Lecture 12 Foreign Exchange Market Flashcards
FOREX
Facilitates the conversion of one country’s currency into another
- sets and quotes exchange rates
- the price of a country’s currency in terms of another country’s currency
- these rates determine costs and returns to global businesses
Offers contract to manage foreign exchange exposure
- these hedging contracts allow global firms to offset their foreign currency exposures and mafana he foreign exchange risk. Thus they can concentrate on their core business
Market characteristics
World’s largest and most liquid financial market
Market is a 24/7 over the counter market
Major trading centre is london
The most popular traced currency is the US dollar
The most popular traded currency pair is the dollar to euro
Currencies are neither traded for immediate delivery or some specified future delivery (forward)
Participants and purposes of the FX market
Companies and individuals transact for the purpose of the international trade of goods and services
Capital market participants transact for the purpose of loving funds into or out of foreign assets
Hedgers who have an exposure to exchange rate risk enter into positions to reduce this risk
Speculators participate to profit from future movements in foreign exchange
Types of FX products
Spot market: currencies for immediate delivery
Forward contracts: which are agreements for a future exchange at a specified exchange rate
FX swaps : which are a combination of a spot contact and forward contract used to roll forward a position in a forward contract
FX options : are options to enter an FX contract some time in the future at a specified exchange rate
Base and quote currency
Given that a foreign exchange quote is simply the ratio of one currency to another, a complete market maker quote must have two ISO designations
First currency quoted is the base currency
2nd ISO currency is the quote currency
One base currency is exchanged for how much quote currency
Direct currency quote
Used the domestic currency as the base currency and the foreign currency as the quote currency
An indirect currency quote
Uses the domestic currency as the quote currency and the foreign currency as base currency
Exchange rate
Ratio of one currency against another
American currency quotation
Expresses the exchange rate as the number of US dollars one unit of foreign currency
European currency quotation
Expresses the exchange rate as the number of foreign currency units per one US dollar
Currency cross rates
Given 3 currencies, a currency cross-rate is the implied exchange rate of a third country pair given the exchange rates of two pairs of three currencies that have a common currency
If Arbitrage is possible, cross rates will be consistent
Effective exchange rate
A measure of whether or not the currency is appreciating or depreciating against a weighted basket of foreign currencies
Hypothetically: UK trades: 30% with USA and 70% with Europe
Spot exchange rate
FX RATE for immediate transactions within 1 or 2 business days
Forward exchange rate
Rate for an exchange to be done in the future. 7,30,60 days
Forward markets are used by businesses to protect against unexpected future changes in exchange rates
Forward rate allows businesses to lock in and exchange rate for some future period of time
Hedgers forward rate market participants
Agents usually firms that enter the forward exchange market to protect themselves against exchange rate fluctuations which entail exchange rate risk - risk of loss due to averse exchange rate movements
