LESSON 3: FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION,

FOREIGN EXCHANGE MARKET, EXCHANGE RATE DETERMINATION, EXPOSURE AND

MANAGEMENT
Exposure
• refers to risk associated with fluctuations in market variables such as exchange rates,
interest rates, and commodity prices. It also refers to the extent to which a business or
individual is subject to potential financial loss due to various risks.

Exposure Management (EM)

• is the process of addressing the access points – or attack vectors – and digital/physical
assets along an organization’s attack surface that could increase overall risk posture by
being vulnerable to threat actors and breaches.

Foreign Exchange
• is the conversion of one currency into another at a specific rate known as the foreign
exchange rate. The conversion rates for almost all currencies are constantly floating as
they are driven by the market forces of supply and demand.
• Top 5 Most Traded Currencies
o United States Dollar (UDS) – 44.15%
o Euro (EUR) – 16.14%
o Japanese yen (JPY) – 8.40%
o British Pound (GBP) – 6.40%
o Australian Dollar (AUD) – 3.48%

• Most liquid trading pairs

o EUR/USD – with 28% of total transaction volume in the forex market in 2023
o USD/JPY – 13%
o GBP/USD – 11%

Factors that affect forex rates

• Economic – CB increasing int. rates
• Psychological – behavioral factors
• Political – things related to politics

Foreign Exchange Market

• is a decentralized and over-the-counter market where all currency exchange trades
occur. It is the largest (in terms of trading volume) and the most liquid market in the world.
• Centers
o New York
o London
o Frankfurt
o Singapore
o Hongkong
o Tokyo
o Sydney
• 24 hours/day; 5 days/week

Types of Forex Market

Options Market
• Exercising the option means purchasing or selling the underlying asset through the
option.
• Traders have the right but not the obligation to exercise the option.
Futures Market
• A centralized exchange where standardized contracts are traded for the future delivery of
a specified currency predetermined price.
• Traders have the right and the obligation to carry out the agreed contract.

Forwards Market
• Unstandardized or customizable contracts where participants can set predetermined
price and date of the future.
• OTC products, not regulated, and are not bound by specific trading rules and regulations.
• Traders have the right and the obligation to carry out the agreed contract.

Swaps Market
• A forex transaction where two parties agree to exchange one currency for another at a
future date.
• Unstandardized or customizable contracts where participants can set predetermined
price and date of the future.
• OTC products, not regulated, and are not bound by specific trading rules and regulations.
Spot Market
• The spot market is the immediate exchange of currencies at the current exchange.
• This allows participant to exchange currency directly with any intermediary with the help
of financial institution.

Interest Rate Parity

• Theory regarding the relationship between the spot exchange rate and the expected spot
rate or forward exchange rate of two currencies, based on interest rates.
Ex:
• Let’s imagine that interest rates in the UK are 5% lower than in the US. So if one invests
their money in the UK, they'll earn 5% less than if they invests it in the US. According to
IPR, this 5% difference should also be reflected in the exchange rate. Specifically, the US
dollar should be expected to be 5% lower in value compared to the British pound.

Covered Interest
• It refers to a theoretical condition in which the relationship between interest rates and
the spot and forward currency values of two countries are in equilibrium. The covered
interest rate parity situation means there is no opportunity for arbitrage using forward
contracts, which often exists between countries with different interest rates.
Uncovered Interest Rate Parity
• It is a theory of finance which states that the relative changes in the foreign exchange rate
over the same length of time are equivalent to the difference in the nominal interest rates
between two countries.

CIRP Formula
UIRP Formula

Purchasing Power Parity

• A theoretical exchange rate that allows you to buy the same amount of goods and
services in every country.
• Example: If you want to live inexpensively, and you can move to any country in the world,
compare prices of a specific fast food chain's burger.
• Government agencies use it to compare the output of countries that use different
exchange rates.
Calculating Purchasing Power Parity
• The relative version of PPP is calculated with the following formula: S = P1/P2
Where:
S = Exchange rate of currency 1 to currency 2
P1 = Cost of good X in Currency 1
P2 = Cost of goox X in Currency 2

Users of PPP
• Economists and Researchers
• International Organizations
• Governments and Policy Makers
• Businesses and Investors
• Academics and Students
• Media and Analysts

Pairing PPP w/GDP

• In contemporary macroeconomics, gross domestic product (GDP) refers to the total
monetary value of the goods and services produced within one country. Nominal GDP
calculates the monetary value in current, absolute terms. Real GDP adjusts the nominal
gross domestic product for inflation.
• Some accounting goes even further, adjusting GDP for the PPP value. This adjustment
attempts to convert nominal GDP into a number more easily compared between
countries with different currencies.

Drawbacks of PPP
• Transport Costs
• Tax Differences
• Government Intervention
• Non-Traded Services
• Market Competition
• Exchange Rate Volatility
• Regional Variations

Forecasting Exchange Rates

Efficient Market Approach
• Financial Markets are efficient if prices reflect all available and relevant information
• Exchange rates will only change when new information arrives
• Predicting exchange rates using the efficient markets approach is affordable and is hard
to beat

Fundamental Approach
• Involves econometrics to develop models that use a variety of explanatory variables
A. Estimate the structural model
B. Estimate future parameter values
C. Use the model to develop forecasts
Technical Approach
• Technical analysis looks for patterns in the past behavior of exchange rates
• Based upon the premise that history repeats itself
• Trust it is at odds with the EMH

Performances of the Forecasters

• Forecasting is difficult, especially with regards to the future
• As a whole forecasters cannot do a better job of forecasting future exchange rates that
the forward rate

Management of Transaction Exposure & Management of Economic Exposure

Transaction Exposure
• A type of business risk incurred due to fluctuations or changes in the foreign exchange
rates for transactions conducted using foreign currencies.
• Typically occurs when a cross-currency contract is done but has not been settled. The
exposure of the transaction comes when there are changes to the foreign exchange.
• Identify, Decide, Choose

Financial Techniques
Forward Contracts - If a firm is required to pay a specific amount of foreign currency in
the future, it can enter a contract that fixes the price for the foreign currency for a future
date.

Future Contracts - Similar to forward contracts. However, futures contracts have

standardized and limited maturity dates, initial collateral and contract sizes.

Money Market Hedge - The forward price is equal to current spot price multiplied by the
ratio of the currency’s riskless returns. This also creates the finance for the foreign
currency transaction.

Options - The options contracts involve an upfront fee and do not oblige the owner to
trade currencies at a specified price, time period and quantity.

Operational Techniques
 Risk Shifting - The firm can completely avoid transaction exposure by not involving itself
in foreign exchange at all. All the transactions can be conducted in the home currency.

Currency Risk Sharing - The two parties involved in the deal can have the understanding
to share the transaction risk.

Leading and Lagging - Leading and lagging involve manipulating currency cash flows in
accordance with the fluctuations. Paying off liabilities when the currency is appreciating
is known as leading. While collecting receivables when the currency is at a low value is
called lagging.

Reinvoicing centers - is a single third-party subsidiary used to conduct all intracompany

trades. The reinvoicing centers carry out transactions in domestic currency, thereby
bearing the losses from the transaction exposures.

Economic Exposure
• Also known as operating or business exposure, is another kind of foreign currency
exposure impacting the company's market value, cash flows, overall financial health
• Typically occurs when there are unexpected currency fluctuations. As foreign exchange
volatility rises so does economic exposure.
Difference of Trans and Econ
Econ Ex Trans Ex
Scope Broader Immediate
Impact Impact
Time Long Near-term
Horizon term/extended
periods
Risk to mitigate the to mitigate
Mitigation overall risks the specific
associated risks
with currency associated
fluctuations with
individual
transactions

Determining Economic Exposure

1. EE is higher for firms having both product prices and input costs sensitive to currency
fluctuations. It is lower when costs and prices are not sensitive to currency fluctuations.
2. EE is higher for firms which do not adjust their markets, product mix, and source of inputs
in accordance with currency fluctuations. Flexibility in adapting to currency rate
fluctuations indicates lesser economic exposure

Measuring Economic Exposure

• Cash Flow at Risk (CFaR) - measures the potential impact of currency fluctuations on a
company’s future cash flows. It involves estimating the sensitivity of cash flows to
changes in exchange rates. This method quantifies the potential risk by considering the
company’s revenue sources, cost structure, and currency exposures.

• Sensitivity Analysis - involves assessing how changes in exchange rates impact key
financial metrics such as revenues, costs, profitability, and market share. By modeling
different exchange rate scenarios, companies can evaluate the potential effects on their
financial performance.

• Value at Risk (VaR) - measures a company’s potential loss due to adverse exchange rate
movements. It estimates the maximum loss within a specified confidence level over
time. VaR helps quantify the potential downside risk associated with exposure

• Net Present Value (NPV) Analysis - helps assess the value of future cash flows by
discounting them to their present value. By incorporating the impact of currency
fluctuations on expected cash flows, companies can quantify the potential changes in
NPV due to exposure.

• Regression Analysis - can identify the statistical relationship between a company’s

financial performance and exchange rate movements. By analyzing historical data,
companies can estimate the sensitivity of economic variables to currency fluctuations.

• Scenario Analysis - involves simulating different exchange rate scenarios and assessing
their impact on a company’s financial performance. Companies can identify potential
risks and opportunities associated with exposure by considering various methods.

Managing Economic Exposure

Operational Strategy
Aims to adjust the current company’s operations to prevent possible risk associated with
future currency fluctuations.
Diversifying production facilities and markets for products - The expansion of
operating facilities and sales to a mixture of markets.
 Sourcing Flexibility - A company considers the acquisition of its key inputs from
different regions.

Diversification of Financing - A company may seek financing from capital markets in

different regions.

Currency Risk Mitigation Strategy

Aims to minimize or eliminate economic exposure through hedging.
Matching Currency Flows - Matching the foreign currency outflows with foreign currency
inflows.

Currency Risk-Sharing Agreements - An agreement between two parties involved in the

purchase and sales contract to share the potential currency risk. The sale/purchase
contract is executed at a predetermined rate.

Back-to-back Loans - Aka “credit swap”. Involves two companies from different
countries entering an arrangement to borrow each other’s currency for a fixed period of
time

Currency Swaps - Companies use this to obtain the required cash flows in foreign
currency at the desired exchange rate.