Fundamentals of Foreign Exchange Market

1. The foreign exchange market
Mohammad Maksudul Huq Chowdhury
Manager
Export Import Bank of Bangladesh Limited, Islampur Branch

2. The Foreign Exchange Market
Foreign exchange means the money of a
foreign country; that is, foreign currency, bank
balances, banknotes, 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 rate. The
foreign exchange market spans the globe, with
currencies trading somewhere every hour of
every business day.

3. The Foreign Exchange Market provides:
 the physical and institutional structure through
which the money of one country is
exchanged for that of another country;
 the determination of rate of exchange
between currencies, and
 is where foreign exchange transactions are
physically completed.

4. Characteristics of FX Market
 The FX market is an over-the-counter market.
 There is no physical location where traders get
together to exchange currencies. Rather traders
are located in the offices of major commercial
banks around the world and communicate using
computer terminals, telephones, telexes, and
other information channels.

5. Characteristics of FX Market
 The FX market is almost a 24 hour market.
 Inter-bank traders are major players in FX market.
 90% of trading takes place with respect to the US
dollars.
 The reasons for quoting most exchange rates
against a common currency (a “vehicle
currency”)

6. Functions of the Foreign Exchange Market
The foreign exchange Market is the mechanism by
which participants:
 transfer purchasing power between countries;
 obtain or provide credit for international trade
transactions, and
 minimize exposure to the risks of exchange
rate changes.
 the facilities for hedging and speculation

7. Market structure
The foreign exchange market consists of two tiers:
 the inter-bank or wholesale market (multiples
of $1 trillion US or equivalent in transaction
size), and
 the client or retail market (specific, smaller
amounts).

8. Types of Transactions
Three types of transactions:
 Spot
 Forward
 Swap

9.  An agreement on price today, with
settlement usually two business days later.
The most common type of foreign exchange
transaction involves the payment and receipt
of the foreign exchange within two business
days after the day the transaction is agreed
upon. The two-day period gives adequate
time for the parties to send instructions to
debit and credit the appropriate bank
accounts at home and abroad.

10. Spot transaction
Settlement = actual delivery of currency for
currency
In the case of the US dollar for the Canadian
dollar (or the Mexican peso), settlement is
on the next day of the transaction.

11. Forward
 An agreement on price today for settlement at
some date (called the “value date”) in the future
(one or two weeks, or 1 ~ 12 months).
 A forward transaction involves an agreement today
to buy or sell a specified amount of a foreign
currency at a specified future date at a rate
agreed upon today.
 Forward contracts can be renegotiated for one or
more periods when they become due.

12. Example
Exxon has a scheduled payment of £25 million in 8
months and buys that amount of British pounds
forward today. No money will change hands now.
FD (forward discount) - If the forward rate is below
the present spot rate, the foreign currency is said to
be at a forward discount with respect to the domestic
currency.
FP (forward premium) - If the forward rate is above
the present spot rate, the foreign currency is said to
be at a forward premium with respect to the
domestic currency.

13. SWAP
 A sale (purchase) of a foreign currency with a
simultaneous agreement to repurchase (resell) it at
some date in the future.
 Usually in the inter-bank market. Refer to a spot
sale of a currency combined with a forward
repurchase of the same currency-as part of a
single transaction.

14.  Swap rate: is the difference between the spot and
forward rates in the currency swap. (a yearly
basis).
Example
 Citibank buys DM 2.5 million from Deutsch Bank for
$1 million, with a simultaneous agreement to sell
the DM back in 6 months for $1.05 million. $50,000
= swap rate.

15. Foreign exchange futures and options
 Foreign exchange futures: is a forward contract for
standardized currency amounts and selected
calendar dates traded on an organized market
(exchange).
 Foreign exchange option: Is a contract giving the
purchaser the right, but not the obligation, to buy
(a call option) or to sell (a put option) a standard
amount of a traded currency on a stated date (the
European option) or at any time before a stated
date (the American option) and at a stated price
(the strike or exercise price).

16. Market Participants
Four broad categories of participants:
 Bank and non-bank foreign exchange
dealers,
 Individuals and firms,
 Speculators and arbitragers, and
 Central banks and treasuries.
 Foreign Exchange Brokers

17. Bank and Non-bank Foreign Exchange Dealers
 Banks and a few non-bank foreign exchange
dealers operate in both the inter-bank 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 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.

18. 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 for their underlying commercial or
investment purpose.
 Some of the participants use the market to
“hedge” foreign exchange risk.

19. 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.

20. Central Banks and Treasuries
 Central banks and treasuries use the market to
acquire or spend their country’s foreign exchange
reserves as well as to influence the price at which
their own currency is traded.
 The motive is not to earn a profit
 Central banks and treasuries differ in motive from
all other market participants.

21. 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.
 Dealers use brokers for their speed, and because
they want to remain anonymous since the identity
of the participants may influence short term
quotes.

22. Market-makers
 Traders in the major money center banks around
the world who deal in two-way prices. They
announce bid and offer prices at which they will
exchange two currencies.
 The difference between the two prices is referred
to as the bid/asked spread, which is traders’
profits.
 Bid (ask or offer) price = a price at which a trader
is willing to buy (sell).

23. Transactions in the Inter-bank Market
 A spot transaction in the inter-bank market is the
purchase of foreign exchange, with delivery and
payment between banks to take place on the
second following business day.
 The date of settlement is referred to as the value
date.
 An outright forward transaction (or a forward)
requires delivery at a future value date of a
specified amount of one currency for a specified
amount of another currency.

24. Transactions in the Inter-bank Market
 The exchange rate is established at the time of the
agreement, but payment and delivery are not
required until maturity.
 Forward exchange rates are usually quoted for
value dates of one, two, three, six and twelve
months.
 A swap transaction in the inter-bank market is the
simultaneous purchase and sale of a given
amount of foreign exchange for two different
value dates (settlement date).

25. Transactions in the Inter-bank Market
 Both purchase and sale are conducted with the
same counterparty.
 Some different types of swaps are:
o spot against forward,
o forward-forward,
o non-deliverable forwards (NDF).

26. Foreign Exchange Rates and Quotations
 A foreign exchange rate is the price of one
currency expressed in terms of another currency.
 A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
 Most foreign exchange transactions involve the US
dollar.

27.  Professional dealers and brokers may state foreign
exchange quotations in one of two ways:
o the foreign currency price of one dollar, or
o the dollar price of a unit of foreign currency.
 Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar.

28.  Foreign exchange quotes:
o direct or
o indirect quote
 A direct quote is a home currency price of a unit
of foreign currency
 An indirect quote is a foreign currency price of a
unit of home currency.
 The form of the quote depends on what the
speaker regard as “home.”
 For example, the exchange rate between US
dollars and the Swiss franc is normally stated:
o SF 1.6000/$ (European terms or direct quote)

29.  However, this rate can also be stated as:
o $0.6250/SF (American terms or indirect quote)
 most inter-bank quotations around the world are
stated in European terms.
 Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate.
 This method of quotation makes it easier to
compare premiums or discounts in the forward
market

30.  If a currency increases in value in the future, it is
traded at a premium, if decreases, it is at a
discount against the other currency.
 Some currency pairs are only inactively traded, so
their exchange rate is determined through their
relationship to a widely traded third currency
(cross rate).
 Cross rates can be used to check on opportunities
for inter-market arbitrage.
 one bank’s (Dresdner) quotation on €/£ is not the
same as calculated cross rate between $/£
(Barclay’s) and $/€ (Citibank).

31. Understanding Exchange Rates
 Dollar/Swiss Francs -- USD/CHF
 Note the order of the currencies
 “USD” comes before the “CHF”
 The first currency($) - Base currency
 Second currency (CHF) - Terms currency
 It is important to remember that Bid & Offer in
trading always refers to the BASE CURRENCY.

33. Forward Rates
 Rate agreed for settlement on an agreed date in
the future
 All rates are derived from Spot rates
 Forward rate is the spot rate adjusted for the
premium / discount
 Forward Rate = Spot Rate + / - premium or
discount

34. Premium/Discount
 Forward price = Spot price plus or minus forward
margin.
 Premium –forward value of currency is higher than
spot rate. A currency with lower rate of interest is
said to be at premium in the forwards. Forward
margins added to spot rate.
 Discount – forward value of currency is lower than
spot rate. A currency with higher rate of interest is
said to be at discount. Forward margins deducted
from spot rate.

35. Factors Determining Exchange Rates
a. Fundamental Reasons:
 Balance of Payment – surplus leads to stronger
currency.
 Economic Growth Rates –High/Low growth
rate.
 Fiscal / Monetary Policy- deficit financing
leads to depreciation of currency.
 Interest Rates –currency with higher interest
will appreciate in the short term.
 Political Issues –Political stability leads to
stable rates

36. Factors Determining Exchange Rates
b. Technical Reasons:
 Government Control can lead to unrealistic
value.
 Free flow of Capital from lower interest rate to
higher interest rates.
c. Speculation – higher the speculation higher the
volatility in rates

37. EXCHANGE RATE SYSTEMS
1. Freely floating or flexible exchange rate:
 Market forces of supply and demand determine
rates.
 Forces influenced by
a. price levels
b. interest rates
c. economic growth
 Rates fluctuate over time randomly.

38. Advantages
 No problems with international liquidity
 Automatic correction in the balance of
payment
 Insulated from external events

39. Disadvantages
 Uncertainty
 Speculation can be destabilizing specially in
the short run
 Today’s crises questioning the power of the
market

40. 2. Managed Float (Dirty Float)
 Market forces set rates unless excess volatility
occurs.
 The government intervenes to influence the
exchange rate

41. 3. Target-Zone Arrangement
 Central bank intervenes to set the exchange
rate at the preannounced price, by selling or
buying foreign exchange currency in return for
the national currency
 Market forces constrained to upper and lower
range of rates
 Members to the arrangement adjust their
national economic policies to maintain target.

42. Forecasting Exchange Rates
Market participants who use foreign exchange
derivatives tend to take positions based on their
expectations of future exchange rates to hedge their
future cash flows denominated in foreign currencies,
especially when they expect that they will be
adversely affected by that exposure. Thus, the initial
task is to develop a forecast of specific exchange
rates. There are various techniques for forecasting
future exchange rates, but no specific technique
stands out because most have had limited success.
Usual forecasting techniques are of the following
types:

43. 1. Technical forecasting - involves the use of
historical exchange rate data to predict future
values. There are also several time-series models that
examine moving average and thus allow a forecaster
to identify patterns.
2. Fundamental forecasting – is based on
fundamental relationships between economic
variables and exchange rates. For example, high
inflation in a given country can lead to depreciation
in its currency.

44. 3. Market-based forecasting – process of developing
forecasts from market indicators, is usually based on
either spot rate or the forward rate.
4. Mixed forecasting – as no single forecasting
techniques has been found to be consistently
superior to the others, some participants of FX market
use a combination of forecasting techniques. Various
forecasts for a particular currency value are
developed using several forecasting techniques.
Each of the techniques used is assigned a weight,
and the techniques believed to be more reliable are
assigned higher weights.

45. Method of payment in International Trade:
Parties to the international transaction normally
negotiate a method of payment based on the
exporter’s assessment of the importer’s
creditworthiness and the norms of their industry. In
International trade there are four methods of
payment. These are:
a. Cash in Advance
b. Open account
c. Collection &
d. Documentary Credit.
The first three are the traditional trade payment
methods. The ordering of the payment and delivery
of goods depends upon the situation and
convenience of the buyer and seller.

46. Cash in Advance
Under this system the buyer puts funds at the disposal
of the seller prior to shipment of goods or provision of
services. In other words, exporter receives the value
of goods/services before shipment through Cheque,
Draft or TT or any other mode. This is an
advantageous system for the exporter as he can use
the fund immediately. But the risk lies to the importer
as he cannot receive goods in quantity & quality in
time as per contract/agreement. In this system the
Credit report of the exporter should be obtained and
carefully to be examined before making payment.

47. Open account
An open account method is an arrangement
between buyer (importer) and seller (exporter)
whereby the goods delivered before payment is
made. Open account thus obviously more
advantageous for the importer as he will pay the
price of the goods after satisfying the delivery date,
quantity & quality. In this system the risk is very
much high for the exporter. Thus he will collect
credit worthiness of the buyer before agreeing
open account business term.

48. Collection
Collection is a method under which goods are
shipped and the Bill of Exchange (Draft) is drawn by
the seller on the buyer. The documents are sent to
the bank with clear instruction for collection
through one of its’ correspondent bank located in
the buyers country. The documents are to be
delivered only after the payment has been made
or Draft is accepted.

49. Documentary Credit
Documentary Credit is the classic form of
international trade payment. This method
substantially reduce payment related risk for both
exporter and importer. Documentary Credit is a
conditional bank undertaking of payment on behalf
of the buyer /applicant /importer to the seller
/beneficiary/exporter against complying
presentation of documents.

50. Balance of Trade
Balance of Trade refers to the net difference value of
Export and Import of commodities from/into a
country. The movement of goods or commodities
between countries is known as the visible trade.
Therefore balance of trade refers to the net balance
of the visible trade of a country. When the value of
the export goods exceed value of import goods for a
given period of time, there is net gain of foreign
exchange to the country and the balance of trade is
said to be favourable or surplus or positive. If the
value of import goods exceeds the value of export
goods within a period then it is called negative or
deficit or unfavourable.

51. Balance of Payment
Balance of Payment is a statement that contain
details of all the international economic transactions
both visible and invisible items of a country within a
given period of time, usually a year. Here visible
items includes export import of commodities/goods
and invisible items are shipping, banking, insurance,
tourist, gift, interest on investment, technical know
how, consultancy etc. The balance arrived at taking
into account both the visible and invisible items in
foreign trade is known as Balance of payment.
Balance of payment includes Balance of trade and
other invisible items of foreign trade. As in the case of
Balance of trade, the total amounts payable and
receivable do not balance and the balance of
payments for a given period ends up in
favourable/surplus/positive or
unfavourable/deficit/negative.