Chapter 11 – Foreign Exchange

Foreign Exchange Market

Foreign exchange market refers to the organizational setting within which individuals,
businesses, governments, and banks buy and sell foreign currencies and other debt
instruments. The foreign exchange market is by far the largest and most liquid market in the
world. The estimated worldwide amount foreign exchange transaction is about $5 trillion a day.
The foreign exchange market is dominated by four currencies: US dollar, Euro, Japanese Yen,
and British pound. Currencies that are not traded are avoided for reasons ranging from political
instability to economic uncertainty. Sometimes a country currency is not exchanged for the
simple reason that the country produces very few products of interest to other countries.
Foreign exchange market is not an organized structure, it has no centralized meeting
place and no formal requirements for participation. The foreign exchange market opens on
Monday morning in Hongkong and Sunday evening in New York. As the day progresses, markets
open in Tokyo, Frankfurt, London, New York, Chicago, San Fransisco,and elsewhere.
A typical foreign exchange market functions at three levels: in transactions between
commercial banks and their commercial customers who are the ultimate demanders and
suppliers of foreign exchange; in the domestic interbank market conducted through brokers;
and in active trading in foreign exchange with banks overseas. Exporters, importers, investors,
and tourists buy and sell foreign exchange from and to commercial banks rather than each
other.
The major banks that trade foreign exchange generally do not deal directly with one
another but instead use the services of foreign exchange brokers. The purpose of a broker is to
permit the trading banks to maintain desired foreign exchange balances. If at a particular
moment a bank does not have the proper foreign exchange balances, it can turn to a broker to
buy additional foreign currency or sell the surplus. Commercial and financial transactions in the
foreign exchange market represent large nominal amounts; they are small in comparison to the
amounts based on speculation

Foreign Currency Trading Becomes Automated

Most foreign exchange trading is now done electronically in an automated forex trading
system. In this system, forex trading is conducted by a computer software program that
analyzes currency price charts and other market activity. In an automated forex trading system,
the trader must first teach the computer software what signals to look for and how to interpret
them. This means that specific rules are established for both trade entries and exits that, once
programmed, can be automatically executed via a computer.

Types of Foreign Exchange Transacti ons

Banks typically engage in three types of foreign exchange transactions: spot, forward, and
swap.
1. Spot Transaction  you can make purchase or sale of currency now as in on the spot. A
spot deal will settle 2 working days after the deal is struck. Spot transaction works:
 a. A trader calls another trader and asks for the price of currency
b. The second trader provides the first trader with prices for both buying and
selling
c. When the traders agree, payment made 2 days later.

Advantage: simple way to meet foreign currency requirements

Disadvantage: greater risk of exchange rate fluctuation because there is no certainty
of the rate until transaction is made.
2. Forward Transaction  to prevent foreign exchange become expensive, there will be
contract with a bank to buy certain currency at stipulated price on the date they are
needed (forward date). Maturity date is more than 2 business days in the future

Advantage: protect against unfavorable movement in exchange rate, avoid an

immediate outlay cash
Disadvantage: not allow gains to be made
3. Currency swap:  conversion one currency to another currency to another currency at
one point in time, with an agreement to convert it to the original currency at s a
specified time in the future. Swap transaction works:
a. US Company needs 15 million Swiss francs for 3 month investment in
Switzerland
b. Agree rate 1.5 francs to a dollar and swap $10 million with a company willing to
swap 15 million francs for 3 months
c. After 3 months, US company return 15 million francs to other company and gets
back $10 million, with adjustment

Interbank Trading
Bid rate: price that the bank is willing to pay for a unit of foreign currency.
Offer rate: price at which the bank is willing to sell a unit of foreign currency.
Spread: difference between bid and offer rate.

Reading Foreign Exchange Quotati ons

Exchange rate: price of one currency in terms of another -the number of dollars required to
purchase 1 British Pound.
Currency depreciation: more units of a nation’s currency to purchase a unit of some foreign
currency.
Currency appreciation: it takes fewer units of a nations currency to purchase a unit of some
foreign currency
Cross exchange rate: resulting rate
Forward and Future Markets
Foreign exchange can be bought and sold for delivery immediately (spot market) or for future
delivery (forward market).

Foreign Currency Opti ons

= provide an opti ons holder the right to buy or sell a fi xed amount of foreign
currency at a prearranged price within a few days or a couple of years.
 Call opti on: gives the holder the right to buy foreign currency at a specifi ed
price.
 Put opti on: gives the holder the right to sell foreign currency at a specifi ed
price.
 Strike price: The price at which the opti on can be exercised.

Exchange Rate Determinati on

Indexes of the Foreign Exchange Value of the Dollar: Nominal and Real Exchange
Rates

The Forward Market