CHAPTER 9

1. Foreign Exchange Markets Overview

The foreign exchange (forex or FX) market is where currencies are traded. It is the
largest financial market in the world, with a daily turnover exceeding trillions of dollars.
This market is crucial for global trade, investment, and finance, as it facilitates the
exchange of currencies, allowing countries to trade goods and services internationally.
Key Aspects:
 Decentralized Market: Unlike stock markets, forex markets are not centralized
but operate over-the-counter (OTC). This means transactions happen directly
between two parties, such as between a bank and a corporation.
 Participants: The main participants in this market include commercial banks,
central banks, institutional investors, corporations, and hedge funds. Retail
traders also play a part but are a smaller segment of the market.
2. Background and History of Foreign Exchange Markets
The forex market has evolved significantly over time, particularly in response to shifts in
global economic policies and exchange rate regimes. The development of this market
can be traced back to the following key historical points:
 Gold Standard Era: In the late 19th and early 20th centuries, many countries
adopted the gold standard, where currencies were convertible into a fixed
amount of gold. This provided stability in exchange rates but limited flexibility.
 Bretton Woods System (1944-1971): Post-World War II, the Bretton Woods
Agreement established a fixed exchange rate system where currencies were
pegged to the U.S. dollar, which was in turn pegged to gold. This system
eventually collapsed in 1971, leading to the era of floating exchange rates.
 Modern Forex Market: After the fall of Bretton Woods, countries adopted
floating exchange rates, allowing their currencies' values to fluctuate based on
market demand and supply. This marked the beginning of the contemporary
forex market as we know it.
3. Foreign Exchange Rates and Transactions
Foreign exchange rates are the prices of one currency in terms of another.
Understanding exchange rates is essential for businesses and governments engaging in
international trade and finance.
Foreign Exchange Rates
An exchange rate indicates how much of one currency is needed to purchase another.
These rates can fluctuate based on numerous factors, including inflation, interest rates,
political stability, and overall economic performance. There are two main types of
exchange rate regimes:
 Fixed Exchange Rate: A government or central bank sets the value of its
currency relative to another currency or a basket of currencies. This system
requires significant foreign exchange reserves to maintain stability.

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  Floating Exchange Rate: Market forces determine the value of the currency,
with no government intervention. Supply and demand in the forex market drive
price changes.
Foreign Exchange Transactions
These refer to the buying and selling of currencies in the forex market. Common types
of forex transactions include:
 Spot Transactions: These are immediate exchanges of currency at the current
market rate. They typically settle within two business days.
 Forward Transactions: These involve agreeing on an exchange rate today for
a transaction that will occur at a future date. Forward contracts help businesses
hedge against the risk of exchange rate fluctuations.
 Swaps: A swap is a combination of a spot and a forward transaction. One party
agrees to exchange currency today and reverse the transaction at a specified
future date, locking in exchange rates.

Main Types of Foreign Exchange Transactions:

1. Spot Transactions
2. Forward Transactions
3. Swap Transactions
Each type of transaction operates differently, and they cater to different needs within
the market, whether it’s immediate currency exchange, future planning, or managing
short-term currency needs.

1. Spot Transactions
Definition: A spot transaction is the most common type of forex transaction. It
involves the immediate exchange of one currency for another at the current market
price, called the "spot rate." Settlement usually takes place within two business days
(T+2), meaning the actual currency transfer happens after two days of agreeing on the
trade.
Simple Example:
 Let’s say a Filipino importer needs to pay a supplier in the United States for a
shipment of electronics worth $10,000. The importer needs to convert
Philippine pesos (PHP) to U.S. dollars (USD).
 Spot Rate: Assume the current exchange rate is PHP 56/USD 1.
 To pay the $10,000 invoice, the Filipino importer would go to their bank or a
currency dealer and perform a spot transaction to buy U.S. dollars.
Calculation:
o $10,000 × 56 PHP = ₱560,000.

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So, the importer would pay ₱560,000 to get $10,000, and the transaction would
settle in two business days, after which the supplier in the U.S. receives the payment in
dollars.

2. Forward Transactions
Definition: A forward transaction is an agreement to exchange currencies at a
predetermined rate on a specific future date. This type of transaction is used by
businesses or investors who want to protect themselves against future fluctuations in
exchange rates, a process known as hedging. The agreed-upon rate is called the
forward rate.
Simple Example:
 A Philippine exporter is set to receive a payment of $50,000 in 90 days for
products they shipped to a buyer in the United States. The exporter is concerned
that the PHP might strengthen over the next three months, making the U.S.
dollars they’ll receive worth less in Philippine pesos.
 To protect against this risk, the exporter enters into a forward contract with
their bank. They agree to exchange $50,000 for PHP at a forward rate of PHP
55/USD in 90 days, no matter what the market rate is at that time.
Calculation:
o $50,000 × 55 PHP = ₱2,750,000.
In this case, when the exporter receives the dollars in 90 days, they exchange them for
₱2,750,000. Even if the market exchange rate drops to PHP 53/USD by then, the
exporter is not affected because the forward contract locked in the higher rate (PHP
55/USD).

3. Swap Transactions
Definition: A swap transaction is a combination of a spot and a forward transaction.
It involves two parties exchanging currencies now (a spot transaction) and then
agreeing to reverse the transaction (a forward transaction) at a specific future date.
Swaps are often used by financial institutions to manage short-term liquidity needs.
Simple Example:
 A European company has temporary excess U.S. dollars but needs euros (EUR)
for a short-term project. They enter into a currency swap with their bank.
 Spot leg: They sell $1,000,000 to their bank at the current spot rate of EUR
0.90/USD and get €900,000 today.
Calculation (Spot):
o $1,000,000 × 0.90 = €900,000.
 Forward leg: They agree to buy back the $1,000,000 from the bank in 30
days at the forward rate of EUR 0.91/USD. This means they’ll return the
€900,000 (plus a small interest cost) in 30 days and get their $1,000,000 back.
Calculation (Forward):

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 o $1,000,000 × 0.91 = €910,000.
After 30 days, the company gives back €910,000 and gets $1,000,000 back,
effectively borrowing €900,000 for 30 days and paying €10,000 in interest.

How Different Market Participants Use Forex Transactions:

 Businesses: Use forex transactions to pay for imports and receive payments for
exports. They often use forward contracts to hedge against currency risk,
ensuring that they lock in favorable exchange rates for future payments.
 Investors: Engage in forex transactions to diversify their portfolios or take
advantage of currency fluctuations for speculative profits. For example, they
might invest in foreign assets and need to convert their domestic currency into
the foreign one.
 Central Banks: Use forex transactions to manage their country’s foreign
exchange reserves and influence their currency's value. They can buy or sell their
own currency in the forex market to stabilize or influence the exchange rate.

Why Foreign Exchange Transactions Matter:

1. Hedging Risks: Businesses and investors use forward contracts and swaps to
protect themselves from unexpected currency fluctuations. This helps manage
risks in international trade and investments.
2. Facilitating International Trade: Spot transactions allow businesses to settle
international trade payments quickly and efficiently, ensuring smooth global
commerce.
3. Managing Liquidity: Swap transactions help financial institutions manage
short-term currency needs without affecting their long-term currency holdings.
4. Arbitrage Opportunities: Forex transactions also enable traders to profit from
discrepancies in exchange rates between different markets, a practice known as
arbitrage. By buying a currency in one market where it's undervalued and selling
it in another market where it’s overvalued, traders can make a profit.

4. Return and Risk of Foreign Exchange Transactions

Forex trading involves both returns and risks. These are driven by fluctuations in
currency values, which can be influenced by macroeconomic factors, political events, or
changes in investor sentiment.
Return on Forex Transactions
The potential for profit in forex trading arises from the difference between buying and
selling rates, which are influenced by supply and demand, economic indicators, and
geopolitical factors. Traders often use leverage (borrowing money) to amplify their
potential gains, though this also increases risk.
Risks in Forex Transactions

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  Exchange Rate Risk: Currencies fluctuate due to changes in market sentiment,
inflation, interest rates, and geopolitical events. This risk can affect businesses
that trade internationally or hold assets in foreign currencies.
 Interest Rate Risk: When central banks change interest rates, it impacts the
attractiveness of their currencies. Higher interest rates usually attract investment
and lead to currency appreciation.
 Political Risk: Government instability, changes in policy, or sudden geopolitical
events can significantly impact exchange rates. Emerging markets are particularly
vulnerable to this type of risk.
 Credit Risk: This arises when one party in a forex transaction defaults on the
agreement. For example, if a counterparty fails to deliver the promised currency
on a forward contract, the other party may face financial losses.
5. Role of Financial Institutions in Foreign Exchange Transactions
Financial institutions such as commercial banks, investment banks, and central banks
play a crucial role in the forex market. They facilitate currency exchanges, manage
liquidity, and influence exchange rates through monetary policy.
Commercial Banks:
 They act as market makers by quoting buying and selling prices for currencies.
 Provide services like hedging to businesses that want to minimize their exposure
to currency risk.
Central Banks:
 They intervene in the forex market to stabilize their currency or influence its
value to achieve economic goals, such as controlling inflation or boosting exports.
 Central banks may buy or sell foreign currency reserves to impact exchange rates
or implement monetary policies that indirectly influence the market.
6. Interaction of Interest Rates, Inflation, and Exchange Rates
The relationship between interest rates, inflation, and exchange rates is a key area of
focus in international finance. Changes in any one of these factors can have significant
effects on the others.
Interest Rates
Interest rate changes can lead to capital flows into or out of a country. Higher interest
rates tend to attract foreign investment, increasing demand for the domestic currency
and causing it to appreciate. Conversely, lower interest rates might lead to currency
depreciation as investors seek higher returns elsewhere.
Inflation
High inflation erodes a currency’s purchasing power, leading to depreciation. Countries
with consistently lower inflation rates tend to have stronger currencies because their
purchasing power remains stable. Inflation differentials between countries can lead to
changes in exchange rates.
7. Purchasing Power Parity (PPP)

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The theory of Purchasing Power Parity (PPP) suggests that in the long run, exchange
rates should adjust so that identical goods in different countries cost the same in terms
of a common currency. For example, if a basket of goods costs $100 in the U.S. and the
equivalent costs £70 in the UK, the exchange rate should eventually adjust to 1.43
USD/GBP (100/70).
PPP is useful for determining whether a currency is undervalued or overvalued relative
to another. However, it does not always hold in the short term due to factors like
transaction costs, tariffs, and differences in the quality of goods.
8. Interest Rate Parity (IRP)
Interest Rate Parity (IRP) is a theory that links interest rates and exchange rates. It
suggests that the difference in interest rates between two countries should equal the
expected change in exchange rates between their currencies.
For example, if interest rates are higher in the U.S. compared to Japan, the U.S. dollar
should depreciate relative to the yen over time to offset the higher returns on U.S.
investments. IRP helps investors understand how currency and interest rate differentials
can impact returns on foreign investments.
Conclusion
The foreign exchange market is complex, but understanding the key concepts like
exchange rates, the role of financial institutions, and the interaction between interest
rates and inflation is essential for comprehending global finance. Exchange rate
movements are influenced by multiple factors, from economic fundamentals like
inflation and interest rates to geopolitical risks and government policies. For businesses
and investors operating in international markets, understanding these dynamics is
crucial to managing risks and making informed decisions.

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