Foreign Exchange Market

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.

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

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, other information channels. telexes, and

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.

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

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).

Types of Transactions Three types of transactions: Spot Forward Swap

An 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 accounts at home and abroad. agreement on price today, with appropriate bank

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.

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.

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.

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.

Foreign exchange futures and options Foreign exchange futures: is a forward contract for standardized currency calendar dates traded on an organized market (exchange). amounts and selected 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).