The Foreign Exchange Market

Jacob N. Messina
Embry-Riddle Aeronautical University
ECON 210

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 Features of the Foreign Exchange Market

oForeign exchange market (forex/FX market) refers to the institution for the exchange of one nation’s currency with that of another nation

oFX markets consist of many different markets such as the exchange between the U.S. dollar and Euro

oThe FX markets are the oldest and original financial markets

oForex markets offer international liquidity, with virtual stability (Andreou, Matsi, & Savvides, 2013).

oA Foreign exchange market is a dealers’ market and a 24-hour over-the-counter (OTC)

oFX markets comprise:

 Forex dealers
 Banks
 Commercial companies
 Hedge funds
 Investors
 Central banks
 Retail forex dealers
 Investment management firms

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 Functions of FX Market

oThe transfer function;

 The market transfers buying power between the nations
participating in the transaction (Andreou et al., 2013).

oThe credit function;

 This market offers credit for foreign trade through the use of
instruments such as bills of exchange (Geromichalos & Jung,
2018).

oThe hedging function;

 Hedging is when importers and exporters join a contract to sell
and purchase items at some future date at the existing
exchange rate and prices (Geromichalos & Jung, 2018).
 Hedging prevents losses caused by fluctuations in the
exchange rate in the future

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 Types of FX Markets

oForex markets are grouped into Spot Markets and Forward Markets

oSpot market is where the payments and receipts are made instantly (Andreou et al., 2013).

oSpot market is conducted daily

oThe dominant rate of exchange is called spot or current rate of exchange

oForward market is where buying and selling of foreign currency is done on a particular future date at a rate set today (Andreou et al., 2013).

oThe prevailing rate of exchange quoted is called the forward exchange rate

oForward contract is established to;

 Make profit via speculation
 Reduce the probability of loss caused by adverse exchange rate changes, via hedging

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 How Currencies are traded in FX Markets

oCurrencies exchanged in pairs

 This impacts how much nation X’s currency country Y can purchase, and vice versa
 FX markets establish the price for the international markets (Geromichalos & Jung, 2018).
 Examples of the most liquid trading pairs are;
 USD/JPY
 EUR/USD
 GBP/USD

oThe value of a nation’s currency relies on whether it is a fixed or free float

 Free market forces influence the relative value of free floating currencies
 Free market forces include;
 Demand/supply relationships
 Examples of floating currencies;
 British Pound
 Japanese Yen
 The U.S. Dollar
 A fixed float is where a nation’s controlling body sets its currency’s corresponding value to other currencies (Andreou et al., 2013).
 Examples of fixed floating currencies;
 The Indian Rupee
 Chinese Yuan
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 Real-World Applications tied to FX Market
oThe ensuing partnership of the different groups of forex traders is a
highly liquid, international market that affects business around the
world

oVariations in exchange rate are a determinant in:

 Global corporate earnings
 Inflation
 The balance of payments account for each nation (Andreou et
al., 2013).

The global landscape of corporate earnings and

balance of payments shifts to favor organizations
that operate in markets with stronger currencies

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 References

oAndreou, E., Matsi, M., & Savvides, A. (2013). Stock and foreign exchange market linkages in emerging economies. Journal of
International Financial Markets, Institutions and Money, 27, 248-268.

oGeromichalos, A., & Jung, K. M. (2018). An over‐the‐counter approach to the forex market. International Economic Review, 59(2), 859-
905.

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