MANAGING AND PROFITING FROM FOREIGN EXCHANGE BY FINANCIAL INSTITUTIONS

Introduction

Managers of financial institutions care a great deal about what foreign exchange rates will be in the future because these rates affect the value of assets on their balance sheets, which may be denominated in foreign currencies. In addition, financial institutions often engage in trading foreign exchange, both for their own account and for their customers. Forecasts of future foreign exchange rates can thus have a big impact on the profits that financial institutions make on their foreign exchange trading operations.

The foreign exchange rates have been highly volatile in recent times and most countries globally have had significant fluctuations of their respective currencies. This therefore brings untold hardship to individuals and businesses alike as it distorts their financial plans, especially an import-dependent country. The foreign exchange market, like other asset markets such as the stock market, displays substantial price volatility. Foreign exchange rates are notoriously hard to forecast. A nation is worse off when its currency falls in value, because it has a negative effect of making it more expensive to buy goods and services from foreign markets.

We will center our discussion on determinants of exchange rates and how exchange rates are managed by financial institutions to make a profit.

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Determinants of Exchange Rates

Exchange rate is the price of one currency in terms of another currency. It is the rate at which one country’s currency is traded for another country’s currency. For every single foreign exchange transaction, when you are either buying one currency or selling another currency, the currency you receive in the exchange is said to be the currency we are buying and the currency you are giving is said to be the currency you are selling.

Generally, exchange rate is influenced by the demand and supply of foreign currency in the exchange market and this demand and supply is determined by the following factors, which we discuss below.

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Inflation Rate

A country with a consistently higher inflation rate tends to have the value of its currency depreciating. What this means for the country is that its purchasing power decreases relative to that of the other country. On the other hand, a country with a consistently lower inflation rate exhibits a rising currency value as its purchasing power increases relative to that of the other country. This explains why a country like USA with lower inflation rate has an appreciating US Dollar as against the Ghana Cedi depreciating as a result of higher inflation rate.

Simply put, in the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country’s relative price level causes its currency to appreciate.

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Interest Rate

A country with a higher interest rate attracts lenders into the economy due to the higher relative return to other country. This therefore attracts foreign capital into the country, which results in a rise in the exchange rate. However, the currency of a country with a higher interest rate is attenuated if inflation rate is also higher in the country relative to another country. Contrastingly, if interest rate is lower, the value of the currency in that country will fall, leading to a depreciating currency. To rephrase it, an increase in the domestic interest rate causes the domestic currency to appreciate, (when domestic real interest rate rises, the domestic currency appreciates) and a decrease in the domestic interest rate causes the domestic currency to depreciate (when domestic interest rate rises due to an expected increase in inflation, the domestic currency depreciates). Contrarily, an increase in the foreign interest rate causes the domestic currency to depreciate; a fall in the foreign interest rate causes the domestic currency to appreciate.

For example, when the government of Ghana increases the interest rate on government bonds, it will whet investors’ appetite to hold these bonds, resulting in higher supply of foreign currencies. This would result in an appreciation of the Ghana Cedi. Countries raise interest rate as a temporary measure of stabilizing the currency. The recent depreciation of the Ghana Cedi against the US Dollars could partly be the result of interest rate hikes by the Federal Reserve (The Fed). For instance, in June this year, the Fed increased the interest rate by 0.75 percentage point. This means that investors of the bonds of the Ghanaian government will get attracted to the US bonds, leading to an increase in US Dollar and consequently leads to an appreciation of the Dollar against the Cedi.

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Balance of Payment/ Current Account Deficits

The balance of payment is a bookkeeping system for recording all receipts and payments that have a direct bearing on the movement of funds between a nation (private sector and government) and foreign countries. Under the balance of payment is the current account, which shows a country’s international transactions that involve currently produced goods and services. It is the country’s trade with the rest of the world. It records the value of exports and imports of both goods and services and international transfers of capital. A deficit current account has a negative impact on the value of a domestic currency, because it depicts that a country is spending more on foreign trade than is earning and therefore the country is borrowing capital from foreign markets to make up the deficit.

Anything that increases the demand for domestically produced goods that are traded relative to foreign-traded goods tends to appreciate the domestic currency. This is because domestic goods will continue to sell well even when the value of the domestic currency is higher. Similarly, anything that increases the demand for foreign goods relative to domestic goods tends to depreciate the domestic currency because domestic goods will continue to sell well only if the value of the domestic currency is lower.

In a nutshell, if a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate; if a factor decreases the relative demand for domestic goods, the domestic currency will depreciate.

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Management of Exchange Rates

Managers of financial institutions, particularly those engaged in international banking, rely on foreign exchange forecasts to make decisions about which assets denominated in foreign currencies they should hold. They obtain foreign exchange forecasts either by hiring economists to generate the forecasts or purchase the forecast from other institutions. In predicting the exchange rate movements, forecasters consider inflation rate, interest rate, balance of payments among others. To cite an example, if they expect domestic real interest rate to rise, they will predict, in line with our analysis, that the domestic currency will appreciate; inversely, if they expect domestic inflation to increase, they will predict that the domestic currency will depreciate.

Another scenario could be that if a financial institution’s manager believes that the dollar will appreciate in the future while the yen will depreciate, the manager will want to sell off assets denominated in yen and instead purchase assets denominated in dollars. Alternatively, the manager may instruct loan officers to make more loans denominated in dollars and fewer loans denominated in yen. Likewise, if the yen is forecasted to appreciate and the dollar to depreciate, the manager would want to switch out of dollar-denominated assets into yen-denominated assets and would want to make more loans in yen and fewer in dollars. If the financial institution has a foreign exchange trading operation, a forecast of an appreciation of the yen means that the financial institution’s manager should tell foreign exchange traders to buy yen. If the forecast turns out to be correct, a higher value of the yen means that the trader can sell the yen in the future and pocket a tidy profit. If the dollar is forecasted to depreciate, the trader can sell dollars and buy them back in the future at a lower price. If the forecast turns out to be correct, and again the financial institution will make a profit. Accurate foreign exchange rate forecasts can thus help a financial institution’s manager generate substantial profits for the institution.