Chapter 1
Foreign currencies
Exchange Market
MAIN CONTENTS
1. Exchange rate
2. Exchange rate quotation
3.Cross exchange rate formula
4. Factors influencing exchange rate
5. Forex transactions
1. Exchange rate
An exchange rate is the value of one nation's currency versus the
currency of another nation or economic zone.
An exchange rate is the rate at which one currency will be
exchanged for another.
(Vietcombank’s exchange rate on 02/14/21)
Currency code – ISO 4217
The national currency codes include 3 letters
The first 2 letters are the abbreviation of country name.
The third letter is the abbreviation of national currency name.
2. Exchange rate quotation
Direct quotation
A direct quote is a foreign exchange rate quoted in fixed units of foreign
currency in variable amounts of the domestic currency. In other words, a
direct currency quote asks what amount of domestic currency is needed to
buy one unit of the foreign currency (most commonly the U.S. dollar in
forex markets). In a direct quote, the foreign currency is the base currency,
while the domestic currency is the counter currency (or quote currency).
1 foreign currency = x domestic currency
Direct quotation are used in many countries such as: Japan, Thailand, Korea,
VietNam, ...
Ex: USD/VND = 23,230
EUR/VND = 25,760
2. Exchange rate quotation
Indirect quotation
Indirect quote is the price of the domestic currency is expressed in terms of
a foreign currency.
1 domestic currency = y foreign currency
Indirect quote is popular in countries such as: England, USA,
Australia, EU,...
Ex: CAD/USD = 1.17
1A=xB
=x
A/B = x
Currency A is called base currency
Currency B is called quote currency
Buying rates Selling rate
USD/VND 23,835 23,840
AUD/VND 17,623 17,700
EUR/USD 1.2188 1.2195
GBP/USD 1.5494 1.5500
Buying rate (Bid price) is the price which the commercial banks
apply to buy foreign currency from their customers.
Selling rate (Ask price) is the price which the commercial banks
apply to sell foreign currency to their customers.
The difference between Selling rate and Buying rate is spread.
Ex 1:
Company A uses VND to buy 10,000 USDs at ACB. Indentify the
amount of VND this company has to pay for the bank? The exchange
rate of USD/VND : 22,950 – 22,990.
Ex 2:
VCB buys 150,000 AUDs from Long Minh Ltd and pays the
company by VND. How much VND Long Minh Ltd will receive in this
transaction. The exchange rate of AUD/VND : 17,240 – 17,580
Ex 3:
An Lộc Ltd sells 50,000 EURs to Sacombank to get USD. Calculate
the amount of USD this company will get? The EUR/USD exchange
rate at Sacombank: 1.2340 – 1.2380.
Ex 4:
Dell buys 80,000 CADs and pays AUD to Citibank. Indentify the
amount of AUD this company has to pay to the bank. The CAD/AUD
exchange rate = 0.9560 – 0.9750.
Cross exchange rate formula
=
x
A cross rate is a foreign currency exchange transaction between
two currencies that are both valued against a third currency.
Apply cross rate formula to calculate the exchange rate.
Ex 1 : Fosco Ltd wants to sell 10,000 USDs for ACB to receive
EUR to pay for their exporter customer. Calculate the amount of EUR
which ACB has to pay for Focos? ACB quotes the exchange rates:
USD/VND = 22,835 – 22,865
EUR/VND = 26,471 – 26,815
In this transaction ACB processes 2 steps:
Step 1: Buy USD and sell VND to this company at current
USD/VND.
Step 2: Buy back VND and sell EUR to this company at current
EUR/VND.
Applying cross rate formula we indentify the EUR/USD exchange
rate at which ACB apply exchange from USD to EUR for this
company:
= x - 26,815 x
EUR/USD = 1.1577 – 1.1743
The amount of EUR which the company receive is: = 8,515.71
EUR
Ex 2: Unilever sells 100,000 GBP to HSBC to get EUR to pay for
materials. Indentify the amount of EUR which HSBC pays for
Unilever?
The exchange rates of HSBC as follow:
GBP/USD = 1.5603 – 1.5650
EUR/USD = 1.2225 – 1.2240
Ex 3 : Nestle wants to buy 100,000 GBPs and pays by CHF with
Citibank. Calculate the cross rate GBP/CHF ? Indentify the amount of
CHF Nestle has to pay Citibank in this transaction ?
The current exchange rates as follow:
GBP/USD = 1.6810 – 1.6820
CHF/USD = 0.7544 – 0.7547
GROUP DISCUSSION
How does Covid-19 pandemic effect the exchange
rate of USD/VND in Vietnam? Explain the reasons
why this affect occurs.
4. Factors influencing the foreign exchange
rate
5.1 Current account
The current account records a nation's transactions with the rest of the
world—specifically its net trade in goods and services, its net earnings on
cross-border investments, and its net transfer payments—over a defined period
of time, such as a year or a quarter.
If the current account balance deficit (or negative, earning
<payment)=> demand > supply => price of foreign currency increases
=> foreign exchange rate surges.
If the current account balance surplus (or positive,
earning>payment), supply > demand => price of foreign currency
decreases.
5.2 Inlfation
Inflation is the decline of purchasing power of a given currency over
time. A quantitative estimate of the rate at which the decline in
purchasing power occurs can be reflected in the increase of an average
price level of a basket of selected goods and services in an economy
over some period of time.
If the inflation of country A is higher than the inflation of country B.
The currency of country A will lose value and depreciate. The currency
of country B will appreciate on the Forex market.
TCK TDK LPB LPA
TDK 1 LPA
Trong đó ∆% Exchange rate = ∆% Inflation rate
A: base currency
B: quoting currency.
TDK: the exchange rate at the beginning of the period.
TCK: the exchange rate at the end of the period.
LPA: Inflation rate of country A.
LPB: Inflation rate of country B.
5.3 Interest rate
High interest rates indicate that a country’s currency is more
valuable. From a foreign investor’s perspective, saving or investing in
that country is more likely to yield better returns. Thus, this would
increase the demand for that country’s currency. To take advantage of
the high rates offered, they would move their funds there. When
demand for a currency goes up vis-à-vis another currency (or
currencies), it is said to strengthen or appreciate => the foreign
exchange rate will decrease.
But when interest rate of country A is too high => the foreign
exchange rate will increase.
5.4 Political stability and economic performance
If a country gets itself into sizeable national debt without a realistic
plan on how to handle it. The risk of defaulting is high and can
negatively affect the value of its currency, thus making the foreign
exchange rate increase.
Political conflict and war can be devastating to a country in a
myriad of ways => foreign exchange rates increase.
Global Pandemics.
5. Forex transactions
5.1 Spot transaction
Spot transaction refers to the exchange or settlement of the
currencies by the buyer and seller within two days.
The spot transaction is the quickest and fastest way to actually
exchange your currency.
Features of spot transactions:
Transactions are settled at the ruling price known as the spot price
or spot rate.
Delivery of the asset takes place immediately or otherwise at T+2
The commercial banks do not charge fee in spot transactions.
Procedure of spot transactions:
5.2 Arbitrage transactions
Concepts.
Arbitrage is the simultaneous purchase and sale of the same
currencies in different markets in order to profit from tiny differences
in the currencies’ listed price.
Rules
Arbitrage traders buy one currency at lower price in one market and
sell this currency at higher price in other market.
The difference of prices between markets must be greater than
transaction fees.
Types of arbitrage transactions.
Base on type of transaction:
Spot Arbitrage: purchase currency in one market at a given price
and simultaneously sell in another market at a higher price
Arbitrage forward: buy and sell forward/furture contracts in
different markets.
Base on the number of market:
Simple Arbitrage : transactions take place in 2 markets
Complex Arbitrage : transactions are carried on in more than 2
markets.
Example
Example 1: At time t, the exchange rates in the international forex
market as follow:
At Singapore: USD/JPY = 78.780 – 78.790
At Tokyo: USD/JPY = 78.740 – 78.750
If you have 1 million USDs, can you use arbitrage to make profit in 2
markets? Indentify the profit in this case.
2.4 Example
Example 2: At time t, : the exchange rates in international forex
market as follow
At NewYork: GBP/USD = 1.5718 – 1.5725
At London: USD/GBP = 0.6410 – 0.6420
With 1 million GBP fund, can you use arbitrage to make profit ?
Calculate the profit in this case.
5.3 Forward operation
Concept.
A currency forward is a binding contract in the
foreign exchange market that locks in the exchange rate for the
purchase or sale of a currency on a future date
Features.
Forward transaction can have customized terms, such as a
particular notional amount or delivery period.
Don't require up-front payments when used by large corporations
and banks.
Forward exchange rate formula
=
= x(
Trong đó:
Fb : buying forward exchange rate.
Sb : buying spot exchange rate.
Fs :selling forward exchange rate.
Ss : selling spot exchange rate
n: time duration of forward contract
Example
Example 1 : The exchange rates and interest rates as follow:
Spot Exchange rate USD/EUR = 0.8179 – 0.8185
Interest rate of USD for 3 month term : 1%/year – 1.5%/year
Interest rate EUR for 3 month term: 2%/year – 2.5%/year
Calculate the 3 month forward exchange rate USD/EUR ?
FbUSD/EUR= 0.8179 + 0.8179 x 3/12 x (2% - 1.5%) = 0.8189
FsUSD/EUR = 0.8185 + 0.8185 x 3/12 x (2.5% - 1%) = 0.8215
Example 2 : The exchange rate and interest rate as follow
Spot exchage rate GBP/JPY = 124.10 – 124.29
Interest rate 4 month term of GBP : 1%/year – 1.5%/year
Interest rate 4 month term of JPY : 1.75%/year – 2.5%/year
Indentify the 4 month forward exchange rate of GBP/JPY ?
Example 3 : The exchange rate and interest rate of ANZ as follow :
Spot exchange rate: AUD/USD = 1.0441 – 1.0500
3 month interest rate of USD : 1%/year – 1.5%/year
3 month interest rate of AUD : 1.75%/year - 2%/year
HP signs a 3 month forward contract to sell 100,000 AUD to get USD.
Calculate the amount of USD HP will get when the contract expires ?
Purpose of forward contract.
Export and Import companies use forward contract to hedge against
the fluctuation of exchange rates. If you are going to get a payment
in foreign currency, you can engage in a forward contract to sell this
foreign currency. In contrast, if you are going to make a payment in
foreign currency, you sign a forward contract to buy this foreign
currency.
Speculators use forward contract to make profit from the variation
of exchange rates. If they predict the price of one currency may
raise, they will sign a forward contract to buy this currency.
5.4 Swap transaction
Concept
A foreign currency swap in VietNam, is an transaction in which the
company conduct concurrently 2 transactions:
Transaction 1: buy (or sell) an amount of foreign currency at spot
rate.
Trasaction 2: sell (or buy) that amount of foreign currency at
forward exchage rate.
Example
Example 1: In order to make a loan of 150,000 CHF in 3 months to
one customer, ACB buy 150,000 CHF at spot exchange rate and at the
same time they sign a forward contract to sell the amount of principal
and interest getting from that loan to VCB.
Calculate the profit of ACB in this transaction.
The spot exchange rate, forward exchange rate and interest rate of
VCB as follow
Spot exchange rate CHF/VND = 21,071 - 21,080
Forward exchange rate of at month term of CHF/VND = 21,090 –
21,095
3-month term loan rate of ACB: 6%/year.
ACB buy 150,000 CHF at spot exchange rate, the amount of VND they
have to pay = 3,162,000,000 VND.
ACB make aloan of 150,000 CHF to their customer in 3 month with
6%/year interest rate. After 3 month they will get
150,000 +150,000 x 6% x 3/12 = 152,250 CHF.
ACB sell the amount and interest of the loan to VCB at 3-month forward
exchange rate, the amount of VND they will receive:
152,250 CHF x 21090 = 3,210,952,500 VND.
The profit of this transaction:
3,210,952,500 – 3,162,000,000 = 48,952,500 VND.
The purpose of swap transaction
Commercial banks and companies use swap transactions to meet
their demand of foreign currency, to ensure the profit and hedge
against the exchange rate risk.
Companies employ a currency swap to secure cheaper debt.
Swaps are also used by speculators in forex market to make profit.
5.5 Option transaction
Concepts
A currency option (also known as a forex option) is a contract that
gives the buyer the right, but not the obligation, to buy or sell a certain
currency at a specified exchange rate on or before a specified date. For
this right, a premium is paid to the seller.
Holder/buyer of option: pays premium and has right to ask writer
to execute the option contract.
Writer/Seller of option: get premium and is obligated to buy (or
sell) an amount of currency when Holder ask to execute the option
contract.
Underlying asset: is currency on which the option contract bases
upon such as USD, EUR, CHF,…
Exercise price or Strike price is the exchange rate at which the
option contract is executed.
Volume is the total amount of currency which the holder want to
sell or buy
Maturity date is the last day the option contract is valid. On or
before this day, investors will have already decided what to do with
their expiring position.
Premium is the current market price of an option contract. It is thus
the income received by the seller (writer) of an option contract to
another party
A put option is a contract giving the owner the right, but not the
obligation, to sell a specified amount of an currency at a pre-
determined price within a specified time frame.
A currency call option is the opposite of a currency put option. The
holder of a currency call option has the right, but not the obligation,
to buy a currency at a specified price within a specific time frame.
American option is a version of an options contract that allows
holders to exercise the option rights at any time before and
including the day of expiration.
European option allows execution only on the day of expiration.
Example.
Example 1: Honda VN is going to make a payment of 100,000 USD in
next 3 months. The company predicts that USD’s price will raise
against VND’s. The company engage in a 3-month European call
option contract of 100,000 USD with strike price at 21,100. The
premium is 20 VND/USD
Calculate the profit/loss of the company in the following cases:
- The spot exchange rate at the maturity date USD/VND: 20.900
- The spot exchange rate at the maturity date USD/VND: 21.300
Example 2:
Fosco is going to get a 50,000 EUR payment from its customer in the next
3 months. Fosco wants to sell the amount of EUR to get VND to pay for
materials. To hedge against the decrease of EUR’s price, the company
engages a put option contract with ACB to sell the amount of EUR at a
strike price EUR/VND= 26,700. The premium of this contract is 30
VND/EUR.
In 3 months later, if the spot exchange rate EUR/VND is 26,400; will the
company execute this option contract ? Indentify the amount of VND the
company receive in this case after deducting the premium.
