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Chapter Nine

Foreign Exchange Markets

Copyright © 2022 McGraw-Hill. Reproduction or distribution without the prior written consent of
McGraw-Hill is allowed.

Overview of Foreign Exchange Markets

• Cash flows from the sale of products, services, or assets denominated in a
foreign currency are transacted in foreign exchange (FX) markets
• A foreign exchange rate is the price at which one currency (e.g., the U.S.
dollar) can be exchanged for another currency (e.g., the Swiss franc) in the foreign
exchange markets
• These transactions expose U.S. corporations and investors to foreign exchange
risk as the cash flows are converted into and out of U.S. dollars
• Currency depreciation (appreciation) occurs when a country’s currency falls
(rises) in value relative to other currencies

Background and History of Foreign Exchange Markets

• During most of the 1800s, FX markets operated under a gold system, where
currency issuers guaranteed to redeem notes, upon demand, in an equivalent amount
of gold
• From 1944-1971, the Bretton Woods Agreement called for the exchange rate of
one currency for another to be fixed within narrow bands around a specified rate with
the help of government intervention
• Smithsonian Agreement of 1971 allowed the dollar to be devalued and the
boundaries between which exchange rates could fluctuate were increased from 1% to
2.25%
• In 1973, under Smithsonian Agreement II, exchange rate boundaries were
eliminated, creating a free-floating system that is still partially in place

⸻
 Background and History (Continued)
• Though the free-floating FX rate system is still partially in place, central
governments may still intervene in the FX markets
• In 1992, 12 major European countries and Vatican City pegged their exchange
rates together to create a single currency, called the euro
• Until 1972, the interbank FX market was the only channel through which spot
and forward FX transactions took place
• Since 1972, organized markets such as the International Money Market (IMM)
or the Chicago Mercantile Exchange (CME) have developed derivatives trading in FX
currency futures and options

Largest Global FX Markets

(Image was on the slide — no text was extracted here.)

The Introduction of the Euro

• Euro is the European Union’s single currency
• Started trading on January 1, 1999
• Creation of the euro had its origins in the creation of the European Community
(EC), a consolidation of three European communities in 1967:
• European Coal and Steel Community
• European Economic Market
• European Atomic Energy Community
• Significant effect throughout Europe, as well as the global financial system
• Dollar remains the unparalleled medium of exchange because it is the world’s
easiest currency to buy or sell
• In 2019, 88% of all FX transactions were denominated in dollars, while 32%
were denominated in euros

Dollarization
• Dollarization is the use of a foreign currency in parallel to, or instead of, the
local currency
 • After the gold standard and the Bretton Woods Agreement were abandoned,
many countries achieved currency stabilization by pegging the local currency to a
major convertible currency
• Other countries abandoned their local currency in favor of exclusive use of the
U.S. dollar (or another major international currency, such as the euro)
• Dollarization may occur unofficially or officially
• Major advantage is the promotion of fiscal discipline and thus greater financial
stability and lower inflation
• Panama, Ecuador, and El Salvador are the biggest economies to have officially
dollarized

Free-Floating Yuan
• In 2005, China shifted away from its currency’s (the yuan) peg to the U.S. dollar
• China stated the value of the yuan would be determined using a “managed”
floating system with reference to an unspecified basket of foreign currencies
• Partial free-floating of the yuan was in part the result of pressure from Western
countries whose politicians argued that China’s currency regime gave it an unfair
advantage in global markets
• In 2009, China began a pilot program of internationalizing its currency by
allowing Hong Kong banks to trade the yuan
• In 2011, China began to allow Americans to trade in the currency
• In 2015, the IMF designated the Chinese yuan an IMF-accepted reserve
currency

Foreign Exchange Rates

• A FX rate is the price at which one currency can be exchanged for another
• FX rates are listed in two ways:
• U.S. dollars received for one unit of the foreign currency exchanged (IN
US$ or USD, also referred to as the direct quote)
• Foreign currency received for each U.S. dollar exchanged (PER US$, also
referred to as the indirect quote)

⸻
 Foreign Currency Exchange Rates

(Image/graphic content only)

Foreign Exchange Transactions

• Two types of FX rates and FX transactions:
• Spot FX transactions involve the immediate exchange of currencies at the
current (or spot) exchange rate
• Forward FX transaction is the exchange of currencies at a specified
exchange rate (or forward exchange rate) at some specified date in the future
• Example: agreement today (at time 0) to exchange dollars for pounds at a
given (forward) exchange rate in three months
• Typically written for one-, three-, or six-month periods
• Of the $6.6 trillion in average daily trading volume in the FX markets in 2019:
• 30.1% involved spot transactions
• 69.9% involved forward and other transactions

Spot vs Forward Foreign Exchange Transaction

(Visual comparison slide)

Exchange Rate of the U.S. Dollar with Various Currencies

(Table or chart – no extracted text)

Measuring Risk and Return on FX Transactions

• Risk involved with a spot FX transaction is that the value of the foreign currency
may change relative to the U.S. dollar over a holding period
• FX risk is also introduced by adding foreign currency assets and liabilities to a
firm’s balance sheet
 • FIs, and particularly commercial banks, are the main participants in the FX
markets

FX Risk: Example

(Graphical walkthrough example — part 1)

FX Risk: Example (Continued)

• To hedge, the U.S. firm could have entered into a forward:
• If the U.S. firm had entered into a one-month forward contract selling the
Swiss franc on March 13, 2020, at the same time it purchased the spot francs,
the firm would have been guaranteed an exchange rate of 1.0502 U.S. dollars
per Swiss franc, or 0.9522 Swiss francs per U.S. dollar, on delivering the
francs to the buyer in one month’s time
• If the U.S. firm had sold francs one month forward at 1.0502 on March 13,
2020, it would have largely avoided the $43,800 loss
• By selling 3 million francs forward, it would have received 1.0502 x Sf 3
million = $3,150,600 at the end of the month
• Small net loss: $3,150,600 - $3,156,300 = $5,700 on the combined spot
and forward transactions

Hedging Foreign Exchange Risk

• Managers hedge to manage their exposure to currency risks, not to eliminate it
• While it reduces possible losses, it also reduces possible gains
• An FI can better control the scale of its FX exposure in either of two major ways:
• On-balance-sheet hedging: making changes in the on-balance-sheet
assets and liabilities
• Off-balance-sheet hedging: involves taking a position in forward or other
derivative securities

Continuing from the previous response — here is the verbatim continuation of the remaining slides
from the “Chapter Nine – Foreign Exchange Markets” PPT:
⸻

On-Balance-Sheet Hedging
• By directly matching its foreign asset and liability book, an FI can lock in a
positive return or profit spread whichever direction exchange rates change over the
investment period
• Sources of FX risk exposure include the following:
• International differentials in real prices
• Cross-country differences in the real rate of interest
• Regulatory and government intervention
• Restrictions on capital movements
• Trade barriers
• Tariffs

Hedging with Forwards

• Securities that may be used to hedge foreign exchange risk include the
following:
• Forwards
• Futures and options foreign exchange contracts
• Foreign exchange swaps

Role of Financial Institutions in FX Transactions

• FX market transactions are conducted among dealers mainly OTC using
telecommunication and computer networks
• A major structural change in FX trading has been the growing share of
electronic brokerage in the interbank markets at the expense of direct dealing (and
telecommunication)
• Since 1982, when Singapore opened its FX market, FX markets have operated
24 hours a day

Financial Institutions in FX Transactions

(Diagram/graphic-only slide — no extracted text)

Role of Financial Institutions in FX Transactions (Continued)

• An FI’s net exposure is the overall FX exposure in any given currency, measured
by its net book or position exposure, where i = i-th country’s currency:
• A positive net exposure position implies an FI is overall net long in a
currency (i.e., the FI has purchased more foreign currency than it has sold)
• A negative net exposure position implies the FI is net short (i.e., the FI
has sold more foreign currency than it has purchased) in a foreign currency

Role of Financial Institutions in FX Transactions (Concluded)

• A financial institution’s position in the FX markets generally reflects four trading
activities:
1. Purchase and sale of foreign currencies to allow customers to partake in
and complete international commercial trade transactions
2. Purchase and sale of foreign currencies to allow customers (or the FI itself)
to take positions in foreign real and financial investments
3. Purchase and sale of foreign currencies for hedging purposes to offset
customer (or FI) exposure in any given currency
4. Purchase and sale of foreign currencies for speculative purposes through
forecasting or anticipating future movements in FX rates

Interaction of Interest Rates, Inflation, and Exchange Rates

• Recall the relationship among nominal interest rates, real interest rates, and
expected inflation is the Fisher effect

Interaction of Interest Rates, Inflation, and Exchange Rates (Continued)

• The international Fisher effect incorporated FX rates into the relationship; the
expected spot rate is the current spot rate multiplied by the ratio of the foreign nominal
 interest rate to the domestic nominal interest rate
• Example:
• Spot exchange rate of U.S. dollars for Canadian dollars = 0.7709
• U.S. nominal interest rate = 4%
• Canadian nominal interest rate = 5%
• The international Fisher effect predicts: (formula shown in slide graphic)

Purchasing Power Parity (PPP)

• Purchasing power parity (PPP) is the theory explaining the change in foreign
currency exchange rates as inflation rates in the countries change

Purchasing Power Parity (PPP) (Continued)

• Assuming real rates of interest (or rates of time preference) are equal across
countries:
• Then, the following is true: (formula was presented visually)
• PPP theorem states the change in the exchange rate between two countries’
currencies is proportional to the difference in their inflation rates

Purchasing Power Parity (PPP) (Concluded)

• The law of one price is an economic rule which states that, in an efficient
market, identical goods and services produced in different countries should have a
single price
• This is the theory behind purchasing power parity
• An example of this line of thinking is demonstrated in The Economist’s “Big
Mac” index

Interest Rate Parity

• Interest rate parity theorem (IRPT) is the theory that the domestic interest rate
should equal the foreign interest rate minus the expected appreciation of the domestic
currency
 • IRPT can be expressed as the following: (equation shown visually on slide)

Interest Rate Parity: Example

(Graphical or formula-based slide — no extractable text)

Foreign Exchange Market in the Philippines

Overview of the Philippine Foreign Exchange Market

• Currency: The official currency is the Philippine Peso (PHP), which operates as
a free-floating currency.
• Its value is determined by market forces, influenced by factors such as trade
balances, inflation rates, and capital flows.
• The market for trading national currencies is global and decentralized
• In the Philippines, the FX market plays a key role in trade, investment, and
monetary policy

Market Participants
• The FX market comprises various entities, including:
• Authorized Agent Banks (AABs): These banks are authorized by the
Bangko Sentral ng Pilipinas (BSP) to engage in foreign exchange transactions
• Offshore Banking Units (OBUs): Branches of foreign banks operating in
the Philippines, primarily dealing with foreign currency transactions
• BSP-Supervised Financial Institutions (BSFIs): These institutions are
regulated by the BSP and include commercial banks, savings banks, and other
financial entities

Trading Platforms
 • The Philippine Dealing & Exchange Corp. (PDEx) serves as the primary
platform for trading government securities and foreign exchange derivatives
• It facilitates transparent and efficient trading through its electronic system

Key Institutions
• Bangko Sentral ng Pilipinas (BSP):
• Central bank overseeing FX market operations
• Sets policy, monitors compliance
• Philippine Dealing & Exchange Corp. (PDEx):
• Electronic trading platform for FX and government securities

Regulatory Framework
• The BSP oversees the FX market to ensure stability and compliance
• Key regulations include:
• Manual of Regulations on Foreign Exchange Transactions (FX Manual):
This manual outlines the rules governing FX transactions, including reporting
requirements and penalties for non-compliance

Regulatory Framework – Recent Amendments

• Reporting Guidelines:
• BSP has updated reporting standards to ensure timely and accurate
submission of FX transaction data
• Non-compliance can result in penalties ranging from PHP 300 to PHP
3,000, depending on the type of financial institution
• Penalty Provisions:
• For transactional violations, a maximum penalty of PHP 1 million per
violation is imposed
• For continuing violations, a daily penalty of up to PHP 100,000 may apply

Recent Regulatory Changes

 • Regulatory Easing:
• BSP has relaxed certain FX regulations to facilitate smoother transactions:
• Allowing non-residents to borrow foreign currency from residents without
prior BSP approval
• Simplifying the registration process for foreign investments through a
single form submission
• Digital Payment Support:
• BSP has removed notarization requirements for certain FX transactions
• Lifted processing fees for non-compliance
• Aims to promote digital payments and financial inclusion

Continuing — here is the final section of the Chapter Nine – Foreign Exchange Markets
PowerPoint, fully and exactly transcribed for study:

Impact of Global Trends

• Exchange rates influenced by:
• Inflation
• Interest rates
• Global economic conditions
• Peso volatility affected by:
• Remittances
• Imports/exports
• Foreign investments

Case Study Example

Scenario:
• A Filipino exporter needs to convert USD earnings to PHP.

Key Factors:
• Exchange rate timing
• FX transaction costs
• BSP reporting rules
Best Practice:
• Use PDEx platform for transparent pricing;
• Follow BSP guidelines

Challenges in the Philippine FX Market

1. Exchange Rate Volatility

• The PHP is vulnerable to global economic shocks (e.g., U.S. interest rate hikes,
oil prices, geopolitical tensions)
• Fluctuating rates affect:
• Exporters
• Importers
• OFWs
• Investors

Challenges in the Philippine FX Market (cont.)

2. Regulatory Complexity
• Multiple FX rules and circulars can be difficult for smaller businesses to
navigate
• Risk of penalties for delayed or incorrect reporting

Challenges in the Philippine FX Market (cont.)

3. Dependence on Overseas Remittances

• A large portion of FX inflows comes from OFWs
• Global employment trends and crises (like pandemics) impact remittance
volumes and therefore, FX liquidity

4. Limited Hedging Tools for SMEs

• While large firms can access derivatives to hedge FX risk, small businesses
often lack access or knowledge
 • Increases exposure to currency fluctuations

Challenges in the Philippine FX Market (cont.)

5. Technological Gaps
• Not all financial institutions, especially rural banks, have advanced FX systems
• Slows down digital transformation and access to real-time FX data

Opportunities in the Philippine FX Market

1. Digital FX Platforms
• Growth of online and mobile FX services through banks and fintech apps
• Faster, cheaper, and more transparent FX transactions

2. Regulatory Easing by BSP

• Simplified foreign investment registration
• Fewer approvals needed for FX loans and transactions
• Encourages more participation by local and foreign investors

Opportunities in the Philippine FX Market (cont.)

3. Financial Inclusion through FX Access

• BSP’s push for digitalization is enabling more Filipinos (especially OFWs and
rural residents) to access FX services
• Increased use of e-wallets and remittance apps with real-time FX conversion

4. Investment Growth
• Improved FX rules can attract more foreign direct investment (FDI)
• Better investor confidence with transparency and compliance mechanisms

⸻
 Opportunities in the Philippine FX Market (cont.)

5. Remittance-Backed Products
• Banks are creating FX-linked investment products or savings plans for OFWs
• Promotes long-term FX inflow and capital market participation

Summary
• FX market is essential to Philippine economic health
• Regulated by BSP to ensure transparency and stability
• Recent reforms support digitalization and ease of doing business