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THE FOREIGN EXCHANGE MARKET

By Derek Boyd,2014-09-29 13:38
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THE FOREIGN EXCHANGE MARKET

THE FOREIGN EXCHANGE MARKET

Foreign Exchange

    Foreign exchange is the act of trading different nations?? moneys. 1.Demand deposits in banks

    2.Paper moneys

    3.Coins

    Foreign exchange rate is the price of one nation??s money in terms of another nation??s money.

Foreign Exchange Market

    The foreign exchange market is the market in which national moneys are traded for other national moneys.

    1.24-hour market / geographic dispersion

    2.Enormous trading volumes ($1.2 trillion on Forex vs. $42 billion on NY Stock Market per day,2001)

    3.Most trading involves U.S. dollars

    4.Retail vs. Interbank part of the market

Levels of Access

     Stock market vs. Forex market:

    1.No central exchange or clearing house: OTC market

    2.Forex market is divided into levels of access.

     Retail parts vs. Interbank parts

    1.Trading volume

    2.Difference in spreads : difference between bid and ask price

Inter-bank Market

    Suppose that bank in London may be unwilling to continue holding the pounds??

    1.The top-tier inter-bank market accounts for more than 50% of all transactions.

    2.Participants in inter-bank market: commercial banks and investment banks

    3.Active participants in retail part of the market: smaller investment banks, multi-national corporations, hedge funds, pension funds, insurance companies, mutual funds, other institutional investors

Exchange Rates

    An exchange rate is the price of one currency in terms of another currency.

    ????? Two currencies involved

    ????? Timing of delivery

    1.? Spot

2.?? Forward

    (An other rate is the future spot rate.)

    As a U.S. dollar price of the other currency.

     $1.7621/?ê $0.1462/rmb

    As the price of the U.S. dollar in units of the other currency.

     ?ê0.5675/$ rmb6.8406/$

    The reciprocals of each other

Direct vs. Indirect Quotation

    1.Direct Quotation: Rates quoted in terms of a variable number of home currency per fixed foreign currency unit.

    rmb6.8406/$

    2.Vice Versa

    $0.1462/rmb

What makes the ER rise or fall?

    All the transactions create supply and demand for foreign currencies, which determine the exchange rate, within certain foreign exchange system.

Demand & Supply

    1.Imports of goods and services and capital outflows (as well as income payments to foreigners) create a demand for foreign currency. 2.Exports of goods and services and capital inflows (as well as income received from foreign sources) create a supply of foreign currency.

Why Does Demand Curve Slope Downward?

    When the pound declines from $1.98 to $1.6, the Americans will find more use of it

    $1.98/ ?ê ?Á ?ê 50 = $99

    $1.60/ ?ê ?Á ?ê 50 = $80

Why Does Supply Curve Slope Upward?

    When the pound declines from $1.98 to $1.6, the British will be reluctant to buy American goods.

    $99 ? $1.98/ ?ê = ?ê 50

    $99 ? $1.60/ ?ê = ?ê 61.87

Why Does Demand Curve Shift??

    The following will drive it to the right:

    Increase in demand for U.K. products. (caused by forces other than changes in the exchange rate)

    A rise in U.S. residents?? willingness to invest in pound-denominated financial assets

Why Does Supply Curve Shift??

    The following will drive it to the right:

    Increase in U.K. residents?? demand for U.S. products (caused by forces other than changes in the exchange rate) .

    A rise in U.K. residents?? willingness to invest in U.S. dollar-denominated financial assets.

Floating Exchange Rates

    1.The simplest system

    2.The formation of exchange rates is market-driven, purely by the interaction of private demand and supply for that currency. 3.No intervention by government or currency authority.

Fixed Exchange Rates

    1.Heavy intervention by government or currency authority. 2.A fixed exchange rate is maintained even if this rate the government chooses differs from the current equilibrium rate.

Changes in Exchange Rates

    Appreciation vs. depreciation under floating exchange rate regime Revaluation vs. devaluation under fixed exchange rate regime.

Can these happen?

    $1.7/?ê in New York while $1.6/?ê in London

    $1.7/?ê, SFr3/Pound & $0.50/SFr exist at a point in time?

Arbitrage in the spot market

    Arbitrage is a process of buying and selling to make a (nearly) riskless pure profit, which ensures the rates in different locations essentially the same.

A Suggested Answer

    Firstly, purchase Swiss Francs with my 150 dollars at $0.5/SFr: $150=SFr300

    Secondly, purchase Pounds in exchange for Swiss Francs at SFr3/?ê: SFr300=?ê100

    Thirdly, receive dollars in exchange for Pounds at $1.7/?ê: ?ê100=$170

    The total profit is $20.

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