Study Notes on Foreign Exchange (FX) Market

1. Direct vs Indirect Quote

Direct Quote: The price of one unit of foreign currency in terms of
the home currency.
Example: 1 USD = 59 PHP (Philippines perspective).

Indirect Quote: The price of one unit of home currency in terms of

foreign currency.
Example: 1 PHP = 0.01695 USD.
Conversion Formula: Indirect Quote = 1 / Direct Quote.
. Direct vs Indirect Quote
2. Plain Vanilla Derivatives
Definition: Basic derivative instruments such as options and swaps.
Call Option: Right to buy a currency at a specified price.
Direct Quote:
Put Option: Right The
to sell price ofatone
a currency unitof
a specified price.
Swaps: Exchange of currencies or interest rates between parties.
foreign currency
Use: Hedging in terms
or speculating in the of the home
FX market.
currency.
3 & 6. Converting Currencies (COSTs & REVENUEs)
Spot Conversion Example: A Philippine company imports $20,000
xample:
worth of1raw
USD = 59 PHP (Philippines
materials.
perspective).
Spot rate: 1 USD = 59 PHP.
PHP Cost = 20,000 x 59 = 1,180,000 PHP.
Forward Conversion Example: The same company hedges by
Indirect
locking aQuote: The
forward rate price
of 1 USD = 60of one
PHP unit
for 90 days.of
home PHPcurrency in terms
Cost = 20,000 of foreign
x 60 = 1,200,000 PHP.
currency.
4. Types of Exchange Rate Systems
Floating: Determined by supply and demand (e.g., USD, Euro).
xample: 1 PHPTied
Fixed (Pegged): = 0.01695 USD.
to another currency (e.g., HKD to USD). 7 75 - .

Managed Float: Combination of market determination and

Conversion Formula:
government intervention (e.g., INR). 753

Indian Rupee
5. Floating Rate System
Features include:
Market-determined value.
High volatility but self-correcting.
Requires hedging for stability.
protect against movements

7. Imports and Exports via FX Strong Vimport=

Imports: Stronger home currency reduces import costs. Example:

a
PHP appreciation lowers costs for imported electronics. boost purchasing
Exports: Weaker home currency increases export competitiveness.
Example: PHP depreciation boosts demand for exported goods.

8. Estimating Forward Premium

Formula: Forward Premium (%) = (Forward Rate - Spot Rate) /
Spot Rate x (360 / Days).
Example: Spot rate = 1 USD = 59 PHP, Forward rate (90 days) = 1
USD = 60 PHP.
Forward Premium = (60 - 59) / 59 x (360 / 90) = 6.78%.

9. Forecasting FX Rates
PPP Approach: Expected Rate = Spot Rate x (1 + Inflation
(Domestic)) / (1 + Inflation (Foreign)).
Example: Spot rate = 1 USD = 59 PHP, Domestic Inflation = 5%,
Foreign Inflation = 2%.
Expected Rate = 59 x (1.05 / 1.02) = 60.73 PHP/USD.

10. Covered Interest Arbitrage

Example: Interest Rate in US: 3%, PH: 6%. Spot rate: 1 USD = 59
PHP, Forward rate: 1 USD = 61 PHP.
Steps: Borrow $1,000 in the US. After 1 year, repay $1,030.
Convert to PHP at the spot rate: 59,000 PHP.
Invest in PH for 1 year: 59,000 × 1.06 = 62,540 PHP.
Convert back using the forward rate: 62,540 ÷ 61 = $1,025.24.
No arbitrage profit here due to forward rate adjustment.
11 & 15. Locational Arbitrage
Locational Arbitrage Example:
Bank A: 1 USD = 58 PHP (Bid), 59 PHP (Ask).
Bank B: 1 USD = 57 PHP (Bid), 58 PHP (Ask).

Steps:
1. Buy USD at Bank B’s ask price (58 PHP).
2. Sell USD at Bank A’s bid price (59 PHP).

Profit for 1,000 USD:

Profit = (Sell Rate - Buy Rate) × Traded Amount
= (59 - 58) × 1,000
= 1,000 PHP.

12. Currency Options

Example: Strike price: 59 PHP/USD, Premium: 2 PHP/USD, Quantity:
1,000 USD.
If USD rises to 62 PHP/USD, exercise the option:
Cost = (59 + 2) × 1,000 = 61,000 PHP.
Profit = (62 × 1,000) - 61,000 = 1,000 PHP.

13. Currency Futures

Example: Futures price: 1 USD = 60 PHP, Quantity: 10,000 USD.
If USD rises to 62 PHP/USD: Profit = (62 - 60) × 10,000 = 20,000 PHP.

14 & 17. Variables Affecting FX

1. Interest Rate Differentials: Higher domestic interest rates attract
foreign capital, strengthening the currency.
2. Inflation: High inflation reduces purchasing power, weakening the
currency.
3. Political Stability: Stability attracts investors, boosting currency
value.
4. Trade Balances: Surplus strengthens the currency; deficit weakens it.
16. FX and Forward
Forward contracts allow businesses to lock in exchange rates for future
transactions, reducing uncertainty.
Example: Spot Rate = 1 USD = 59 PHP. Forward Rate (6 months) = 1
USD = 60 PHP.
If USD appreciates to 62 PHP, the forward contract saves 2 PHP/USD.

18. Inflation and PPP

High inflation in a country weakens its currency under the purchasing
power parity (PPP) theory.
PPP Formula: Expected Rate = Current Rate × (1 + Domestic
Inflation) / (1 + Foreign Inflation).
Example: US Inflation = 2%, PH Inflation = 5%, Spot Rate = 1 USD =
59 PHP.
Expected Rate = 59 × (1.05 / 1.02) = 60.73 PHP/USD.

19. Borrowing Between Countries

Borrowing in foreign currencies can lead to gains or losses depending
on FX fluctuations.
Example: A Philippine company borrows $1M at 59 PHP/USD. If PHP
depreciates to 62 PHP/USD, repayment increases by:
Additional Cost = 1M × (62 - 59) = 3M PHP.

20. FX and FIs (Financial Institutions)

Financial institutions facilitate FX transactions, hedging, and arbitrage
for clients. They earn through spreads and trading fees.
Example: Banks offer hedging tools like forwards, swaps, and options
to manage FX risks for businesses.

21. Forwards vs Futures

Forwards: OTC contracts, customizable, subject to counterparty risk.
Futures: Standardized, exchange-traded, less counterparty risk.

Example: A forward contract for 1M USD at 59 PHP/USD differs from

a standardized futures contract of 100,000 USD.
22. Government Intervention
Governments intervene in FX markets to stabilize currencies, control
inflation, or boost competitiveness.
Methods:
- Direct Intervention: Buying/selling currency reserves.
- Indirect Intervention: Changing interest rates or capital controls.
Example: Central banks selling USD to strengthen PHP.

23. Bid and Ask

Bid: Price a dealer is willing to pay (buy).
Ask: Price a dealer is willing to sell.
Example: Spot Rate = 1 USD = 58 PHP (Bid), 59 PHP (Ask).
Spread = Ask - Bid = 1 PHP.
Buying 1,000 USD costs 59,000 PHP; selling earns 58,000 PHP.

24. FX Concepts
Key concepts include:
- Spot and Forward Rates: Immediate vs future transactions.
- Cross Rates: Exchange rates derived from two currency pairs.
- Hedging: Protecting against FX risk using derivatives.

25. Pegged Currency

A pegged currency is tied to another currency’s value (e.g., HKD to USD
at 7.8 HKD/USD).
Advantages: Stability, predictability for trade.
Disadvantages: Requires large reserves, limits monetary policy.

26. PPP (Purchasing Power Parity)

Theory that exchange rates adjust to equalize purchasing power across
countries.
Example: A basket of goods costing $100 in the US should cost PHP
equivalent using the exchange rate.

PPP Formula: Expected Rate = Current Rate × (1 + Domestic

Inflation) / (1 + Foreign Inflation).
27. Hedging Affecting Pegged and Unpegged Currency
Hedging reduces FX risk for both pegged and unpegged currencies.

Example: A firm locks forward rates for an import transaction

regardless of the exchange system.

28. Dirty, Free, Gold, Bretton Woods Era

- Free Float: Fully market-determined exchange rates.
- Dirty Float: Managed exchange rates with occasional government
intervention.
- Gold Standard: Currencies tied to gold reserves (pre-1971).
- Bretton Woods: Fixed exchange rates, replaced by free float in
1973.

29. Bonds and Cross-Border Investing

Cross-border bond investments involve FX risk due to currency
fluctuations.

Example: A bond yielding 5% in USD provides a different return

when converted to PHP, depending on the FX rate.

30. Cross Rates

Exchange rate between two currencies derived from a third currency.

Example: USD/JPY = 110, USD/PHP = 59.

PHP/JPY = USD/PHP ÷ USD/JPY = 59 ÷ 110 = 0.536 PHP/JPY.

31. Appreciation and Depreciation

Appreciation: Currency value increases relative to another.
Example: PHP appreciates from 59 PHP/USD to 58 PHP/USD.

Depreciation: Currency value decreases.

Example: PHP depreciates from 59 PHP/USD to 62 PHP/USD.
 a

32. Inflation, Interest Rates, and Currencies

Forin
~
How Inflation Affects Exchange Rates:
- High Inflation: Domestic currency depreciates as purchasing power
decreases. Exports become cheaper, while imports become expensive.
- Low Inflation: Currency tends to appreciate due to higher purchasing
power.

Example: US Inflation = 2%,

PH Inflation = 5%.
PHP is expected to depreciate relative to USD.

Using PPP Formula:

Expected Exchange Rate = Current Rate x (1 + Domestic Inflation) / (1 +
Foreign Inflation).
If the current spot rate is 1 USD = 59 PHP:
Expected Rate = 59 x (1.05 / 1.02) = 60.73 PHP/USD.

How Interest Rates Affect Exchange Rates:

- High Interest Rates: Attract foreign capital, causing currency
appreciation.
- Low Interest Rates: Reduce capital inflows, causing currency
depreciation.

Example:
(Interest Rate Parity): US Interest Rate = 3%
Philippine Interest Rate = 6%
Spot Rate = 1 USD = 59 PHP.

Forward Rate (1 year):

Forward Rate = Spot Rate x (1 + Foreign Interest Rate) / (1 + Domestic
Interest Rate).
Forward Rate = 59 x (1.06 / 1.03) = 60.83 PHP/USD.

Combined Effects:
- High Inflation and Low Interest Rates: Lead to currency depreciation.
- Low Inflation and High Interest Rates: Support currency appreciation.