FUNCTIONS AND TERMINOLOGIES USED IN THE

INTERNATIONAL
UNIT 5 SECTION
BUSINESS
3
Unit 5, section
FOREIGN 3: functions and terminologies
EXCHANGE MARKET used in the foreign exchange
market

You are welcome to Section 3 of unit 5. Section 2 looked at the overview of e

foreign exchange market and the key participants involved in the financial
transactions. The foreign exchange market is a mechanism through which
transactions can be made between one country’s currency and that of
another. The exchange market also facilitates international investment and
capital flows. This Section will look the functions of the foreign exchange
market, the exchange rate systems and the terminologies used for
transactions

By the end of the Section, you should be able to;

 outline and explain any three functions of the foreign exchange market
 compare and contrast the exchange rates system
 explain at least five terminologies used for transactions at the foreign
exchange market.

Read on

Functions of the Foreign Exchange Market

Anyone who owns money denominated in one currency and wants to
convert that money to a second currency participates in the foreign
exchange market. An American tourist exchanging American dollars for
Ghana cedis is utilising the foreign exchange market. The foreign exchange
market exists to facilitate the conversion of currencies, thereby allowing
individuals and firms to conduct trade more efficiently across national
boundaries. The functions of the foreign exchange market include;
 Currency Conversion – this market converts the currency of one
country into the currency of another. Every country has a national
currency and are mostly used domestically. Examples include Ghana
(Cedi), Nigeria (Naira), and America (American Dollars). However, due
to regional economic integration, the European Union (excluding
Britain) uses one currency known as the Euro. One is expected to use
the national currency to trade in that country. A tourist from Britain
cannot use the Pounds Sterling (name of their currency) to buy things in
Ghana. The pounds sterling has to be converted (at the bank or forex
bureau) to the cedi before effective transactions can take place. This
activity is one of the functions of the foreign exchange market.
International businesses participate in the foreign exchange market to
facilitate international trade and investment, to invest spare cash in
short-term money market accounts abroad, and to engage in currency
speculation.
 Currency Hedging – the practice of insuring against potential losses
that result from adverse changes in exchange rates as well as protecting
credit transactions. Hedge fund is mostly used for this activity. Hedge
fund is an investment company that buys and sells financial assets such
as bonds, stocks and currencies.

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 Currency Arbitrage – instantaneous purchase and sale of a currency in

different markets for profit. Suppose a currency trader in New York
notices that the value of Euros is lower in Tokyo than in New York, the
trader can buy Euros in Tokyo and sell them in New York to earn a
profit from the difference.
 Currency Speculation – this is the purchase or sale of a currency with
the expectation that its value will change and generate a profit. The
trader may bet that a currency's price will go either up or down in the
future. Speculation is much riskier than arbitrage because the value, or
price, of currencies is quite volatile. It is also referred to as short selling.

Exchange Rate Systems

Movements in a currency's exchange rate affect the activities of both
domestic and international companies. A country with a weak currency will
see a decline in the price of its exports and an increase in the price of its
imports. A company that sells its products in a country with a strong
currency, while sourcing from a country with a weak currency tends to
improve profits. For example, if a company pays its Ghanaian suppliers in a
falling local currency (cedi) and sells its products in a German rising
currency (Euro), the company benefits in the long term. The amount of
profit a company earns from its international subsidiary is partly dependent
on exchange rates.

Exchange rates are determined by the activities of the five groups discussed
above, as well as through purchasing power parity (PPP) and interest rate
parity (Fisher effect). The PPP theory holds that the exchange rate between
two currencies will be determined by the relative purchasing power of these
currencies. So, if the price of goods and services in Germany is rising faster
than in the United States, according to PPP theory, the value of the Euro
will decline in order to adjust the country’s PPP. In order to relate interest
rates to exchange rates, it is first necessary to relate interest rates to
inflation. This is done through the Fisher effect, which describes the
relationship between inflation and interest rates in two countries. There are
three key elements in the Fisher effect: (a) the nominal rate of interest,
which is the interest rate that is being charged to a borrower; (b) the rate of
inflation in the country; and (c) the real interest rate, which is the difference
between the nominal rate and the inflation rate. The Fisher effect holds that
as inflation rises, so will the nominal interest rate, because lenders will want
to protect the real interest rate. So if bankers in both the United States and
Germany want to earn a five percent real interest rate and the rate of
inflation in Germany is higher than that in the United States, the nominal
rate of interest will also be higher in Germany.

The link between interest rates and exchange rates is explained by the
international Fisher effect (IFE), which holds that the interest rate differential
is an unbiased predictor of future changes in the spot exchange rate. So, if
nominal interest rates in Germany are higher than those in the United States,

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the value of the Euro will fall by that interest rate differential in the future.
This differential is also important in determining forward exchange rates
because this rate would be that which neutralises the difference in interest rates
between the two countries. For example, if interest rates in Germany are
higher than those in the United States, the forward exchange rate for the Euro
would be lower than that for the dollar by the interest rate differential, so the
yield in dollars on a US investment would be equal to the yield in dollars of a
Euro investment, converted at the forward rate. Thus, the forward rate would
allow investors to trade currencies for future delivery at no exchange risk and
no differential in interest income. If such a differential exist, traders would
then take advantage of this situation and earn until the difference is eliminated.

The exchange rate systems include:

Fixed/Pegged Exchange Rate System

Under a pegged rate system, the rate of exchange is fixed for a reasonably
fixed period of time. Under this system, a Ghanaian importer will have a
reasonably good idea of the exchange rate he will face since it is maintained
with a (relatively) narrow range determined by the operations of the
monetary authorities.

The case of fixed exchange rate regime claims that:

 the need to maintain a fixed exchange rate imposes monetary discipline
on country
 floating exchange rate regimes are vulnerable to speculative pursue
 the uncertainty that accompanies floating exchange rates puts danger on
the growth of international trade and investment, and
 far from correcting trade imbalances, depreciating a currency on the
foreign exchange market tends to cause price inflection.

Floating/Flexible Exchange Rate System

This is a system whereby market conditions (demand and supply) of foreign
exchange are allowed to determine the rate of exchange. Under this system,
the importer may not be fully aware about the rate that he/she must pay. In
such circumstances, the importer may, if he/she knows sufficiently well in
advance that he/she will be importing goods from another country to engage
in certain operations on the forward exchange market in order to reduce his
uncertainty. The system claims that it gives countries autonomy regarding
their monetary policy as floating exchange rates facilitate smooth
adjustments of trade imbalances.

Exchange risk is the probability that a company will be unable to adjust

prices and costs to offset changes in the exchange rate. There are a number
of reasons why businesses need to develop strategies for managing currency
exchange rate risk. One reason is that it is often impossible to pass exchange
rate increases along in the form of higher prices. One way of dealing with

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this situation is to negotiate a lower price with the seller and thus share the
effects of the devaluation. A second way is to pass along as much of the
price increase as possible and accept the rest. A third, and complementary,
approach is to take steps to minimise exchange risk, most commonly by
exchange risk avoidance, exchange risk adaptation, risk transfer, or currency
diversification.

Exchange risk avoidance is the elimination of exchange risk by doing

business locally. Exchange risk adaptation is the use of hedging to provide
protection against exchange rate fluctuations. Risk transfer is the use of an
insurance contract or guarantee that transfers the risk to an insurance
company or guarantor. Currency diversification is the spreading of financial
assets across several or more currencies. Exchange risk adaptation is most
commonly used.

Terminologies Used In the Foreign Exchange Market

Individuals and organisations must be conversant with the terminologies
used for transactions in the foreign exchange market. This is to help them
appreciate the operations by making informed decisions.
 Foreign exchange risk - A forward exchange rate is an exchange rate
governing future transactions. Engaging in currency swaps can reduce
foreign exchange risk through the use of forward exchange rates
 Spot exchange market - If transactions take place immediately goods
and services are exchanged, this is called a spot market. The buyer
receives the foreign exchange he/she has bought and the seller delivers
immediately. Example is the forex bureau transactions.
 Forward exchange market - The forward exchange market deals not only
in foreign exchange, but in promises to buy or sell foreign exchange at a
specified rate and at a specified time in the future with payment to be made
upon delivery. These promises are known as forward exchange and the
price at which they are traded is the forward rate of exchange. A contract is
entered into in which a seller agrees to sell a certain amount of foreign
exchange to be delivered at a future date and at a predetermined price. The
forward market shifts the burden of foreign exchange risk from individual
or firms to the banks and other participants in the forward market.
 Forward premium - If currency sells at an anticipated value with
respect to the other currency in the forward market then we call this the
forward premium.
 Forward discount - This is the situation whereby currency is sold at a
discount to another at a depreciated value with respect to the other
currency in the forward market.
 Hedging - With spot market, there is only the existence of exchange risk
but a different situation happens with the forward market. With the
forward market, the individual can hedge or cover the foreign exchange
risk. With hedging, a contract is signed with a bank today to exchange
future cash flows at a fixed rate today that is the current forward rate. In

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addition hedging will also depend on how risk-averse traders are.

Hedging is important especially in market with flexible exchange rates
as it permits exporter and importers to protect themselves against risk
connected with exchange rate fluctuation thus enabling them to
concentrate on pure trading fluctuations.
 Speculation - Speculation is assumed the development of future spot
rates and it takes place exclusively on the forward market. A speculator
who expects the spot rate to increase in the future buys forward in order
to sell spot when he receive his delivery of the currency that he has
bought forward. On the contrary, a speculator who expects the spot rate
to fall sells forward with the intention of buying spot when he needs
currency for delivery. A speculator hopes of making profits by taking
exchange rate risks.
 Arbitrage - This involves the simultaneous purchases and sale of a
currency in different foreign exchange markets. For example, arbitrage
occurs when dollars are bought in New York and simultaneously sold in
the same amount in London. Arbitrage becomes profitable whenever the
prices of a currency in one market differ even slightly from its prices in
another market. Thus, exchange arbitrage provides the link between
exchange rates in the market of one country and the exchange rates in
the market of other countries.
 Swap - Swap involves the buying of spot currency and simultaneously
selling it forward or the reverse. A swap is the simultaneous purchase
and sale of a given amount of foreign exchange for two different value
dates.
 The spot rate is the exchange rate applied when the current exchange
rate is used for immediate receipt of a currency.
 The forward rate is the exchange rate applicable to the collection or
delivery of foreign currencies at some future date. The primary
function of the forward market is to provide protection against
currency risk. Dealers quote currency exchange rates in two ways.
 The direct quote, also known as the normal quote, is the number of
units of domestic currency needed to acquire one unit of foreign
currency.
 The indirect quote is the number of units of foreign currency
obtained for one unit of domestic currency.

Many transactions involve payments to be made immediately or in the

future. Such transactions include lending activities and purchases on credit.
The function of the foreign exchange market is to ensure that such
transactions are effectively handled. Individuals and firms need to appreciate
how such transactions are effected to enhance informed decision making.
Exchange rates and their effect on businesses were also addressed.

Now assess your understanding of this Section by answering the following

self-assessment questions. Good luck!

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Activity 5.3
 Describe the two main types of foreign exchange management used
today. Provide examples of nations which use each type of system.
 Identify and explain any five terminologies used in foreign exchange
market transactions. (refer to your notes)

Did you score all? That’s great!

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