Exchange rate is the

rate at which one

currency is
converted into
another

http://www.indexmundi.com/xrates/table.aspx
$ - US dollar - USD
€ - Euro - EUR
£ - British pound - GBP
¥ - Japanese yen - JPY
$ - Australian dollar - AUD
$ - Canadian dollar - CAD
$ - Hong Kong dollar - HKD
 In 2001, $1 = € 1.065
(one US dollar buys 1.065 euro)
 In 2008, $1= € 0.685
(one US dollar buys 0.685 euro)
* Dollar had fallen sharply in value against
Euro. US product become cheaper in
Europe but Europe product become
expensive in US.
 Conversion:
$1 = €0.79
€ 1 = $1.26 (1/0.79)
 Currency Conversion
Exchange rate £1 = $2.00
US tourist go to Britain and want to buy
perfume that cost £30
 Cost of perfume(USD) £30 x 2 = $60
 In US, the same perfume cost only $45.
 Compare: Price of the same perfume is
more expensive in Great Britain.
 Have spare cash & wish to invest for short
term money markets
 Example: A US company has $10million
and want to invest in 3 months. If invest in
US interest rate only 4%, if invest in Korea
interest rate 12%.
 So, better invest in Korea to get more
profit.
 CURRENCY SPECULATION
 Current exchange rate $1 = ¥ 120
 A US company want to invest $10m into yen
and predicts dollar to depreciate (fall)
against yen after 3 months.
 Company receive ¥ 1.2 billion ($10m X 120)
 After 3 months, dollar value depreciates
against yen $1 = ¥ 100.
 Then the co’ exchange ¥ 1.2 billion and
gets $12 million in return. (¥1.2 billion/100)
 Earn $2 million profit ( $12m -$10m)
 Another type of currency speculation is
Carry Trade.
 Borrow in one currency where interest rate
(for borrowing) are low then use the money
to invest in another country’s currency
where interest rate (deposit/investment) are
high.
 Borrow from Japanese bank that offer
borrowing rate of 1% then convert the
money to USD and deposit in America’s
bank that offer 6% interest on the deposit.
 Gain 5% margin (6%-1%)
 Determined by demand and supply.
 When market open, spot exchange rate
£1 = $2.00
 Many people want US dollar (short supply);
only few people want British pound (plenty
supply)
 At the end of the day, spot exchange rate
£ 1 = $ 1.98
 Dollar appreciate against pound; pound
depreciate against dollar. Now each pound
buy fewer dollars.
 Co’ A (US) import computer from Co’ B (Japan) and
need to pay ¥200,000 for each computer in 30 days
when the product arrives.
 6/5 Current exchange rate: $1 = ¥120
Each computer cost Co’ A $1,667 (200,000/120)
Co’ A will sell computer $ 2,000 each and gained
profit $333 ($2,000- $1,667)
 6/6 Exchange rate: 1 USD = ¥95 (dollar depreciates)
Each computer will cost Co’ A $2,105 (200,000/95)
and loose $105 ($2,000- $2,105)
 The best way - enter into forward exchange contract
and set agreed exchange rate $1 = ¥110
 Each computer will cost $1,818 (200,000/110)
and co’ A guaranteed profit $182 (2,000 – 1,818)
 Apple assembles laptop in US. Apple buy screen
from Japan and at the same time sell finished laptop
in Japan. Apple need to pay $1 million to Japan
supplier today and set 90 days forward exchange
rate for Japanese buyer to pay ¥120 million.
 Spot exchange rate $1= ¥ 120.
5 May -Apple need to pay Japan screen supplier $1
million. Sell it to its bank and get ¥120 million (1
million x 120) in return and make payment.
 After 90 days, forward exchange rate $1=¥110
5 July -Apple receive ¥120 million payment. Sell the
money to its bank(US) and receive $1.09 million
(120,000/110)
 Apple end up with more dollar than it started with
(+$90,000)
 Make profit - buying a currency low in A
market and selling it high in B market.
 A dealer take USD 100,000 and buy
SFr 550,000 in New York (USD1= SFr5.50)
and immediately sell the SFr 550,000 in
London which then yield USD 110,000.
(USD1 = SFr5.00)
 Trader gained USD 10,000 from the
transaction. (USD 110,000 – USD 100,000)
 Law of one price
- in competitive markets free of transportation
costs and barriers to trade, identical products
sold in different countries must sell for the
same price when their price is expressed in
terms of the same currency

 Exchange rate 1USD = RM 3.1

 A shoe that retails for USD30 in New York,
should sell for RM 93.00 in Kuala Lumpur.
(USD 30 x RM 3.1 = RM 93.00).
 Let say, if sell the shoe with high price in
KL, RM 150. People may prefer to buy it in
New York . High demand in New York will
slowly increase price of the shoe in New
York and low demand in KL will decrease
the price of the shoe in KL. This will
continue until price equalized.
 Price shoe cost $33 in New York and
RM 102.30 (33 x 3.1) in Kuala Lumpur.
 By comparing prices of identical products in different
currencies, we can determine PPP exchange rate (if
market were efficient)
 Example:
Basket of goods costs in US= $200
Basket of good costs in Japan = ¥20,000

PPP predicts dollar/yen exchange rate

E $/¥ = P $/P¥
= $200/ ¥20,000
= $ 0.01 per Japanese yen

-: $1 = ¥100
 According to PPP theorem, the prices
should be the same if not it implies that the
currency is either overvalued or
undervalued.
 Example:
Average price of Big Mac in Euro $ 4.50
Average price of Big Mac in US $ 3.54
Euro/dollar exchange rate = 4.50/3.54
= 1.27
-: Euro was overvalued by 27% against US
dollar
 Early of the year, basket of good cost in US =$200,
basket of good cost in Japan =¥20,000
-: PPP $1 = ¥100
 End of the year, basket of good cost in US =$200,
basket of good cost in Japan =¥22,000
-: PPP $1 = ¥110

 Because of 10% price inflation, Japanese yen has

depreciated by 10% against dollar whereby $1 will buy
10% more yen at the end of the year.
 Fisher Effect – there are strong relationship
between inflation rates & interest rates.
i= r + I
Example:
Real rate of interest (r) = 5%
Annual inflation expected (I) = 10%
Nominal interest rate (i) = 5%+10%
= 15%
 Fisher Effect – real interest rate is the same
worldwide, any difference in interest rates
between countries reflects differing expectations
about inflation rates.
 If rate of inflation (I) in US is greater than in
Japan, US nominal interest rates (i) will be
greater than Japanese nominal interest rates (i).
 Fundamental analysis– draw upon economic factors
like interest rates or balance of payment information.
Example: US run deficit on balance of payment current
account (import > export), US currency will
depreciate.
 Technical analysis – uses price and volume data to
determine past trends, which are expected to continue
in future.