Summary currency risk
Chapter 6: the foreign exchange market
The foreign exchange market provides the physical and institutional structure
through which:
- the money of one country is exchanged for that of another country,
- the rate of exchange between currencies is determined,
- and foreign exchange transactions are physically completed.
Foreign exchange means the money of a foreign country.
A foreign exchange transaction is an agreement between a buyer and seller that a
fixed amount of one currency will be delivered for other currency at a specified rate.
Geographical extent of the foreign exchange market
The foreign exchange market spans the globe, with prices moving and currencies
trading somewhere every hour of every business day.
Major currency trading centres: London, New York, Tokyo
Functions of the foreign exchange market
The foreign exchange market is the mechanism by which:
- participants transfer purchasing power between countries,
o necessary because international trade and capital transactions normally
involve parties living in countries with different national currencies.
- obtain or provide credit for international trade transactions,
o because the movement of goods between countries takes time,
inventory in transit must be financed.
- and minimize exposure to the risks of exchange rate changes
o the foreign exchange market provides “hedging” facilities for
transferring foreign exchange risk to someone else more willing to carry
risk.
Market participants
The foreign exchange market consists of 2 tiers:
- the interbank or wholesale market
- the client or retail market
5 categories of participants operate within these 2 tiers:
1. Bank and nonbank foreign exchange dealers
a. They profit from buying foreign exchange at a “bid” price and reselling it
at a slightly higher “ask” price. They also earn money by changes in
exchange rates.
b. Competition among dealers worldwide narrows the spread between
bids and offers and so contributes to making the foreign exchange
market efficient.
c. Dealers in the foreign exchange departments of large international
banks function as “market makers”. Such dealers stand willing at all
times to buy and sell those currencies in which they specialise and thus
maintain an “inventory” position in those currencies.
2. Individuals and firms conducting commercial or investment transactions
, a. Importers and exporters, international portfolio investors, MNEs,
tourists, and others use the foreign exchange market to facilitate
execution of commercial or investment transactions.
3. Speculators and arbitragers
a. Seek to profit from trading in the market itself.
b. Speculators seek all of their profit from exchange rate changes
c. Arbitragers try to profit from simultaneous exchange rate differences in
different markets
d. A large part of this is conducted on behalf of major banks
4. Central banks and treasuries
a. Use the market to acquire or spend their country’s foreign exchange
reserves as well as to influence the price at which their own currency is
traded.
b. Motive is to influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
c. They do their job best when they willingly take a loss.
5. Foreign exchange brokers
a. Agents who facilitate trading between dealers without themselves
becoming principals in the transaction.
b. It is a broker’s business to know at any moment exactly which dealers
want to buy or sell any currency.
c. Dealers use brokers to expedite the transaction and to remain
anonymous, since the identity of participants may influence short-term
quotes.
Types of transactions in the interbank market
Transactions in the foreign exchange market can be executed on a spot, forward, or
swap basis.
A spot transaction requires almost immediate delivery of foreign exchange.
A forward transaction requires delivery of foreign exchange at some future date,
either on an “outright” basis or through a “futures” contract.
An outright forward transaction requires delivery at a future value date of a
specified amount of one currency for a specified amount of another currency. The
exchange rate is established at the time of agreement, but payment and delivery are
not required until maturity.
A swap transaction is the simultaneous exchange of one foreign currency for
another. A common type of swap is a spot against forward. The dealer buys a
currency in the spot market and simultaneously sells the same amount back to the
same bank in the forward market.
, Size of the foreign exchange market
Foreign exchange rates and quotations
A foreign exchange rate is the price of one currency expressed in terms of another
currency. A foreign exchange quotation is a statement of willingness to buy or sell
at an announced rate.
Free floating currencies
- No state intervention on FOREX markets: exchange rates reflect supply and
demand conditions
- Examples $, ¥ (yen), £, €
Fixed exchange rates
- Central Bank buys or sells its currency at a fixed price in order to stabilize the
value to another currency
- Examples: gold standard; Bretton Woods ($ key role), EU currencies before
start of the €
Managed Floating exchange rates
- Examples ¥ (Chinese Yuan)
Chapter 6: the foreign exchange market
The foreign exchange market provides the physical and institutional structure
through which:
- the money of one country is exchanged for that of another country,
- the rate of exchange between currencies is determined,
- and foreign exchange transactions are physically completed.
Foreign exchange means the money of a foreign country.
A foreign exchange transaction is an agreement between a buyer and seller that a
fixed amount of one currency will be delivered for other currency at a specified rate.
Geographical extent of the foreign exchange market
The foreign exchange market spans the globe, with prices moving and currencies
trading somewhere every hour of every business day.
Major currency trading centres: London, New York, Tokyo
Functions of the foreign exchange market
The foreign exchange market is the mechanism by which:
- participants transfer purchasing power between countries,
o necessary because international trade and capital transactions normally
involve parties living in countries with different national currencies.
- obtain or provide credit for international trade transactions,
o because the movement of goods between countries takes time,
inventory in transit must be financed.
- and minimize exposure to the risks of exchange rate changes
o the foreign exchange market provides “hedging” facilities for
transferring foreign exchange risk to someone else more willing to carry
risk.
Market participants
The foreign exchange market consists of 2 tiers:
- the interbank or wholesale market
- the client or retail market
5 categories of participants operate within these 2 tiers:
1. Bank and nonbank foreign exchange dealers
a. They profit from buying foreign exchange at a “bid” price and reselling it
at a slightly higher “ask” price. They also earn money by changes in
exchange rates.
b. Competition among dealers worldwide narrows the spread between
bids and offers and so contributes to making the foreign exchange
market efficient.
c. Dealers in the foreign exchange departments of large international
banks function as “market makers”. Such dealers stand willing at all
times to buy and sell those currencies in which they specialise and thus
maintain an “inventory” position in those currencies.
2. Individuals and firms conducting commercial or investment transactions
, a. Importers and exporters, international portfolio investors, MNEs,
tourists, and others use the foreign exchange market to facilitate
execution of commercial or investment transactions.
3. Speculators and arbitragers
a. Seek to profit from trading in the market itself.
b. Speculators seek all of their profit from exchange rate changes
c. Arbitragers try to profit from simultaneous exchange rate differences in
different markets
d. A large part of this is conducted on behalf of major banks
4. Central banks and treasuries
a. Use the market to acquire or spend their country’s foreign exchange
reserves as well as to influence the price at which their own currency is
traded.
b. Motive is to influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
c. They do their job best when they willingly take a loss.
5. Foreign exchange brokers
a. Agents who facilitate trading between dealers without themselves
becoming principals in the transaction.
b. It is a broker’s business to know at any moment exactly which dealers
want to buy or sell any currency.
c. Dealers use brokers to expedite the transaction and to remain
anonymous, since the identity of participants may influence short-term
quotes.
Types of transactions in the interbank market
Transactions in the foreign exchange market can be executed on a spot, forward, or
swap basis.
A spot transaction requires almost immediate delivery of foreign exchange.
A forward transaction requires delivery of foreign exchange at some future date,
either on an “outright” basis or through a “futures” contract.
An outright forward transaction requires delivery at a future value date of a
specified amount of one currency for a specified amount of another currency. The
exchange rate is established at the time of agreement, but payment and delivery are
not required until maturity.
A swap transaction is the simultaneous exchange of one foreign currency for
another. A common type of swap is a spot against forward. The dealer buys a
currency in the spot market and simultaneously sells the same amount back to the
same bank in the forward market.
, Size of the foreign exchange market
Foreign exchange rates and quotations
A foreign exchange rate is the price of one currency expressed in terms of another
currency. A foreign exchange quotation is a statement of willingness to buy or sell
at an announced rate.
Free floating currencies
- No state intervention on FOREX markets: exchange rates reflect supply and
demand conditions
- Examples $, ¥ (yen), £, €
Fixed exchange rates
- Central Bank buys or sells its currency at a fixed price in order to stabilize the
value to another currency
- Examples: gold standard; Bretton Woods ($ key role), EU currencies before
start of the €
Managed Floating exchange rates
- Examples ¥ (Chinese Yuan)
