Josje Machielsen
Summary Currency Risk Y3,Q1
Table of Contents
Chapter 6, The foreign exchange market ..................................................... 2
Chapter 7, International Parity Conditions ................................................. 8
Chapter 8, Foreign currency derivatives..................................................... 12
Chapter 10, transaction and translation exposure ................................ 17
Chapter 11, Operating exposure .................................................................... 23
This summary includes all the slides, learning objectives and the book.
, Josje Machielsen
Chapter 6, The foreign exchange market
Learning objectives chapter 6
• Examine the what, when, where and why of currency trading in the global
marketplace.
• Understand the definitions and distinctions between spot, forward, swaps, and
other types of foreign exchange financial instruments.
• Learn the forms of currency quotations used by currency dealers, financial
institutions and agents of all kinds when conducting foreign exchange transactions.
• Analyze the interaction between changing currency values, cross exchange rates,
and the opportunities arising from intermarket arbitrage.
Currency Risk
The exchange of money between different countries and thus valutas. The risk is paying
too much due to changes over time (fluctuations). Assess the risk to which a company is
exposed to.
Foreign exchange markets (FOREX)
• A foreign exchange transaction:
- An agreement between a buyer and a seller
- That a fixed amount of one currency will be delivered for some other currency
- At a specified rate
• The FOREX markets provide the physical and institutional structure through which
- The money of one country (currency) is exchanged for that of another country
- The rate of exchange between currencies is determined
- Foreign exchange transactions are ‘physically’ completed
The main characteristics of FOREX markets
1. The geographic extent
The foreign exchange market spans the globe, with prices moving and currencies trading
somewhere every hour of every business day. Global currency trading is indeed a 24 hour-
a-day process.
Who – Major banks and exchanges in all important trade centers (London, New York,
Japan, Singapore, Frankfurt, Zurich, etc.
Where –Trading floors, refers to an area where trading activities in financial instruments,
such as equities, fixed income, futures etc., takes place. Trading floors sit in the buildings
of various exchanges, such as the New York Stock Exchange (NYSE) and the Chicago
Board of Trade.
How – Sophisticated networks (dealing in a split second).
2. The daily transaction volume/ Size of the FOREX markets
The bank for international settlements (BIS), in conjunction with central banks around the
world, conducts a survey of currency trading activity every three years. The most recent
survey estimated daily global net turnover in the foreign exchange market to be $3.2
trillion. The global foreign exchange turnover is divided into three categories of currency
instruments: spot transaction, forward transactions and swap transactions.
3. The functions of FOREX markets
The foreign exchange market is the mechanism by which participants transfer
purchasing power between countries, obtain or provide credit for international trade
transactions, and minimize exposure for to the risks of exchange rate changes.
• Transfer of purchasing power is necessary because international trade and capital
transactions normally involve parties living in countries with different national
currencies. Usually each pary want to deal in its own currency, but the invoice can
only be one currency, therefore, one party must deal in a foreign currency
, Josje Machielsen
4. The market’s participants
The FOREX markets consist of two tiers (two levels)
1. The interbank or wholesale market
Individual transactions in the interbank market are usually for large sums that are
multiples of a million U.S. dollars or the equivalent value in other currencies.
2. The client or retail market (‘over the counter’)
Contracts between a bank and its clients are usually for specific amounts.
Five broad categories of participants operate within these two tiers, see below:
• Bank and nonbank foreign exchange dealers
o Operate in both interbank and client markets
o They profit from buying foreign exchange at a ‘bid’ price and reselling it at a
slightly higher ‘ask’ price (also called offer).
o Dealers in the foreign exchange departments of large international banks often
function as ‘market makers.’
• Individual and firms conducting commercial or investment transactions
o Importers and exporters, international portfolio investors, MNEs, tourist and
other use the foreign exchange market to facilitate execution of commercial
or investment transactions.
• Speculators and arbitrageurs
o They seek to profit from the trading in the market itself
o They operate in their own interest, without a need of obligation to serve
clients or to ensure a continuous market.
o Dealers seek profit from the spread between bids and offers in addition to
what they might gain from changes in exchange rates.
o Speculators seek all of their profit from exchange rate changes
o Arbitrageurs try to profit from simultaneous exchange rate differences in
different markets.
• Central banks and treasuries
o 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.
• Foreign exchange brokers
o Foreign exchange brokers are agents who facilitate trading between dealers
without themselves becoming principals in the transaction
o They charge a small commission.
Notes:
Summary Currency Risk Y3,Q1
Table of Contents
Chapter 6, The foreign exchange market ..................................................... 2
Chapter 7, International Parity Conditions ................................................. 8
Chapter 8, Foreign currency derivatives..................................................... 12
Chapter 10, transaction and translation exposure ................................ 17
Chapter 11, Operating exposure .................................................................... 23
This summary includes all the slides, learning objectives and the book.
, Josje Machielsen
Chapter 6, The foreign exchange market
Learning objectives chapter 6
• Examine the what, when, where and why of currency trading in the global
marketplace.
• Understand the definitions and distinctions between spot, forward, swaps, and
other types of foreign exchange financial instruments.
• Learn the forms of currency quotations used by currency dealers, financial
institutions and agents of all kinds when conducting foreign exchange transactions.
• Analyze the interaction between changing currency values, cross exchange rates,
and the opportunities arising from intermarket arbitrage.
Currency Risk
The exchange of money between different countries and thus valutas. The risk is paying
too much due to changes over time (fluctuations). Assess the risk to which a company is
exposed to.
Foreign exchange markets (FOREX)
• A foreign exchange transaction:
- An agreement between a buyer and a seller
- That a fixed amount of one currency will be delivered for some other currency
- At a specified rate
• The FOREX markets provide the physical and institutional structure through which
- The money of one country (currency) is exchanged for that of another country
- The rate of exchange between currencies is determined
- Foreign exchange transactions are ‘physically’ completed
The main characteristics of FOREX markets
1. The geographic extent
The foreign exchange market spans the globe, with prices moving and currencies trading
somewhere every hour of every business day. Global currency trading is indeed a 24 hour-
a-day process.
Who – Major banks and exchanges in all important trade centers (London, New York,
Japan, Singapore, Frankfurt, Zurich, etc.
Where –Trading floors, refers to an area where trading activities in financial instruments,
such as equities, fixed income, futures etc., takes place. Trading floors sit in the buildings
of various exchanges, such as the New York Stock Exchange (NYSE) and the Chicago
Board of Trade.
How – Sophisticated networks (dealing in a split second).
2. The daily transaction volume/ Size of the FOREX markets
The bank for international settlements (BIS), in conjunction with central banks around the
world, conducts a survey of currency trading activity every three years. The most recent
survey estimated daily global net turnover in the foreign exchange market to be $3.2
trillion. The global foreign exchange turnover is divided into three categories of currency
instruments: spot transaction, forward transactions and swap transactions.
3. The functions of FOREX markets
The foreign exchange market is the mechanism by which participants transfer
purchasing power between countries, obtain or provide credit for international trade
transactions, and minimize exposure for to the risks of exchange rate changes.
• Transfer of purchasing power is necessary because international trade and capital
transactions normally involve parties living in countries with different national
currencies. Usually each pary want to deal in its own currency, but the invoice can
only be one currency, therefore, one party must deal in a foreign currency
, Josje Machielsen
4. The market’s participants
The FOREX markets consist of two tiers (two levels)
1. The interbank or wholesale market
Individual transactions in the interbank market are usually for large sums that are
multiples of a million U.S. dollars or the equivalent value in other currencies.
2. The client or retail market (‘over the counter’)
Contracts between a bank and its clients are usually for specific amounts.
Five broad categories of participants operate within these two tiers, see below:
• Bank and nonbank foreign exchange dealers
o Operate in both interbank and client markets
o They profit from buying foreign exchange at a ‘bid’ price and reselling it at a
slightly higher ‘ask’ price (also called offer).
o Dealers in the foreign exchange departments of large international banks often
function as ‘market makers.’
• Individual and firms conducting commercial or investment transactions
o Importers and exporters, international portfolio investors, MNEs, tourist and
other use the foreign exchange market to facilitate execution of commercial
or investment transactions.
• Speculators and arbitrageurs
o They seek to profit from the trading in the market itself
o They operate in their own interest, without a need of obligation to serve
clients or to ensure a continuous market.
o Dealers seek profit from the spread between bids and offers in addition to
what they might gain from changes in exchange rates.
o Speculators seek all of their profit from exchange rate changes
o Arbitrageurs try to profit from simultaneous exchange rate differences in
different markets.
• Central banks and treasuries
o 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.
• Foreign exchange brokers
o Foreign exchange brokers are agents who facilitate trading between dealers
without themselves becoming principals in the transaction
o They charge a small commission.
Notes:
