Factors That Influence the Foreign Currency Exchange Rates

It is common knowledge that there are major considerations in formulating a strategy for
any market, be it stocks, futures, or currencies. Listed below are some of the economic
factors to consider in foreign exchange trading.

1. Supply and demand. The exchange rate is the reflection of the balance between supply
and demand for the currencies. Interest rates and the overall strength of the economy are
the two primary factors that affect supply and demand. Economic indicators such as gross
domestic product, foreign investment directly and indirectly, interest rates, and trade of
balance reflect the overall health of the economy. They are responsible for the changes in
the supply and demand of the currency that ultimately affects the exchange rate of the
country.

2. Inflation. It refers to the relative purchasing power of a currency of one country against
another country. Thus, the cost of buying one unit of a certain product in one country may
be lesser compared to another country with higher inflation when purchasing the same
product. The differences in inflation serve as a basis for why different currencies have
varying purchasing power and currency rates. It tends to show that countries with lower
inflation have stronger purchasing power as compared to countries with higher inflation.

3. Interest rates. Interest rates are highly correlated with inflation and exchange rates.
Because of its high correlation, the central bank of a country uses interest rates to reduce
inflation within the country, In general, a country with a high- interest rate attracts foreign
capital because it helps strengthen the local currency rates. However, if these rates remain
to be high for a long period, the tendency is that inflation starts to sneak up, resulting in a
devalued currency. Also, a high- Interest rate is not good for the stock market because
investors will start selling the stocks causing the country's currency to weaken.

4. Balance of trade. The balance of trade depicts the net difference between the exports
and the imports of the country. When the value of the exports is lower than the imports, the
balance of trade will show a deficit which is considered to be not favorable. For example, if
the Philippine peso is sold for other currencies such as U.S. dollars, to pay for the imports,
the value of the peso will depreciate due to the outflow of dollars. On the other hand, if the
exports are more than the Imports, money will flow into the Philippines and it will increase
the value of the currency.

5. Government interventions. This normally happens when the regulatory body of the
country, like the BSP, directly intervenes to regulate the exchange rate of the currency by
reevaluation, devaluation, or by manipulating the flow of foreign currencies to meet or
maintain the desired exchange rate.
6. Political stability. Having stable politics in the country is one of the most important
aspects of attracting foreign investments that eventually help to prop up the exchange rate.
Likewise, if there is a lot of political unrest, foreign investors will avoid that country resulting
in a lower exchange rate. Political stability also affects various economic drivers and
financial policies that have long-term effects on the country's exchange rate.

7. Public debt. Many countries, to prop up the economy, borrow money to finance
economic growth and support various government spending. However, if the country
outpaces economic growth, it could increase inflation and discourage foreign investments.
In certain cases, the government might increase the printing of money to finance the public
debt but at the expense of driving up inflation.

Transactions in the Foreign Exchange Market

The transactions in the foreign exchange market are done in the following ways:

1. Spot foreign exchange transactions. It is the buying and selling of foreign currency in
the foreign exchange market (local or interbank) based on the spot rate. The actual delivery
and payment of the foreign currency take place immediately, normally two business days
after the transaction date (T+2). The settlement date is called the value date. It is on the
value date where the net balances owed by one bank to another bank in the world are
calculated through the computerized Clearing House Interbank Payment System (CHIPS)
located in New York. A typical spot transaction in the interbank market is when a Philippine
bank contracts on a Monday for the transfer of USD1,000,000 to the account of a US bank.
If the spot exchange rate is PHP50/USD, the Philippine bank would transfer USD1,000,000
to the US bank on Wednesday and the US bank would transfer PHP50,000,000 to the
Philippine bank at the same time. On the other hand, if a Filipino would travel to London and
needs a GBP 1,000, must go to the bank or dealer. The bank or the dealer will Indicate the
rate at which the London pound will cost in peso, let's say PHP70/ GBP. If the rate is
acceptable, the traveler must pay the bank PHP70,000 in exchange for the GBP1,000 plus
any necessary transaction cost.

2. Forward foreign exchange transactions. They are also known as forward. Just like the
spot transaction, the forward transactions also require delivery but at a future value date at
the specified amount of one currency against another currency. The exchange rate is
determined by the agreement between the buyer and seller. However, the payment and
delivery will take place in the future as determined by the parties. The value date for the
forward exchange rate normally takes place in one, two, three, six- and twelve months or
certain occasions, any number of days over more than a year.
For instance, Mr. X needs USD100,000 on December 16 to pay his obligation to a US
company. On October 14, Mr. X enters a contract with the bank to purchase USD100,000
with a value date

of December 16. The spot rate on September 14, is USD/PHP49.50 and the forward rate on
December 16 is USD/PHP52.50. On December 16, which is the value date, Mr. X will pay
the amount of PHP5,250,000.

The forward exchange rate can be a discount of a premium. It is a premium on the forward
rate when less foreign currency has been obtained from the domestic currency. Thus, the
spot rate is said to be higher than the forward rate. On the other hand, it is a discount on a
forward rate when more foreign currency is obtained than the domestic currency. It is a
situation where the spot rate is lower than the forward rate.
Example:

Forward Rates

Spot Rate 30 Days 90 Days 180 Days The forward rate at a

discount or premium

Philippine 50.00 50.25 50.40 50.55 Discount

peso

British pound 0.5188 0.5192 0.5195 0.5199 Discount

Australian 1.0850 1.0835 1.0830 1.0825 Premium

dollar

Swiss franc 0.8975 0.8970 0.8969 0.8965 Premium

The Philippine peso and the British pound are both discounted on the forward rate because
the spot rate is lower than the forward rate. Consequently, both the Australian dollar and the
Swiss Franc are premiums on the forward rate because the spot rates are higher than the
forward rates.

3. Swaps transactions. It is an agreement between two parties to exchange specified

periodic cash flows in the future. A currency swap transaction is used to hedge against the
exchange rate risk from a mismatched currency from the firm's balance sheets, particularly
the firm's assets and liabilities. One example of this currency swap is the fixed-fixed
currency swaps. Now, let us consider a US financial institution with fixed-rate assets
amounting to USD300 million. All the assets were financed by AUD400 million five-year
bonds that have a fixed annual coupon payment of 5 percent. On the other hand, an
Australian financial institution has all its AUD400 million assets financed by USD300 million
five-year bonds that have a fixed annual coupon payment of 5 percent. The two financial
institutions are exposed to their corresponding currency risk. The US financial Institution is
exposed to the currency risk that the dollar will decline in purchasing power against the
Australian dollar in the next five years making it costly to finance the annual coupon interest
and principal payments on its Australian dollar- denominated bonds. Likewise, the
Australian financial institution is exposed to the foreign exchange risk that the US dollar will
appreciate against the Australian dollar making it more expensive to cover the US dollar
bond coupon and principal payments. To minimize their foreign exchange risk, the two
financial institutions can hedge their exposures off the balance sheet. It is done by entering
into a currency swap where the US financial institution will send US dollars to the Australian
financial institution to pay for the annual coupon and principal payments on its five-year
bonds. On the other hand, the Australian financial Institution will send Australian dollars to
the US financial institution to cover the coupon and principal payment on its five-year bond.
As the result of the currency swap between the two financial institutions, the US financial
institution was able to transform its fixed-rate Australian dollar bond liabilities into fixed-rate
American dollar liabilities. Likewise, the Australian financial institution was able to convert its
US dollar bond liabilities to Australian dollar liabilities. In this way, both financial institutions
were able to transform their corresponding fixed-rate liabilities into their respective cash
flows from their asset portfolio. In dealing with this kind of exchange cash flow, the two
financial institutions must agree on a fixed exchange rate for the cash flows at the start of
the period.

However, if the agreed foreign exchange rate change from the rate previously agréed by the
two parties, one of the parties would end up losing to the point that a new swap would
probably be entered into a more favorable rate to one for the parties. To clarify, if the US
dollar appreciates against the Australian dollar over the term of the swap, the agreement
becomes costly on the part of the US financial Institution. The same thing, if the Australian
dollar appreciates against the US dollar, the Australian financial institution would find the
agreement to be costly on their part.

Base and Variable Currencies

In quoting the exchange rate between two currencies, it is a must to keep the number of
units of one currency fixed while making changes in the other to reflect the changes. The
base currency is the currency with a constant number of units while the currency with a
varying number of units is termed variable currency. The base currency always appears as
the first currency in a forex pair quotation and is followed by the second currency as the
variable currency also known as a quote or counter currency. For instance, if the price of the
USD/PHP 50, it means that one USD is exchanged for PHP50. In this case, the USD is the
base currency and the PHP is the variable currency. Or if the pairing is PHP/USD = 0,02, it
means that you need 0.02 USD to buy one PHP. In the Forex markets, the USD is normally
considered the base currency for quotes are expressed as a unit of USD 1 per other
currency as quoted in the pair.

Direct and Indirect Quotations

A direct quote, which is also known as a "price quotation," is the one that expresses how
much domestic currency is needed to buy a unit of foreign currency. On the other hand, an
Indirect currency quote, which is also known as a "volume quotation," is contrary to a direct
quote. An indirect quote expresses how much foreign currency is needed to buy per unit of
the domestic currency.

In quoting the exchange rate for a currency, there must be a designation as to which will be
the base currency between the foreign or domestic currency. When using direct quotes, the
domestic currency is the variable currency and the foreign currency is the base currency.
For example, let us say that to buy one US dollar needs Php50. Using the direct quote
USD/PHP, the USD as the base currency, and the PHP as the domestic currency, we will
have PHP50 to buy one U.S. dollar. On the other hand, an indirect quote (PHP/USD) is an
exchange quote that uses the domestic currency as the base currency and the foreign
currency as the variable currency. Therefore, 0.02 PHP/USD in Manila would be an indirect
quote. USD0.02 is obtained by dividing USD1 by PHP50.

Some currencies are generally quoted in Indirect form, they are called commonwealth
currencies. Examples of these are the British pound, the Australian dollar, and the euro. The
currency pairing will appear as follows: GBP/USD, AUD/USD, and EURO/USD. It simply
means, how much USD to buy one GBP, one AUD, or one EURO.

Consider the Philippine Peso as the domestic currency. In the Philippines, this quotation
would take the form of USD 1 = PHP 50. This represents a direct quotation since it
expresses the amount of domestic currency (PHP) per unit of foreign currency (USD). The
Indirect form would be the reciprocal of the direct quote, or PHP1 = USD 0.01.

Next, consider the British pound. In the United Kingdom, this quotation would take the form
of GBP 1= USD 1.650. This represents an Indirect quotation since it expresses the amount
of foreign currency (USD) per unit of domestic currency (GBP). The direct form of this quote
would be USD 1 = GBP 0.0606
To further understand the direct and Indirect quotes, a table is presented below using the
Phillippine peso and British pound as the domestic currency and USS as the foreign
currency.

Direct quote Indirect quote

[(domestic currency to buy [Foreign Currency (US$) to

one US$(Foreign Currency)] buy one domestic currency]

Philippine peso ₱50 $0.02

(₱50/$1) ($1/₱50)

British Pound £0.0606 $1.65

(£1/$1.65) ($1.65/£1)

On the other hand, if we consider the USS as the domestic currency and the Philippine
peso and British pound as the foreign currency, the table would appear as:

Direct quote Indirect quote

[(domestic currency to buy [Foreign Currency (US$) to

one US$(Foreign Currency)] buy one domestic currency]

Philippine peso $0.02 ₱50

($1/₱50) (₱50/$1)

British Pound $1.65 £0.6061

($1.65/£1) (£1/$1.65)

Cross Rates

Most of the examples given above are based on the US dollar. What about if an Australian
goes to Switzerland and would be interested in buying a Swiss franc. In this case, we have
to use the cross rate. The table below shows how much US dollars to buy 1 Philippine peso
(indirect quote) or how much Philippine peso to buy one US dollar (direct quote). In the
same way, it shows how much US dollars are needed to buy one British pound (indirect
quote) or how much British pound is needed to buy one US dollar.
 Direct quote Indirect quote

[(domestic currency to buy [Foreign Currency (US$) to

one US$(Foreign Currency)] buy one domestic currency]

Philippine peso ₱50 $0.02

(₱50/$1) ($1/₱50)

British Pound £0.6061 $1.65

(£1/$1.65) ($1.65/£1)

The table, however, does not show any exchange rate of how much Philippine peso is
needed to buy one British pound or how much British pound is needed to buy one Philippine
peso. Nevertheless, since both currencies, the Philippine peso, and the British pound use
the US dollar in getting their quote, we can use the same table to get the ₱/£ or the £/₱

If we use the Indirect quote, we can get that £/₱ to be

= $1.65 = ₱82.50 per pound

$0.02

If we use the direct quote, we can get that £/₱ to be

= ₱50.00 = PHP 82.50 per pound
£0.6061

It can also be obtained by multiplying $1.65 x P50 = P82.50 per pound.

On the other hand, if we want to get the ₱/£ using the indirect quote above, we would have

= ₱=$0.02=60.0121 per peso

£$165

If we use the direct quote for ₱/£

= £ = $0.6061= £0.0121 per peso
₱ 50.00

It can also obtained by multiplying $0.02 x 60.6061 = £0.0121per peso