The value of the Australian dollar has been fairly volatile of late. It has swung from the mid fifties to the eighty cent range in the last few years alone. So where is the Australian dollar headed?

Since January, the Australian dollar has fallen from US$0.76 to US$0.70 by March. And some are forecasting that this trend will continue. While the falling Aussie dollar may be good for exporters, farmers and for other Australian manufacturers competing with imports, it’s also good news for the Australian sharemarket as around 30 per cent of earnings from companies listed on the Australian sharemarket come from overseas. For consumers however, the falling Australian dollar means higher prices, and therefore the risk of an increase in inflation.  But why is the Australian falling and is this trend set to continue over the longer term?

The falling Australian dollar is a result of the fact that the difference between interest rates in Australia and those of other currencies will continue to reduce. While Australia’s interest rates have remained low over the last few years, they have been a lot higher than many other countries including Japan, the United Sates and much of Europe. This led to foreign investment in Australia in order to take advantage of the higher interest rates, which in turn led to a stronger demand for Australian dollars. However, as other countries increase their interest rates, the differential becomes less important to foreign investors and the demand for the Australian dollar drops.

Another reason for the fall in demand for the Australian dollar may be the fact that the New Zealand dollar has been falling due to increasing speculation that the Reserve bank of New Zealand will have to cut interest rates as recession fears grow. The Australian Dollar has been caught up in the selling of the New Zealand Dollar.

Where to for the Aussie dollar?
According to Dr Shane Oliver, Head of Investment Strategy and Chief Economist at AMP Capital Investors, “A longer term measure of the fair value for the Australian Dollar indicates fair value is around US$0.70. This is based on what economists call ‘purchasing power parity’”.

While US$0.70 may be considered fair value based on purchasing power parity, it does not mean that the Australian dollar will settle at this value, as markets are often subject to wild swings and fluctuations. Another effect on the Australian dollar will be whether the resources boom can sustain its momentum for any length of period. And while China continues to demand our resources, it seems that despite short term fluctuations, commodity prices will be likely to rise in the foreseeable future.

Dr Shane Oliver believes that “the recent weakness in the Australian Dollar is unlikely to represent the start of a renewed downtrend. Australian interest rates are likely to remain above global interest rates for the foreseeable future and commodity prices are likely to remain high. As such, our assessment is that the Australian dollar will remain in the US$0.68 to US$0.80 range.”

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On 1 January 2002, 12 European countries ditched their own currencies and adopted the euro. Here we look at the integrated currency that was introduced in order to make doing business across Europe much easier and to help build a unified European currency to counter the strength of the Greenback. Here we take a look at the euro.

Firstly, it’s important to know which European countries have so far adopted the euro as their national currency. The 12 euro countries are:

1. Austria
2. Belgium
3. Finland
4. France
5. Germany
6. Greece
7. Ireland
8. Italy
9. Luxembourg
10. The Netherlands
11. Portugal
12. Spain

Countries such as Norway and Britain have decided not to adopt the euro at this stage.
 
The euro was introduced in order to promote growth and economic stability across Europe, for the participating euro countries at least. And since the euro’s introduction, it appears that the euro is achieving its intended aims. The euro is also becoming an increasingly important player on the international monetary scene. According to Pedro Solbes, Economic and Monetary Affairs Commissioner, “It has important benefits for our external economic partners. For them, it means reduced volatility in monetary relations and improved trade and investment conditions.”

While the participating countries’ former currencies struggled against the US Dollar, the Yen and other currencies such as the Pound Sterling, the euro is showing signs of strength, even in these early years. One important sign of the continuing strength of the euro is that it is now a regular and important component of the world’s foreign currency reserves. The currencies that make up the world’s foreign currency reserves are part of an exclusive club which includes the US Dollar, the Yen, the Pound Sterling, and now the euro.

The euro is becoming increasingly popular outside the European Union as well. It is now widely being used in countries such as Lebanon, Israel and Egypt in the Middle East, countries within Africa and emerging countries within Europe such as Croatia, Hungary, Poland and Turkey.

While there were naturally many teething problems across participating countries when the euro was initially introduced, these countries are now enjoying the benefits, with a more transparent pricing policy and an easing of tensions caused through currency exchange rates among European currencies.

Evidence of the euro’s success can be found in the fact that in the euro’s first two years, GDP in the combined euro countries grew by around 3 per cent per year. This growth was above the expected GDP growth for these countries.

Will the euro replace the US dollar as the international currency?
While the US dollar will likely remain the dominant international currency in the foreseeable future, the euro may gain in popularity. As mentioned, it is already widely being used outside Europe in countries across the Middle East and Africa and also in European countries that have not yet adopted the euro.

Factors that may influence broader international use of the euro include the large size of the economy now using the euro, the stability of the euro and the fact that the euro is helping to integrate financial markets across Europe.

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As with other industries within the Australian financial services sector, there have been sweeping changes to the regulation of foreign exchange markets within Australia. Here we look at these regulatory changes that have been introduced due to financial services reform.

Previously, foreign exchange dealers were authorised by the Reserve Bank of Australia (RBA), however with the introduction of the Financial Services Reform Act (FSRA) in 2001, licensing became the responsibility of the Australian Securities and Investments Commission (ASIC). While a transitional period was put in place in order to allow dealers to remain operating under an RBA authorisation, foreign exchange dealers had to become licensed by ASIC in order to operate by 11 March 2006. From that day, RBA authorisation would no longer apply.

Prior to the Financial Services Reform Act (2001), foreign exchange dealing was largely self-regulated and operated without the regulation of any centralised foreign exchange board, as in contrast to the Australian Stock Exchange, for example.

Now foreign exchange dealers must either hold an Australian Financial Services (AFS) Licence or otherwise be authorised by a Licensee. An AFS Licence is now required because under the Corporations Act 2001, foreign exchange deals, where currency is not immediately exchanged, are deemed to be a financial product (ie there is financial risk involved).

Relief from the new licensing regime
There are however exceptions to this licensing regime, with some foreign exchange dealers in derivatives not required to hold an AFS licence or to be authorised by a licensee. In January 2005, ASIC provided licensing relief to some overseas dealers and market makers in derivatives and foreign exchange contracts.

According to the ASIC ruling in Licensing relief for some overseas dealers or market makers in derivatives and foreign exchange contracts relief “applies to foreign companies that meet the equivalent requirements in Regulation 7.6.01(1)(ma) under the Corporations Act 2001, namely:

• the derivative or foreign exchange contract is issued, acquired or disposed of under an agreement that sets out the terms and conditions for future dealing in a derivative or foreign exchange contract between the two parties to the agreement;
• the other party to the agreement:
• is a wholesale client in Australia;
• initiated the agreement;
• holds an Australian financial services licence which permits it to make a market or deal in the financial product;
• the person relying on the exemption is not in this jurisdiction; and
• each party is dealing in the financial product on its own behalf.”

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The ASIC website provides detailed information on the licensing requirements for foreign exchange dealers including product training and ongoing professional development requirements. More information is available at www.asic.gov.au

Currency options have become an invaluable tool for reducing foreign exchange risk. What kinds of options are available and how do they work?

Currency options are similar to those used by share traders in order to make money on the future value of a company’s share price. They work by allowing the holder of the option the right to enter into a foreign exchange contract at some point during a pre-agreed period. The holder of the option can choose to enter into the contract, or to let it lapse, if the contract will not benefit them.

As in the sharemarket, there are basically two types of options:

• Put options, and
• Call options.

A put option gives the option buyer the right to sell a particular currency at the agreed strike price (or exercise price), prior to the expiration date. A. call option gives the option buyer the right to buy a particular currency at the strike price prior to the expiration date. The strike price is determined at the time the option is bought.

Options provide the buyer with the right to buy or sell the underlying currency prior to the expiration date. The buyer of the option is not obliged to buy or sell the option prior to the expiration date if it is not to their advantage. If the currency is ‘out-of –money’ in other words it is more advantageous to purchase the currency at the current market rate, then the option expires without being used and becomes worthless.   

Foreign currency option deals in Australia usually involve Australian dollars as the underlying currency.

As importers are looking to sell Australian dollars, they would generally purchase put options. While exporters are looking to buy Australian dollars they would therefore purchase call options.

There are also many variations to these two types of options including knockouts and knock ins and basket options.

Options are different from Forward Exchange Contracts in that there is no obligation to exercise the right of the options, if the currency exchange rate puts the options ‘out of the money’. Forward Exchange Contracts on the other hand, oblige both parties to either buy or sell foreign currency at a fixed rate in the future.

There are two types of Forward Exchange Contracts:

1. Fixed term contracts
2. Optional term contracts.

Fixed term contracts involve the currency exchange taking place at a specified date in the future.

Optional term contracts are more flexible. A time period is nominated in which the exchange must take place. This timeframe is not usually more than a month. Therefore, the exchange can be for six months in the future with the deal having to take place within the last month.

Options offer the opportunity to insure against adverse fluctuations in foreign currency exchange rates and are increasingly being used by importers, exporters, farmers and others who are dealing with foreign currency throughout the year.