Chapter 9 Finmar

CHAPTER 9
FOREIGN EXCHANGE MARKETS (FOREX)

Is a global online network that buy and sell currency. It has no physical location, instead it is an over-the-counter market that
operates 24/7
💡 It is the largest and most liquid financial market in the world
EXCHANGE RATES - the rate at which a country’s currency can be traded for another country’s currency. Two components:
Domestic and Foreign currency
Flexible exchange rates - changes continously and is determined by the FOREX market
Fixed exchange rates - rarely changes and is set by the government
WHY IS EXCHANGE RATE IMPORTANT

Because they affect the relative price of domestic and foreign goods.
💡 Exchange rates are among the most watched and constantly evaluated economic measures.
FACTORS INFLUENCING THE MOVEMENTS OF EXCHANGE RATES

It fluctuates due to the imbalances between the supply and demand of the currency in the market.
💡 The more demand the more value.
INFLATION - Decreases the value of money, therefore making it harder for domestic manufacturers to export products
abroad.
INTEREST RATES - If a country has high interest rates in their currency, it will provide higher returns for lenders, due to this
there would be an increase in demand for that currency
BALANCE OF PAYEMENTS - The difference in how much a country is importing versus exporting. When countries import
goods, they buy the goods using that other currency which would increase the demand for that currency.
GOVERNMENT INTERVENTIION - Through intervention, the central bank of a country may support or depress the value of
its currency.
RECESSION - Recession causes lower interest rates which lowers the demand and therefore the value of the currency.
POLITICAL, ECONOMIC CONDITIONS, AND PUBLIC DEBT
HOW IS FOREIGN EXCHANGE TRADED
It is traded in the foreign exchange market which is an organized OTC market where currency is bought and sold by dealers.
SPOT TRANSACTIONS - Uses the spot exchange rate and involves immediate (two-day) exchange of bank deposits.
💡 The spot rate is the rate of exchange at the transaction date.
FORWARD TRANSACTIONS - Uses the forward exchange rate and involves the exchange of bank deposits at a
specified future date.
💡 The forward exchange rate is the rate of exchange at a specified future date.
DIRECT QUOTES - Indicates the units of domestic currency required to buy one unit of foreign currency.
CHAPTER 9 1
INDIRECT QUOTES - Indicates the number of foreign currency required to buy one unit of domestic currency:
Indirect Quote = 1/Direct Quote
CROSS RATES - The indirect computation of the exchange rate of one currency from the exchange rates of two other
currencies
ARBITRAGE/TRIANGLE ARBITRAGE - Buy and sell strategy in more than one market to make a riskless profit.
CHAPTER 9 2
Take one euro, convert it into dollars, then back into euros again. What would happen is that the trader would have more
euros than what he had before. This occurs because of spot exchange rates.
💡 Person involved in arbitrage is called arbitrageur
INTERACTION IN FOREIGN MARKETS

The equilibrium exchange rate in floating markets are determined by the supply and demand of currencies.
If the exchange rate is too high, it would create a deficit in the balance of payments
If the exchange rate is too low, it would create a surplus in the balance of payments.
CHAPTER 9 3
MANAGED FLOAT - It is the current method of exchange rate determination wherein the central banks intervenes to maintain a
fairly stable exchange rate.
💡 The reason this happens is because floating rates change and so permits adjustments to eliminate balance of payments
deficits or surplus.
THEORY OF PURCHASING POWER PARITY
Exchange rates between any two countries will adjust to reflect changes in the price levels of the two countries
💡 This relies solely on changes in the relative price levels and assumes that all the goods in both countries are
identical
FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN
1. Relative Price Levels
A rise in price level causes currency to depreciate, while a decrease causes currency to appreciate
2. Trade Barriers
Trade barriers decrease the number of imported goods thus causing currency to appreciate
3. Preferrence for Domestic vs. Foreign Goods
Increased demand for exports causes currency to appreciate, while increase demand for imports, causes currency to
depreciate.
4. Productivity
Higher country productivity leads to higher currency value.
ADDITIONAL INFO:
An exchange rate is basically domestic bank deposits that are in terms of foreign bank deposits.
To investigate short-run determination of exchange rates the asset market approach is used.
The differnce between the earlier approarch and the current and modern approach is as follows
CHAPTER 9 4
EARLIER APPROACH MODERN APPROACH
Emphasized the role of export and demand Focuses on the decisions to hold domestic or foreign
assets
FOREIGN EXCHANGE RISKS

Importers, exporters, investors, and multinational firms are exposed to foreign exchange risks when doing international
transactions that involve more than one currency. They may receive less revenue if the value of the currency falls.
To combat this firms can:
Hedge in the forward exchange markets, money markets, and currency future markets.
Minimize receivables and liabilities denominated in foreign currencies
Use of trigger pricing
Minimizing risks through diversification
💡 A speculative forward contract does not hedge any exposure, rather it creates the exposure.
CHAPTER 9 5

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CHAPTER 9

FOREIGN EXCHANGE MARKETS (FOREX)

💡 It is the largest and most liquid financial market in the world

Fixed exchange rates - rarely changes and is set by the government

WHY IS EXCHANGE RATE IMPORTANT

FACTORS INFLUENCING THE MOVEMENTS OF EXCHANGE RATES

💡 The more demand the more value.

POLITICAL, ECONOMIC CONDITIONS, AND PUBLIC DEBT

HOW IS FOREIGN EXCHANGE TRADED

💡 The spot rate is the rate of exchange at the transaction date.

💡 Person involved in arbitrage is called arbitrageur

INTERACTION IN FOREIGN MARKETS

THEORY OF PURCHASING POWER PARITY

FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN

1. Relative Price Levels

3. Preferrence for Domestic vs. Foreign Goods

Higher country productivity leads to higher currency value.

FOREIGN EXCHANGE RISKS

Minimize receivables and liabilities denominated in foreign currencies

Use of trigger pricing

Minimizing risks through diversification

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