CHAPTER 10

FOREIGN
EXCHANGE
MARKET

Contents
Roles and functions
Market instruments
Types of transactions
Participants in the foreign exchange

market
Foreign exchange rates theories
Current developments

Foreign Exchange Market

The market where one currency is
traded for another is called foreign
exchange market
Every international sale or purchase
of commodities, services or assets,
there corresponds an international
sale or purchase of currencies

Introduction

Provides the physical and institutional structure

through which the money of one country is
exchanged for that of another country, the rate of
exchanged is determined, and foreign exchange
transactions are physically completed
Foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount
of one currency will be delivered for some other
currency at a specified rate
Example??

Introduction

The foreign exchange market spans the globe,

with prices moving and currencies trading
somewhere every hour of every business day
Global currency trading is indeed a 24-hour-aday process
Banks engaged in foreign exchange trading
are connected by highly sophisticated
telecommunications network
Reuters, Telerate and Bloomberg are leading
suppliers of foreign exchange rate information

Features of Foreign Exchange Market

Location: OTC Market banks and
brokers at a financial centre
Wholesale and Retail segments
Size : Daily turnover of over $3.98

trillion
24 hours market
Efficiency
Currencies traded

Functions of the Foreign

Exchange Market
1.

Transfer of purchasing power between countries

International trade involve two countries with different

currencies. The trade can be invoiced in one particular

currency only
2.

Obtain or provide credit for international trade

transactions
Since the movement of goods takes time, inventory in

transit must be financed. The use of bankers acceptance

and letters of credit as sources of credit.
3.

Minimize exposure to the risks of exchange rate

changes
Provide hedging facilities for transferring foreign exchange

rate risk to someone else willing to carry the risk

Market Instruments

Other than the currency traded on spot

transactions, there are also derivatives currency.
Currency Forward/Futures
Currency Options

Just refer to our derivatives market definitions for

forward, futures and options. The only difference
here is the underlying asset which is currency
and price is denoted by an exchange rate. So,
fluctuations of exchange rates means risk.

Type of Transactions
1.
2.
3.

Spot
Forward
Swap

Type of Transactions

Spot transactions

The exchange rate for immediate delivery is

called Spot Exchange Rate and is denoted
by S (.) e.g. S (RM./USD) = RM3.59/1USD

Here immediate delivery means delivery

after two business days

The market where the purchase and sale of

currencies is contracted for spot delivery is
called the Spot Market

Type of Transactions

Forward Transaction
Requires delivery at a future value date of a

specified amount of one currency for a

specified amount of another currency
The exchange rate is established at the time
of the agreement, but payment and delivery
are not required until maturity
Value dates of one, two, three, six and
twelve months

Type of Transactions

Swap transaction
The simultaneous purchase and sale of a

given amount of foreign exchange for two

different value dates
Both purchase and sale are conducted with
the same counterparty
A common type of swap is a spot against
forward
The dealer buys currency in the spot market and

simultaneously sells the same amount back to

the same bank in the forward market

Foreign Exchange Rates and

Quotations

A foreign exchange rate is the price of

one currency expressed in terms of
another currency
Interbank quotations can be made
based on
The foreign currency price of one RM

(US$0.3227/RM) or
The RM price of a unit of one foreign
currency (RM3.0960/US$)

Foreign Exchange Rates and

Quotations

Direct and Indirect Quotes

In case of direct quotes, a unit of foreign

currency is quoted in terms of domestic currency

For example:
At Mumbai foreign exchange market , the US
dollar is quoted as:
USD 1 = Rs. 45.1525/1650
Spot (bid) = Rs. 45.1525/$
Spot (ask) = Rs. 45.1650/$

Rule : Buy low: Sell high

Cont
In case of indirect quotes, a unit of
domestic currency is quoted in terms of
foreign currency
For example:
At Mumbai foreign exchange market , the
quotation are made as:
Rs. 100 = USD 2.0762/0767
Spot (bid) = $ 2.0767/Rs.100
Spot (ask) = $ 2.0762/ Rs.100

Rule : Buy high: Sell low

Quotations at the FX Market

The quotes are usually made in the

form of buy and sell or bid and
ask rates
Buy/ Bid

Exchange dealer is ready to buy

Sell/ Ask

Exchange dealer is ready to sell

Sometimes ask is also referred as offer price

Spread

Ask and bid differential is called the

spread
When quotes are direct :
Spread = Ask Bid
When quotes are indirect :
Spread = Bid Ask

The spread between bid and ask price

will be the profit for the dealer.

Market Participants
1.

Bank and non-bank foreign exchange

dealers
Profit from the difference between bid (buying)

price and ask (selling) price

Dealers in the foreign exchange departments of
large international banks often function as
market makers
Currency trading is quite profitable for
commercial and investment banks
Normally market-making banks do not market in
every currencies

Market Participants
2.

Individuals and firms conducting

commercial and investment transactions
Importers and exporters, international portfolio

investors, MNEs, tourists etc

3.

Speculators and arbitragers

Seek to profit from the market itself
Speculators seek their profits from exchange

rate changes
Arbitragers profit from simultaneous
exchange rate differences in different markets

Market Participants
4.

Central banks
Use the market to acquire or spend their countrys

foreign exchange reserve as well as to influence the

price at which their own currency is traded
Differ in motives and behavior from other participants
5.

Foreign exchange brokers

Agents who facilitate trading between dealers without

themselves becoming principals in the transaction

Charge a small commission
Dealers use brokers for speed and because they want
to remain anonymous, since identity of participants
may influence short-term quotes

Foreign Exchange Rate Theories

Law of One Price

If the identical product or service can be sold in two different markets, and no

restrictions exist on the sale and transportation costs of moving the product
between markets, the products price should be the same in both markets.

Purchasing Power Parity

If the law of one price is true for all goods and services, the purchasing power

parity (PPP) exchange rate could be found from any individual set of prices
By comparing the prices of identical products denominated in different
currencies, we could determine the real or PPP exchange rate that should
exist if markets were efficient.
Absolute PPP states that spot exchange rate is determined by the relative
prices of similar baskets of goods.
Example: BigMac in Switzerland costs Sfr6.30, while the same BigMac in the
United States costs $2.54. Purchasing power parity exchange rate
= Sfr6.30/$2.54 = Sfr2.4803/$

Foreign Exchange Rate Theories

Relative Purchasing Power Parity

Says that the relative change in prices between two

countries over a period of time determines the

change in the exchange rate over that period
If a country experiences inflation rates higher than
those of its main trading partners, and its exchange
rate does not change, its exports of goods and
services become less competitive with comparable
products produced elsewhere
Imports become more price competitive
Deficit in the current account in the balance of payments

Foreign Exchange Rate Theories

The Fisher Effect

States that nominal interest rates in each country are equal to the

required real rate of return plus compensation for expected inflation

The International Fisher Effect

The relationship between the percentage change in the spot exchange

rate over time and the differential between comparable interest rates in
different national capital markets
Spot exchange rate should change in an equal amount but in the
opposite direction to the difference in interest rates between two
countries
(S1 S2) / S2 = iH iF , given that the spot exchange rates use indirect

quotes
Justification for the international fisher effect is that investors must be

rewarded or penalized to offset the expected change in exchange rates

Interest Rate Parity

Factors that Determine the

Exchange Rates