UNIT VI

The foreign exchange market

LEARNING OBJECTIVES

After studying this unit, you should be able to:

• define the organization of the foreign exchange market;

• outline the functions of the FOREX;

• characterize participants of the foreign exchange market;

• classify exchange rate transactions;

• characterize exchange rate transactions;

• characterize hedging instruments;

• define terminology related to the FOREX.

Starting-up

Exercise 1. Comment on the following quotations. What do the authors mean? Do you agree with them?

1. “Having a surplus is allowing us to intervene in the exchange market and support an exchange rate we deem convenient.”(Carlos Moss)e

2.“Under the floating exchange rate system, the initiative to take on speculators is in the hands of the central bank, while under the fixed exchange rate system, the initiative is actually in the hands of speculative capital.” (Ba Shusong)

Reading

The fundumentals of the foreign exchange market

The trading of currency and bank deposits denominated in particular currencies takes place in the foreign exchange market. The Foreign Exchange market, also known as the “Forex” or “FX” market, is the largest financial market in the world. The volume of these transactions worldwide averages over $1 trillion daily.

The FX market is considered an over-the-counter or “interbank” market in which several hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in foreign currencies. It has no central trading location and the transactions are conducted over the telephone or via an electronic network.

The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. Individual transactions in the interbank market usually involve large sums. By contrast, contracts between a bank and its client are usually for specific amounts, sometimes down to the last penny. There are plenty of participants in the Forex.

Foreign exchange dealers are banks, and a few nonblank foreign exchange dealers that operate in both the interbank and client markets. They profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price. This difference is known as the spread. Dealers in the foreign exchange departments of large international banks often function as market makers. They stand willing to buy and sell those currencies in which they specialize by maintaining an inventory position in those currencies. Participants in commercial and investment transactions, for example importers and exporters, international portfolio investors, multinational firms, tourists etc. use the foreign exchange market to facilitate execution of commercial or investment transactions. Some of these participants use the foreign exchange market to hedge foreign exchange risk. Speculators and arbitragers seek to profit from trading in the market and operate in their own interest. Speculators seek all of their profit from exchange rate changes. Arbitragers try to profit from simultaneous exchange rate differences in different markets. Central banks and treasuries use the market to acquire or spend their country's foreign exchange reserves as well as to influence the price at which their own currency is traded. Foreign exchange brokers are agents who facilitate trading between dealers. For this service, they charge a small commission, and maintain access to hundreds of dealers worldwide via open telephone lines. It is a broker's business to know at any moment exactly which dealers want to buy or sell any currency. This knowledge enables the broker to find a counterpart for a client quickly.

The largest money center banks headquartered in New York, London, Tokyo, and other financial capitals of the world not only maintain large inventories of key foreign currencies, but also trade currencies with each other through an exchange of deposits. For example, if a major US bank needs to acquire pounds sterling, it can contact a correspondent bank in London and ask that bank to deliver an additional amount of sterling to the US bank’s correspondent account. In turn, the US bank will increase the dollar denominated deposit held with it by the London bank. In this way money never really leaves the country of its origin; only deposits denominated in various currencies have their ownership transferred from one holder to the next.

The central institutions in modern FX markets are commercial banks with their foreign exchange departments responsible for dealing with and managing the purchase and sale of foreign currencies. Foreign exchange dealing is the exchange of the currency of one country for the currency of another.

The price of one currency expressed in terms of another is called the exchange rate. The basic idea of foreign exchange dealing is making profit on selling and buying currencies. Currencies are traded in pairs. Dealers and brokers usually quote not one, but two exchange rates for each pair of currencies: a bid (buy) price and an ask (sell) price. Dealers buy at the bid price and sell at the ask price, profiting from the spread between the bid and ask prices. Professional traders may take advantage of the arbitrage opportunity if there is a difference in price for a particular currency between two markets (for example, of pounds in New York and in London).

In an era of floating exchange rates, dealing in foreign exchange can be exceedingly risky. Banks typically employ a wide variety of currency-hedging techniques to help shelter their own and their customer’s currency risk exposure. The problem of fluctuating currency is very serious if payment must be made in future. Thus, there are two kinds of exchange rate transactions: spot and forward transactions. Settlement for a spot transaction is usually within one or two business days, in contrast, a forward contract is an agreement to deliver a specified amount at a set price on some future date (known as the value date) within 1,2,3,6 or 12 months. The exchange rates are called the spot exchange rate and forward exchange rate respectively. In the event customers do not know when they will need foreign currency, an option forward contract is frequently used. An option is an agreement between two parties for the option to buy or sell an asset at a certain future time for a certain price agreed today. “A call” is an option to buy, and “a put” is an option to sell. The recent volatility of foreign exchange rates has given rise to a number of techniques to deal with currency risk. Among such hedging instruments are currency options, currency futures contracts and currency swaps. A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency futures contract is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. A swap involves the exchange of principal and interest in one currency for the same in another currency.

WORD LIST

foreign exchange (FOREX) – іноземна валюта

foreign exchange market – валютний ринок

foreign exchange department – валютний відділ банку

deposits denominated in currency – валютні депозити

dollar denominated deposit – доларовий депозит

interbank market – ринок міжбанківських операцій

down to the last penny – до копієчки

inventory position - стан запасів

execution of transactions - виконання операцій

to hedge foreign exchange risk – хеджувати валютні ризики

simultaneous - одночасний

maintain access to … - забезпечувати доступ до …

maintain large inventories of key foreign currencies

a correspondent bank - банк –кореспондент

exchange rate – валютний курс

floating exchange rate – плаваючий валютний курс

domestic (national) currency – національна валюта

foreign currency – іноземна валюта

currency fluctuations – коливання валют

fluctuating currency - нестабільна валюта

arbitrage opportunity – можливість арбітражної операції

employ a wide variety techniques - використовувати різні методи

shelter risk exposure – захистити від ризику

settlement - розрахунок

spot transaction - операція спот

forward transactions - операція форвард

volatility – волатильність, мінливість, нестабільність

currency option – валютний опціон

futures contract - ф’ючерсний контракт

currency swaps - валютні свопи

Exercise 1.

Give Ukrainian equivalents for the following words and phrases:

Foreign exchange market, the volume of transactions, to average, interbank market, to buy and sell deposits denominated in foreign currencies, to consist of two tiers, wholesale market, retail market, to involve large sums, down to the last penny, to profit from sth., bid price, ask price, spread, foreign exchange department, to stand willing to buy and sell, international portfolio investors, multinational firms, to facilitate execution of commercial or investment transactions, to hedge foreign exchange risk, arbitrager, to seek profit, simultaneous, treasury, to acquire foreign exchange reserve, to facilitate trading, to charge a small commission, to find a counterpart, to be headquartered, to maintain large inventories, to deliver, dollar denominated deposit, holder, foreign exchange dealing, to quote the exchange rate, arbitrage opportunity, to employ a wide variety of currency-hedging techniques, to shelter currency risk exposure, fluctuating currency, spot and forward transactions, settlement, business day, at a set price, respectively, volatility of foreign exchange rate, to give rise to sth.

Exercise 2.

Give English equivalents for the following words and phrases:

Обсяг операцій, у середньому дорівнювати, депозити в іноземній валюті, позабіржовий ринок, складатися з двох рівнів, оперувати великими коштами, до копієчки, валютний дилер, отримати прибуток від чого-небудь, ціна покупця, ціна продавця, валютний відділ банку, бути готовим придбати та продати, міжнародний портфельний інвестор, сприяти проведенню торговельних та інвестиційних операцій, хеджувати валютні ризики, спекулянт, арбітражер, прагнути отримати прибуток, одночасний, казначейство, поповнити або витратити резерви в іноземній валюті, валютний брокер, стягувати невелику комісію, знайти контрагента, в усьому світі, мати головний офіс, мати великі запаси, торгувати валютою, власник доларового депозиту, валютна операція, котирувати курси валют, плаваючий валютний курс, використовувати різні методи хеджування валютного курсу, захищати від валютних ризиків, нестабільна валюта, операція спот, розрахунок, дата валютування, банківський день, за встановленою ціною, призвести до появи, коливання валютного курсу, валютні опціони, ф’ючерсні валютні контракти, валютні свопи.

Exercise 3

Match synonyms

A B

fixed rate	owner
holder	to protect
to shelter	pegged rate
to acquire	stock
inventory	settlement date
volatility	instability
value date	to buy

Match the opposites

A B

floating rate	forward
fluctuating	retail
spot	to prevent
wholesale	stable
to give rise	fixed rate

Exercise 4.

Match words and phrases in the box with their definitions (1-14):

an ask	floating exchange rate
to quote	forward transaction
to hedge	exchange rate
a bid	spot transaction
business day	foreign exchange reserve
speculator	currency fluctuations
arbitrager	settlement

1) the exchange rate in one currency at which a dealer will buy another currency.

2) the exchange rate at which a dealer will sell the other currency.

3) a person who buys and sells goods, property, currency or shares in a company in the hope of making a quick profit.

4) a person who  profits by simultaneously purchasing and selling currency to take advantage of spreads created by market conditions.

5) an exchange rate for a currency that is not controlled by the government but changes as the demand for the currency changes.

6) to protect oneself against the risk of losing money in the future because of changes in the value of shares, currencies etc., e.g. by buying or selling futures, options.

7) to give a market price for shares, gold or foreign currency.

8) a transaction that involves the immediate (two-day) exchange of bank deposits.

9) a transaction that involves the exchange of bank deposits at some specified future date.

10) the relation in value between one currency and another.

11) every official working day of the week.

12) deposits of a foreign currency held by a central bank.

13) the action of paying money that you owe.

14) changes in the value of one currency relative to another.

Exercise 5.

Fill in the missing prepositions.

On, at, for (2), from, with, in (5).

1. Dealing _____ currency risk involves such hedging instruments as currency options, currency futures contracts and currency swaps. 2. Dealing or trading _____ foreign currency is an increasingly popular investment activity. 3. Some of FX market participants deal _____ currencies as an investment. 4. When an American firm buys foreign goods, services, or financial assets U.S. dollars (typically, bank deposits denominated ___ U.S. dollars) must be exchanged _____ foreign currency (bank deposits denominated ___ the foreign currency).5. Alpari (UK) Limited is an award-winning Forex broker headquartered ____ the heart of the City of London and with subsidiaries in Germany, Japan and India as well as a Representative Office in China. 6. Banks trade international currencies to profit ____ changes in exchange rates, obtain currency for direct foreign investments or secure currency needed by the banks' customers. 7. The task of a broker is to find a counterpart ____ a client quickly. 8. A futures contract is an obligation to exchange a good or instrument ______ a set price ____a future date.

Exercise 5.

Match two columns. Use the correct forms of word combinations to complete the sentences below.

spot exchange to trade to charge currency

currencies fluctuations commissions transaction rate

1. Banks may exchange currencies in a ____________ in which two parties agree on an _____________and make an immediate currency trade. Or they may agree to a forward transaction in which they will ________________at a specific future time.

2. Forex trading is a zero-sum game: one counterparty to the trade wins, the other side loses. Brokers who only ______________do not assume the role of counterparty to customer trades, and thus have no reason to manipulate prices or spreads to the customers' disadvantage.

3. Any individual or company engaged in overseas business should be aware of the risks of ______________. 

Exercise 6.

Choose the correct part of speech to complete the sentences. Change the form if necessary.