Foreign Exchange Markets

and Exchange Rates

 Foreign Exchange Markets
and Exchange Rates
LEARNING GOALS:
After reading this chapter, you should be able to:
• Understand the meaning and functions of the
foreign exchange market
• Know what the spot, forward, cross, and effective
exchange rates are
• Understand the meaning of foreign exchange risks,
hedging, speculation, and interest arbitrage
 Introduction
• The foreign exchange market is the market in which
individuals, firms, and banks buy and sell foreign
currencies or foreign exchange.
• The foreign exchange market for any currency —say,
the U.S. dollar—is comprised of all the locations
(such as London, Paris, Zurich, Frankfurt, Singapore,
Hong Kong, Tokyo, and New York) where dollars are
bought and sold for other currencies.
• These different monetary centers are connected
electronically and are in constant contact with one
another, thus forming a single international foreign
exchange market.
 Introduction
• The foreign exchange market is merely a part of the money
market in the financial centers.
• It is not restricted to any given country or a geographical
area. It is the market for a national currency (foreign
money) anywhere in the world, as the financial centers of
the world are united in a single market.
• There is a wide variety of dealers in the foreign exchange market.
The most important among them are the banks. Banks dealing in
foreign exchange have branches with substantial balances in
different countries.
• Through their branches and correspondents, the services of such
banks, usually called “Exchange Banks,” are available all over the
world.
 Introduction
• These banks discount and sell foreign bills of exchange,
issue bank drafts, effect telegraphic transfers and other
credit instruments, and discount and collect amounts on
the basis of such documents.
• Other dealers in foreign exchange are bill brokers who help
sellers and buyers in foreign bills to come together. They
are intermediaries and unlike banks are not direct dealers.
• Acceptance houses are another class of dealers in foreign
exchange. They help effect foreign remittances by
accepting bills on behalf of customers. The central bank
and treasury of a country are also dealers in foreign
exchange. Both may intervene in the market occasionally.
Functions of the Foreign Exchange Markets
• The following are the important functions of a
foreign exchange market:
1. To transfer finance, purchasing power from one
nation to another. Such transfer is affected
through foreign bills or remittances made through
telegraphic transfer. (Transfer Function).
2. To provide credit for international trade. (Credit
Function).
3. To make provision for hedging facilities, i.e., to
facilitate buying and selling spot or forward
foreign exchange. (Hedging Function).
Functions of the Foreign Exchange Markets
• The principal function of foreign exchange markets is the
transfer of funds or purchasing power from one nation and
currency to another. This is usually accomplished by an
electronic transfer and increasingly through the Internet.
• A domestic bank instructs its correspondent bank in a
foreign monetary center to pay a specified amount of the
local currency to a person, firm, or account.
• The demand for foreign currencies arises when tourists
visit another country and need to exchange their national
currency for the currency of the country they are visiting,
when a domestic firm wants to import from other nations,
when an individual or firm wants to invest abroad, and so
on.
Functions of the Foreign Exchange Markets
• Conversely, a nation’s supply of foreign currencies arises
from foreign tourist expenditures in the nation, from export
earnings, from receiving foreign investments, and so on.
• For example, suppose a U.S. firm exporting to the United
Kingdom is paid in pounds sterling (the U.K. currency). The
U.S. exporter will exchange the pounds for dollars at a
commercial bank.
• The commercial bank will then sell these pounds for dollars
to a U.S. resident who is going to visit the United Kingdom,
to a U.S. firm that wants to import from the UK and pay in
pounds, or to a U.S. investor who wants to invest in the UK
and needs the pounds to make the investment.
Functions of the Foreign Exchange Markets
• A nation’s commercial banks operate as clearinghouses
for the foreign exchange demanded and supplied in the
course of foreign transactions by the nation’s residents.
• Those U.S. commercial banks that find themselves with
an oversupply of pounds will sell their excess pounds
(through the intermediary of foreign exchange brokers)
to commercial banks that happen to be short of pounds
needed to satisfy their customers’ demand.
• In the final analysis, then, a nation pays for its tourist
expenditures abroad, its imports, its investments abroad,
and so on with its foreign exchange earnings from tourism,
exports, and the receipt of foreign investments.
Functions of the Foreign Exchange Markets
• If the nation’s total demand for foreign exchange
exceeds its total foreign exchange earnings, the rate
at which currencies exchange for one another will
have to change to equilibrate the total quantities
demanded and supplied.
• If such an adjustment in the exchange rates were not
allowed, the nation’s commercial banks would have
to borrow from the nation’s central bank.
• The nation’s central bank would then act as the
“lender of last resort” and draw down its foreign
exchange reserves (a BOPs deficit of the nation).
 Levels of Transactors or Participants
• On the other hand, if the nation generated an excess supply of
foreign exchange in the course of its business transactions
with other nations (and if adjustment in exchange rates were
not allowed), this excess supply would be exchanged for the
national currency at the nation’s central bank, thus increasing
the nation’s foreign currency reserves (a BOPs surplus).
• Thus, four levels of transactors or participants can be
identified in foreign exchange markets.
• At the bottom, or at the first level, are such
traditional users as tourists, importers, exporters,
investors, and so on. These are the immediate users
and suppliers of foreign currencies.
 Levels of Transactors or Participants
• Second level is the commercial banks, which act as clearing
houses between users and earners of foreign exchange.
• At the third level are foreign exchange brokers, through
whom the nation’s commercial banks even out their foreign
exchange inflows and outflows among themselves (the so-
called interbank or wholesale market).
• Finally, at the fourth and highest level is the nation’s central
bank, which acts as the seller or buyer of last resort when
the nation’s total foreign exchange earnings and
expenditures are unequal.
• The central bank then either draws down its foreign
exchange reserves or adds to them.
 Daily Trading in Foreign Exchange Markets
• The Bank for International Settlements (BIS) in Basel,
Switzerland, estimated that the total of foreign
exchange trading or “turnover” for the world as a
whole averaged $6.6 trillion per day in April 2019, up
from $3.3 trillion in 2007, $1.9 trillion in 2004, and
$1.2 trillion in 2001.
• Banks located in the UK accounted for nearly 37% of
all foreign exchange market turnover, followed by
the US with about 18%, Japan with about 6%,
Singapore, Switzerland, and Hong Kong each with
about 5%, Australia with about 4%, and the rest with
other smaller markets.
Functions of the Foreign Exchange Markets
• Another function of foreign exchange markets is the
credit function. To promote foreign trade, credit is
usually needed when goods are in transit and also to
allow the buyer time to resell the goods and make the
payment. In general, exporters allow 90 days for the
importer to pay. When foreign bills of exchange are used
in international payments, a credit for about 3 months,
till their maturity, is required.
• As a result, the exporter receives payment right away,
and the bank will eventually collect the payment from
the importer when due. Still another function of foreign
exchange markets is to provide the facilities for hedging
and speculation.
Functions of the Foreign Exchange Markets
• Hedging means the avoidance of a foreign exchange risk.
When exchange rate, i. e., the price of one currency in terms
of another currency, change, there may be a gain or loss to
the party concerned. Under this condition, a person or a firm
undertakes a great exchange risk if there are huge amounts of
net claims or net liabilities which are to be met in foreign
money.
• Exchange risk as such should be avoided or reduced. For this
the exchange market provides facilities for hedging
anticipated or actual claims or liabilities through forward
contracts in exchange.
• A forward contract which is normally for 3 months is a
contract to buy or sell foreign exchange against another
currency at some fixed date in the future at a price agreed
upon now.
 Types of Foreign Exchange Markets
• Foreign exchange market is of two types, viz.; retail market
and wholesale market, also termed as the inter-bank market.
• In retail market, travelers and tourists exchange one currency
for another. The total turnover in this market is very small.
• Wholesale market comprises of large commercial banks,
foreign exchange brokers in the inter-bank market,
commercial customers, primarily MNCs and Central banks
which intervene in the market from time to time to smooth
exchange rate fluctuations or to maintain target exchange
rates.
• Over 90% of the total volume of the transactions is
represented by inter-bank transactions and the remaining
10% by transactions between banks and their non-bank
customers.
 Features of the Foreign Exchange Markets
• The foreign exchange is similar to the over-the
counter market in securities. It has no centralized
physical market place (except for a few places in
Europe and the futures market of the International
Monetary Market of the Chicago Mercantile
Exchange) and no fixed opening and closing time.
• The trading in foreign exchange is done over the
telephone, telexes, computer terminals and other
electronic means of communication.
• It is interesting to note that bulk of the turnover in
the international exchange market is represented by
speculative transactions.
 Participants in Foreign Exchange Market
• Participants in Foreign exchange market can be
categorized into five major groups, viz.; commercial
banks, Foreign exchange brokers, Central bank, MNCs
and Individuals and Small businesses.
1. Commercial Banks:
• The major participants in the foreign exchange market
are the large Commercial banks who provide the core of
market. As many as 100 to 200 banks across the globe
actively “make the market” in the foreign exchange.
• These banks serve their retail clients, the bank
customers, in conducting foreign commerce or making
international investment in financial assets that require
foreign exchange.
 Participants in Foreign Exchange Market
• These banks operate in the foreign exchange market
at two levels. At the retail level, they deal with their
customers-corporations, exporters and so forth.
• At the wholesale level, banks maintain an inert bank
market in foreign exchange either directly or through
specialized foreign exchange brokers.
• The bulk of activity in the foreign exchange market is
conducted in an inter-bank wholesale market-a
network of large international banks and brokers.
• Whenever a bank buys a currency in the foreign
currency market, it is simultaneously selling another
currency.
 Participants in Foreign Exchange Market
• A bank that has committed itself to buy a certain
particular currency is said to have long position in
that currency. A short-term position occurs when the
bank is committed to selling amounts of that
currency exceeding its commitments to purchase it.
2. Foreign Exchange Brokers:
• Foreign exchange brokers also operate in the
international currency market. They act as agents
who facilitate trading between dealers. Unlike the
banks, brokers serve merely as matchmakers and do
not put their own money at risk.
 Participants in Foreign Exchange Market
• They actively and constantly monitor exchange rates
offered by the major international banks through
computerized systems and are able to find quickly an
opposite party for a client without revealing the identity
of either party until a transaction has been agreed upon.
• This is why inter-bank traders use a broker primarily
to disseminate as quickly as possible a currency
quote to many other dealers.
3. Central banks
• CBs frequently intervene in the market to maintain the
exchange rates of their currencies within a desired range
and to smooth fluctuations within that range.
 Participants in Foreign Exchange Market
• The level of the bank’s intervention will depend upon
the exchange rate regime flowed by the given
country’s Central bank.
4. MNCs:
• MNCs are the major non-bank participants in the
forward market as they exchange cash flows
associated with their multinational operations.
• MNCs often contract to either pay or receive fixed
amounts in foreign currencies at future dates, so
they are exposed to foreign currency risk.
• This is why they often hedge these future cash flows
through the inter-bank forward exchange market.
 Participants in Foreign Exchange Market
5. Individuals and Small Businesses:
• Individuals and small businesses also use foreign
exchange market to facilitate execution of
commercial or investment transactions.
• The foreign exchange needs of these players are
usually small and account for only a fraction of all
foreign exchange transactions.
• Even then they are very important participants in the
market. Some of these participants use the market to
hedge foreign exchange risk.
 Segments of Foreign Exchange Market
• There are two segments of foreign exchange market,
viz., Spot Market and Forward Market.
1. Spot Market:
• In spot market currencies are exchanged immediately
on the spot. This market is used when a firm wants
to change one currency for another on the spot.
• Within minutes the firm knows exactly how many
units of one currency are to be received or paid for a
certain number of units of another currency.
• For instance, a US firm wants to buy 4000 books from
a British Publisher.
 Segments of Foreign Exchange Market
• The Publisher wants four thousand British Pounds for
the books so that the American firm needs to change
some of its dollars into pounds to pay for the books.
• If the British Pound is being exchanged, say, for US $
1.70, then £ 4,000 equals $ 6800.
• The US firm simply pays $ 6800 to its bank and the bank
exchanges the dollars for 4000 £ to pay the British Publisher.
• In the Spot market risks are always involved in any
particular currency. Regardless of what currency a
firm holds or expects to hold, the exchange rate may
change and the firm may end up with a currency that
declines in values if it is unlucky or not careful.
 Segments of Foreign Exchange Market
2. Forward Market:
• Forward market has come into existence to avoid
uncertainties. In forward market, a forward contract
about which currencies are to be traded, when the
exchange is to occur, how much of each currency is
involved, and which side of the contract each party is
entered into between the firms.
• With this contract, a firm eliminates one uncertainty,
the exchange rate risk of not knowing what it will
receive or pay in future.
• However, it may be noted that any possible gains in
exchange rate changes are also estimated and the
contract may cost more than it turns out to be worth.
 Segments of Foreign Exchange Market
• For example, suppose that the 90 day forward price of the
British pound is 2.0 (US$ 2.00 per £) or quoted £ 0.50 per US
$, and that the current spot price is US $ 1.65. If a firm enters
into a forward contract at the forward exchange rate, it
indicates a preference for this forward rate to the unknown
rate that will be quoted 90 days from now in the spot market.
• However, if the spot price of the pound increases by 100 per
cent during the next 90 days, the pound would be US $ 3.3000
and the £ 5,00,000 could be converted into US $ 1,650,000.
• The forward market, therefore, can remove the uncertainty of
not knowing how much the firm will receive or pay. But it
creates one uncertainty-whether the firm might have been
better off by waiting.
 Importance of Major Currencies
• Relative International Importance of Major Currencies in 2010
(in Percentages)
Foreign International International Trade Foreign
Exchange Bank Loans Bond Invoicing Exchange
Trading Offering Reserves
U.S. dollar 42.5 58.2 38.2 52.0 61.5
Euro 19.6 21.4 45.1 24.8 26.2
Japanese 9.5 3.0 3.8 4.7 3.8
Yen
Pound 6.5 5.5 8.0 5.4 4.0
Sterling
Other 18.7 9.8 4.4 13.1 4.4
Currencies
Functions of the Foreign Exchange Markets
• With electronic transfers, foreign exchange markets
have become truly global in the sense that currency
transactions now require only a few seconds to
execute and can take place 24 hours per day.
• As banks end their regular business day in San
Francisco and Los Angeles, they open in Singapore,
Hong Kong, Sydney, and Tokyo;
• By the time the latter banks wind down their regular
business day, banks open in London, Paris, Zurich,
Frankfurt, and Milan; and before the latter close,
New York and Chicago banks open.
 Foreign Exchange Rates
• Assume for simplicity that there are only two
economies, the United States and the European
Monetary Union (EMU), with the dollar ($) as the
domestic currency and the euro (€) as the foreign
currency.
• The exchange rate (R) between the dollar and the
euro is equal to the number of dollars needed to
purchase one euro. That is, R = $/ €.
• For example, if R = $/ € = 1, this means that one
dollar is required to purchase one euro.
 Foreign Exchange Rates
Four ways to determine the rate of foreign exchange are:
(a) Demand for foreign exchange (currency)
(b) Supply of foreign exchange
(c) Determination of exchange rate
(d) Change in Exchange Rate!
• In a system of flexible exchange rate, the exchange rate of a
currency (like price of a good) is freely determined by forces
of market demand and supply of foreign exchange.
• Expressed graphically the Intersection of demand and
the supply curves determines the equilibrium exchange
rate and equilibrium quantity of foreign currency.
• This is called equilibrium in foreign exchange market.
 Foreign Exchange Rates
• Let us assume that there are two countries—Bangladesh
and USA—and the exchange rate of their currencies, viz.,
taka and dollar are to be determined.
• Presently there is floating or flexible exchange regime in
both Bangladesh and USA. Therefore, the value of currency
of each country in terms of the other currency depends
upon the demand for and supply of their currencies.
(a) Demand for foreign exchange (currency):
• Demand for foreign exchange is caused (i) to purchase
abroad goods and services by domestic residents, (ii) to
purchase assets abroad, (iii) to send gifts abroad, (iv) to
invest directly in shops, factories abroad, (v) to undertake
foreign tours, (vi) to make payment of international trade etc
 Foreign Exchange Rates
• The demand for dollars varies inversely with taka price of
dollar, i.e., higher the price, the lower is the demand.
• The demand curve in Fig. 10.1 is downward sloping
because there is inverse relationship between foreign
exchange rate and its demand.
(b) Supply of foreign exchange:
• Supply of foreign exchange comes (i) when foreigners
purchase home country’s (say, Bangladesh’s) goods and
services through our exports
• (ii) when foreigners make direct investment in bonds and
equity shares of home country
• (iii) when speculation causes inflow of foreign exchange
• (iv) when foreign tourists come to home country
 Foreign Exchange Rates
• The supply curve is upward sloping because there is direct
relationship between foreign exchange rate and its supply.
(c) Determination of exchange rate:
• This is determined at a point where demand for and
supply of foreign exchange are equal. Graphically,
intersection of demand and supply curves determines
the equilibrium exchange rate of foreign currency.
• At any particular time, the rate of foreign exchange must
be such at which quantity demanded of foreign currency
is equal to quantity supplied of that currency.
• It is proved with the help of the following diagram. The
price on the vertical axis is stated in terms of domestic
currency (i.e., how many taka for one US dollar).
 Foreign Exchange Rates
• The horizontal axis measures quantity demanded or
supplied of foreign exchange (i.e., dollars). In this figure,
demand curve is downward sloping which shows that less
foreign exchange is demanded when exchange rate
increases (i.e., inverse relationship).
• The reason is that rise in the price of foreign exchange
(dollar) increases the taka cost of foreign goods which
makes them more expensive. The result is fall in imports
and demand for foreign exchange.
• The supply curve is upward sloping which implies that
supply of foreign exchange increases as the exchange rate
increases (i.e., direct relationship). Home country’s goods
(Bangladeshi goods) become cheaper to foreigners because
taka is depreciating in value.
 Foreign Exchange Rates
• As a result, demand for Bangladeshi goods increases.
Thus, our exports should increase as the exchange
rate increases. This will bring greater supply of
foreign exchange. Hence, the supply of foreign
exchange increases as the exchange rate increases
which proves the slope of supply curve.
• In the Fig. 10.1, demand curve and supply curve of
dollars intersect each other at point E which implies
that at exchange rate of OR (QE), quantity demanded
and supplied are equal (both being equal to OQ).
Hence, equilibrium exchange rate is OR and
equilibrium quantity is OQ.
 Foreign Exchange Rates
(d) Change in Exchange Rate:
• Suppose, exchange rate is 1 dollar = taka 80. An
increase in Bangladesh’s demand for US dollars,
supply remaining the same, will cause the demand
curve DD shift to D’D’.
• The resulting intersection will be at a higher exchange
rate, i.e., exchange rate (price of dollar in terms of
taka) will rise from OR to OR, (say, 1 dollar = 85 taka).
• It shows depreciation of Bangladeshi currency (taka)
because more taka (say, 85 instead of 80) are
required to buy 1 US dollar. Thus, depreciation of
currency means a fall in the price of home currency.
 Foreign Exchange Rates
• Likewise, an increase in supply of US dollar will cause supply
curve SS shift to S’S’ and as a result exchange rate will fall
from OR to OR2. It indicates appreciation of Bangladeshi
currency (taka) because cost of US dollar in terms of taka has
now fallen, say, 1 dollar = tk 80, i.e., less takas are required to
buy 1 US dollar or now tk 80 instead of tk 85 can buy 1 dollar.
Thus, appreciation of currency means ‘a rise in the price of
home currency’.
 Foreign Exchange Rates
• What is the difference between a fixed and a floating
exchange rate
• A fixed exchange rate denotes a nominal exchange
rate that is set firmly by the monetary authority with
respect to a foreign currency or a basket of foreign
currencies.
• By contrast, a floating exchange rate is determined in
foreign exchange markets depending on demand and
supply, and it generally fluctuates constantly.
 Foreign Exchange Rates
• Different countries have their own currencies. In
England, a Big Mac from McDonald's costs £4, in South
Africa it costs R20 and in Norway it costs 48kr.
• The meal is the same in all three countries but in some
places it costs more than in others. If £1=R12.41,
and 1 kr=R1.37, this means that a Big Mac in England
costs R49.64 and a Big Mac in Norway costs R65.76.
• Saba wants to travel to see her family in Spain. She has been
given R10 000 spending money. How many euros can she buy
if the exchange rate is currently euro 1=R10.68?
Answer: Let the equivalent amount in euros be x
• x=10 000/10.68=936.33
• Saba can buy euro 936.33 with R10 000.
 Foreign Exchange Rates
• Study the following exchange rate table:
Country Currency Exchange Rate
United Kingdom (UK) Pounds (£) R14.13
United States (USA) Dollars ($) R7.04

• In South Africa the cost of a new Honda Civic is R173 400. In

England the same vehicle costs £12 200 and in the
USA $21 900. In which country is the car the cheapest?
Answer: To answer this question we work out the cost of the car
in rand for each country and then compare the three answers
to see which is the cheapest.
• Cost in rands = cost in currency times exchange rate.
• Cost in UK: 12 200×14.13/1=R172 386
• Cost in USA: 21 900×7.04/1=R154 400
 Foreign Exchange Rates
• Comparing the three costs we find that the car is the
cheapest in the USA.
• Yaseen wants to buy a book online. He finds a publisher in
London selling the book for £7.19. This publisher is offering
free shipping on the product. He then finds the same book
from a publisher in New York for $8.49 with a shipping fee
of $2. Next he looks up the exchange rates to see which
publisher has the better deal. If $1=R11.48 and £1=R17.36,
which publisher should he buy the book from?
Answer: London publisher: 7.19×17.36/1= R124.82
• New York publisher: (8.49+2)×11.48/1= R120.43.
• Therefore Yaseen should buy the book from the New
York publisher.
 Cross-Exchange Rate
• Besides the exchange rate between the U.S. dollar
and the euro, there is an exchange rate between the
U.S. dollar and the British pound ( ￡ ), between the
U.S. dollar and the Swiss franc, the Canadian dollar
and the Mexican peso, the British pound and the
euro, the euro and the Swiss franc, and between
each of these currencies and the Japanese yen.
• Once the exchange rate between each of a pair of
currencies with respect to the dollar is established,
however, the exchange rate between the two
currencies themselves, or cross-exchange rate, can
easily be determined.
 Foreign Exchange Rates
• For example, if the exchange rate (R) were 2 between the
U.S. dollar and the British pound and 1.25 between the
dollar and the euro, then the exchange rate between the
pound and the euro would be 1.60 (i.e., it takes €1.6 to
purchase 1 ￡ ). Specifically,
• R = € / ￡ = $ value of ￡ / $ value of € = 2/1.25 = 1.60
• A cross exchange rate is mostly used when the currency
pair being traded does not involve the US Dollar.
• The reason behind it is that conventionally if one wanted
to convert a non-USD currency into another non-USD
currency, the process requires you to convert it first to
USD then converting the USD into the currency of
preference.
 Foreign Exchange Rates
• However, this is not always necessary as some rates
are usually quoted on various forex platforms.
• Traditionally, the bigger of the two currencies was
assumed as the base currency. The Euro and the
British Pound are always considered as the base
currencies in all pairs that they are part of except
where the Euro has been paired with the British
pound.
• The following is a list of the order of priorities for
base currency:
• EUR, GBP, AUD, NZD, USD, CAD, JPY
 Foreign Exchange Rates
• To calculate the cross exchange rate, you need the
bid prices of both currencies involved when paired
with the USD. It’s quite easy when the USD is the
base currency in one pairing and the quote currency
in the other pairings.
• You just have to multiply the two bid prices with your
cross rate calculator to get the cross rate.
• For example: In the case of the GBP/CAD. The bid
prices are as follows: GBP/USD=1.5700,
USD/CAD=0.9300.
• Thus the cross rate (GBP/CAD) will be
1.5700*0.9300=1.4601.
 Foreign Exchange Rates
• At times, the USD might be the base or quote
currency of both pairings. When this is the case,
reciprocal paring is done where one of the currencies
is flipped.
• For example: When the bid price for EUR-GBP is
1.2440, and the bid price for USD-GBP is 1.8146, to
get the cross rate we simply multiply with our cross
rate calculator, the EUR-USD rate and the USD- GBP
rate, that is, 1/1.2440*1.8146=1.4587