CHAPTER 10

Contents
Roles and functions
Market instruments
Types of transactions
Participants in the foreign exchange
market
Foreign exchange rates theories
Current developments

Introduction
Foreign exchange markets consist of
global telecommunications network among
large commercial banks that serve as
financial intermediaries
The need to exchange currencies
The price at which banks will buy a
currency (bid price) is slightly lower than
the price at which they will sell it (ask price)
The existence of the financial intermediaries
(commercial banks) makes the market more
efficient
Eliminate the problem of finding a counterparty
Introduction
Exchange Rate
An exchange rate is simply the ratio of one currency
valued against another. The first currency is referred
to as the base currency and the second as the
counter or quote currency. If buying, an exchange
rate specifies how much you have to pay in the
counter or quote currency to obtain one unit of the
base currency. If selling, the exchange rate specifies
how much you get in the counter or quote currency
when selling one unit of the base currency.

EUR/USD
base currency/quote currency

Bid/Ask Price
A currency exchange rate is typically given as a bid price and
an ask price. The bid price is always lower than the ask price.
The bid price represents what will be obtained in the quote
currency when selling one unit of the base currency. The ask
price represents what has to be paid in the quote currency to
obtain one unit of the base currency.

EUR/USD: .9726 / .9731

Example
The first component (before the slash) refers to the BID price
(what you obtain in USD when you sell EUR). In this example,
the BID price is .9726. The second component (after the slash)
is used to obtain the ASK price (what you have to pay in EUR if
you buy USD). In this example, the ASK price is .9731.

Introduction
Functions of the Foreign
Exchange Market
1. Transfer of purchasing power between
countries
International trade involve two countries with
different currencies. The trade can be invoiced in
one particular currency only
2. Obtain or provide credit for international trade
transactions
Since the movement of goods takes time, inventory
in transit must be financed. The use of bankers
acceptance and letters of credit as sources of credit.
3. Minimize exposure to the risks of exchange
rate changes
Provide hedging facilities for transferring foreign
exchange rate risk to someone else willing to carry
the risk
Market Instruments
Other than the currency traded on spot
transactions, there are also derivatives
currency.
Currency Forward/Futures
Currency Options

Just refer to our derivatives market
definitions for forward, futures and options.
The only difference here is the underlying
asset which is currency and price is
denoted by an exchange rate. So,
fluctuations of exchange rates means risk.
Type of Transactions
1. Spot
2. Forward
3. Swap

Spot transactions
Requires almost immediate delivery of
foreign exchange
In the interbank market, normally it takes
two business day to settle the transaction
Type of Transactions
Forward Transaction
Requires delivery at a future value date of a
specified amount of one currency for a
specified amount of another currency
The exchange rate is established at the time
of the agreement, but payment and delivery
are not required until maturity
Value dates of one, two, three, six and
twelve months
Type of Transactions
Swap transaction
The simultaneous purchase and sale of a
given amount of foreign exchange for two
different value dates
Both purchase and sale are conducted with
the same counterparty
A common type of swap is a spot against
forward
The dealer buys currency in the spot market
and simultaneously sells the same amount
back to the same bank in the forward market
Type of Transactions
Foreign Exchange Rates and
Quotations
A foreign exchange rate is the price of
one currency expressed in terms of
another currency
Interbank quotations can be made
based on
The foreign currency price of one RM
(US$0.3227/RM) or
The RM price of a unit of one foreign
currency (RM3.0960/US$)

Direct and Indirect Quotes
Have to identify home country currency
A direct quote is a home currency price of a
unit of foreign currency
An indirect quote is a foreign currency price
of a unit of home currency
Foreign Exchange Rates and
Quotations
Bid and Ask quotations
A bid is the price in one currency at which a
dealer will buy another currency
An ask is the price at which a dealer will sell
the other currency
The spread between bid and ask price will
be the profit for the dealer.
Foreign Exchange Rates and
Quotations
Market Participants
1. Bank and non-bank foreign exchange
dealers
Profit from the difference between bid (buying)
price and ask (selling) price
Dealers in the foreign exchange departments of
large international banks often function as
market makers
Currency trading is quite profitable for
commercial and investment banks
Normally market-making banks do not market in
every currencies
2. Individuals and firms conducting
commercial and investment transactions
Importers and exporters, international portfolio
investors, MNEs, tourists etc
3. Speculators and arbitragers
Seek to profit from the market itself
Speculators seek their profits from exchange
rate changes
Arbitragers profit from simultaneous exchange
rate differences in different markets

Market Participants
4. Central banks
Use the market to acquire or spend their countrys
foreign exchange reserve as well as to influence
the price at which their own currency is traded
Differ in motives and behavior from other
participants
5. Foreign exchange brokers
Agents who facilitate trading between dealers
without themselves becoming principals in the
transaction
Charge a small commission
Dealers use brokers for speed and because they
want to remain anonymous, since identity of
participants may influence short-term quotes
Market Participants
Factors that Determine the
Exchange Rates
The value of a currency adjusts to
change in demand and supply
conditions, moving toward equilibrium
Appreciate (increase in value) versus
depreciate (decrease in value)
Supply and demand of a currency are
influenced by various factors:
Differential inflation rates
Differential interest rates
Government intervention
Differential inflation rates
Example:
US inflation is greater than European inflation
Demand for European goods will increase,
reflecting in an increased in US demand for euros
The supply of euros to be sold for dollars will
decline as the European desire for US goods
decreases
This condition will place an upward pressure on
the value of euro
What about the opposite?
Factors that Determine the
Exchange Rates
Differential interest rates
Affect exchange rates through capital flows between
countries
Example:
Assume US interest rates are higher than European
interest rates
The demand by US investors for European interest-
bearing securities decreases as these securities
become less attractive
The supply of euros to be sold in exchange for dollars
increases as European investors increase their
purchase of US interest-bearing securities
This condition places a downward pressure on the
value of euro
Vice versa?
Factors that Determine the
Exchange Rates
Government intervention
Central banks commonly consider adjusting
a currencys value to influence economics
condition
For example, the government may wish to
weaken the currency to increase demand for
exports, which can stimulate the economy.
Nevertheless, this can cause inflation.
Direct intervention
By selling some of its reserves
Factors that Determine the
Exchange Rates
Government intervention
Indirect intervention
By influencing the factors that determine the
currency value
For example, interest rate
Foreign exchange controls
Factors that Determine the
Exchange Rates
Foreign Exchange Regime
An exchange-rate regime is the way an authority
manages its currency in relation to other currencies
and the foreign exchange market. It is closely related
to monetary policy and the two are generally
dependent on many of the same factors.

The basic types are a floating exchange rate, where
the market dictates movements in the exchange rate;
a pegged float, where a central bank keeps the rate
from deviating too far from a target band or value;
and a fixed exchange rate, which ties the currency to
another currency, mostly more widespread
currencies such as the U.S. dollar or the euro or a
basket of currencies.
Foreign Exchange Rate
Theories
Law of One Price
If the identical product or service can be sold in two different
markets, and no restrictions exist on the sale and transportation
costs of moving the product between markets, the products
price should be the same in both markets.
Purchasing Power Parity
If the law of one price is true for all goods and services, the
purchasing power parity (PPP) exchange rate could be found
from any individual set of prices
By comparing the prices of identical products denominated in
different currencies, we could determine the real or PPP
exchange rate that should exist if markets were efficient.
Absolute PPP states that spot exchange rate is determined by
the relative prices of similar baskets of goods.
Example: BigMac in Switzerland costs Sfr6.30, while the same
BigMac in the United States costs $2.54. Purchasing power
parity exchange rate
= Sfr6.30/$2.54 = Sfr2.4803/$
Relative Purchasing Power Parity
Says that the relative change in prices between
two countries over a period of time determines
the change in the exchange rate over that
period
If a country experiences inflation rates higher
than those of its main trading partners, and its
exchange rate does not change, its exports of
goods and services become less competitive
with comparable products produced elsewhere
Imports become more price competitive
Deficit in the current account in the balance of
payments


Foreign Exchange Rate
Theories
The Fisher Effect
States that nominal interest rates in each country are equal to
the required real rate of return plus compensation for expected
inflation
The International Fisher Effect
The relationship between the percentage change in the spot
exchange rate over time and the differential between
comparable interest rates in different national capital markets
Spot exchange rate should change in an equal amount but in the
opposite direction to the difference in interest rates between two
countries
(S
1
S
2
) / S
2
= i
H
i
F
, given that the spot exchange rates use
indirect quotes
Justification for the international fisher effect is that investors
must be rewarded or penalized to offset the expected change in
exchange rates

Foreign Exchange Rate
Theories
Interest Rate Parity
Interest rate parity is a no-arbitrage condition
representing an equilibrium state under which
investors will be indifferent to interest rates
available on bank deposits in two countries.
Two assumptions central to interest rate parity
are capital mobility and perfect substitutability of
domestic and foreign assets.
Given foreign exchange market equilibrium, the
interest rate parity condition implies that the
expected return on domestic assets will equal
the exchange rate-adjusted expected return on
foreign currency assets

Foreign Exchange Rate
Theories