Unit 5 Foreign Exchange Rate

1. Unit 5 Foreign Exchange Rate

2. I. Definition of Foreign Exchange Rate Foreign exchange rates are simply the prices of foreign currencies in terms of one’s own.

3. II. Quotation Methods of Exchange Rates

4. A. Direct Quotation Method It reflects the amount of home currency that is required to buy the foreign currency. And China uses Direct quotation. E.g. Taking RMB as the home currency, $1 = RMB 8.3 foreign currency home currency

5. B. Indirect Quotation Method the indirect quotation method is the reverse, the home currency is expressed as a unit and the price is shown by the number of units of foreign currency that are required to purchase one unit of home currency. E.g. Taking RMB as the home currency, RMB 1 = $ 0.1204 home currency foreign currency

6. C. Cross-Exchange Rates Most exchange rate quotation tables express currencies relative to the dollar, however, in some instances, the exchange rate between two non-dollar currencies is needed. This type of rate is known as a cross-exchange rate because it reflects the amount of one foreign currency per unit of another foreign currency. Formula of cross-exchange rate: value of 1 unit of currency A in units of currency B = value of currency A in $ / value of currency B in $ E.g. 1 Mexican peso = $ 0.07 1 C $ = $ 0.70 value of Mexican peso in C$ = $ 0.07 / $ 0.70 = C$ 0.10 (That is 1 C$ = 10 Mexican pesos.)

7. II. Types of Exchange Rates

8. A. Spot Exchange Rate (现汇汇率) • When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange rates. The value of one currency is determined by the interaction between the demand and supply of that currency relative to the demand and supply of another currency.

9. B. Forward Exchange Rate (远期汇率) • To avoid fluctuation of spot rate, many firms engage in a forward exchange (sign a forward contract). A forward exchange occurs when two parties agree to exchange currency at a specified rate and execute that deal at some specific date in the future. Exchange rates governing such future transactions are referred to as forward exchange rate.

10. Take dollars as an example: If the forward rate is higher than the spot rate, the dollar is sold at a premium(升水) on the forward market; If the forward rate is lower than the spot rate, the dollar is sold at a discount(贴水) on the forward market.

11. An example of using a forward contract by a firm to avoid risk: A US firm imports laptops from a Japanese seller and sell those laptops in America @ $2,000 per unit, the current spot rate is $1= ¥ 120, A/Ps in 30 days are ¥200,000 per unit. so the current price of each computer = 200,000/120=$1,667, profits of each computer = $2,000-$1,667=$333 In 3o days, there are 2 possibilities: a) Japanese Yen appreciates, $1= ¥95 price of each computer = 200,000/95=$2,105 profits of each computer = 2,000-2,105 = -$105 (In order to avoid such fluctuation risk, the US firm can sign a forward contract @ $1= ¥110 to fix the exchange rate in 3o days.) b) Japanese Yen depreciates, $1= ¥130 price of each computer = 200,000/130 =$1,538 profits of each computer = $2,000-$1,538 = $462 (Without using a forward contract, the US firm gain more.)