Unit 4 Foreign Exchange Market

I. Definitions of Foreign Exchange & Foreign Exchange

Market

A. Foreign exchange is defined as the currency of another country.

E.g. To a Japanese, u.s. dollar is foreign exchange, and to an American, Japanese Yen is foreign exchange.

B. The foreign exchange market is a market for converting the currency of one country into that of another country. The major participants in the foreign exchange market are large commercial banks that operate at two levels-retail and inter-bank:a) at the retail level, they deal with bank customers who want to buy or sell foreign exchange;

b) at the inter-bank level, usually through foreign exchange brokers, they trade in foreign exchange with other domestic and foreign banks, and brokers will receive commissions for their services.

II. The Functions of Foreign Exchange Market

A. Currency Conversion

• The payments a company receives for its exports and income it receives from foreign investments may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency;

• International businesses use foreign exchange markets when they must pay a foreign company for its products or services in that country’s currency;

• International businesses use foreign exchange markets when they have spare cash that they wish to invest for short-terms in money market. E.g. A US firm has $10 m and wants to invest it for 3 months. The interest rate in US is 8%, while the interest rate is 12% in France. Hence, the company may change its $ 10 m into francs for investments to earn more interests of another 4% .

A. Currency Conversion

• Currency speculation (short-term movements of funds from one currency to another one in the hopes of profiting from the fluctuations in exchange rates) is another use of foreign exchange markets. E.g. A US company has $ 10 m to invest for 3 months. Suppose the company suspects that US dollar is overvalued against franc. That is the company expects the value of the dollar to depreciate against franc. The current dollar/franc exchange rate is $1=FFr 6, the company exchange its $ 10 m into francs and receive FFr 6o m. In 3 months, $1=FFr 5 (dollar depreciate against franc), then the company exchange its FFr 60 m into $ 12 m. Thus, the company gets profits = $12 m-$10 m = $ 2 m.

B. Insuring Against Foreign Exchange Risk

• The second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable change in exchange rates. Through forward and future contracts (to fix future delivery exchange rate), the foreign exchange market provides a means of removing the foreign exchange risk.

III. Characteristics of Foreign Exchange Market

• The foreign exchange market is a global single market of banks, brokers, and foreign exchange dealers in many locations connected by electronic communication systems, such as telephone, fax and computer.

• The foreign exchange market has been growing at a rapid pace, which reflects a general growth in the volume of cross-border trade and investment.

• The foreign exchange market never sleeps, and it provides 24-hour trading, because of the development of Internet technology.

• Most foreign exchange transactions involve dollars. Dealers may trade one country’s currency for another one’s with the dollars as intermediary, because the volume of international transactions involving dollars is great. It is not hard to find dealers who wish to trade dollars for other currencies.

• Euro US dollars Japanese Yen

• trading cost is bigger