter 2: Exchange Rate

2.2.2. FX Swaps Transaction

— A FX swap transaction is the simultaneous

buying and selling of a similar currency when
the value date of buying and selling are
different.
EX: Company A & Bank X sign a FX swap contract in
which company A promise to buy spot and sell forward
3months 1million EUR against USD with swap rate.

Chapter 2: Exchange Rate

14
 01/08/2020

2.2.3. Currency Futures transaction

— Currency future contract is a contract specifying a

standard volume of a particular currency to be
exchanged on a specific settlement date at a
certain price.
- Specifies a standard volume of a particular currency to
be exchanged on a specific settlement date.
- The futures rate is the exchange rate at which one can
purchase or sell a specified currency on the specified
settlement date.
- The future spot rate is the spot rate that will exist at a
future point in time and is uncertain as of today.

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

2.2.4. Currency Options transaction

— An currency option is a financial instrument

(derivative) that gives the holder the right – but not
the obligation – to sell (put) or buy (call) a currency at
a set price at an expiration date
— The seller of the option must fulfill the contract if the
buyer desires
— The buyer of the option pay a premium to the seller
for the privilege of choosing to use the option or not
— Two types of option: call option and put option

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

15
 01/08/2020

2.2.4. Currency Options transaction

v Currency Call Options
§ Grants the right to buy a specific currency at a
designated strike price or exercise price within a
specific period of time.
§ If the spot rate rises above the strike price, the owner
of a call can exercise the right to buy currency at the
strike price.
§ The buyer of the option pays a premium.
§ An call option is:
- In-the-money if the strike price < spot price (profit)
- At-the-money if the strike price = spot price (indifference)
- Out-of-the-money if the strike price > spot price (loss)
Chapter 2: Exchange Rate
Chapter 2_ The Exchange Rate

2.2.4. Currency Options transaction

Firms can use call options to:

¡ hedge payables
¡ hedge project bidding to lock in the dollar cost of
potential expenses.
¡ hedge target bidding of a possible acquisition.
¡ Speculate on expectations of future movements in
a currency.

Chapter 2: Exchange Rate

Chapter 2_ The Exchange Rate

16
 01/08/2020

2.2.4. Currency Options transaction

v Currency Put Options
§ Grants the right to sell a currency at a specified strike
price or exercise price within a specified period of
time.
§ If the spot rate falls below the strike price, the owner of
a put can exercise the right to sell currency at the
strike price.
§ The buyer of the options pays a premium.
§ An put option is:
- In-the-money if the strike price > spot price
- At-the-money if the strike price = spot price
- Out-of-the-money if the strike price < spot sprice
Chapter 2: Exchange Rate
Chapter 2_ The Exchange Rate

2.2.4. Currency Options transaction

Hedging with Currency Put Options:

§ Corporations with open positions in foreign currencies can
use currency put options in some cases to cover these
positions.
§ Some put options are deep out of the money, meaning
that the prevailing exchange rate is high above the
exercise price. These options are cheaper (have a lower
premium), as they are unlikely to be exercised because
their exercise price is too low.
§ Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore more
likely to be exercised. Consequently, these options are
more expensive.
Chapter 2: Exchange Rate
Chapter 2_ The Exchange Rate

17