Foreign-Exchange Markets

Foreign-Exchange Markets
In every country prices are expressed in units of
currency, either that issued by the country’s central bank
or a different one in which individuals prefer to
denominate their transactions. The value of the currency
itself, however, can be judged only against an external
reference. This reference, the exchange rate, thus
becomes the fundamental price in any economy.
Foreign-Exchange Markets
The foreign-exchange markets underpin all other financial
markets. They directly influence each country’s foreign-trade
patterns, determine the flow of international investment and
affect domestic interest and inflation rates. They operate in
every corner of the world, in every single currency
 How currencies are traded
The foreign-exchange markets comprise four different markets, which function separately yet are closely interlinked.

The Spot Market - Currencies for immediate delivery are traded on the spot market. A tourist’s purchase of
foreign currency is a spot-market transaction, as is a firm’s decision immediately to convert the receipts from an
export sale
into its home currency.

The Futures Market - The futures markets allow participants to lock in an exchange rate at certain future dates by
purchasing or selling a futures contract. For 15 example, an American firm expecting to receive SFr10m might
purchase Swiss franc futures contracts on the Chicago Mercantile Exchange. This would effectively guarantee that
the francs the firm receives can be converted into dollars at an agreed rate, protecting the firm from the risk that the
Swiss franc will lose value against the dollar before it receives the payment.
 How currencies are traded
The Options Market - A comparatively small amount of currency trading occurs in options markets.

The Derivatives Market - Most foreign-exchange trading now occurs in the derivatives market. Technically, the term
derivatives describes a large number of financial instruments, including options and futures. In common usage, however, it
refers to instruments that are not traded on organized exchanges. These include the following:

Forward contracts - are agreements similar to futures contracts, providing for the sale of a given amount of currency at a
specified exchange rate on an agreed date.

Foreign-exchange swaps - involve the sale or purchase of a currency on one date and the offsetting purchase or sale of the
same amount on a future date, with both dates agreed when the transaction is initiated.

Forward rate agreements - allow two parties to exchange interest-payment obligations, and if the obligations are in
different currencies there is an exchange-rate component to the agreement.

Barrier options - and collars are derivatives that allow a user to limit its exchange-rate risk.
 How currencies are traded
Although large-scale
derivatives trading is a recent
development, derivatives
have supplanted the spot
market as the most important
venue for foreign-exchange
trading
Currency markets and related
markets
In most cases, foreign-exchange trading is closely linked with the trading of
securities, particularly bonds and money-market instruments. An investor who
believes that a particular currency will appreciate will not want to hold that currency
in cash form, because it will earn no return. Instead, the investor will buy the desired
currency, invest it in highly liquid interest-bearing assets, and then sell those assets
to obtain cash at the time the investor wishes to sell the currency itself.
Gearing up
Gearing up Investors often wish to increase their exposure to a particular currency
without putting up additional money. This is done by increasing leverage or gearing.
The simplest way for a currency-market investor to gain leverage is to borrow money to
purchase additional foreign currency

Futures and options contracts allow investors to take larger bets on exchange-rate
movements relative to the amount of cash that is required upfront.
 The Players
Participants in the foreign-exchange markets can be grouped into four categories:

Exporters and importers - Firms that operate internationally must pay suppliers and workers in
the local currency of each country in which they operate, and may receive payments from customers in many different countries

Investors - The investor must enter the foreign-exchange markets to obtain the currency to make a purchase, to convert the
earnings from its foreign investments into its home currency, and again when it terminates an investment and repatriates its capital

Speculators - Speculators buy and sell currencies solely to profit from anticipated changes in exchange rates, without
engaging in other sorts of business dealings for which foreign currency is essential.

Governments - National treasuries or central banks may trade currencies for the purpose of affecting exchange rates. A
government’s deliberate attempt to alter the exchange rate between two currencies by buying one and selling the other is called
intervention.
 The main trading locations
The currency markets have no single physical location. Most trading occurs in the interbank markets, among
financial institutions which are present in many different countries.

Table 2.1 on the next page lists the biggest

national markets for trading in traditional
foreign-exchange products, including spot-
market transactions and simple types of
exchange-rate derivatives. The amount of
average daily trading reported in Table 2.1 far
exceeds the amount of spot-market trading
shown in Figure 2.1 on Slide 6, because some of
the instruments considered traditional can be
categorized as derivatives.
 Favorite currencies

In the traditional market, the most widely

traded currency is the US dollar, which
has accounted for 40–45% of all spot
trading since the first comprehensive
survey in 1989.

The most popular currency trade:

 Settlement
Once two parties have agreed upon a currency trade, they must make
arrangements for the actual exchange of currencies, known as settlement

Large trades in the spot and derivatives markets, however, are another
matter. When two parties have agreed a trade, they turn to banks to arrange
the movement of whatever sums are involved.
 Herstatt Risk
The greatest risk arises from the fact
that trading often occurs across many
time zones.
 Why exchange rates change
In the very short run exchange rates may be extremely volatile,
moving in response to the latest news. Investors naturally gravitate to
the currencies of strong, healthy economies and avoid those of weak,
troubled economies.
 Why exchange rates change
Real interest rates - In the longer run, however, exchange rates are determined
almost entirely by expectations of real interest rates. A country’s real interest rate is
the rate of interest an investor expects to receive after subtracting inflation.

Covered interest arbitrage - The mechanism whereby real interest rates affect
exchange rates is called covered interest arbitrage

Covered interest parity - This guaranteed profit, however, will be fleeting. Many
investors, whose computers are constantly scanning the markets for price anomalies,
will spot this unusual opportunity
 Managing exchange rates
Governments’ decisions about exchange-rate management
continue to be the single most important factor shaping the
currency markets. Many different exchange-rate regimes have
been tried. All fall into one of three basic categories: fixed, semi-
fixed or floating.
 Fixed-rate systems There are various types of fixed-rate systems.

Gold standard - The oldest type of fixed-rate regime is a metallic standard. Under a gold standard a
country’s money supply is directly linked to the gold reserves owned by its central bank, and notes and
coins can be exchanged for gold at any time

Bretton Woods - An alternative type of fixed-rate regime is that established at Bretton Woods, which
was based on foreign currencies as well as gold. The Bretton Woods system tried to solve the problems
of the gold standard by allowing countries with persistent balance-of-payments deficits to devalue
under certain conditions.

Pegs - Another form of fixed exchange rates is a pegged rate. This means that a country decides to hold
the value of its currency constant in terms of another currency, usually that of an important trading
partner.
 Fixed-rate shortcomings
Despite their differences, all fixed-rate systems have the same
shortcomings. As long as people are free to move money into and out
of a country, interest rates must rise high enough for investors to want
to hold its currency because they can earn an attractive return. The
country’s central bank is therefore forced to use its monetary powers
solely for the purpose of keeping the exchange rate stable.
Semi-fixed systems The practical problems with fixed-rate regimes have led to hybrid systems meant to
provide exchange-rate stability, leaving the government more flexibility to pursue
other economic goals.
Bands - The European Exchange Rate Mechanism, to which most EU countries adhered before adopting the
new single currency in 1999, involved agreement that exchange rates against the German mark would stay
within certain bands. So long as a currency remained within its band, it was allowed to float. If, however, a
currency lost or gained considerable value against the mark and reached the top or bottom of its band, the
country’s central bank was obliged to adjust interest rates to keep the exchange rate within the band.

Target Zones - These are similar to bands except that governments’ commitments are non-binding. A
government might proclaim its desire for its currency to trade within a certain range against another currency,
but might not commit itself to acting to keep the exchange rate within that range.

Pegs and Baskets - A third variant of managed float is for a country to peg to a basket of foreign currencies,
rather than to just one. If a country pegs to a single currency and that currency then rises relative to a third
currency, imports from the third country will become cheaper and exports to that country harder to sell

The Crawling Peg - This is a mechanism for adjusting an exchange rate, usually in a pre-announced way. This is
less rigid than a fixed exchange rate, but it entails the same basic commitment: the central bank must use its
monetary policy to keep the currency depreciating at the desired rate, rather than for other ends.
 Floating rates

In a floating-rate system, exchange rates are not the target of

monetary policy. Governments and central banks use their policies
to achieve other goals, such as stabilizing domestic prices or
stimulating economic growth, and allow exchange rates to move
with market forces. The world’s main currencies now float freely
against one another, creating a large demand for currency trading
 Comparing Currency Valuations
How can markets and policymakers judge whether a
currency is extremely overvalued or undervalued?

This is not a simple question. There is, however, considerable

empirical evidence that foreign-exchange markets frequently
overshoot.
 Indications of overshooting
There are three different indications that a currency may be seriously mis valued.

First, its exchange rates with other currencies may not be moving towards covered interest parity, suggesting
that the markets expect a sharp rise or fall in the immediate future.

Second, a country may run a large and persistent balance-of-payments deficit or surplus. Although it is not
uncommon for a country to have a balance-of-payments deficit or surplus for many years, an extremely large
deficit or surplus can indicate that the currency is far too strong or weak relative to
the currencies of major trading partners.

The Third indication of misevaluation is when the before-tax prices of traded goods in one country are very
different from the prices in another. This approach draws on the theory of purchasing power parity, which holds
that a given amount of money should be able to purchase similar amounts of traded goods in different countries
 Managing floating rate
When they decide that exchange rates have veered far from levels they
deem appropriate, governments and their central banks may endeavor to
move the market. The spread between the buy and sell prices provides
the dealer’s profit and covers the cost of running the trading operation.
The prices any dealer offers on screen, however, are strictly indicative;
recent trades may or may not have occurred at these prices, and a
customer may not be able to obtain a quoted price
 Forward rates
As well as spot rates, Table 2.5 also gives
forward rates for the most heavily traded
currencies, the pound sterling and the
Canadian dollar. These represent the prices
an investor would pay for currency to be
delivered in one, three or six months.
 Cross rates
A different kind of table is required to report currency cross rates. Table 2.6 lists the
identical currencies across the top and down the left hand side. The individual cells in
the table offer each country’s exchange rate with respect to the other country, without
requiring that either currency be converted into a third currency, such as dollars.
Currency Indexes
Evaluating changes in the exchange rate between two currencies
is simple enough. Evaluating how a particular currency has
performed over time, however, is much trickier, as the
performance of that currency against many other currencies
must be considered
 Trade-Weighted Exchange Rat

The most widely used method for

doing this is constructing a trade
weighted exchange rate, which is
an index incorporating a
currency’s performance against a
basket containing the currencies of
all of its trading partners.