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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.
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
Decide whether to
hedge foreign currency
cash flows
(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