Chapter 7The Foreign Exchange Market

Outlines…• Introduction,• The Structure Of Foreign Exchange Market,• Functions of foreign exchange markets• Spot Market• Forward Market• Hedging• Speculation• Arbitrage

Introduction

The Foreign Exchange Market is the market in which different currencies are bought or sold for one another.

For example, dollars are traded for yens, yens for pounds, pounds for Afghani and Afghani for dollars etc..

The structure of Foreign Exchange Market

Main players of foreign Exchange MarketThe principle participants in the foreign exchange

markets are,1. Traders:

Individuals who buy and sell foreign currency for their employers

2. Brokers: Individuals who work in brokerage firms where they often deals in foreign currencies.

The structure of Foreign Exchange Market …

3 Speculators:

A group of brokers invest in stock in the hope of gain but with the risk of loss.

4. Hedgers: A group of people to make counterbalance sales or purchases in international markets as protection against adverse movement in the exchange rates.

5 Arbitragers: A group of people who are making an exchange of one currency for a second currency, the second for a third, and the third for the first in order to make profit.

Cont’d

6. Government:Although the currencies of most developed countries are allowed to float on the open market, government will sometime intervene as buyers or seller in order to maintain a particular price. For example many countries of the world holds US dollars, so it would be not in their best interest to see the dollar drop sharply. So the government would intervene to buy or sell the dollars in the market place in order to maintain the value of US currency.

Functions of Foreign Exchange Market

The main functions of foreign exchange markets are

1. To transfer funds through one currency of a country to another currency

2. To provide short term credit to finance trade between countries through various credit instruments

3. To facilitate avoidance of foreign exchange risks.

From the point of view of foreign exchange transactions, there are two types markets:

1. The Spot Exchange Market

2. The Forward Exchange Market

Kinds of Foreign Exchange Markets

1 Spot Market

In the spot market, the delivery of the foreign exchange has to be made “ on the spot” usually with in two days of the transaction.

The exchange rate at which the transaction take place is called the “spot rate”.

The spot exchange rate is determined by immediate market demand and supply of foreign exchange.

Forward MarketIn the forward market, the foreign exchange is

bought and sold for delivery at a future date at an agreed rate to day. The rate at which the forward exchange contract is agreed upon is called the “ forward rate”

The usual forward exchange contract and rate for 1month, 3 months, 6 months, 9 months and 1 year.

Links of foreign exchange market

1. Hedging: An important factor influencing the forward rate

is hedging. Hedging involves an agreement to sell or buy the required foreign exchange at today’s agreed rate on some future date, usually 3months.

Hence, It is the act of avoiding or covering the foreign exchange risks, because foreign exchange rates fluctuates continuously. It can be explained through an Example:

ExampleFor Example a US. Exporter sells goods to a British firms

and expect to receive $ 10,000 after 3 months. The British firms ( Importer) fears that the exchange rate

between Dollars and Pound will change during this period and would cause increase of cost in his currency. In order to avoid this risk, he covers himself by hedging.

The British firms buy $10,000 at today’s forward rate for the pound. After 3 months he pays for his goods from the $ bought at the forward rate 3 months hence, regardless of the spot rate of Pound at that time.

2 Speculation

Speculators

Speculators

2. Speculation:Speculation is apposite to hedging. In hedging

we minimize the risk of fluctuation in exchange rate while in Speculation we accept risk.

Speculation is based on the Expectations about the future rate of foreign currency.

For example:

Speculators

A speculator who except the spot rate of a foreign currency to increase in relation to his home currency in 3 months, he buys the foreign currency in the forward market. He sells it at the spot exchange rate after 3 months. If his expectation turns out to be correct, he earns a profit, other wise he may suffer loss e.g suppose the forward rate is 50 Afs per $, a speculator expect that the spot rate will be 51 Afs 3 months from now.

He will buy $ forward at 50 Afs in the hope of selling them 3 months from now at 51 Afs.

3 Arbitrage

Arbitrage means the buying and selling of a foreign currency in two markets in order to profit from the exchange rate differences between the markets.

End of Chapter # 7

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