TOPIC 3: THE ECONOMICS OF THE FOREIGN EXCHANGE MARKET
Learning Objectives
By the end of this topic you should be able to:
• Define foreign exchange market
• Understand the geographical extent of the foreign exchange market
• Understand the organization of foreign exchange market
• Explain the three main functions performed by the foreign exchange market
• Identify the main participants of foreign exchange market
• Understand the exchange rate mechanism and difference types of markets within the foreign exchange
market
• Identify the types of transactions, including spot, forward and swap transactions
• Understand different methods of stating exchange rates, quotations, and changes in exchange rate.
1.BACKGROUND TO FOREIGN EXCHANGE
What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is
the value of another country's currency compared to that of your own. If you are traveling to another
country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the
price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange
rate for USD 1.00 is EGP 5.50, this means that for every U.S. dollar, you can buy five and a half
Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries,
because the exchange rate must maintain the inherent value of one currency against the other.
Foreign exchange (forex or FX for short) is one of the most exciting, fast-paced markets around the
world. Until recently, trading in the forex market had been the domain of large financial institutions,
corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the
Internet has changed all of this, and now it is possible for average investors to buy and sell currencies
easily with the click of a mouse.
The foreign exchange market is the "place" where currencies are traded. Currencies are important to
most people around the world, whether they realize it or not, because currencies need to be exchanged in
order to conduct foreign trade and business
As you know, money is anything that is accepted as a medium of exchange. In most of the world, people
accept pieces of paper imprinted with pictures of national heroes or local wonders of nature as money.
But in each nation, they accept different pieces of paper
This means that if someone in the United States wants to buy something from someone in, say,
Tanzania, he/she must first exchange his/her local currency—dollars—for the currency accepted in
Tanzania —shillings. This currency conversion occurs at an exchange rate market.
The exchange rate—the price of one nation's currency in terms of another nation's—is a central concept
in international finance. Virtually any nation's currency can be converted into the currency of any other
nation, thanks to exchange rates and the foreign exchange market. For instance, let's say the current
exchange rate between the U.S. dollar and the Tanzanian shillings is $1 to 1000 sh. This means that $1
will buy 1000 shs and that 1000 shs will buy $1. (I am ignoring transaction costs, such as the
commission charged by the bank or foreign exchange broker who does the currency conversion.)
Importers and exporters need foreign currency in order to complete transactions. Banks and brokers
maintain inventories of foreign exchange, that is, various currencies, and convert currencies as a service
, to customers. Traders and speculators make (or lose) money on the movement of foreign exchange rates
(which I'll describe later). As you will see, central banks also play a role in the foreign exchange market.
Foreign exchange means the money of a foreign country that is foreign currency bank balances, bank
notes, cheques and drafts. A foreign exchange transaction is an agreement between a buyer and seller
that a fixed amount of one currency is delivered at a specified rate for some other currency.
2. GEOGRAPHICAL EXTENT OF FOREIGN EXCHANGE MARKET
Geographically the foreign exchange market spans the globe, with prices moving and currencies traded
somewhere every hour of every business day.
Major world trading starts each morning in Sidney and Tokyo, moves to Hong Kong and Singapore,
passes on to Bahrain, shifts to the main European markets of Frankfurt, Zurich and London, jumps the
Atlantic to New York, goes west to Chicago and ends up in Francisco and Los Angeles.
The market is deepest, or most liquid, early in the European afternoon, when the market of both Europe
and the US east coast are open. This period is regarded as the best time to ensure the smooth execution
of a very order.
3. ORGANIZATION OF THE FOREIGN MARKET
If there were a single international currency, there would be no need for a foreign exchange market.
The foreign exchange market is not a physical place; rather it is electronically linked networks of banks,
foreign exchange brokers and dealers whose main function is to bring together buyers and sellers of
foreign exchange. It is not confined to any one country but is dispersed through out the leading financial
centers of the world: London, New York city, Paris, Zurich, Amsterdam, Tokyo, Toronto, Milan,
Frankfurt and other cities.
Trading is generally done by telephone or telex machine. Foreign exchange traders in each bank usually
operate out of a separate foreign exchange trading room.
Each trader has several telephones and surrounded by display monitors and telex and fax machines
feeding up-to- the minute information.
The forex market provides plenty of opportunity for investors. However, in order to be successful, a
currency trader has to understand the basics behind currency movements.
4. FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
The main functions of foreign exchange market are: -
• Transfer of purchasing power
• Provision of credit
• Minimization of foreign exchange risk.
4.1 TRANSFER OF PURCHASING POWER
Transfer of purchasing power is necessary because international trade and capital transactions normally
involves parties living in countries with different national currencies. Each part usually wants to deal in
its own currency, but the trade or capital transaction can be invoiced in only one single currency.
If a Japanese exporter sells Toyota automobiles to a Tanzanian importer, the Japanese seller could
invoice the Tanzanian buyer in Japanese yen, Tanzanian shilling or any convenient third – country
currency, such as USD. The currency will be agreed as part of the deal.
Learning Objectives
By the end of this topic you should be able to:
• Define foreign exchange market
• Understand the geographical extent of the foreign exchange market
• Understand the organization of foreign exchange market
• Explain the three main functions performed by the foreign exchange market
• Identify the main participants of foreign exchange market
• Understand the exchange rate mechanism and difference types of markets within the foreign exchange
market
• Identify the types of transactions, including spot, forward and swap transactions
• Understand different methods of stating exchange rates, quotations, and changes in exchange rate.
1.BACKGROUND TO FOREIGN EXCHANGE
What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is
the value of another country's currency compared to that of your own. If you are traveling to another
country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the
price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange
rate for USD 1.00 is EGP 5.50, this means that for every U.S. dollar, you can buy five and a half
Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries,
because the exchange rate must maintain the inherent value of one currency against the other.
Foreign exchange (forex or FX for short) is one of the most exciting, fast-paced markets around the
world. Until recently, trading in the forex market had been the domain of large financial institutions,
corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the
Internet has changed all of this, and now it is possible for average investors to buy and sell currencies
easily with the click of a mouse.
The foreign exchange market is the "place" where currencies are traded. Currencies are important to
most people around the world, whether they realize it or not, because currencies need to be exchanged in
order to conduct foreign trade and business
As you know, money is anything that is accepted as a medium of exchange. In most of the world, people
accept pieces of paper imprinted with pictures of national heroes or local wonders of nature as money.
But in each nation, they accept different pieces of paper
This means that if someone in the United States wants to buy something from someone in, say,
Tanzania, he/she must first exchange his/her local currency—dollars—for the currency accepted in
Tanzania —shillings. This currency conversion occurs at an exchange rate market.
The exchange rate—the price of one nation's currency in terms of another nation's—is a central concept
in international finance. Virtually any nation's currency can be converted into the currency of any other
nation, thanks to exchange rates and the foreign exchange market. For instance, let's say the current
exchange rate between the U.S. dollar and the Tanzanian shillings is $1 to 1000 sh. This means that $1
will buy 1000 shs and that 1000 shs will buy $1. (I am ignoring transaction costs, such as the
commission charged by the bank or foreign exchange broker who does the currency conversion.)
Importers and exporters need foreign currency in order to complete transactions. Banks and brokers
maintain inventories of foreign exchange, that is, various currencies, and convert currencies as a service
, to customers. Traders and speculators make (or lose) money on the movement of foreign exchange rates
(which I'll describe later). As you will see, central banks also play a role in the foreign exchange market.
Foreign exchange means the money of a foreign country that is foreign currency bank balances, bank
notes, cheques and drafts. A foreign exchange transaction is an agreement between a buyer and seller
that a fixed amount of one currency is delivered at a specified rate for some other currency.
2. GEOGRAPHICAL EXTENT OF FOREIGN EXCHANGE MARKET
Geographically the foreign exchange market spans the globe, with prices moving and currencies traded
somewhere every hour of every business day.
Major world trading starts each morning in Sidney and Tokyo, moves to Hong Kong and Singapore,
passes on to Bahrain, shifts to the main European markets of Frankfurt, Zurich and London, jumps the
Atlantic to New York, goes west to Chicago and ends up in Francisco and Los Angeles.
The market is deepest, or most liquid, early in the European afternoon, when the market of both Europe
and the US east coast are open. This period is regarded as the best time to ensure the smooth execution
of a very order.
3. ORGANIZATION OF THE FOREIGN MARKET
If there were a single international currency, there would be no need for a foreign exchange market.
The foreign exchange market is not a physical place; rather it is electronically linked networks of banks,
foreign exchange brokers and dealers whose main function is to bring together buyers and sellers of
foreign exchange. It is not confined to any one country but is dispersed through out the leading financial
centers of the world: London, New York city, Paris, Zurich, Amsterdam, Tokyo, Toronto, Milan,
Frankfurt and other cities.
Trading is generally done by telephone or telex machine. Foreign exchange traders in each bank usually
operate out of a separate foreign exchange trading room.
Each trader has several telephones and surrounded by display monitors and telex and fax machines
feeding up-to- the minute information.
The forex market provides plenty of opportunity for investors. However, in order to be successful, a
currency trader has to understand the basics behind currency movements.
4. FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
The main functions of foreign exchange market are: -
• Transfer of purchasing power
• Provision of credit
• Minimization of foreign exchange risk.
4.1 TRANSFER OF PURCHASING POWER
Transfer of purchasing power is necessary because international trade and capital transactions normally
involves parties living in countries with different national currencies. Each part usually wants to deal in
its own currency, but the trade or capital transaction can be invoiced in only one single currency.
If a Japanese exporter sells Toyota automobiles to a Tanzanian importer, the Japanese seller could
invoice the Tanzanian buyer in Japanese yen, Tanzanian shilling or any convenient third – country
currency, such as USD. The currency will be agreed as part of the deal.
