Topic 10 - FOREX

• Foreign Exchange Market


  Where individuals, firms and banks buy and sell foreign currencies or foreign exchange
• Functions of the Foreign Exchange Markets

  • Transfer purchasing power from one nation and currency to another
  • Provide credit for foreign transactions
  • Provide the facilities for hedging and speculation
• Participants in the Foreign Exchange Market

  • Those needing currency to fund transactions (tourists, importers, exporters, investors, etc.)
  • Commercial banks
  • Foreign exchange brokers
  • Central banks
• Open Economy Macroeconomics

  Deals with the home country trading in aggregate with the rest of the world (ROW); hence, relative prices of home good (measured in £ sterling) with respect to the price level in ROW (measured in $ or Euro or Yuan) becomes highly significant
• Exchange Rate


  The number of dollars needed to purchase one euro
• Exchange Rate Systems


  • Fixed
  • Freely floating
  • Managed float
  • Pegged
  • Currency Board
  • Dollarisation

  
• Fixed Exchange Rate System

  Rates are held constant or allowed to fluctuate within very narrow bands only

  
• Freely Floating Exchange Rate System

  Rates are determined by market forces without governmental intervention
• Managed Float Exchange Rate System

  Exchange rates can move freely daily, and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction
• Pegged Exchange Rate System

  The currency's value is pegged to a foreign currency or to some unit of account, and therefore moves in line with that currency or unit against other currencies

  
• Currency Boards


  A system for pegging the value of the local currency to some other specified currency. Domestic currency is backed 100% by a foreign currency
• Dollarization

  Replacement of a country's currency with US dollars
• Exchange Rate Arrangements

  • Pegged to US dollar
  • Floating Rate System

  
• Direct Quotation


  The value of a foreign currency in terms of the home currency
• Indirect Quotation


  The number of units of a foreign currency per unit of home currency
• Bid/Ask Spread

  Ask rate - Bid rate
• Cross Exchange Rate


  The exchange rate between two currencies themselves, calculated from their respective exchange rates against the dollar
• Effective Exchange Rate


  A weighted average of the exchange rates between the domestic currency and the nation's most important trading partners

  
• Arbitrage


  The purchase of currency in one market for immediate re-sell in another market
• Balance of Payments

  A summary statement of international transactions for a nation for a specified period of time
• Increase in US demand for imports of goods and services from UK

  Increases demand for pounds under a flexible exchange rate
• When the Indian rupee depreciates, exports increase and imports decrease in India
• Spot rate


  The exchange rate that calls for payment and receipt of the foreign exchange within two business days from the date when the transaction was made
• Forward rate


  The exchange rate that calls for delivery of the foreign exchange one, three, six, twelve or twenty-four months after the date the contract is signed
• Forward discount

  The percentage per year by which the forward rate is below the spot rate
• Forward premium

  The percentage per year by which the forward rate is above the spot rate
• Currency Swap

  A spot sale of a currency combined with a forward repurchase of the same currency – as part of a single transaction
• Foreign Exchange Futures

  • Forward currency contracts for standardized currency amounts and select dates trade on an organized market
  • Traded currencies: Japanese yen, Canadian dollar, British pound, Swiss franc, Australian dollar, Mexican peso, Euro
• Currency Futures vs Forward Market

  • Futures market only trades a few currencies in standardized contracts, with few specific delivery dates, subject to daily limits on exchange rate fluctuations, and trading occurs only on a few geographical locations
  • Forward market has more flexibility in terms of currencies, contract sizes, and delivery dates
• Foreign Exchange Options

  Contracts giving the purchaser the right, but not the obligation, to buy (call option) or to sell (put option) a standard amount of a traded currency on a stated date (European option) or any time before the stated date (American option) at a stated price (strike or exercise price)
• Foreign Exchange Risk


  Arises from future payments and receipts in a foreign currency (transaction exposure), and from valuing inventories and assets held abroad in terms of domestic currencies (translation exposure)
• Arbitrage does not include any risk
• Hedging

  The avoidance of foreign exchange risk, through options like buying at the current spot rate and depositing the receipts, buying a forward contract, or buying a call option
• Speculation

  The acceptance of foreign exchange risk in the hope of making a profit
• Stabilizing Speculation


  The purchase of a foreign currency when the domestic price falls or is low, in the expectation that it will soon rise, leading to a profit, OR the sale of a foreign currency when the domestic price rises, in the expectation that it will fall
• Destabilizing Speculation


  The sale of a foreign currency when the domestic price falls or is low, in the expectation that it will fall even lower, OR the purchase of a foreign currency when the domestic price rises, in the expectation that it will rise even higher