CHAPTER 3

Foreign Exchange and its

Significance
WHAT IS FOREIGN EXCHANGE
(FOREX) 

Foreign exchange, or forex, is

the conversion of one
country's currency into
another. 
 Foreign exchange is bought and sold because
payments from one country to another require
the exchange of domestic for foreign currency,

Rate of Exchange since each can use its own currency only for
domestic trade.

Foreign exchange is like almost any other

commodity, the price or “rate of exchange” of
which fluctuates in accordance with demand
and supply. By definition then, a rate of
exchange is simply the price which must be paid
in terms of local currency in exchange for a unit
of foreign money.
Thus, if the rate of dollar is 48 in terms pesos, it
simply indicates the fact that for every dollar,
one must be ready and willing to offer 48 pesos.
In as much as the exchange rates are prices, like
all prices they are subject to fluctuations in
accordance with the interaction of the market
forces of supply and demand. Specifically, with
respect to the rates of exchange , their
fluctuations are determined in the market by
the international demand for the supply of
currencies.
Classification of Rates
As in the purchase and sale of
any commodity, many different
prices or rates are quoted, and
they vary from bank to bank
and from one time to another.
1. Buying rate and selling
rate
2. Sight or demand and time
rate
3. Spot and forward rate
Buying Rate and Selling Rate
The main difference
Buying Selling between buying rates and
selling rates is on the
basis of the position of
the bank. A buying rate is
a price at which bank will
buy a unit of foreign
currency.
On the other hand , a
selling rate is the price at
which the bank will sell a
unit of that currency.
Sight or Demand Rates and
Time Rates
Apply to the purchase and sale
of foreign exchange
instruments which are payable
upon presentation to the
drawees (when the reserved
order is purchased). While
time rates refer to instruments
that have maturity dates.
(Should be paid on the agreed
date)
Spot Rate and Forward Rate Exchange rates can have what is called
a spot rate, or cash value, which is the
current market value. It is being paid
after the immediate delivery of the
instrument. Alternatively, an exchange
rate may have a forward value, which is
based on expectations for the currency
to rise or fall versus its spot price. (Can
get a discount once paid earlier than
the agreed date depending on the rate
of foreign exchange on that agreed
date)
Forward rate values may fluctuate due
to changes in expectations for future
interest rates in one country versus
another. For example, let's say that
traders have the view that the eurozone
will ease monetary policy versus the
U.S. In this case, traders could buy the
dollar versus the euro, resulting in the
value of the euro falling.
Significance of
Exchange Rates

Today, we live in a world where the exchange of goods and services

happens for money. This money is in the form of a particular
currency. Now, the value of one currency will not be the same as
that of another and this is where the need for foreign exchange
arises. This is why Foreign Currency is the spine of international
investments and global trading. Without it, it would be nearly
impossible to determine the value of goods and services imported
and exported by different countries to each other. And without
having the possibility to trade, companies that rely on overseas
resources and talent would be completely crippled. Also, there
would be major problems for foreign travelers to buy or sell
anything while abroad thereby making foreign exchange so
important.
Supply and Demand for Foreign
Exchange
From the point of view of
any nation, any foreign
exchange transaction has
the effect of either
increasing or decreasing
its supply of foreign
exchange. It should be
made clear at the outset
that exports result in an
increase in the supply of
foreign exchange,
whether exports of goods
or services.
Merchandise Exports and Imports
Under present day conditions, such as favorable balance of
trade would mean an increasing supply of foreign exchange.
Tourist’s Expenditures
When tourist travel, they make sue of Philippine transport
facilities, eat food prepared in the Philippines with the use of
domestic resources and domestic labor and buy tickets for
entertainment. All these mean money for this country, which
obviously becomes a source of supply of foreign exchange.

Shipping Services
It is necessary to stress the importance of ocean shipping to a
country’s economy. The possession of an adequate and strong
merchant marine, which has been the objective of many
countries in the world including the Philippines, means not
only an earner of foreign exchange by providing shipping
services to countries which do not have such transportation
facilities in moving their products to different foreign markets
but, in times of emergency, as facilities for transporting troops
and supplies.
Banking and Insurance Services
In many principal cities of the world are located commercial banks some
of which are owned by nationals while a few which act or serve as agent
banks of certain banking institutions are owned by foreigners. The profit
derive in the operation are remitted to their head offices, and this
results in an outflow of foreign exchange.
Similar situation can be observed in field of insurance. These insurance
companies issue marine insurance policies to exporters to cover exports
to different countries of the world. It will create a demand for foreign
exchange in the country where foreign insurance companies render
their services. The foreigners doing business in foreigners doing
business in foreign countries create a supply of foreign exchange for
their countries since the payment of services rendered will have to be
remitted to their respective countries.
Immigrant Remittances
Sending money from other country going to the birth country
Miscellaneous Items
Quite a number of individual belonging to the moneyed-group invest in
a sizeable amount of their money abroad. Some of them go into actual
investments themselves by putting up plants, factories and
establishments in foreign countries with the expectation of reward in
the future.
Foreign Exchange Market
The foreign exchange market or the ‘forex market’, is a system which
establishes an international network allowing the buyers and sellers to
carry out trade or exchange of currencies of different countries.
The principal market facilities for foreign exchange transactions consist
largely of commercial banks who are authorized agent banks of the
Central Bank of the country. A number of the larger commercial banks
maintain balances in one or more foreign countries and in some
instances operate branches abroad.
Accordingly, balances are built up by the purchase of drafts or claims
payable abroad and are reduced as a consequence of sales of such
funds made to purchasers thereof or debtors in need of them.
Commercial banks are constantly coming into possession of foreign
bills as for instance when exporters turn over their proceeds from their
sales abroad and have them converted into their equivalent in local
currency. Thus, commercial banks serve as a market place for foreign
exchange transactions buying and selling foreign exchange.
Characteristics of the Foreign
Exchange Market
• Market Transparency: It is effortless to monitor the fluctuations in
the value of currencies of different countries in a forex market easily
through account tracking and real-time portfolio, without the
involvement of brokers.
• Dollar is Extensively Traded Currency: The USD, which is paired with
almost every country’s currency and listed on the forex, is the most
widely traded currency in the world.
• Most Dynamic Market: The value of the currencies in the forex
market keeps on changing every second and function twenty-four
hours a day. This makes it one of the most active markets in the
world.
• International Network of Dealers: The foreign exchange market
establishes a medium among the dealers and also with the
customers. There are dealer’s institutions located globally to carry
out the exchange and trading activities.
• “Over-The-Counter” Market: In different countries, the forex market
is the highly unregulated market initiating over the counter trade by
the banks through telex and telephone.
• High Liquidity: The currency is considered to be the most widely
traded financial instrument across the globe, making the forex
market highly liquid.
• Twenty-Four Hour Market: The foreign exchange market is
operational for twenty-four hours of the day, initiating the active
trade and exchange of currencies at any time.
The participants in a forex market include the
following five parties:
1. Central Bank: The central bank regulates the exchange rates
of the currency of their respective country to ensure
fluctuations within the desired limit and keep control over the
money supply in the market.
2. Commercial Banks: The commercial banks are the medium
of forex transactions, facilitating international trade and
exchange to its customers along with other forex functions like
making foreign investments.
3. Traditional Users: The traditional users involve foreign
tourists, companies carrying out business operations across
the globe, patients taking treatment in other country’s
hospitals and students studying abroad.
4. Traders and Speculators: The traders and speculators are
the opportunity seekers and look forward to making a profit
through trading on short-term market trends.
5. Brokers: They are considered to be financial experts who
act as an intermediary between the dealers and the investors
by providing the best quotations.
Advantages of Foreign Exchange
Market
1. High Leverage: A forex investor can avail the facility of leverage or loan
of up to 20 or 30 times of his/her capacity, for trading in the forex market.
2. International Trade: Every country has its currency and therefore, to
facilitate trade activities between two countries, the forex market is
essential.
3. Trading Option: For the speculators or traders, foreign exchange market
is just like other financial markets where they can make money on short
term fluctuations in the currencies.
4. Flexibility: We know that the forex market is a twenty-four-seven
market, and there is no minimum or maximum limit of the exchange
amount. It provides the flexibility of investment or exchange to the traders.
5. Hedging Risk: The forex market provides for hedging the risk of loss on
currency fluctuations while carrying global business operations and trading
in foreign currency.
6. Low Transaction Costs: Since brokers are not very much entertained in
the forex market, the transaction cost (called as ‘spread’) charged by the
dealers is reasonably low if compared to other financial markets.
7. Inflation Control: To maintain the economic stability in the country
and control situations like inflation, the central bank maintains a forex
reserve which consists of currencies of different countries around the
world.
Disadvantages of Foreign
Exchange Market

1. Leverage Risks: Leverage refers to loan in other terms. Forex

market initiates the leverage of up to 20 to 30 times the
investment capacity of the traders or speculators, which may
even lead the loss of the entire amount of the investor.
2. Counterparty Risks: The forex is highly unregulated with no
central authority for currency exchange or trading risk
mitigation. Thus, it may encounter the risk of non-fulfilment of
the obligations by any of the parties involved in such a
contract.
3. Operational Risks: Since forex is a twenty-four hours
market, it is difficult to manage its operations by humans. As a
result, the traders rely on the algorithms, and trading desks
spread, respectively, to safeguard their investment in their
absence.