The Foreign Exchange Market: Unit 5 Section

INTERNATIONAL
UNIT 5 SECTION 2 THE FOREIGN EXCHANGE MARKET

BUSINESS Unit 5, section 2: The foreign exchange market
You are welcome to Section 2 of unit 5. Section 1 reviewed the evolution of

the international monetary system and its influence on international
businesses. A distinguishing feature of international business is the use of
foreign currencies. Unlike domestic transactions, international transactions
involve the currencies of two or more nations. The exchanges of one
currency for another in international transactions rely on a mechanism called
the foreign exchange market. This Section will look at how the foreign
exchange market works, factors that influence the supply and demand for a
currency and the key participants in the global monetary and financial
systems.
By the end of the Section, you should be able to;

 explain the meaning and functions of the foreign exchange market
 outline and explain the factors that influence the supply and demand for
a currency and
 identify and explain some key participants in the global monetary and
financial systems.
Read on
Foreign Exchange Market

Foreign exchange represents all forms of money that are traded
internationally, including foreign currencies, bank deposits, checks, and
electronic transfers. Foreign exchange resolves the problem of making
international payments and facilitates international investment and
borrowing among firms, banks, and governments. Currencies such as the
U.S. dollar, yen, and euro are traded on the foreign exchange market, the
global marketplace for buying and selling national currencies. The market
has no fixed location. Rather, trading occurs through continuous buying and
selling among banks, currency traders, governments, and other exchange
agents located worldwide.
The foreign exchange market is a mechanism through which transactions

can be made between one country’s currency and that of another. Foreign
exchange market is a commodity that consists of currencies issued by
countries other than one's own. It exists to facilitate this conversion of
currencies, thereby allowing firms to conduct trade more efficiently across
national boundaries. The exchange market also facilitates international
investment and capital flows.
The price of foreign exchange is set by the demand and supply in the
marketplace. If you buy from a supplier whose currency is appreciating
against yours, you may need to pay a larger amount of your currency to
complete the purchase. Exporters or importers worry about losses that arise
from currency fluctuations. Exporters and licensors also face risk because
foreign buyers must either pay in a foreign currency or convert their
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Unit 5, section 2: The foreign exchange market BUSINESS
currency into that of the vendor. For example, if a seller in Accra sells goods
to a buyer in Cape Coast, he/she is paid in cedis. Despite the distance
between the buyer and seller, they use the same currency. However, if a
buyer in Ghana buys goods from a seller in Holland, the problem of foreign
exchange occurs, because the buyer wants to pay in cedis whereas the seller
wants to receive his payment in Euros. The Ghanaian importer must then
purchase Euros through his bank, forex bureau or bureau de change. The
bank, forex bureau or bureau de change in turn will purchase Euros in the
foreign exchange market.
Over 150 currencies are in use in the world today. The tendency of each
country preferring to use its own unique currency complicates international
business transactions. The values of these national currencies, and thus their
exchange rates, fluctuate constantly and managers must keep them in mind.
A convertible or hard currency can be readily exchanged for other
currencies.
Convertible currencies are hard, stable currencies that are universally

accepted and used most often for international transactions, such as the U.S.
dollar, Japanese yen, British pound, and European euro. Nations prefer to
hold hard currencies as reserves because of their strength and stability in
comparison to other currencies. A currency is nonconvertible or soft when it
is not acceptable for international transactions. Examples include Ghana
Cedis, Nigerian Naira and a host of others.
The largest foreign exchange market is in London, followed by New York,

Tokyo and Singapore. Because the dollar is used to facilitate most currency
exchange, it is known as the primary transaction currency for the foreign
exchange market. A foreign exchange rate is defined as the price of one
currency in terms of another. In other words the exchange rate may be
defined in two ways; as the amount of the foreign currency that may be
bought for 1 unit of the domestic currency, or as the cost in domestic
currency of purchasing 1 unit of foreign currency. Using the Cedi-Dollar (¢-
$), suppose that last year the exchange rate was ¢2.50 = $1. Now, if the rate
has gone to ¢3.50 = $1. What is the effect of this change on Ghanaians?
Effects on Ghanaian firms:

 Ghanaian firms will pay more for inputs from the U.S.
 Higher costs incurred will reduce profitability, thus, requiring higher
prices.
 Ghanaian firms can increase their exports to the U.S.
 Ghanaian firms can raise their prices to the U.S.
 Increased exports to the U.S. will lead to higher revenues
It should be noted that dealers usually quote foreign exchange rates in two
folds: the rate at which the foreign currency is offered for sale (the bid
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price), and the (lower) rate at which the foreign currency will be purchased
(the ask price). The difference between the two, the spread, is the gross
profit margin of the dealer.
Factors that Influence the Supply and Demand for a Currency

In a free market, the “price” of any currency (the exchange rate) is
determined by demand and supply. It therefore means that;
 the greater the supply of a currency, the lower its price.
 the lower the supply of a currency, the higher its price.
 the greater the demand for a currency, the higher its price.
 the lower the demand for a currency, the lower its price.
Factors that influence the supply of and demand for a currency include
economic growth, which is the annual increase in real GDP, in which the
inflation rate is subtracted from the growth rate. To accommodate economic
growth, the central banks increase the nation's money supply. Economic
growth is associated with an increase in the supply and demand of the
nation's money supply and, by extension, the nation's currency. Thus, it has
a strong influence on the supply and demand for national currencies.
Finally, exchange rates are often affected by the unpredictable behavior of

investors. Herding is the tendency of investors to mimic each other’s'
actions. Momentum trading occurs when investors buy stocks for which
prices have been rising and sell stocks for which prices have been falling.
These practices tend to occur in the wake of financial crises.
Inflation reduces the purchasing power of the currency and also affects the
value of the nation's currency. It occurs when demand for money grows more
rapidly than supply, or the central bank increases the nation's money supply
faster than output. Interest rates and inflation are closely related. In
countries with high inflation, interest rates tend to be high because investors
expect to be compensated for the inflation-induced decline in the value of
their money. If inflation is running at 8 percent, for example, banks must
pay more than 8 percent interest to attract customers to open savings
accounts. Inflation occurs when,
 demand for money grows more rapidly than supply, or
 the central bank increases the nation’s money supply faster than output.
Inflation directly affects the value of the nation’s currency. If it results from
an excessive increase in the money supply, all else being equal, the price of
that money (expressed in terms of foreign currencies) will fall. The link
between interest rates and inflation, and between inflation and the value of
currency, implies that there is a relationship between real interest rates and
the value of currency. For example, when interest rates in Japan are high,
foreigners seek profits by buying Japan’s interest-bearing investment
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Unit 5, section 2: The foreign exchange market BUSINESS
opportunities, such as bonds and deposit certificates. Investment from

abroad will have the effect of increasing demand for the Japanese yen.
When a nation's currency is expensive to foreigners, its exports are likely to
fall. When a nation's currency is cheap to foreigners, exports increase.
Conclusively, when the value of a nation's currency depreciates over a

prolonged period, consumer and investor confidence can be undermined as
depreciation weakens the nation's ability to pay foreign lenders, possibly
leading to economic and political crisis. To minimise these effects,
governments influence the value of their own currencies effective
management of their balance of payments, the annual accounting of all
economic transactions of a nation with all other nations. This represents the
difference between the total amount of money coming into and going out of
a country.
Participants in the Global Monetary and Financial Systems

As companies engage in international trade and are paid by their customers
abroad, they typically acquire large quantities of foreign exchange and
convert them into the currency of the home country. The major commercial
world banking centres are in London, New York, Tokyo, Frankfurt, and
Singapore, with London having the world's greatest concentration of
international banks. Although the participants may be based within
individual countries with their own respective trading centres, the market
itself is universal and open to all across the world. The trading centres are in
close and continuous contact with one another and the participants deal in
more than one market.
There are five major groups that are active participants in foreign exchange
markets:
 traders/brokers, speculators, hedgers, arbitrageurs and governments.
Foreign exchange traders work in commercial banks where they buy and
sell foreign currency for their employer. Foreign exchange brokers work
in brokerage firms where they often deal in both spot rate and forward
rate transactions.
 Speculators are participants who take an open position and assume the
risks with rising or falling foreign exchange prices.
 Foreign exchange hedgers limit their potential losses by locking in
guaranteed foreign exchange positions.
 Foreign exchange arbitrageurs simultaneously buy and sell currency in
two or more foreign markets and profit from the exchange rate
differences.
 Governments sometimes intervene as buyers or sellers in order to create
or maintain a particular price.
In some countries, banks are owned by the state and are seen as extensions
of government whereas in other countries, they face little or no regulation
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and often lack safety nets that might prevent their failure. Major central
banks include the Federal Reserve Bank of the United States, Reserve Bank
of India, the Bank of England, and the Bank of Japan. Based in Basel,
Switzerland, the Bank for International Settlements is an international
organisation that fosters cooperation among central banks and other
governmental agencies. It provides banking services to central banks, assists
them in devising sound monetary policies, support stability in the global
monetary and financial systems, and help governments to avoid becoming
too indebted.
There are three types of exchange rates that are important to those dealing in
foreign exchange: spot, forward and cross. A spot rate is the rate quoted for
current foreign currency transactions. The forward rate is the rate quoted for
the delivery of foreign currency at a predetermined future date, such as 90
days from now. The cross rate is an exchange rate that is computed from the
other two rates. This rate is of interest to dealers or businesses that are doing
business in more than two currencies.
We have been able to appreciate the foreign exchange market as a

mechanism through which financial instruments (cash, cheques or drafts,
wire transfers, telephone transfers and contracts to sell or buy currency in
the future) that are denominated in different currencies can be transacted.
This market is fully operational and dependent on the supply and demand
for a currency. We concluded by looking at the key participants in the global
monetary and financial systems,
Now assess your understanding of this Section by answering the following

self-assessment questions. Good luck!
Activity 5.2
 Explain the concept of currency risk. How can inflation and interest
create currency risk?
Did you score all? That’s great! Keep it up.
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INTERNATIONAL

UNIT 5 SECTION 2 THE FOREIGN EXCHANGE MARKET

You are welcome to Section 2 of unit 5. Section 1 reviewed the evolution of

By the end of the Section, you should be able to;

Foreign Exchange Market

The foreign exchange market is a mechanism through which transactions

Convertible currencies are hard, stable currencies that are universally

The largest foreign exchange market is in London, followed by New York,

Effects on Ghanaian firms:

Factors that Influence the Supply and Demand for a Currency

Finally, exchange rates are often affected by the unpredictable behavior of

opportunities, such as bonds and deposit certificates. Investment from

Conclusively, when the value of a nation's currency depreciates over a

Participants in the Global Monetary and Financial Systems

We have been able to appreciate the foreign exchange market as a

Now assess your understanding of this Section by answering the following

Did you score all? That’s great! Keep it up.

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