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Contents I. Introduction 2
II. The structure of the foreign exchange market 3
1. What is the foreign exchange? 3
2. The participants of the foreign exchange markets 4 3. Instruments of the foreign exchange markets 5 III. Foreign exchange rates 6
1. Determining foreign exchange rates 6
2. Supply and Demand for foreign exchange 7 3. Factors affecting foreign exchange rates 11 IV. Conclusion 13
V. Recommendations 14
VI. Literature used 16
Introduction Trade and payments across national borders require that one of the parties to the transaction contract to pay or receive funds in a foreign currency. At some stage, one party must convert domestic money into foreign money. Moreover, knowledgeable investors based in each country are aware of the opportunities of buying assets or selling debts denominated in foreign currencies when the anticipated returns are higher abroad or when the interest costs are lower. These investors also must use the foreign exchange market whenever they invest or borrow abroad. I’d like to add that the foreign exchange market is the largest market in the world in terms of the volume of transactions. That the volume of foreign exchange trading is many times larger than the volume of international trade and investment reflects that a distinction should be made between transactions that involve only banks and those that involve banks, individuals, and firms involved in international trade and investment. The phenomenal explosion of activity and interest in foreign exchange markets reflects in large measure a desire for self-preservation by businesses, governments, and individuals. As the international financial system has moved increasingly toward freely floating exchange rates, currency prices have become significantly more volatile. The risks of buying and selling dollars and other currencies have increased markedly in recent years. Moreover, fluctuations in the prices of foreign currencies affect domestic economic conditions, international investment, and the success or failure of government economic policies. Governments, businesses, and individuals involved in international affairs find it is more important today than ever before to understand how foreign currencies are traded and what affects their relative values. In this work, we examine the structure, instruments, and price- determining forces of the world*s currency markets. The structure of the foreign exchange market What is the foreign exchange? The foreign exchange markets are among the largest markets in the world, with annual trading volume in excess of S160 trillion. The purpose of the foreign exchange markets is to bring buyers and sellers of currencies together. It is an over-the-counter market, with no central trading location and no set hours of trading. Prices and other terms of trade are determined by negotiation over the telephone or by wire, satellite, or telex. The foreign exchange market is informal in its operations: there are no special requirements for market participants, and trading conforms to an unwritten code of rules. You know that almost every country has its own currency for domestic transactions. Trading among the residents of different countries requires an efficient exchange of national currencies. This is usually accomplished on a large scale through foreign exchange markets, located in financial centers such as London, New York, or Paris—in order of importance—where exchange rates for convertible currencies are determined. The instruments used to effect international monetary payments or transfers are called foreign exchange. Foreign exchange is the monetary means of making payments from one currency area to another. The funds available as foreign exchange include foreign coin and currency, deposits in foreign banks, and other short-term, liquid financial claims payable in foreign currencies. An international exchange rate is the price of one (foreign) currency measured in terms of another (domestic) currency. More accurately, it is the price of foreign exchange. Since exchange rates are the vehicle that translates prices measured in one currency into prices measured in another currency, changes in exchange rates affect the price and, therefore, the volume of imports and exports exchanged. In turn the domestic rate of inflation and the value of assets and liabilities of international borrowers and lenders is influenced. The exchange rate rises (falls) when the quantity demanded exceeds (is less than) the quantity supplied. Broadly speaking, the quantity of U.S. dollars supplied to foreign exchange markets is composed of the dollars spent on imports, plus the amount of funds spent or invested by U.S. residents outside the United States. The demand for U.S. dollars arises from the reverse of these transactions. Many newspapers keep a daily record of the exchange rates in the highly organized foreign exchange market, where currencies of different nations are bought and sold. For instance, the Wall Street Journal shows the price of a currency in two ways: first the price of the other currency is given in U.S. dollars, and second the price of the U.S. dollar is quoted in units of the other currency. Pairs of prices represent reciprocals of each other. These rates refer to trading among banks, the primary marketplace for foreign currencies. 2. The participants of the foreign exchange markets The foreign exchange market is extremely competitive so there are many participants, none of whom is large relative to the market. The central institution in modern foreign exchange markets is the commercial bank. Most transactions of any size in foreign currencies represent merely an exchange of the deposits of one bank for the deposits of another bank. If an individual or business firm needs foreign currency, it contacts a bank, which in turn secures a deposit denominated in foreign money or actually takes delivery of foreign currency if the customer requires it. If the bank is a large money center institution, it may hold inventories of foreign currency just to accommodate its customers. Small banks typically do not, hold foreign currency or foreign currency- denominated deposits. Rather, they contact large correspondent banks, which in turn contact foreign exchange dealers. The major international commercial banks act as both dealers and brokers. In their dealer role, banks maintain a net long or short position in a currency, and seek to profit from an anticipated change in the exchange rate. (A long position means their holdings of assets denominated in one currency exceed their liabilities denominated in this same currency.) In their broker function, banks compete to obtain buy and sell orders from commercial customers, such as the multinational oil companies, both to profit from the spread between the rates at which they buy foreign exchange from some customers and the rates at which they sell foreign exchange to other customers, and to sell other types of banking services to these customers. Frequently, currency-trading banks do not deal directly with each other but rely on foreign exchange brokers. These firms are in constant communication with the exchange trading rooms of the world*s major banks.
Their principal function is to bring currency buyers and sellers together. Security brokerage firms, commodity traders, insurance companies, and scores of other nonbank companies have come to play a growing role in the foreign exchange markets today. These Nonbank Financial Institutions have entered in the wake of deregulation of the financial marketplace and the lifting of some foreign controls on international investment, especially by
Japan and the United Kingdom. Nonbank traders now offer a wide range of services to international investors and export-import firms, including assistance with foreign mergers, currency swaps and options, hedging foreign security offerings against exchange rate fluctuations, and providing currencies needed for purchases abroad. In main all participants of an exchange market are usually divided on two groups. The first group of participants is called speculators; by definition, they seek to profit from anticipated changes in exchange rates.
The second group of participants is known as arbitragers. Arbitrage refers to the purchase of one currency in a certain market and the sale of that currency in another market in response to differences in price between the two markets. The force of arbitrage generally keeps foreign exchange rates from getting too far out of line in different markets. 3. Instruments of the foreign exchange markets . Cable and Mail Transfers Several financial instruments are used to facilitate foreign exchange trading. One of the most important is the cable transfer, an execute order sent by cable to a foreign bank holding a currency seller*s account. The cable directs the bank to debit the seller*s account and credit the account of a buyer or someone the buyer designates. The essential advantage of the cable transfer is speed because the transaction can be carried out the same day or within one or two business days. Business firms selling their goods in international markets can avoid tying up substantial sums of money in foreign exchange by using cable transfers. When speed is not a critical factor, a mail transfer of foreign exchange may be used. Such transfers are written orders from the holder of a foreign exchange deposit to a bank to pay a designated individual or institution on presentation of a draft. A mail transfer may require days to execute, depending on the speed of mail deliveries.
. Bills of Exchange One of the most important of all international financial instruments is the Bill of Exchange. Frequently today the word draft is used instead of bill. Either way, a draft or bill of exchange is a written order requiring a person, business firm, or bank to pay a specified sum of money to the bearer of the bill. We may distinguish sight bills, which are payable on demand, from time bills, which mature at a future date and are payable only at that time.
There are also documentary hills, which typically accompany the international shipment of goods. A documentary bill must be accompanied by shipping papers allowing importers to pick up their merchandise. In contrast, a clean hill has no accompanying documents and is simply an order to a bank to pay a certain sum of money. The most common example arises when an importer requests its bank to send a letter of credit to an exporter in another country. The letter authorizes the exporter to draw bills for payment, either against the importer*s bank or against one of its correspondent banks.
. Foreign Currency and Coin Foreign currency and coin itself (as opposed to bank deposits) is an important instrument for payment in the foreign exchange markets. This is especially true for tourists who require pocket money to pay for lodging, meals, and transportation. Usually this money winds up in the hands of merchants accepting it in payment for purchases and is deposited in domestic banks. For example, U.S. banks operating along the Canadian and
Mexican borders receive a substantial volume of Canadian dollars and
Mexican pesos each day. These funds normally are routed through the banking system back to banks in the country of issue, and the U.S. banks receive credit in the form of a deposit denominated in a foreign currency. This deposit may then be loaned to a customer or to another bank.
. Other Foreign Exchange Instruments A wide variety of other financial instruments are denominated in foreign currencies, most of this small in amount. For example, traveler*s checks denominated in dollars and other convertible currencies may be spent directly or converted into the currency of the country where purchases are being made. International investors frequently receive interest coupons or dividend warrants denominated in foreign currencies. These documents normally are sold to a domestic bank at the current exchange rate. Foreign exchange rates 1. Determining foreign exchange rates As I’ve already mentioned the prices of foreign currencies expressed in terms of other currencies are called foreign exchange rates. There are today three markets for foreign exchange: the spot market, which deals in currency for immediate delivery; the forward market, which involves the future delivery of foreign currency; and the currency futures and options market, which deals in contracts to hedge against future changes in foreign exchange rates. Immediate delivery is defined as one or two business days for most transactions. Future delivery typically means one, three, or six months from today. Dealers and brokers in foreign exchange actually set not one, but two, exchange rates for each pair of currencies. That is, each trader sets a bid
(buy) price and an asked (sell) price. The dealer makes a profit on the spread between the bid and asked price, although that spread is normally very small. 2. Supply and Demand for foreign exchange The underlying forces that determine the exchange rate between two currencies are the supply and demand resulting from commercial and financial transactions (including speculation). Foreign-exchange supply and demand schedules relate to the price, or exchange rate. This is illustrated in Figure 1, which assumes free-market or flexible exchange rates. Figure 1 Before examining this figure, we need to define two terms.
Depreciation (appreciation) of a domestic currency is a decline (rise) brought about by market forces in the price of a domestic currency in terms of a foreign currency. In contrast, devaluation (revaluation) of a domestic currency is a decline (rise) brought about by government intervention in the official price of a domestic currency in terms of a foreign currency.
Depreciation or appreciation is the appropriate concept to deal with floating, or flexible, exchange rates, whereas devaluation or revaluation is appropriate when dealing with fixed exchange rates. In the dollar-pound exchange market, the demand schedule for pounds represents the demands of U.S. buyers of British goods, U.S. travelers to
Britain, currency speculators, and those who wish to purchase British stocks and securities. It slopes downward because the dollar price to U.S. residents of British goods and services declines as the exchange rate declines. An item selling for Ј1 in Britain would cost S2.00 in the U.S. if the exchange rate were Ј1/S2.00 U.S. If this exchange rate declined to
Ј1/S1.50 U.S., the same item is S.50 cheaper in the United States, increasing the demand for British goods and thus the demand for pounds. The supply schedule of pounds represents the pounds supplied by British buyers of U.S. goods, British travelers, currency speculators, and those who wish to purchase U.S. stocks and securities. It slopes upward because the pound price to British residents of U.S. goods and services rises as the S price of the Ј falls. Assuming an exchange rate of Ј1 /S2.00 U.S., a S2.00 item in the U.S. costs Ј1 in Britain. If this exchange rate declined to Ј1/S1.50
U.S., the same item is 33 percent more expensive in Britain, decreasing the demand for dollars to buy U.S. goods and thus reducing the supply of pounds. The equilibrium exchange rate in Figure 1 is Ј1/S2.00 U.S. The amounts supplied and demanded by the market participants are in balance. Figure 2 To understand better the schedules, several of the factors that might cause these curves to shift are discussed next. If there is a decrease in national income and output in one country relative to others, that nation*s currency tends to appreciate relative to others. The domestic income level of any country is a major determinant of the demand for imported goods in that country (and hence a determinant of the demand for foreign currencies). Figure 2 shows the effects of a decline in national income in
Britain (assuming all other factors remain constant). The decrease in
British income implies a decrease in demand for goods and services (both domestic and foreign) by British people. This reduction in demand for imported goods leads to a reduction in the supply of pounds, which is shown by a leftward shift of the supply curve in Figure 2 (from S to
S). If the exchange rate floats freely, the British pound appreciates against the U.S. dollar. If the exchange rate is artificially maintained at the old equilibrium of Ј1/S2.00 U.S., however, a balance-of-payments surplus (for Britain) likely results. Figure 3 In Figure 3, an initial exchange-rate equilibrium of Ј1/S2.00 U.S. is assumed. Now presume the rate of price inflation in Britain is higher than in the United States. British products become less attractive to U.S. buyers (because their prices are increasing faster), which causes the demand schedule for pounds to shift leftward (D to D). On the other hand, because prices in Britain are rising faster than prices in the
U.S., U.S. products become more attractive to British buyers, which causes the supply schedule of pounds to shift to the right (S to S). In other words, there is an increased demand for U.S. dollars in Britain. The reduced demand for pounds and the increased supply (resulting from British purchases of U.S. goods) mandates a newer, lower, equilibrium exchange rate. Furthermore, as long as the inflation rate in Britain exceeded that in the United States, the British pound would continually depreciate against the U.S. dollar. Differences in yields on various short-term and long-term securities can influence portfolio investments among different countries and also the flow of funds of large banks and multinational corporations. If British yields rise relative to others, an investor wishing to take advantage of these higher interest rates must first obtain British pounds to buy the securities. This increases the demand for British pounds shift the demand schedule in Figure 4 to the right (D to D). British investors are also less inclined to purchase U.S. securities, moving the supply schedule of pounds to the left (S to S). Both activities raise the equilibrium exchange rate of the British pound in terms of U.S. dollars. Figure 4 3. Factors affecting foreign exchange rates . Balance-of-Payments Position The exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. One of the most important factors is the status of a nation*s balance-of-payments position. When a country experiences a deficit in its balance of payments, it becomes a net demander of foreign currencies and is forced to sell substantial amounts of its own currency to pay for imports of goods and services. Therefore, balance-of-payments deficits often lead to price depreciation of a nation*s currency relative to the prices of other currencies. For exampl...
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