Unit VI the foreign exchange market

LEARNING OBJECTIVES

After studying this unit, you should be able to:

• examine topics and subtopics and predict content related to the functioning of the foreign exchange market;

• apply reading skills to comprehend, analyze, and interpret texts related to the organization and functions of the foreign exchange market, classification and characteristics of its participants, the peculiarities of hedging instruments (i.e. recognize main ideas in paragraphs, definitions, explanations, examples, classifications, comparisons and contrasts, sequence of events, cause / effect, pros and cons);

• use strategies to reinforce comprehension skills (i.e. cite evidence for main ideas, answer literal and critical comprehension questions);

• identify the main ideas, recall important details of a listening segment pertaining to the foreign exchange market, take notes from spoken context as well as relate new information to previously acquired concepts;

• give spontaneous and prepared monologs, dialogs, and group interaction using topical vocabulary;

• summarize, annotate, render and translate texts related to the issues covered in the unit.

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)

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)

Exercise 2. Read the text.

The Fundamentals 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 nonbank 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 the forward exchange rate respectively. 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. In the event customers do not know when they will need foreign currency, an option forward contract is frequently used A currency option is 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. “A call” is an option to buy, and “a put” is an option to sell. Currency futures contract is a futures contract to exchange one currency for another on a specified date in the future at a price (exchange rate) that is fixed on the purchase date. A foreign exchange swap (a currency swap) is an agreement between two parties to exchange two currencies at a certain exchange rate at a certain time in the future. For example, if a company knows that it will need British pounds in the future and another company knows that it will need U.S. dollars, they agree to swap the two at the agreed-upon exchange rate. This eliminates the risk that the exchange rate will change in a way that is disadvantageous to one party or the other.