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The Foreign Exchange

Market (FOREX)
The Foreign Exchange Market
Foreign exchange means the money of a foreign
country; that is, foreign currency, bank
balances, bank notes, checks and drafts.
A 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 date.
The Foreign Exchange Market
Foreign Exchange Market is:
The physical and institutional structure
through which the currency of one country is
exchanged for that of another country
The place where the determination of foreign
Exchange rate between currencies carry out
The place where foreign exchange
transactions are physically completed
Function of the FOREX Market
The transfer of funds or purchasing power from one
nation and currency to another.
Demand for foreign currencies
-Import/expenditures abroad/investment abroad
Supply of foreign currencies
-Export/earnings from tourism/receipt of foreign investments
Obtain or provide credit for international trade
transactions
Minimize exposure to the risks of exchange rate
changes by providing the facilities for hedging and
speculation
FX Market Participants
The foreign exchange market consists
of two tiers:
o The interbank or wholesale market
(multiples of $1MM US or equivalent in
transaction size)
o The client or retail market (specific,
smaller amounts)
FX Market Participants
Five broad categories of participants operate
within these two tiers;
o bank and nonbank foreign exchange dealers,
o individuals and firms,
o speculators and arbitragers,
o central banks and treasuries, and
o foreign exchange brokers
Bank and Nonbank Foreign Exchange Dealers
Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
The profit from buying foreign exchange at a bid
price and reselling it at a slightly higher offer or ask
price.
Dealers in the foreign exchange department of
large international banks often function as market
makers.
These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an inventory position in those currencies.
Individuals and Firms
Individuals (such as tourists) and firms (such as
importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
market.
Their use of the foreign exchange market is necessary
but nevertheless incidental to their underlying
commercial or investment purpose.
Some of the participants use the market to hedge
foreign exchange risk.
Speculators and Arbitragers
Speculators and arbitragers seek to profit from
trading in the market itself.
They operate in their own interest, without a need or
obligation to serve clients or ensure a continuous
market.
While dealers seek the bid/ask spread, speculators
seek all the profit from exchange rate changes and
arbitragers try to profit from simultaneous exchange
rate differences in different markets.
Central Banks and Treasuries
They use the market to acquire or spend their countrys
foreign exchange reserves as well as to influence the
price at which their own currency is traded.

They may act to support the value of their own currency


because of policies adopted at the national level or because
of commitments entered into through membership in joint
agreements such as the European Monetary System.
Central Banks and Treasuries
The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their
currency in a manner that will benefit the interests
of their citizens.

As willing loss takers, central banks and


treasuries differ in motive from all other market
participants.
Foreign Exchange Brokers
Foreign exchange brokers are agents who facilitate
trading between dealers without themselves
becoming principals in the transaction. For this
service, they charge a commission.

It is a brokers business to know at any moment exactly


which dealers want to buy or sell any currency.
Types of Foreign Exchange Transactions in
the Interbank Market
Sometimes the type of transaction used as the
name for the market
The major types of these transaction or market
Spot Transaction or Market
Forward Transaction or Market
Future Transaction or Market
SWAP Transaction or market
Option Transaction or Market
Spot Transaction/Market
The spot transaction is when the buyer and seller of
different currencies settle their payments within the
two days of the deal.
It is the fastest way to exchange the currencies. Here,
the currencies are exchanged over a two-day period,
which means no contract is signed between the
participants.
The exchange rate at which the currencies are
exchanged is called the Spot Exchange Rate. This
rate is often the prevailing exchange rate.
Spot Transaction/ Market
A Spot transaction in the interbank market is the
purchase of foreign exchange, with delivery and
payment between banks to take place, normally, on the
second date following business day.
The date of settlement is referred to as the value
date
The market in which the spot sale and purchase of
currencies is facilitated is called as a Spot Market.
Participants of this Mkt; Commercial bank, Brokers,
customer of commercial and central bank
Forward Transaction/Market
A forward transaction is a future transaction where
the buyer and seller enter into an agreement of sale
and purchase of currency at a fixed exchange rate on a
definite date in the future.
An outright forward transaction (usually called just
forward) requires delivery at a future value date of a
specified amount of one currency for a specified amount of
another currency.
Forward Transaction/Market
The rate at which the currency is exchanged is
called a Forward Exchange Rate.
Forward exchange rates are usually quoted
for value dates of one, two, three, six and
twelve months.
The exchange rate is established at the time of
the agreement, but payment and delivery are not
required until maturity.
Forward Transaction/Market
Buying Forward and Selling Forward describe the
same transaction (the only difference is the order
in which currencies are referenced.)
The market in which the deals for the sale and
purchase of currency at some future date is made
is called a Forward Market.
Participant of this market: Arbitrageurs,
Speculators, Hedgers, Traders
Future Transaction/Market
The future transactions are also the forward
transactions and deals with the contracts in the
same manner as that of normal forward
transactions.
But however, the transactions made in a future
contract differs from the transaction made in the
forward contract on the following grounds:
Future Transaction/Market
The forward contracts can be customized on the
clients request, while the future contracts
are standardized such as the features, date, and the
size of the contracts is standardized.
The future contracts can only be traded on the
organized exchanges, while the forward contracts can
be traded anywhere depending on the clients
convenience.
No margin is required in case of the forward
contracts, while the margins are required of all the
participants and an initial margin is kept
as collateral so as to establish the future position.
Swap Transactions
A swap transaction in the interbank market is 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.
The Swap Transactions also involve a simultaneous
borrowing and lending of two different currencies
between two investors.
Here one investor borrows the currency and lends
another currency to the second investor.
The obligation to repay the currencies is used as
collateral, and the amount is repaid at a forward rate.
Swap Transactions
The swap contracts allow the investors to
utilize the funds in the currency held by
him/her to pay off the obligations
denominated in a different currency without
suffering a foreign exchange risk.
Option Transactions
The foreign exchange option gives an investor
the right, but not the obligation to exchange the
currency in one denomination to another at an
agreed exchange rate on a pre-defined date.
An option to buy the currency is called as a Call
Option, while the option to sell the currency is
called as a Put Option.
Correspondent Banking
Relationships
The interbank market is a network of correspondent
banking relationships, with large commercial banks
maintaining demand deposit accounts with one
another, called correspondent banking accounts.
The correspondent bank account network allows for
the efficient functioning of the foreign exchange
market.
Correspondent Banking Relationships
Example: Consider U.S. Importer desiring to purchase
merchandise from Dutch Exporter invoiced in euros, at a
cost of 512,100. U.S. Importer will contact his U.S. Bank
and inquire about the /$ exchange rate. Say U.S. Bank
offers a price of 1.0242/$1.00. If U.S. Importer accepts the
price, U.S. Bank will debit U.S. Importers demand deposit
account $500,000 512,100/1.0242 for the purchase of the
euros. U.S. Bank will instruct its correspondent bank in the
euro zone, EZ Bank, to debit its correspondent bank
account 512,100 and to credit that amount to Dutch
Exporters bank account. U.S. Bank will then debit its
books 512,100, as an offset to the $500,000 debit to U.S.
Importers account, to reflect the decrease in its
correspondent bank account balance with EZ Bank.
Correspondent Banking
Relationships
This rather contrived example assumes that U.S. Bank
and Dutch Exporter both have bank accounts at EZ
Bank. A more realistic interpretation is to assume that
EZ Bank represents the entire euro zone banking
system. Additionally, the example implies some type of
communication system between U.S. Bank and EZ
Bank.
Correspondent Banking
Relationships
The Society for Worldwide Interbank Financial
Telecommunications (SWIFT) allows international
commercial banks to communicate instructions of the
type in this example to one another.
SWIFT is a private nonprofit message transfer system
with headquarters in Brussels, with intercontinental
switching centers in the Netherlands and Virginia.
Correspondent Banking
Relationships
The Clearing House Interbank Payments System
(CHIPS) in cooperation with the U.S. Federal Reserve
Bank System, called Fedwire, provides a clearinghouse
for the interbank settlement of U.S. dollar payments
between international banks.
Economic Theories of Exchange Rate Determination
This section will provide a brief overview of the many
different theories to determine exchange rate and
their relative usefulness in forecasting
The theories discussed in this section include
o Purchasing power parity approach
o Balance of payments (flows) approach
o Asset market approach
o Monetary approach
o Technical analysis
The Determinants of Foreign Exchange Rates

International Parity Conditions


1. Relative inflation rates (RPPP)
2. Relative interest rates (international Fisher effect)
3. Forward exchange rates
4. Interest rate parity (IRP)

Technical Analysis
Is there a well-developed Monetary Approach
and liquid money and capital Is there a sound and secure
market in that currency? Spot banking system in-place to support
Exchange currency trading activities?
Rate

Asset Market Approach Balance of Payments


1. Relative real interest rates 1. Current account balances
2. Prospects for economic growth 2. Portfolio investment
3. Supply & demand for financial assets 3. Foreign direct investment
4. Outlook for political stability 4. Official monetary reserves
5. Speculation & market liquidity 5. Exchange rate regimes
6. Contagion & corporate governance
Purchasing Power Parity
In one of the earliest theories, the exchange rate was
considered to settle at a level where a basket of goods
cost the same, whether it was imported or bought
domestically.
If the price of the same basket of goods was different
from one country to another, arbitrage would
continue until the exchange rate came to a level
where the prices were the same.
In other words, the equilibrium level of the exchange
rate was such that the purchasing power of the
different currencies was equal.
This was the Purchasing Power Parity theory or PPP
Purchasing Power Parity
In short, the theory of PPP states that the exchange
rate is determined as the relative prices of goods
The theory also is also suggestive of the "law of
one price" wherein the pricing of identical goods
be the same on a global basis.
PPP is the oldest and most widely followed exchange rate
theory
Most exchange rate determination theories have PPP
elements embedded within their frameworks
However, PPP calculations and forecasts are plagued with
structural differences across countries (e.g., different tax
rules or many non-tradable production factors) and
significant challenges of data collecting in estimation
Balance of Payments (Flows) approach
The Balance of Payments (Flows) approach
argues that the equilibrium exchange rate is
determined through the demand and supply of
currency flows from current and financial
account activities
The BOP method is the second most utilized theoretical
approach in exchange rate determination
Today, this method is largely dismissed by academics , but
practitioners still rely on different variations of the theory for
decision making
This framework is appealing since the BOP transaction
data is readily available and widely reported
Balance of Payments (Flows) approach
Critics may argue that this theory emphasizes on flows
of currency, but stocks of currency or financial
assets of residents play no role in exchange rate
determination
The asset market approach argues that exchange rates
are altered by shifts in the supply and demand of
financial assets
The monetary approach considers the currency
stocks of residents
Asset Market Approach
The Asset Market Approach argues that the exchange rate
should be determined by expectations about the future
of an economy, not current trade flows
Since the prospect of an economy is reflected on the
demand of financial assets in that economy, the asset
market approach believes that changes of exchange rates
are affected by changes of the supply and demand for
a wide variety of financial assets:
Shifts in the supply and demand for financial assets alter exchange
rates (not the demand and supply of financial assets determine the
exchange rate)
The asset market approach is also called the relative price of
bonds or portfolio balance approach
Asset Market Approach
More specifically, if the demand for domestic
financial assets increases, the demand for the
domestic currency will increase, which could
results in the appreciation of the domestic
currency
Changes in monetary and fiscal policy alter
expected returns and perceived relative risks of
financial assets, which in turn alter the demand
and supply of financial assets and thus exchange
rates
Monetary Approach
The Monetary Approach states that the
supply and demand for currency stocks, as
well as the expected growth rates of
currency stocks, will determine the price level
or the inflation rate and thus explain changes
of the exchange rate according to PPP
The arguments are all about currency stocks of
residents
The inference is to link the demand or the supply
of currencies with residents behavior to adjust the
stock of currencies
Monetary Approach
Main results of the monetary approach are as follows:
Currency supply domestic currency depreciation
1. Currency supply supply of currency > demand of
currency residents current currency holding > residents
desired currency holding residents spend the currency
price level according to PPP, domestic currency depreciates
2. Domestic currency supply growth rate > foreign currency supply
growth rate domestic currency depreciates vs. foreign
currency
Interest rate domestic currency depreciation
1. Interest rate opportunity cost for residents to hold the
currency increases demand of currency residents
current currency holding > residents desired currency
holding residents spend the currency price level
according to PPP, domestic currency depreciates
2. Increase of domestic interest rate > increase of foreign interest
rate domestic currency depreciates against foreign currency
Monetary Approach
Real income domestic currency appreciation
1. Real income (= real GDP = outputs of products
and services ) number of transactions
demand of currency residents current
currency holding < residents desired currency
holding residents decrease the spending of the
currency price level (or because the supply of
products and services , price level and less currency
is spent to achieve the same utility) according to
PPP, domestic currency appreciates
2. Domestic real income growth rate > foreign real
income growth rate (domestic economic growth >
foreign economic growth) domestic currency
appreciates against foreign currency
Monetary Approach
The monetary approach omits a number of factors:
The failure of PPP to hold in the short to medium term
The change of the interest rate and the real income will
affect the economic activities and thus affect the currency
supply
In the above inference, however, the change of the interest rate
and the real income affect only the currency demand
Currency demand appearing to be relatively unstable over
time
There are many factors other than the interest rate and the real
income to affect the money demand, e.g., the economic boom or
recession, so the money demand is difficult to be predicted
Technical analysis
Technical analysis is based on the belief that the
study of past price behaviors provides insights into
future price movements
Due to the poor forecasting performance of many
fundamental theories, the technical analysis draws more
attention and becomes popular
The primary assumption of the technical analysis is that the
movements of any market driven price (e.g., exchange
rates) must follow trends
More specifically, technical analysts, traditionally referred
to as chartists, focus on price and volume data to identify
trends that are expected to continue into the future and next
exploit trends to make profit
Exchange Rate Forecasting
Why Firms Forecast Exchange Rates?
MNCs need exchange rate forecasts for their:
hedging decisions,
short-term financing decisions,
short-term investment decisions,
capital budgeting decisions,
earnings assessments, and
long-term financing decisions.
Corporate Motives for Forecasting Exchange Rates

Decide whether to
hedge foreign currency
cash flows

Decide whether to Dollar


invest in foreign 1QA\
cash
Forecasting projects flows
exchange rates
Decide whether Value
foreign subsidiaries 1QA\
of the
should remit earnings firm

Decide whether to obtain Cost of


financing in foreign capital
currencies
Forecasting Techniques
The numerous methods available for forecasting
exchange rates can be categorized into four general
groups:
technical,
fundamental,
market-based, and
mixed.
Technical Forecasting
Technical forecasting involves the use of historical
data to predict future values.
E.g. time series models.
Speculators may find the models useful for predicting
day-to-day movements.
However, since the models typically focus on the near
future and rarely provide point or range estimates, they
are of limited use to MNCs.
Generally very short term horizons
Technical Analysis
Uses charts and price patterns to forecast future moves
in spot exchange rates.
Looks for price patterns that have historically signed a
future move.
Assume historical relationship will result in similar
moves in the future.
Not interested in explaining the source of the
expected future move.
Not interested in financial information or news.
Fundamental forecasting
Fundamental forecasting is based on the fundamental
relationships between economic variables and
exchange rates.
E.g. subjective assessments, quantitative measurements
based on regression models and sensitivity analyses.
Fundamental Analysis
Fundamental Analysis
Examines economic relationships and financial data to
arrive at a forecast.
Short term horizons: Asset Choice Model
Long term horizons: Parity Models
Fundamental Analysis: Short Term
Asset Choice:
Examines why one currency might be preferred over
others. Variables include:
Relative interest rates (current and anticipated)
Political/country risk
Safe haven effects
Carry trade strategies and carry trade unwinds
Essentially, trying to identify why the demand for a
currency will change.
Fundamental Analysis: Long Term
Parity Models
Through these models one attempts to calculate an
equilibrium exchange rate in the future.
Analysis built on long standing economic theories of
exchange rate determination.
Purchasing Power Parity Model
International Fisher Effect
Purchasing Power Parity
One of the oldest exchange rate models.
Assumes that exchange rates will change to offset
relative prices levels between countries.
Countries with relatively high rates of inflation will
show currency depreciation
Countries with relatively low rates of inflation will
experience currency appreciation
In equilibrium, the amount of depreciation (or
appreciation) will be equal to the inflation differential.
Purchasing Power Parity Example
Assume:
Spot GBP/USD: $1.80
Forecasted UK rate of inflation (annualized) for the next
12 months: 2.5%
Forecasted US rate of inflation (annualized) for the next
12 months: 1.0%
PPP Spot GBP/USD Forecast
1 year change in GBP: $1.80 x .015 = 0.027.
1 year spot GBP: $1.80 - .027 = $1.773
6 month GBP: $1.80 (0.027/2) = $1.80 0.0135 = $1.7865
Purchasing Power Parity Example
Assume:
Spot USD/CAD: 1.20
Forecasted CAD rate of inflation (annualized) for the
next 12 months: .5%
Forecasted US rate of inflation (annualized) for the next
12 months: 2.5%
PPP Spot USD/CAD Forecast
1 year change in CAD: 1.20 x .020 = 0.024.
1 year spot CAD: 1.20 - 0.024 = 1.176
6 month CAD: 1.20 (.024/2) = 1.20 - .012 = 1.188
International Fisher Effect
Assume that exchange rates will change in direct
proportion to relative differences in long term interest
rates.
Assumes that long term interest rates capture the markets
expectation for inflation.
Countries with relatively high rates of long term interest rates
(i.e., high inflation) will show currency depreciation.
Countries with relatively low rates of long term interest rates
(i.e., low inflation) will show currency appreciation.
In equilibrium, the amount of depreciation (or
appreciation) will be equal to the long term interest rate
differential.
International Fisher Effect Example
Assume:
Spot EUR/USD = $1.50
Current 1 year German Government Bond rate = 2.15%
Current 1 year U.S. Government Bond rate = 4.5%
IFE Spot EUR/USD Forecast
1 year change in EUR = $1.50 x 0.0235 = 0.03525
1 year spot EUR = $1.50 + .03525 = $1.53525
International Fisher Effect Example
Assume:
Spot USD/JPY = 98.00
Current 1 year Japanese Government Bond rate = 0.5%
Current 1 year U.S. Government Bond rate = 4.5%
IFE Spot USD/JPY Forecast
1 year change in JPY = 98.00 x 0.04 = 3.92
1 year spot JPY = 98.00 - 3.92 = 94.08
International Fisher Effect Example
Note that the use of PPP to forecast future exchange
rates is inadequate since PPP may not hold and future
inflation rates are also uncertain.
Fundamental forecasting
In general, fundamental forecasting is limited by:
the uncertain timing of the impact of the factors,
the need to forecast factors that have an immediate
impact on exchange rates,
the omission of factors that are not easily quantifiable,
and
changes in the sensitivity of currency movements to
each factor over time.
Market-based forecasting
Market-based forecasting uses market indicators to
develop forecasts.
The current spot/forward rates are often used, since
speculators will ensure that the current rates reflect
the market expectation of the future exchange rate.
For long-term forecasting, the interest rates on risk-
free instruments can be used under conditions of IRP.
Interest Rate Parity (IRP)
IRP is an arbitrage condition that must hold when
international financial markets are in equilibrium.
The term arbitrage can be defined as the act of
simultaneously buying and selling the same or
equivalent assets or commodities for the purpose of
making certain, guaranteed profits.
In this case there is no arbitrage profit
IRP Example
Suppose that you have $1 to invest over, say, a one-year
period. Consider two alternative ways of investing your
fund:
(1) Invest domestically at the U.S. interest rate, or,
alternatively,
(2) (2) invest in a foreign country, say, the U.K., at the
foreign interest rate and hedge the exchange risk by
selling the maturity value of the foreign investment
forward.
It is assumed here that you want to consider only
default-free investments.
IRP Example
If you invest $1 domestically at the U.S. interest rate (i$), the
maturity value will be $1(1 + i$)
To invest in the U.K., on the other hand, you carry out the
following sequence of transactions:
1. Exchange $1 for a pound amount, that is, (1/S), at the
prevailing spot exchange rate (S).
2. Invest the pound amount at the U.K. interest rate (i), with
the maturity value of (1/S)(1 + i).
3. Sell the maturity value of the U.K. investment forward in
exchange for a predetermined dollar amount, that is,
$[(1/S)(1 + i)]F, where F denotes the forward exchange rate.
Arbitrage equilibrium then would dictate that the
future dollar proceeds (or, equivalently, the dollar
interest rates) from investing in the two equivalent
investments must be the same, implying that

(1 + i$) = (F/S)(1 + i)
which is a formal statement of IRP
The effective dollar interest rate from the U.K.
investment alternative is given by
(F/S)(1 + i) - 1
Being an arbitrage equilibrium condition involving the
(spot) exchange rate, IRP has an immediate
implication for exchange rate determination. To see
why, let us reformulate the IRP relationship in terms of
the spot exchange rate
S=[(1 + i)/ (1 + i$) ]*F
To forecast the forward
F=[ (1 + i$)/ (1 + i) ]*S
Thus, other things being equal the spot exchange rate
depends on relative interest rates b/n two countries
Mixed forecasting
Mixed forecasting refers to the use of a combination of
forecasting techniques.
The actual forecast is a weighted average of the various
forecasts developed.
Currency Convertibility
Currency convertibility and government policy
Freely convertible: residents/non-residents allowed to
purchase unlimited amounts of a foreign currency with
the local currency
Not freely convertible: residents/non-residents not
allowed to purchase unlimited amounts of a foreign
currency with the local currency
Countertrade
Barter agreements by which goods and services can be
traded for other goods and services
Used to get around the non-convertibility of
currencies

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