TOPIC 11

FOREIGN
EXCHANGE
MARKET
Structure of Foreign Exchange
Market
• Characteristics of the market

– No single marketplace
– An OTC market
– Dealers
– Twenty-four hour trading
– Efficient communications systems
– Exchange rate between two currencies
– Demand and supply - determine the rate of
exchange
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 Operations of the FX market
• The FX market:
– Is a global market, operating 24 hours a day according to business hours
across the time zones

• The FX market never sleep

– The time zone chart below gives some idea of the 24-hour trading
potential between the world-wide financial centre
GMT

0 4 8 12 16 20 24

Sydney
Tokyo

London

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 Structure of Foreign Exchange
Market
• Major Participants

– Large multinational commercial banks

– Foreign exchange departments of investment
banks
– Central banks
– Businesses
– Individuals
 Foreign Exchange Market
• The foreign exchange market allows
currencies to be exchanged in order to
facilitate international trade or financial
transactions.
• The system for exchanging foreign
currencies has evolved from the gold
standard, to agreements on fixed
exchange rates, to a floating rate system.
 Spot Rate
• Done on a spot basis (spot rate)
• Exchange of currencies – currency is brought against the
sale of another currency, delivery date for the settlement
of the deal is two working days after the date the deal is
entered into.

• Day of spot deal Delivery day

Monday Wednesday
Tuesday Thursday
Wednesday Friday
Thursday Monday
Friday Tuesday
Forward Exchange Contracts
• Purpose: to hedge foreign exchange exposure.
• Benefit of hedging:
(a) customer knows the exchange rate he is buying
or selling in a particular currency sometime in the
future, regardless of the market fluctuations.
(b) Customer is able to ascertain the amount of
Ringgit needed for a payment or amount of Ringgit
received in advance.
(c) Profits on exports or cost of imports are
determined, thus allowing for better cash
management.
Forward Exchange Contracts
• Example:
An importer needs foreign currency to pay for
his imports in future. If exchange rate goes
up, he will need more Ringgit to pay for his
imports.
Thus, to minimize his foreign exchange risk,
he can enter into a forward exchange
contract - buy foreign currency from the bank
at a future date.
Forward Exchange Contracts
• Types of forward exchange contract
(a) Fixed Forward Exchange Contract
- delivery date (value date) is fixed at
some specified date.
(b) Option Forward Exchange Contract
- customer has the option to take up
the contract at any time during the
option period.
 Foreign Exchange
Transactions
• Banks provide foreign exchange services for a
fee: a bank’s bid (buy) quote for a foreign
currency will be less than its ask (sell) quote.
bid/ask spread = ask rate – bid rate
ask rate
Example Suppose bid price for £ = $1.52,
ask price = $1.60.
Spread = (1.60 – 1.52) = .05 or 5%
1.60
 Foreign Exchange
Transactions
• The spread on currency quotations is
positively influenced by order costs,
inventory costs, and currency risk, and
negatively influenced by competition, and
volume.

• The markets for heavily traded currencies

like the €, £, and ¥ are very liquid.
 Exchange Rates in the Short Run: Equilibrium

• Equilibrium
– Supply = Demand at E*
– If Et > E*, Demand <
Supply, sell $, value of
Et 
– If Et < E*, Demand >
Supply, buy $, value of
Et 

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 1. Explaining Changes in Exchange Rates: Increase in iD

1. Demand curve
shifts right when
– iD : people will
hold more dollars
2. This causes
domestic currency
($) to appreciate.

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 2. Explaining Changes in Exchange Rates: Increase in iF

1. Demand curve
shifts left when
– iF : because
people want to
hold fewer dollars
2. This causes
domestic currency
to depreciate.

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 3. Explaining Changes in Exchange Rates: Increase in
Expected Future FX Rates

1. Demand curve
shifts right when
– E:te1because
people want to
hold more dollars
2. This causes
domestic currency
to appreciate.

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Explaining Changes in Exchange Rates: Response to i 
Because πe 

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 Explaining Changes in Exchange Rates: Changes in the
Money Supply

1. Ms , P , Eet+1 ,
shifting demand
curve from D1 to D2.
2. In long run, iD returns
to old level, and
demand shifts from
D2 to D3 (exchange
rate overshooting)

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 Trading Foreign Exchange
• Commercial banks are dealers.
• Maintain inventory of currencies to meet customer needs.
• Must avoid large currency losses with changes in
exchange rates.
• Regulation prohibits U. S. banks from making speculative
currency trades.
• Trading is generally done by telephone, telex, or the
Swift (Society for Worldwide Inter-bank Financial
Telecommunications) system
• Inter-bank clearing system through correspondent
relationships
• Trading by small group of traders

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