11F 378 Exchange Rates-1

11F 378 Exchange Rates-1 - Understanding Exchange Rates...

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Understanding Exchange Rates Foreign exchange rates (the price of one country’s currency in terms of another’s) are important because they affect the price of domestically produced goods and abroad and the cost of foreign goods bought domestically. The globalization of the financial services industry has meant that FIs are increasingly exposed to foreign exchange (FX) risk. FX risk can occur as a result of trading in foreign currencies, making foreign currency loans (such as a loan in pounds to a corporation), buying foreign-issued securities (Germen euro-denominated government bonds), or issuing foreign currency-denominated debt (Japanese yen certificates of deposit) as a source of funds. FOREIGN EXCHANGE MARKETS A. The electronic trading of foreign currencies between commercial banks, dealers, and businesses is called the foreign exchange market. B. The foreign exchange markets have no central marketplace. Participants trade via sophisticated communications systems. C. The amount of one currency needed to purchase one unit of another currency is called the exchange rate. D. Foreign exchange rates are expressed in two ways. The direct quote shows that the amount of Canadian dollars is required for one unit of foreign currency. That is, II. S = (domestic currency) / (foreign currency) = C$ / SF r III. With this definition, an increase in S means a depreciation of Canadian dollars. IV. With the direct quote, the exchange rate is the number of units of domestic currency needed to buy one unit of foreign money. The Canadian dollar price of foreign goods is equal to the foreign price of foreign goods multiplied with the exchange rate. Example: If an IBM computer costs ¥150,000 in Japan, with a spot exchange rate $/¥ = 0.01 and zero transportation costs, this computer will cost $1,500 = (150,000)(0.01) in Canada. A. The other alternative (most commonly used) is the indirect quote that is the reciprocal of the direct quote listing the amount of foreign currency that you can buy for one Canadian dollar. That is, V. S = (foreign currency) / (domestic currency) = SF r / C$
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VI. An increase in S indicates that the domestic currency (C$) appreciates. With the indirect quote, the exchange rate is the number of units of foreign currency that can be acquired with one unit of domestic money. The Canadian dollar price of foreign goods is equal to the foreign price of foreign goods divided by the exchange rate. Example: Suppose a Japanese auto costs 2,000,000 yen in Japan. Ignoring transportation costs, with an exchange rate ¥/$ = 100, this auto will cost $20,000 = 2,000,000/100 in Canada. A. The exchange rate is a relative price – the price of one national currency in terms of another - and is determined by supply and demand. The demand for dollars in the foreign exchange market reflects the demand by foreign residents for Canadian goods, services and financial claims. The supply of dollars comes from the demand by Canadian for foreign goods, services and financial claims.
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11F 378 Exchange Rates-1 - Understanding Exchange Rates...

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