The Determining Factors in the Exchange Rates

An exchange rate ( besides known as Foreign-Exchange rate or Forex rate or FX rate ) is the rate at which one currency can be exchanged for another. For illustration, the currency exchange rate for GBP-USD is 1.5393 or to cite it the other manner around USD-GBP is 0.6502 ( Bloomberg, 2010 ) .

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Determinants of Exchange Ratess

Exchange rates are volatile and are capable to rapid alterations owing to the forces of supply and demand of the currencies in visible radiation which in bend are affected by a few other factor determiners. The alterations could be a smooth line of disposition or decline every bit good as be an absolute anomalousness which it normally is. The exchange rate can be fixed by the Central bank for one. The factors that put force per unit area on this fixed rate or change the floating exchange rates include existent variables like

Trade Balance

Balance of trade is one of the effectual determiners of the exchange rates. A excess in the balance would take to a higher demand for the domestic currency ( here the GBP ) appreciating its value while a shortage in the trade history would impact otherwise.

Law of One Monetary value

Harmonizing to the jurisprudence of one monetary value, the monetary value of individual good should be the same worldwide if expressed in the same currency presuming that there are no other costs attached. Given that the exchange rates should repair consequently to counterbalance for rising prices differences in the two states. Say the same good merchandising for 2 lbs cost $ 4.5 in US ( The value are non existent ) . Here the exchange rate should reflect the rising prices difference.

Besides the existent variables the alterations besides frequently follow the Monetary and Financial variable such as

Interest Ratess

Exchange rates and Interest rates go manus in manus. A alteration in involvement rate stirs a alteration in the exchange rate and it goes the other manner around every bit good. A higher involvement rate attracts foreign investing into the state which fills the foreign modesty and lessens the comparative demand for foreign currency. Consequently the grasp in the domestic currency takes topographic point and exchange rate alteration. Same would be the consequence for an opposite alteration in the involvement rates abroad. Similarly a lessening in domestic involvement rates would name for depreciation in the currency. So an addition in the involvement rates in Britain would take to an grasp of GP relation to the USD.


Higher rising prices frequently accompanies lower involvement rate and therefore depreciation in the currency or higher exchange rate ( if quoted as GBP-USD ) and frailty versa. The alteration in the buying power between the two states is reflected though the involvement rate, nevertheless, its practical analysis would sometime undertaking otherwise.

Political and Economic influence

Political instability and economic convulsion are two of the major plagues of a state ‘s economic system. A state undergoing any of these two or both non merely fails to pull foreign investing but besides drives off the bing 1s. This puts the whole economic system in major pandemonium. The exchange rates for one rise drastically projecting high depreciation in the currency which non merely summarizes the normal exchange rate fluctuation but shows the image of major down falls of many of other economic and fiscal elements of the state like the involvement rates, rising prices etc. So a stable political state of affairs and Economic growing would be given to make better for the state both in saving sense and in the currency market.

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Empirical Evidence

The empirical grounds that supports the fund flow statement can be seen in the construct of long term and short term position of alterations in the involvement rates that in bend influence the flow of financess and therefore impact the exchange rate consequently. It can be better understood this manner. Long term alterations in the involvement rate ( say a hopeful addition ) would bring on the financess or foreign currency to flux in the long term and therefore keep back in the short tally. This would do depreciation ( a rise in exchange rate if its is quoted indirecty ) in the currency in short tally. On the other manus A short tally addition in the involvement rate would bring on influx of foreign currency and hence a domestic currency grasp.

The Asset attack is apparent in the exchange market of currency where they are sold and bought at specified rate ( The Exchange Rate ) assets. The jurisprudence of one monetary value holds here for if the exchange rate would differ between two topographic points the arbitrage would force towards the one acceptable monetary value as the exchange rate.

Foreign Exchange Citation

An exchange system citation is stated as the figure of units of “ quote currency or the foreign currency ” that can be exchanged for one unit of “ basal currency or domestic currency ” .

For illustration, in a citation that says the GBP/USD exchange rate is 1.5393 ( 1.5393 USD per GBP, the quote currency is USD and the base currency is GBP ( Bloomberg, 2010 ) .

There are two ways to cite an exchange rate,

Direct Citation

From a state ‘s position ( say Britain or UK ) , quotes utilizing a state ‘s domestic currency as the ‘quote currency ‘ ( e.g. , GBP 0.6496 = USD 1.00 ) are known as direct citation or monetary value citation from that state ‘s position ( Bloomberg, 2010 ) .

Indirect Quote

From a state ‘s position ( say Britain or UK ) , quotes utilizing a state ‘s domestic currency as the ‘base currency ‘ ( e.g. , GBP 1 = USD 1.5393 ) are known as indirect citation or measure citations from that state ‘s position ( Bloomberg, 2010 ) .


Topographic point and Forward Exchange Ratess

Topographic point and forward exchange rate can be defined as follows

Topographic point Rate

The current exchange rate is largely referred to as the ‘Spot Rate ‘ .

Forward Exchange Rate

An exchange rate that is quoted and traded on the current or present twenty-four hours nevertheless, delivered or paid for on specified day of the month in the hereafter is known as ‘Forward Exchange Rate ‘


Calculating the Forward Exchange Rate

A forward exchange rate s calculated by utilizing the undermentioned expression

Forward Exchange Rate = S [ ( 1+rq ) N / ( 1+rb ) N ]

Where S = Spot monetary value ( USD/GBP=0.6496 )

rq = Interest rate in UK ( say 4.6 % )

rubidium = Interest rate in US ( say 5.3 % )

n = Time period ( say figure of clip period is 1 )


Forward Exchange rate = 0.6496 = 0.6496x 0.9934 = 0.6452

Therefore frontward rate 1 USD = 0.6452GBP

The spread can so be calculated by from topographic point rate

Time Series Plot

In 2009 the lb was seen to deprecate along the general tendency boulder clay March where the exchange rate quoted indirectly was seen excessively peek. However the one-year tendency of British Pound was observed to hold a general tendency of falling exchange rate demoing an grasp against the US dollar in the twelvemonth 2009 besides the random fluctuation along them monthly chart

Get downing from an exchange rate USD/GBP of 0.68, or in GBP/USD footings 1.45, it was seen to lift every bit high as to around 0.73 in USD/GBP citation or autumn to GBP/USD citation of 1.37, and so fell to shut at USD/GBP of 0.63, or rose to GBP/USD of 1.60, by the twelvemonth terminal.

The Exchange rate quoted above are mere estimates taken from the charts in the appendix but along the one-year tendency line the British Pound is seen to hold appreciated and the exchange rate has fallen by 7.3 % in direct citations and in indirect footings the exchange rate has risen by 10.3 % in the twelvemonth 2009 harmonizing the charts provided in the Appendix taken from Yahoo, 2009.

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Part B

Foreign Exchange Risk Exposure

Exchange Rate hazard or Currency hazard is the hazard of incurring a loss at the custodies of fluctuation or motion in the exchange rates.

There are three types of hazards that exchange rate are exposed to,

Transaction Hazard Exposure

Translation Hazard Exposure

Economic Hazard Exposure

A Transaction Risk may be imposed in the class of a colony of any foreign exchange dealing incurring a loss or a addition.

A Translation Risk may be imposed when alterations in accounting income or balance sheet take topographic point due to the alteration in the exchange rate.

An Economic Hazard may be imposed if the value of a company alters following an unannounced alteration in the exchange rate.

Our concern remains with the first type of hazard exposure associated with the exchange rate fluctuation, The Transaction Risk, given the state of affairs of imparting 10 million US dollars to a British Based house presuming we are a US based house.

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Suppose holding lent the British house 10 million dollars, both the companies are exposed to hazard of fluctuation in the Exchange rate. If the British Pound appreciated against the dollar it would accordingly bring on a loss of value of the money Lent to the British house. And hence we would potentially be exposed to a hazard of losing some worth of are invested money for the continuance of loaning period.

Our client on the other manus would be at a hazard of losing value or incurring a loss if the Pound really depreciated against dollar and they would hold to pay back more in term of Pound since a dollar would be worth more lbs after the depreciation of Pound against a dollar during the lending period.

In order to get by with this hazard exposure there are some fiscal market instruments that companies and persons put to utilize to cut down their hazard to minimum or fudge themselves against evitable hazards. The client and our house can both use any of these contracts to avoid the exchange rate hazard and to merchandise on specified monetary value

These instruments are,






Forwards is one of the most common types of fudging tool which involves the purchaser and the marketer to hold on a hereafter specific monetary value of trade on a specified day of the month to avoid the hazard of potentially unfavorable fluctuation in the exchange rate or monetary value by negociating on common evidences.


Futures non unlike forwards are contracts that involve the trade between purchaser and the marketer at a hereafter specified day of the month and exchange rate, nevertheless, the contract is much more standardised is non every bit much customizable in footings of day of the month and sum as forwards.


Options are contracts similar to Forwards ad hereafters that empower the purchaser with the right to exert the trade at a specified monetary value before a given day of the month on which the contract expires. However, the purchaser is under no duty if he does non wish to.

There are two types of Option contracts

Call Option

Put option Option

Call Option is the right to buy and Put Option is the right to sell.

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Barters are contracts in which the involved parties exchange certain benefits or they agree to trade certain watercourse of hard currency flows over a period of clip. There are four types of barters based on the instruments that are being used. They are viz. ,

Interest Rate Swap

Currency Swap

Equity Swap

Commodity Swap

Interest Rate Swap Vs Currency Swap

Interest Rate Barters

An exchange of fixed rate burden for drifting rate loan takes topographic point within an Interes rate Swap and it applies the rule of comparative advantage.

Currency Swap

Currency Swap as the name implies is barter of one currency for another. The exchange of hard currency flow takes topographic point so that one party wages in one currency and the other party wages in 2nd.

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The cognition of currency barter would hold been most good to our client for fudging against the currency hazard by merely holding to do imbursement in several currencies. However, it would hold worked cleanly, to the extent that it does, if British house was based in US and Us house was based in UK.

Part C

Foreign currency options

A Foreign Currency Option or a Currency Option is a contact that provides the holder with the right, though non the duty, to purchase or sell the currency at a specified rate before a certain specified day of the month that the contract expires on. A premium or fee is normally paid to the agent that depends upon how much contracts have been purchased. Currency Options stay as one of the best ways for many companies and corporations to fudge against the hazard of inauspicious fluctuating motions in the exchange rates.

There are two common types of Currency Options.

Vanilla Option

Topographic point Option

Vanilla Option

The signifier of Currency Option that resembles a stock or security option is the basic signifier of Currency Option besides known as the Vanilla Option. The purchaser has the right to buy or sell the currency at a specified monetary value called the work stoppage monetary value. A premium or fee is paid to the individual who writes the option contract, normally the agent. The bargainer, nevertheless, has the freedom to take the work stoppage monetary value and the day of the month the contract expires on.

Topographic point Option

A SPOT option or Single Payment Options Trading ( SPOT ) is besides known as an alien forex option. The premium is paid by the bargainer with a proposal of a specified state of affairs. In the instance of an event that the anticipation comes true, bargainer gets a final payment that is really the difference between the Strike Price that is quoted in the contract and the value of currency as predicted by the bargainer. In the event of anticipation non coming true, the bargainer non merely does n’t acquire the final payment but besides loses the premium fee paid for the contract. A Topographic point option besides comes in more than one signifier such as,

Average Option

One-Touch Option

An Average Topographic point Option is the sort in which the difference between the work stoppage monetary value and the mean rate of exchange over clip is taken as the pay-off.

A One-Touch SPOT Option is the sort in which the bargainer receives a final payment if the currency exchange rate is the same as the one predicted by the bargainer.

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Buying Call Option VS Writing A Put Option

Buying a Call Option

If the monetary value of a stock or security or an exchange rate is lifting or expected to lift excessively rapidly in a given period of clip so to minimise the possibility or hazard of losing money in the given status of purchasing the plus in the hereafter, we buy a call option. However, in instance an unexpected alteration we alternatively stop up losing money.

Writing Put Option

If the monetary value of a stock or security is falling or expected to fall excessively rapidly in a given period of clip so to minimise the possibility or hazard of losing money in the given status of selling the plus in the hereafter, we write a Put Option, nevertheless, like in the instance of purchasing Call option, if the alterations in the monetary value do non happen as predicted, we may really stop up losing the money instead than deriving from the contract.

Similar Contracts Traded on Different Premium

Hazard is the chance of an event happening otherwise than predicted. With regard to fiscal market hazard is the possibility of losing money or non acquiring the expected return on any investing on stock, security or any other assets. In the event of such incident occurring, investor requires a collateral or security for his investings which is provided in the signifier of hazard premium- a compensation for the hazard attached to any investing.

So if two option contracts, similar in all respects but the termination day of the month, would hold different lengths of clip for hazard exposure. Premium would be charged for counterbalancing the hazards that are attached to the factor of capriciousness that is associated with a longer period of clip and the fact that if the event does non happen as predicted so we end up losing money. Hence with different degrees of hazard exposure owing to different continuances of contracts would do them to be traded in the market for different premiums.

Deep in the Money Option

An option that has a work stoppage monetary value excessively far above the market rate of an plus, in instance of a call option, and in instance of a put option, excessively far below the market monetary value, is known as a Deep-in-the-money Option. The chief factor finding the value of an option plus is the clip it takes for the contract to mature. The potency for deriving net income is low besides the fact that these contracts are highly expensive. Therefore for the ground given that there is merely excessively much hazard attached to it and the possibility of acquiring higher return are excessively low, the Deep-in-the-money option would barely be exercised by most of the investors and the really long adulthood day of the months make the contracts unable to run out unexercised.

Call or Put

If the GBP were deprecate against the US dollar that would intend that every US dollar is worth more of Pounds in worth. Since the exporter receives payment in lbs that is deserving less in dollars. The depreciation would do them to pass more lbs to purchase a dollar or have fewer dollars for every lb. And therefore they ‘d be worse off in that scenario.

To fudge themselves from the hazard of lb depreciation, our client would be better off purchasing a call option that would cut down the hazard of losing money if the lb depreciated since they could purchase dollar at a specified rate within the specified clip and so sell them at the current rate like an plus or instead shall we say invest without losing much money. However, if after purchasing the option contract lb really appreciates, so our clients in UK would be worse off.


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