FOREIGN EXCHANGE 1.

Functions of Foreign Exchange Market

MARKET 2.
3.
Equilibrium Exchange Rate
Foreign Exchange Transaction
BY
D R . M D. SA R A F R A Z EQ U B A L
FOREIGN EXCHANGE MARKET
Where individuals, firms and banks
buy and sell foreign currencies or
foreign exchange.
FUNCTIONS OF THE FOREIGN EXCHANGE MARKETS
1. Transfer purchasing power from one nation and
currency to another.
Demand for currency arises when:
Tourists visit another country
Domestic firm wants to import from other countries
Individual wants to invest abroad
Supply of currency arises from:
Foreign tourist expenditures
Export earnings
Receiving foreign investments
FUNCTIONS OF THE FOREIGN EXCHANGE MARKETS
2. Provide credit for foreign transactions
Credit is needed when goods are in transit, and to allow the
buyer time to resell the goods to make the payment.
3. Provide the facilities for hedging and speculation
About 90% of foreign exchange trading reflects purely
financial transactions, and only about 10% trade financing.
STRUCTURE OF FOREIGN EXCHANGE
MARKETS

Central Bank
Buyer or seller of last resort in the foreign
exchange market

Brokers
Clearinghouse for surpluses and shortages
between the commercial banks

Commercial Banks
Serve as the clearinghouses for currency
exchange

Participants
Those needing currency to fund transactions
Tourists, importers, exporters, investors, etc
FOREIGN EXCHANGE RATES
The price of one currency in terms of another is called the rate of foreign
exchange or just the exchange rate.
 Assume only two economies, the United States and the European Monetary Union.
Domestic currency = dollar ($), Foreign currency = euro (€)
 The exchange rate between the dollar and the euro (R) is equal to the number of
dollars needed to purchase one euro.
 R = $/€,
 If R = $/€ = 1, then one dollar is required to purchase one euro.
FOREIGN EXCHANGE RATES
Under a flexible exchange system, R is determined by the intersection of
market demand and supply curves for euros.
Depreciation is an increase in the domestic price of the foreign currency.
If the dollar price of the euro increases from $1 to $1.50, the dollar has
depreciated.
Appreciation refers to a decline in the domestic price of the foreign
currency.
If the dollar price of the euro decreases from $1 to $0.50, the dollar has
appreciated.
THE FLEXIBLE EXCHANGE RATE SYSTEM
Under the flexible exchange rate system, the exchange rate is determined
daily in the FEM by the forces of supply and demand.
The exchange rate moves freely in response to the market forces, as
government and central bank refrain from systematic intervention
This system is known as the freely flexible ( or clean floating) exchange
rate system.
DEMAND CURVE OF FOREIGN EXCHANGE
R = $/ €
The U.S. demand for euros is negatively
inclined, indicating that the lower the
exchange rate (R), the greater the quantity of
euros demanded by U.S. residents.
 The reason is that the lower the exchange rate
(i.e., the fewer the number of dollars required
to purchase a euro), the cheaper it is for U.S.
residents to import from and to invest in the
European Monetary Union, and thus the
greater the quantity of euros demanded by
U.S. residents.

Demand of Foreign
Exchange
 SUPPLY CURVE OF FOREIGN EXCHANGE

R = $/ €
On the other hand, the U.S. supply of
euros is usually positively inclined
indicating that the higher the exchange
rate (R), the greater the quantity of euros
earned by U.S. residents and supplied to
the United States.
 The reason is that at higher exchange
rates, EMU residents receive more
dollars for each of their euros. As a
result, they find U.S. goods and
investments cheaper and more
attractive and spend more in the United
States, thus supplying more euros to the
United States. Supply of Foreign
Exchange
 EQUILIBRIUM EXCHANGE
RATE
 Under a flexible exchange rate system, the dollar price of
the euro (R) is determined, just like the price of any
commodity, by the intersection of the market demand and
supply curves for euros.

 This is shown in Figure, where the vertical axis measures

the dollar price of the euro, or the exchange rate, R = $/ €,
and the horizontal axis measures the quantity of euros.

 The market demand and supply curves for euros intersect

at point E, defining the equilibrium exchange rate of R = 1,
at which the quantity of euros demanded and the quantity
supplied are equal at € 200 million per day.

 At a higher exchange rate, the quantity of euros supplied

exceeds the quantity demanded, and the exchange rate will
fall toward the equilibrium rate of R = 1. At an exchange
rate lower than R = 1, the quantity of euros demanded The Exchange Rate
exceeds the quantity supplied, and the exchange rate will Under a Flexible
be bid up toward the equilibrium rate of R = 1.
Exchange
CROSS EXCHANGE RATE
TYPES OF FOREIGN EXCHANGE TRANSACTION

Banks typically engage in three types of foreign exchange

transactions:
 spot transaction,
 forward transaction and
 swap transaction.
SPOT TRANSACTION
A spot transaction is where you can make an outright purchase or sale of a currency
now, as in “on the spot.”
A spot deal will settle (in other words, the physical exchange of currencies takes place)
two working days after the deal is struck. The two-day period is known as immediate
delivery.
By convention, the settlement date is the second business day after the date the
transaction is agreed to by the two traders. The two-day period provides ample time for
the two parties to confirm the agreement and arrange the clearing and necessary
debiting and crediting of bank accounts in various international locations.
 The spot exchange rate is at or close to the current market rate because the transaction
occurs in real time and not at some point in the future.
HERE’S HOW A SPOT TRANSACTION WORKS:
• A trader calls another trader and asks for the price of a currency, say the euro. This call
expresses only a potential interest in a deal, without the caller indicating whether he or she
wants to buy or sell.
• The second trader provides the first trader with prices for both buying and selling.
• When the traders agree to do business, one will send euros and the other will send, say
dollars. By convention, the payment is actually made two days later.
Spot dealing has the advantage of being the simplest way to meet your foreign currency
requirements, but it also carries with it the greatest risk of exchange rate fluctuations, because
there is no certainty of the rate until the transaction is made. Exchange rate fluctuations can
effectively increase or decrease prices and can be a financial planning ordeal for companies
and individuals.
FORWARD TRANSACTION
All the foreign exchange transactions we have considered so far are spot
transactions. Their distinguishing feature is that they require immediate
delivery, or exchange of currencies on the spot. (In practice, the settlement
of spot transactions usually requires a couple of days.)
The rate of exchange used in the settlement of spot transactions is called the
spot rate; the market for spot transactions, the spot market.
In many cases, a business or financial institution knows it will be receiving
or paying an amount of foreign currency on a specific date in the future.
A forward transaction will protect you against unfavorable movements in
the exchange rate.
Forward transactions differ from spot transactions in that their maturity
date is more than two business days in the future. A forward exchange
contract’s maturity date can be a few months or even years in the future.
FORWARD TRANSACTION
A forward transaction is merely an agreement (called the forward contract) between two
parties (either a bank and a customer or two banks) that calls for delivery at some prescribed
time in the future of a specified amount of foreign currency by one of the par- ties against
payment in domestic currency by the other party at a price (called the forward rate) agreed
upon now when the contract is signed.
FORWARD TRANSACTION
The exchange rate is fixed when the contract is initially made. No money
necessarily changes hands until the transaction actually takes place,
although dealers may require some customers to provide collateral in
advance.

 Notice that in a forward transaction, the buyer and seller are locked into a
contract at a fixed price that cannot be affected by any changes in market
exchange rates. This tool allows the market participants to plan more
safely, since they know in advance what their foreign exchange will cost.
FORWARD DISCOUNT AND FORWARD PREMIUM
Forward discount: If the forward rate is below the present spot rate,
the foreign currency is said to be at a forward discount with respect to
the domestic currency.
For example, if the spot rate is $1= €1 and the three-month forward rate is $0.99= €1,
we say that the euro is at a three-month forward discount of 1 cent or 1 percent (or at a
4 percent forward discount per year) with respect to the dollar.

Forward premium: However, if the forward rate is above the present

spot rate, the foreign currency is said to be at a forward premium
For example, if the spot rate is still $1 = €1 but the three-month forward rate is instead
$1.01 = €1, the euro is said to be at a forward premium of 1 cent or 1 percent for three
months, or 4 percent per year.
SWAP TRANSACTIONS
A currency swap is the conversion of one currency to another currency at one point in
time, with an agreement to convert it to the original currency at a specified time in the
future.
A spot sale of a currency combined with a forward repurchase of the same currency –
as part of a single transaction.
Most interbank trading involving the purchase or sale of currencies for future delivery
are done as currency swaps.
The rates of both exchanges are agreed to in advance.
TYPES OF FOREIGN EXCHANGE TRANSACTION
Here’s how a swap transaction works:

•Suppose a U.S. company needs 15 million Swiss francs for a three-

month investment in Switzerland.
•It may agree to a rate of 1.5 francs to a dollar and swap $10 million
with a company willing to swap 15 million francs for three months.
•After three months, the U.S. company returns the 15 million francs to
the other company and gets back $10 million, with adjustments made
for interest rate differentials.
The key aspect is that the two banks arrange the swap as a single transaction in
which they agree to pay and receive stipulated amounts of currencies at specified
rates.
Swaps provide an efficient mechanism through which traders can meet their foreign
exchange needs over a period of time. Traders are able to use a currency for a period
in exchange for another currency that is not needed during that time.