CHAPTER 3.

FOREIGN EXCHANGE MARKET, EXCHANGE RATE

DETERMINATION, EXPOSIRE AND MANAGEMENT

Learning Outcomes

At the end of the chapter, you should be able to:

1. Analyze the structure and functioning of the foreign

exchange market.
2. Evaluate the various factors that influence exchange rate
determination including economic, political and market-
driven forces.
INTRODUCTION

The Forex market is a dynamic and integral component of the global

economy. Whether for international trade, investment, or speculative purposes,
understanding how the Forex market operates is crucial for anyone looking to
engage in global finance. It provides unique opportunities but also comes with
significant risks, particularly for those unfamiliar with its complexities.

Nature and Definition of Foreign Exchange Market

Foreign Exchange (Forex) refers to the global marketplace for trading

national currencies against one another, characterized by a daily trading volume of
approximately $6.6 trillion (Nusratullayevna, 2023). This decentralized market
operates over-the-counter (OTC), facilitating the buying, selling, and trading of
currencies at current or agreed-upon prices (Satyanaryana, 2023).
Foreign Exchange Market is the market in which exchange rates are
determined. It is a place where the trading of currencies and bank deposits
denominated in particular currencies takes place. The Forex market is influenced by
various factors, including economic indicators, political stability, and market
sentiment, making it a complex environment for traders (Meirinaldi et al., 2022)

Purpose of the Forex Market:

 Facilitate International Trade: Businesses and organizations use Forex to

exchange one currency for another when conducting international transactions.
 Investment: Investors and traders participate in Forex to profit from changes in
currency values.
 Hedging: Companies use Forex markets to hedge against currency risk,
especially when dealing with foreign suppliers or customers.

Concept of Foreign Exchange Rate

An exchange rate is defined as the price of one currency in terms of another,

serving as a crucial mechanism for international transactions and economic
interactions. It reflects the value of a currency relative to another and is influenced
by various factors, including market demand and supply, inflation, and interest
rates. The exchange rate represents the ratio at which one currency can be
exchanged for another(Meng, 2024).
 The foreign exchange rate (FX rate) is defined as the price at which one
currency can be exchanged for another, reflecting the relative value of currencies in
the global market. It plays a crucial role in international trade, investment decisions,
and economic performance. The FX rate indicates how much of one currency is
needed to purchase another, influencing trade balances and capital flows(AbuKuiek
et al., 2023).

Note: When a currency increases in value, it experiences appreciation, but when it

falls in value and is worth fewer dollars, it undergoes depreciation. In every
exchange rate quotation, therefore, there are always two currencies involved.
How foreign exchange rates affects our own daily lives in particular and the
Philippine economy in general?
 When the Philippine Peso becomes more valuable relative to foreign currencies,
foreign goods become cheaper (the greater amount of goods you can buy) for
Filipinos and Philippine goods become more expensive for foreigners.
 When the Philippine Peso falls in value, foreign goods become more expensive
for Filipinos and Philippine goods become cheaper for foreigners.

Whenever there is a great demand for dollars or other foreign currencies and
the Bangko Sentral has no adequate supply of such foreign currencies, then the
value of foreign currencies increases. In short, foreign exchange rates are basically
determined by law of supply and demand. If a central bank has no sufficient
international reserves, it imposes controls on demand, such as import control and
other similar measures so as to prevent the devaluation of the peso.

Importance of FOREX Rate

 Affects the relative price of domestic and foreign goods. The dollar price of
Philippine goods to American is determined by the interaction of two factors:
the price of Philippine goods in peso and the dollar/peso exchange rate.
 It serves as the basic link between the local and the overseas market for various
goods, services and financial assets. Using the exchange rate, we are able to
compare prices of goods, services, and assets quoted in different currencies.
 Affects the cost of servicing (principal and interest payments) on the country’s
foreign debt. A peso appreciation reduces the amount of pesos needed to buy
foreign exchange to pay interest and maturing obligations.

Kinds of FOREX Rate Transactions

 Spot Transactions – the predominant type of exchange rate transaction which

involves the immediate exchange of bank deposits denominated in different
currencies. Spot Exchange Rate – the exchange rate for a spot transaction.

 Forward Transactions – a transaction that involves the exchange of bank

deposits denominated in different currencies at some specified future date.
Forward Exchange Rate – the exchange rate for a forward transaction.
Changes in Exchange Rates
Under a floating exchange rate system, if more dollars are demanded than
are offered, the price of the dollar in terms of the peso will tend to increase; that is, it
will cost more pesos to acquire one dollar. If, on the other hand, more dollars are
offered than are demanded, the value of the dollar in terms of the peso will tend to
decrease; that is, it will cost less pesos to acquire
one dollar. In contrast, under a fixed rate system, a change in the exchange rate is
effected through an official announcement by the central bank.

Floating/Flexible Exchange Rate System. It is a system where the price of the dollar
relative to the peso is determined by the free market forces of demand and supply.
At present, this is our country`s foreign exchange rate policy.

A flexible exchange rate system is characterized by the value of a currency

being determined by market forces without direct government or central bank
intervention. This system allows for adjustments in response to economic
conditions, which can serve as a shock absorber for economies, particularly in
emerging markets. (Kohler & Stockhammer, 2022).

Types of Exchange Rates in the Basis of Monetary Policies

 Adjustable pegged rate – is fixed by the monetary authorities regardless of
demand and supply conditions in the market. The IMF may impose a fixed rate
of exchange in pursuance to restrictive policies in order to correct
disequilibrium in the balance of payments. It was also a measure to correct
deficit in the balance of payment.

 Free floating rate without official interventions – the opposite of the pegged
rate wherein the rate of exchange is determined by the interplay of demand and
supply condition at the foreign exchange market. The monetary authorities do
not intervene to influence the rate.

 Free floating rate with official intervention – this is known as the dirty float. The
monetary authorities allow the rate to fluctuate in accordance with the demand
and supply factors but the government intervenes in cases of extreme
fluctuations through open market operations. The Philippines is presently
adopting this policy.
Participants in the Foreign Exchange Market
 Foreign Exchange Dealers – they are those who are engaged in the buying and
selling of foreign exchange and who makes profit out of the difference between
the buying and selling of foreign exchange. In includes institutions as well as
individuals and brokers who act as middlemen in the foreign exchange market.

 Foreign Exchange Suppliers – they are those earn foreign exchange and, who
sell their money at the foreign exchange market in terms of domestic currency
and sometimes in other foreign currencies. Hence, creates supply of foreign
exchange in the market.

 Foreign Exchange Users – they are those who are in need of foreign exchange
such importers, Filipino tourists and students studying abroad.
 Activity 5.

1. List down the member-countries of the ASEAN and look/give its each
own currency.
2. Relate the relationship between them. (refer to number 1.)

The Bangko Sentral ng Pilipinas (BSP) maintains a floating exchange rate

system. Exchange rates are determined on the basis of supply and demand in the
foreign exchange market. The role of the BSP in the foreign exchange market is
principally to ensure orderly conditions in the market. The market-determination of
the exchange rate is consistent with the Government’s commitment to market-
oriented reforms and outward-looking strategies of achieving competitiveness
through price stability and efficiency.

In the Philippines, peso-dollar trading among Bankers Association of the

Philippines (BAP) member-banks and between these banks and the BSP are done
through the Philippine Dealing System (PDS).

Philippine Dealing System – the inter-bank foreign exchange center in the

Philippines. Here banks engage in buying and selling of foreign exchange with each
other.

Philippine Dealing and Exchange Corp. (PDEx) – an electronic platform

wherein the BAP-member banks participate in peso-dollar trading.

The BAP appointed PDEx as the official service provider for the USD/PHP
spot trading (which involve the purchase or sale of the US dollar for immediate
delivery, i.e., within one day for US dollars), and Reuters, as the exclusive distributor
of all PDEx data. Trading through the PDEx allows nearly instantaneous
transmission of price information and trade confirmations. Meanwhile, banks which
do not subscribe to PDEx can continue to deal peso-dollar spot transactions via
their Reuters Dealing screens.

Commercial banks in the Philippines are allowed to engage in spot, outright

forward, and swap transactions in Philippine pesos/US dollar and other third
currency transactions. Interbank trading is conducted among member-banks of the
BAP, and between these banks and the BSP. Member-banks of the PDS can also
deal through brokers.

At present, there are two foreign exchange brokers in the Philippines,

 Tulett Prebon (Philippines), Inc.
 CAP Philippines Inc.

For third currency trading, most commercial banks use the Reuters Dealing
and the Bloomberg Financial Services. The US dollar and Philippine peso legs of the
PDS transactions are settled in a Payment-versus-Payment (PvP) electronic system
for the local interbank spot and forward foreign exchange market.

The PvP links two real-time gross settlements systems:

 the BSP’s Philippine Payments and Settlements System (PhilPaSS) for the peso
transactions
 the Philippine Domestic Dollar Transfer System (PDDTS) for dollar transactions.
Philippine Depository and Trust Corporation (PDTC) - the designated clearing
entity for peso-dollar transactions of commercial banks under the BAP.

The PDDTS - is a local clearing and electronic communications system

operated by the BAP, the Philippine Clearing House Corporation (PCHC), Philippine
Securities and Settlements Corp. (PSSC) and Citibank, Manila.

It provides the banking industry with a facility to move US dollar funds from
one Philippine bank to another on the same day without having to go through
correspondent banks in the US. The system allows online, real-time gross
settlement of domestic interbank US dollar transfer and third party account-to-
account US dollar transfers.

In addition, it provides a facility for online inquiry and settlement of foreign

exchange transactions, where the PDDTS participants enter interbank US dollar and
Philippine peso transfer instruction in a single screen.