FOREIGN EXCHANGE MARKET AND TRANSACTIONS

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o From 1876 to 1913 each currency was convertible

to gold at a specified rate & thus exchange rate

between two currencies was determined by their

relative convertibility rates per ounce of gold.

o Suspended during World War-I during 1914.

o In 1930s some countries pegged their currencies to

the dollar or pound, but due to instability in FE

market, system did not work.


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o In 1944, Bretton Woods Agreement called forfixed exchange rates between currencies, whichlasted till 1971.

o During this period, governments would intervene

to prevent exchange rates from moving morethan 1 % above or below their initiallyestablished levels.

o

In 1971, US $ was overvalued

foreign demandwas less than supply (to be exchanged for othercurrencies) Exchange rates were allowed tofluctuate by 2.25% in either direction from newly

set rates.


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o Even after various efforts, governmentsstill had difficulty maintaining exchangerates within stated boundaries.

o By March 1973, the more widely tradedcurrencies were allowed to fluctuate in

accordance with the market forces & theofficial boundaries were eliminated.


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o The foreign exchange market is the placewhere one currency is bought or sold foranother currency.


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o Transfer of purchasing power.o Hedging facilities.o Reducing foreign exchange risks: the risk

exist that the exchange values of nationalcurrency may fluctuate i.e. transactionexposure.

o Obtain or provide credit for internationaltrade transactions.


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o Its trading volume.o The extreme liquidity of the market.o The large number & variety of, traders in

the market.o Its geographical dispersion.o Its long trading hours-24hrs a day(except

on weekends).o The variety of factors that affects exchange

rate.


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o A foreign exchange rate is the price of onecurrency expressed in terms of anothercurrency.

o A foreign exchange quotation (or quote) isa statement of willingness to buy or sell at an

announced rate.


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Many currency pairs are only inactively traded, so theirexchange rate is determined through their relationship toa widely traded third currency referring to CrossExchange Rate.

Both the Mexican Peso (Ps) and the Nepaleserupee(NPR) are commonly quoted against US $. Assumethe following quotes .09760$=1MXN 0.01358$=1NPR:

Cross Rate = Mexican Peso/ US DollarNepalese rupee/ US Dollar

= 1MXN/.09760 $1NPR /.01358 $

= 0.1391 MXN/NPR


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o Foreign currency dealers provide twoquotes:

Bid Price: Price at which the dealer iswilling to buy foreign currency.

Ask Price: Price at which the dealer iswilling to sell foreign currency.


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o Banks act as market makers and realisetheir profits from the spread which is thedifference between the bank bid and askquote called bid and ask spread:

Bid-Ask Spread = (Ask-Bid)/Ask

%38.1100

4484.1

4482.14484.1

%

spread


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Currencies are sometimes described asovervalued or undervalued that can bedetermined by:

Purchasing Power Parity Interest Parity


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Goods that are freely trade should costsame everywhere, when measured in thesame currency.

The exchange rate between currenciesshould be that currencies have equivalentpurchasing power.

Exchange rate change over the long termbecause power of one currency increase/decrease related to other currency.


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Foreign exchange market is in equilibriumwhen the rate of return on deposit of anytwo currencies measured in the samecurrency are equal.


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Five main groups of transactions arecovered : spot transactions, forwards,swaps, futures, and options.

Forwards, swaps, futures, and optionsbelong to the class of financial instrumentscalled derivatives.

Derivatives are contracts that derive theirvalue from some underlying assetin thiscase, the asset is currency.


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o Spot MarketA market for the immediate purchase and delivery

of currency

o Spot Exchange RatesMarket prices of foreign exchanges in the spot

market that are the rates pertaining to the tradingof foreign-currency.

o Participants of spot market are commercial banks, brokers and clients of commercial and central

banks.


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o Forward Exchange MarketA market for contracts that ensures the future delivery

of and payment for a foreign currency at a specifiedexchange rate.

o Forward Exchange RatesThe prices of contracts traded in the forward

exchange market.

Premiums and discounts in forward contracts.

o Purpose of a Forward: the act of reducingexchange rate risk or hedging.


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Series of forward under one contract forlong term.

It enables two parties havingcomplimentary foreign exchangeobligations to pair up.

They are customized for the needs of

parties with predetermined date and rate.


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They specify a standard volume ofcurrency to be exchanged on a date infuture.

Basis elements: type of currency amt ofcurrency, future rate and settlement date.

Canadian dollar contract contains-1,00,000

CAD, Swiss franc -1,25,000CHF andBritish pound- 62,500 GBP.


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Allow owners to buy or sell currency atspecified price with in a specified time.

Currency call option- contract grantingowner right to buy a currency.

Currency put option- contract grantingowner right to sell a currency.

Euro optionexercised only on date ofexpiration of contract and US option- anytime during the contract period.


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In order to exercise call and put option, spot rate mustreach a threshold called strike price before optionexpires.

Fee paid to buy an option-premium. Whether optionexercised or not.


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FOREIGN EXCHANGE MARKET AND TRANSACTIONS

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