Foreign exchange market
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Exchange rate regime
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Foreign exchange market
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Bureau de change
The foreign exchange (currency or forex or FX) market exists wherever one currency
is traded for another. It is by far the largest financial market in the world, and includes
trading between large banks, central banks, currency speculators, multinational
corporations, governments, and other financial markets and institutions. The average
daily trade in the global forex and related markets currently is over US$ 3 trillion.
Retail traders (individuals) are a small fraction of this market and may only participate
indirectly through brokers or banks, and are subject to forex scams .
Market size and liquidity
The foreign exchange market is unique because of
its trading volumes,
the extreme liquidity of the market,
the large number of, and variety of, traders in the market,
its geographical dispersion,
its long trading hours: 24 hours a day (except on weekends),
the variety of factors that affect exchange rates.
the low margins of profit compared with other markets of fixed income
(but profits can be high due to very large trading volumes)
According to the BIS, average daily turnover in traditional foreign exchange markets is
estimated at $3.21 trillion. Daily averages in April for different years, in billions of US
dollars, are presented on the chart below:
This $3.21 trillion in global foreign exchange market "traditional" turnover was broken
down as follows:
$1,005 billion in spot transactions
$362 billion in outright forwards
$1,714 billion in forex swaps
$129 billion estimated gaps in reporting
In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.
Exchange-traded forex futures contracts were introduced in 1972 at the Chicago
Mercantile Exchange and are actively traded relative to most other futures contracts.
Forex futures volume has grown rapidly in recent years, and accounts for about 7% of the
total foreign exchange market volume, according to The Wall Street Journal Europe
(5/5/06, p. 20).
Average daily global turnover in traditional foreign exchange market transactions totaled
$2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London,
New York, Tokyo and Singapore Foreign Exchange Committee data. Overall turnover,
including non-traditional foreign exchange derivatives and products traded on exchanges,
averaged around $2.9 trillion a day. This was more than ten times the size of the
combined daily turnover on all the world’s equity markets. Foreign exchange trading
increased by 38% between April 2005 and April 2006 and has more than doubled since
2001. This is largely due to the growing importance of foreign exchange as an asset class
and an increase in fund management assets, particularly of hedge funds and pension
funds. The diverse selection of execution venues such as internet trading platforms has
also made it easier for retail traders to trade in the foreign exchange market. 
Because foreign exchange is an OTC market where brokers/dealers negotiate directly
with one another, there is no central exchange or clearing house. The biggest geographic
trading centre is the UK, primarily London, which according to IFSL estimates has
increased its share of global turnover in traditional transactions from 31.3% in April 2004
to 32.4% in April 2006. RPP
The ten most active traders account for almost 73% of trading volume, according to The
Wall Street Journal Europe, (2/9/06 p. 20). These large international banks continually
provide the market with both bid (buy) and ask (sell) prices. The bid/ask spread is the
difference between the price at which a bank or market maker will sell ("ask", or "offer")
and the price at which a market-maker will buy ("bid") from a wholesale customer. This
spread is minimal for actively traded pairs of currencies, usually 0–3 pips. For example,
the bid/ask quote of EUR/USD might be 1.2200/1.2203. Minimum trading size for most
deals is usually $100,000.
These spreads might not apply to retail customers at banks, which will routinely mark up
the difference to say 1.2100 / 1.2300 for transfers, or say 1.2000 / 1.2400 for banknotes
or travelers' checks. Spot prices at market makers vary, but on EUR/USD are usually no
more than 3 pips wide (i.e. 0.0003). Competition has greatly increased with pip spreads
shrinking on the major pairs to as little as 1 to 2 pips.
 Market participants
Foreign exchange market
Real estate market
Financial market participants
Banks and Banking
Source: Euromoney FX survey
Top 10 Currency Traders
% of overall volume, May 2007 Name % of volume
1 Deutsche Bank 19.30
2 UBS AG 14.85
3 Citi 9.00
4 Royal Bank of Scotland 8.90
5 Barclays Capital 8.80
6 Bank of America 5.29 Unlike a
7 HSBC 4.36 stock
8 Goldman Sachs 4.14 market,
9 JPMorgan 3.33 participants
10 Morgan Stanley 2.86 have access
to the same
prices, the forex market is divided into levels of access. At the top is the inter-bank
market, which is made up of the largest investment banking firms. Within the inter-bank
market, spreads, which are the difference between the bid and ask prices, are razor sharp
and usually unavailable, and not known to players outside the inner circle. As you
descend the levels of access, the difference between the bid and ask prices widens (from
0-1 pip to 1-2 pips only for major currencies like the Euro). This is due to volume. If a
trader can guarantee large numbers of transactions for large amounts, they can demand a
smaller difference between the bid and ask price, which is referred to as a better spread.
The levels of access that make up the forex market are determined by the size of the
―line‖ (the amount of money with which they are trading). The top-tier inter-bank market
accounts for 53% of all transactions. After that there are usually smaller investment
banks, followed by large multi-national corporations (which need to hedge risk and pay
employees in different countries), large hedge funds, and even some of the retail forex
market makers. According to Galati and Melvin, ―Pension funds, insurance companies,
mutual funds, and other institutional investors have played an increasingly important role
in financial markets in general, and in FX markets in particular, since the early 2000s.‖
(2004) In addition, he notes, ―Hedge funds have grown markedly over the 2001–2004
period in terms of both number and overall size‖ Central banks also participate in the
forex market to align currencies to their economic needs.
The interbank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars
daily. Some of this trading is undertaken on behalf of customers, but much is conducted
by proprietary desks, trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating
interbank trading and matching anonymous counterparts for small fees. Today, however,
much of this business has moved on to more efficient electronic systems. The broker
squawk box lets traders listen in on ongoing interbank trading and is heard in most
trading rooms, but turnover is noticeably smaller than just a few years ago.
 Commercial companies
An important part of this market comes from the financial activities of companies seeking
foreign exchange to pay for goods or services. Commercial companies often trade fairly
small amounts compared to those of banks or speculators, and their trades often have
little short term impact on market rates. Nevertheless, trade flows are an important factor
in the long-term direction of a currency's exchange rate. Some multinational companies
can have an unpredictable impact when very large positions are covered due to exposures
that are not widely known by other market participants.
 Central banks
National central banks play an important role in the foreign exchange markets. They try
to control the money supply, inflation, and/or interest rates and
often have official or unofficial target rates for their currencies. They can use their often
substantial foreign exchange reserves to stabilize the market. Milton Friedman argued
that the best stabilization strategy would be for central banks to buy when the exchange
rate is too low, and to sell when the rate is too high — that is, to trade for a profit based
on their more precise information. Nevertheless, the effectiveness of central bank
"stabilizing speculation" is doubtful because central banks do not go bankrupt if they
make large losses, like other traders would, and there is no convincing evidence that they
do make a profit trading.
The mere expectation or rumor of central bank intervention might be enough to stabilize
a currency, but aggressive intervention might be used several times each year in countries
with a dirty float currency regime. Central banks do not always achieve their objectives.
The combined resources of the market can easily overwhelm any central bank. Several
scenarios of this nature were seen in the 1992–93 ERM collapse, and in more recent
times in Southeast Asia.
 Investment management firms
Investment management firms (who typically manage large accounts on behalf of
customers such as pension funds and endowments) use the foreign exchange market to
facilitate transactions in foreign securities. For example, an investment manager with an
international equity portfolio will need to buy and sell foreign currencies in the spot
market in order to pay for purchases of foreign equities. Since the forex transactions are
secondary to the actual investment decision, they are not seen as speculative or aimed at
Some investment management firms also have more speculative specialist currency
overlay operations, which manage clients' currency exposures with the aim of generating
profits as well as limiting risk. Whilst the number of this type of specialist firms is quite
small, many have a large value of assets under management (AUM), and hence can
generate large trades.
 Hedge funds
Hedge funds, such as George Soros's Quantum fund have gained a reputation for
aggressive currency speculation since 1990. They control billions of dollars of equity and
may borrow billions more, and thus may overwhelm intervention by central banks to
support almost any currency, if the economic fundamentals are in the hedge funds' favor.
 Retail forex brokers
Retail forex brokers or market makers handle a minute fraction of the total volume of the
foreign exchange market. According to CNN, one retail broker estimates retail volume at
$25–50 billion daily, which is about 2% of the whole market and it has been reported by
the CFTC website that inexperienced investors may become targets of forex scams.
characteristics Most traded currencies
There is no unified or Currency distribution of reported FX market turnover
centrally cleared ISO 4217 % daily share
market for the majority Rank Currency
of FX trades, and there
is very little cross- 1 United States dollar USD $ 88.7%
border regulation. Due 2 Eurozone euro EUR € 37.2%
to the over-the-counter 3 Japanese yen JPY ¥ 20.3%
(OTC) nature of
currency markets, there 4 British pound sterling GBP £ 16.9%
are rather a number of 5 Swiss franc CHF Fr 6.1%
marketplaces, where 6 Australian dollar AUD $ 5.5%
different currency 7 Canadian dollar CAD $ 4.2%
instruments are traded. 8 Swedish krona SEK kr 2.3%
This implies that there
is not a single dollar 9 Hong Kong dollar HKD $ 1.9%
rate but rather a 10 Norwegian krone NOK kr 1.4%
number of different
rates (prices), Other 15.5%
depending on what Total 200%
bank or market maker
is trading. In practice
the rates are often very close, otherwise they could be exploited by arbitrageurs
instantaneously. A joint venture of the Chicago Mercantile Exchange and Reuters, called
FxMarketSpace opened in 2007 and aspires to the role of a central market clearing
The main trading centers are in London, New York, Tokyo, and Singapore, but banks
throughout the world participate. Currency trading happens continuously throughout the
day; as the Asian trading session ends, the European session begins, followed by the
North American session and then back to the Asian session, excluding weekends.
There is little or no 'inside information' in the foreign exchange markets. Exchange rate
fluctuations are usually caused by actual monetary flows as well as by expectations of
changes in monetary flows caused by changes in GDP growth, inflation, interest rates,
budget and trade deficits or surpluses, large cross-border M&A deals and other
macroeconomic conditions. Major news is released publicly, often on scheduled dates, so
many people have access to the same news at the same time. However, the large banks
have an important advantage; they can see their customers' order flow.
Currencies are traded against one another. Each pair of currencies thus constitutes an
individual product and is traditionally noted XXX/YYY, where YYY is the ISO 4217
international three-letter code of the currency into which the price of one unit of XXX is
expressed (called base currency). For instance, EUR/USD is the price of the euro
expressed in US dollars, as in 1 euro = 1.3045 dollar. Out of convention, the first
currency in the pair, the base currency, was the stronger currency at the creation of the
pair. The second currency, counter currency, was the weaker currency at the creation of
The factors affecting XXX will affect both XXX/YYY and XXX/ZZZ. This causes
positive currency correlation between XXX/YYY and XXX/ZZZ.
On the spot market, according to the BIS study, the most heavily traded products were:
EUR/USD: 28 %
USD/JPY: 18 %
GBP/USD (also called sterling or cable): 14 %
and the US currency was involved in 88.7% of transactions, followed by the euro
(37.2%), the yen (20.3%), and the sterling (16.9%) (see table). Note that volume
percentages should add up to 200%: 100% for all the sellers and 100% for all the buyers.
Although trading in the euro has grown considerably since the currency's creation in
January 1999, the foreign exchange market is thus far still largely dollar-centered. For
instance, trading the euro versus a non-European currency ZZZ will usually involve two
trades: EUR/USD and USD/ZZZ. The exception to this is EUR/JPY, which is an
established traded currency pair in the interbank spot market.
 Factors affecting currency trading
See also: Exchange rates
Although exchange rates are affected by many factors, in the end, currency prices are a
result of supply and demand forces. The world's currency markets can be viewed as a
huge melting pot: in a large and ever-changing mix of current events, supply and demand
factors are constantly shifting, and the price of one currency in relation to another shifts
accordingly. No other market encompasses (and distills) as much of what is going on in
the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any
single element, but rather by several. These elements generally fall into three categories:
economic factors, political conditions and market psychology.
 Economic factors
These include economic policy, disseminated by government agencies and central banks,
economic conditions, generally revealed through economic reports, and other economic
Economic policy comprises government fiscal policy (budget/spending practices) and
monetary policy (the means by which a government's central bank influences the supply
and "cost" of money, which is reflected by the level of interest rates).
Economic conditions include:
Government budget deficits or surpluses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country's currency.
Balance of trade levels and trends: The trade flow between countries illustrates the
demand for goods and services, which in turn indicates demand for a country's currency
to conduct trade. Surpluses and deficits in trade of goods and services reflect the
competitiveness of a nation's economy. For example, trade deficits may have a negative
impact on a nation's currency.
Inflation levels and trends: Typically, a currency will lose value if there is a high level
of inflation in the country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand, for that particular currency.
Economic growth and health: Reports such as gross domestic product (GDP),
employment levels, retail sales, capacity utilization and others, detail the levels of a
country's economic growth and health. Generally, the more healthy and robust a country's
economy, the better its currency will perform, and the more demand for it there will be.
 Political conditions
Internal, regional, and international political conditions and events can have a profound
effect on currency markets.
For instance, political upheaval and instability can have a negative impact on a nation's
economy. The rise of a political faction that is perceived to be fiscally responsible can
have the opposite effect. Also, events in one country in a region may spur positive or
negative interest in a neighboring country and, in the process, affect its currency.
 Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a
variety of ways:
Flights to quality: Unsettling international events can lead to a "flight to quality," with
investors seeking a "safe haven". There will be a greater demand, thus a higher price, for
currencies perceived as stronger over their relatively weaker counterparts.
Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may
rise from economic or political trends. 
"Buy the rumor, sell the fact:" This market truism can apply to many currency
situations. It is the tendency for the price of a currency to reflect the impact of a particular
action before it occurs and, when the anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as a market being "oversold" or
"overbought". To buy the rumor or sell the fact can also be an example of the cognitive
bias known as anchoring, when investors focus too much on the relevance of outside
events to currency prices.
Economic numbers: While economic numbers can certainly reflect economic policy,
some reports and numbers take on a talisman-like effect: the number itself becomes
important to market psychology and may have an immediate impact on short-term market
moves. "What to watch" can change over time. In recent years, for example, money
supply, employment, trade balance figures and inflation numbers have all taken turns in
Technical trading considerations: As in other markets, the accumulated price
movements in a currency pair such as EUR/USD can form apparent patterns that traders
may attempt to use. Many traders study price charts in order to identify such patterns. 
 Algorithmic trading in forex
Electronic trading is growing in the FX market, and algorithmic trading is becoming
much more common. There is much confusion about the technique. According to
financial consultancy Celent estimates, by 2008 up to 25% of all trades by volume will be
executed using algorithm, up from about 18% in 2005.
 Financial instruments
A spot transaction is a two-day delivery transaction, as opposed to the futures contracts,
which are usually three months. This trade represents a ―direct exchange‖ between two
currencies, has the shortest time frame, involves cash rather than a contract; and interest
is not included in the agreed-upon transaction. The data for this study come from the spot
market. Spot has the largest share by volume in FX transactions among all instruments.
One way to deal with the Forex risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A
buyer and seller agree on an exchange rate for any date in the future, and the transaction
occurs on that date, regardless of what the market rates are then. The duration of the trade
can be a few days, months or years.
Main article: Currency future
Foreign currency futures are forward transactions with standard contract sizes and
maturity dates — for example, 500,000 British pounds for next November at an agreed
rate. Futures are standardized and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures contracts are usually
inclusive of any interest amounts.
Main article: Forex swap
The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded through
Main article: Foreign exchange option
A foreign exchange option (commonly shortened to just FX option) is a derivative where
the owner has the right but not the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange rate on a specified date. The FX
options market is the deepest, largest and most liquid market for options of any kind in
 Exchange Traded Fund
Main article: Exchange-traded fund
Exchange-traded funds (or ETFs) are Open Ended investment companies that can be
traded at any time throughout the course of the day. Typically, ETFs try to replicate a
stock market index such as the S&P 500 (e.g. SPY), but recently they are now replicating
investments in the currency markets with the ETF increasing in value when the US Dollar
weakness versus a specific currency, such as the Euro. Certain of these funds track the
price movements of world currencies versus the US Dollar, and increase in value directly
counter to the US Dollar, allowing for speculation in the US Dollar for US and US Dollar
denominated investors and speculators.
Controversy about currency speculators and their effect on currency devaluations and
national economies recurs regularly. Nevertheless, many economists (e.g. Milton
Friedman) have argued that speculators perform the important function of providing a
market for hedgers and transferring risk from those people who don't wish to bear it, to
those who do. Other economists (e.g. Joseph Stiglitz) however, may consider this
argument to be based more on politics and a free market philosophy than on economics.
Large hedge funds and other well capitalized "position traders" are the main professional
Currency speculation is considered a highly suspect activity in many countries. While
investment in traditional financial instruments like bonds or stocks often is considered to
contribute positively to economic growth by providing capital, currency speculation does
not, according to this view; it is simply gambling, that often interferes with economic
policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to
raise interest rates for a few days to 150% per annum, and later to devalue the krona.
Former Malaysian Prime Minister Mahathir Mohamad is one well known proponent of
this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros
and other speculators.
Gregory Millman reports on an opposing view, comparing speculators to "vigilantes"
who simply help "enforce" international agreements and anticipate the effects of basic
economic "laws" in order to profit.
In this view, countries may develop unsustainable financial bubbles or otherwise
mishandle their national economies, and forex speculators made the inevitable collapse
happen sooner. A relatively quick collapse might even be preferable to continued
economic mishandling. Mahathir Mohamad and other critics of speculation are viewed as
trying to deflect the blame from themselves for having caused the unsustainable
economic conditions. Given that Malaysia recovered quickly after imposing currency
controls directly against IMF advice, this view is open to doubt.
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Also known as the spot currency or forex market, the foreign currency exchange market is the largest
market in the world, consisting of about $1.9 trillion in transactions every day. It is different from other
markets not only because of its tremendous volume but also because of its extreme liquidity. The
forex market is an over the counter, or decentralized market. This means that traders may choose
from a number of dealers to make a trade with, as opposed to the stock market for example, in which
all trades of a particular stock must pass through one point. This allows for much more price
The market is essentially composed of six types of participants: commercial and investment banks,
central banks, corporations, global funds, and retail clients (individual traders). Commercial and
investment banks trade on what is known as the ‘interbank’ market and make up the largest portion
of forex trading. They trade for themselves as well as for their customers, and balance accounts by
trading with each other. Central banks, large corporations, and hedge funds all trade on the interbank
system as well. As the largest investors in forex, and with their well-established credit relationships,
the members of the interbank system trade with the best rates. About three quarters of the daily
volume of the forex market is exchanged in the interbank system.
Central banks function in the forex market as regulatory agencies with the responsibility of
maintaining their country’s money supply, and therefore do not speculate. Some directly influential
actions they take include setting overnight lending rates, buying and selling government securities to
adjust the size of the money supply, and buying/selling their own currency in the open market to
influence interest rates.
The main uses of the forex market for corporations are hedging against currency depreciation to
protect future transactions and buying/selling currencies to pay international employees. Global
managed profit-seeking funds generate a lot of volume in the forex market through foreign financial
investments. They constitute about 20% of total market volume. Individuals account for the rest,
using the forex market mostly for speculative purposes and sometimes to hedge. Because of online
retail dealers, individuals can participate in forex trading under similar conditions as those on the
interbank level; spreads are only slightly wider and execution is just as easy and effective.
Foreign currency trading on the retail level is based on speculation on changes in the exchange rate
between two currencies. Changes in the exchange rate are due to changes in the value of each
currency relative to the other in the pair, and are measured in points in percentage, or pips. The
foreign currency exchange market is a global market, in operation every week from Sunday at
5:00pm EST to Friday at 4:00pm EST. In every trade, one currency in the pair is borrowed in order to
buy the other, typically in lots of 100,000 units each. Currencies and actions are chosen in
expectation of a particular outcome. This expectation is usually derived using two kinds of analysis of
the market: technical and fundamental. Technical analysis refers to the use of various statistical
studies of charts of the past behavior of any currency pair in order to predict future movement.
Fundamental analysis involves the use of different economic indicators as well as all news with the
potential of influencing the forex market to predict future movements of exchange rates. The chances
for profit are equal regardless of whether an exchange rate is increasing or decreasing, as long as
the appropriate corresponding action is taken. For every currency pair there is a ‘bid’ and an ‘ask’
price. The bid is the price at which a trader can sell the currency pair, and the ask is the price at
which the trader can buy it. The difference between the bid and the ask is known as the ‘spread,’ and
is the cost of the trade, or the amount that the trade will have to make to break even. Trades are
made on margin, with a minimum requirement of 1%. This allows for much more leverage than other
markets, as well as security against losses.
It may be said that the history of the forex market began with the origin of the global free-floating
currency system. This originated with the Bretton Woods Accord, held in 1944 in New Hampshire,
attended by delegates from Great Britain, France, and the United States. The conference was held
with the intention of creating a post-World War II global environment in which all the ravaged
economies of Europe could rebuild. The outcome of the accord was the International Monetary Fund
(IMF), an aid agency, and the pegging of the major currencies to the US dollar, the only major
currency left unharmed by the war. This action did bring stability back to Europe, although it
ultimately collapsed. Similar agreements were made in its place, though with the new intention of
ending the dependence of European currencies on the US dollar. By 1973 these too had failed,
marking the conversion to a free-floating system, which was mandated in 1978. By 1993 there were
no longer any agreements at all, allowing all currencies to move independently.
During the 1980s computers and other technology made substantial new developments that had a
significant impact on the forex market, for example by increasing the speed with which international
transactions could be made. Jumping from nearly a billion dollars a day in the 1980s to almost $1.9
trillion a day now, the forex market has experienced major growth in recent years. Subsequent
progression in the process of globalization has also been influential, as large corporations employ
more people internationally (and therefore must exchange currency to pay them) and the economic
policy of different nations becomes increasingly interrelated.
Slide 1: • Name : Anita Babbar (Eco. PGT) • Subject :Economics • Topic :Foreign
exchange rate and its determination • School :Kulachi Hansraj Model School
Slide 2: Foreign Exchange Rate
Slide 3: Objective is to acquaint students about determination of foreign exchange rate in
the highly volatile international market. Post globalization foreign exchange rate has
assumed all the more significance & evokes unprecedented interest. Foreign exchange
rate is neither rigidly fixed nor rigidly flexible in any economy of the world. It is under
Govt. regulations & changes if any are minimal in nature.
Slide 4: Meaning of Foreign Exchange Rate It is the price of one currency in terms of
other. It is the rate at which exports and imports of a nation are valued at a given point in
Slide 5: Foreign Exchange Market It is the market where the national currencies are
traded for one another. It performs mainly three functions: 3.To transfer the purchasing
power between countries. 4.To provide credit channels for foreign trade. 3. To protect
against foreign exchange risks.
Slide 6: Who needs Foreign Exchange? When people wish to operate in the foreign
exchange market they intend to buy or sell foreign exchange depending on their demand
for and supply of foreign exchange.
Slide 7: Demand and Supply Side 2.Demand Side People desire to have or acquire
Foreign 3. exchange for the following reasons: (d)To purchase goods and services from
other countries (e)To send a gift abroad or make a visit abroad. (f)To purchase financial
assets in a particular country (g)To speculate on the value of foreign currencie
Slide 8: Supply Side 2. Foreign currencies flow into the domestic economy due to the
following: (c)Foreigners purchasing home, country’s goods and services through exports.
(b) Foreign investment in home country through joint ventures or through financial
market operations. (c) Foreign currencies flow into the economy due to currency dealers
and speculators. (d) Foreign tourists visiting domestic territory or sending a gift.
Slide 9: Equilibrium in the Foreign Exchange Market Foreign exchange market like any
other market is characterised by a downward sloping demand curve and an upward
sloping supply curve. s e d
Slide 10: The price on the vertical axis is stated in terms of domestic currency. The
horizontal axis measures the quantity demanded or supplied. The intersection of the
demand and supply curves determines the equilibrium exchange rate (Req) and the
equilibrium quantity (Qeq) of foreign currency, i.e., US($). This is shown in the
Slide 11: Price Rs/$ S$ R’ S’$ Req R’’ D’$ D$ Qeq Q’’ Q’ Demand and Supply of US $
Slide 12: In this figure the demand curve (D$) is downward sloping. This means that less
foreign exchange is demanded as the exchange rate increases.
Slide 13: This is due to the fact that the rise in the price of foreign exchange will increase
the rupee cost of foreign goods, which makes them more expensive. As a result, imports
will decline. Thus the demand for foreign exchange will also decrease.
Slide 14: In this figure the supply curve (S$) is upward sloping which means that supply
of foreign exchange increases as the exchange rate increases.
Slide 15: This makes home country’s goods become cheaper to foreigner since the rupee
is depreciating in value. The demand for our exports should therefore increase as the
exchange rate increases. The increased demand for our exports will mean greater supply
of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate
Slide 16: • Thus the foreign exchange rate will be determined where demand for &
supply of foreign exchange are equal. • The demand curve & supply curve intersect each
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Fixed exchange rate
From Wikipedia, the free encyclopedia
Jump to: navigation, search
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate
Foreign exchange market
Foreign exchange option
Bureau de change
A fixed exchange rate, sometimes (less commonly) called a pegged exchange rate, is a
type of exchange rate regime wherein a currency's value is matched to the value of
another single currency or to a basket of other currencies, or to another measure of value,
such as gold. As the reference value rises and falls, so does the currency pegged to it. In
addition, fixed exchange rates deprive governments of the use of an independent
domestic monetary policy to achieve internal stability. However, in certain situations,
fixed exchange rates may be preferable for their greater stability. For example, the Asian
financial crisis was improved by the fixed exchange rate of the Chinese renminbi, and the
IMF and the World Bank now acknowledge that Malaysia's adoption of a peg to the US
dollar in the aftermath of the same crisis was highly successful. Following the devastation
of World War II, the Bretton Woods system allowed Western Europe to have fixed
exchange rates until 1970 with the US dollar. 
Yet others argue that the fixed exchange rates (implemented well before the crisis) had
become so immovable that it had masked valuable information needed for a market to
function properly. That is, the currencies did not represent their true market value. This
masking of information created volatility which encouraged speculators to "attack" the
pegged currencies and as a response these countries attempt to defend their currency
rather than allow it to devalue. These economists also believe that had these countries
instituted floating exchange rates, as opposed to fixed exchange rates, they may very well
have avoided the volatility that caused the Asian financial crisis. Countries like Malaysia
adopted increased capital controls believing that the volatility of capital was the result of
technology and globalization, rather than fallacious macroeconomic policies which
resulted not in better stability and growth in the aftermath of the crisis but sustained pain
Countries adopting a fixed exchange rate must exercise careful and strict adherence to
policy imperatives, and keep a degree of confidence of the capital markets in the
management of such a regime, or otherwise the peg can fail. Such was the case of
Argentina, where unchecked state spending and international economic shocks
disbalanced the system and ended up forcing an extremely damaging devaluation (see
Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis). On
the opposite extreme, China's fixed exchange rate with the US dollar until 2005 led to
China's rapid accumulation of foreign reserves, placing an appreciating pressure on the
1 Maintaining a fixed exchange rate
4 See also
 Maintaining a fixed exchange rate
Typically, a government wanting to maintain a fixed exchange rate does so by either
buying or selling its own currency on the open market. This is one reason governments
maintain reserves of foreign currencies. If the exchange rate drifts too far below the
desired rate, the government buys its own currency off the market using its reserves. This
places greater demand on the market and pushes up the price of the currency. If the
exchange rate drifts too far above the desired rate, the opposite measures are taken.
Another, less used means of maintaining a fixed exchange rate is by simply making it
illegal to trade currency at any other rate. This is difficult to enforce and often leads to a
black market in foreign currency. Nonetheless, communist countries are highly successful
at using this method due to government monopolies over all money conversion. This is
the method employed by the Chinese government to maintain a currency peg or tightly
banded float against the US dollar. Throughout the 1990s China was highly
successful at maintaining a currency peg using a government monopoly over all currency
conversion between the Yuan and other currencies.
The main criticism of fixed exchange rate is that flexible exchange rates serve to
automatically adjust the balance of trade. When a trade deficit occurs, there
will be increased demand for the foreign (rather than domestic) currency which will push
up the price of the foreign currency in terms of the domestic currency. That in turn makes
the price of foreign goods less attractive to the domestic market and thus pushes down the
trade deficit. Under fixed exchange rates, this automatic re-balancing does not occur
From Wikipedia, the free encyclopedia
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Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate
Foreign exchange market
Foreign exchange option
Bureau de change
In finance, the exchange rate (also known as the foreign-exchange rate, forex rate or
FX rate) between two currencies specifies how much one currency is worth in terms of
the other. For example an exchange rate of 123 Japanese yen (JPY, ¥) to the United
States dollar (USD, $) means that JPY 123 is worth the same as USD 1. The foreign
exchange market is one of the largest markets in the world. By some estimates, about 2
trillion USD worth of currency changes hands every day.
The spot exchange rate refers to the current exchange rate. The forward exchange rate
refers to an exchange rate that is quoted and traded today but for delivery and payment on
a specific future date.
2 Free or pegged
3 Nominal and real exchange rates
4 Uncovered interest rate parity
5 Balance of payments model
6 Asset market model
7 Fluctuations in exchange rates
8 Foreign exchange markets
9 See also
10 External links
An exchange rate quotation is given by stating the number of units of a "price currency"
that can be bought in terms of 1 unit currency (also called base currency). For example,
in a quotation that says the EUR/USD exchange rate is 1.3 (USD per EUR), the price
currency is USD and the unit currency is EUR.
Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = $1.45 in
the US) are known as direct quotation or price quotation (from that country's
perspective) () and are used by most countries.
Quotes using a country's home currency as the unit currency (e.g., $2.1091 = £1 in the
UK) are known as indirect quotation or quantity quotation and are used in British
newspapers and are also common in Australia, New Zealand and the eurozone.
direct quotation: 1 foreign currency unit = x home currency units
indirect quotation: 1 home currency unit = x foreign currency units
Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating,
or becoming more valuable) then the exchange rate number decreases. Conversely if the
foreign currency is strengthening, the exchange rate number increases and the home
currency is depreciating.
When looking at a currency pair such as EUR/USD, many times the first component
(EUR in this case) will be called the base currency. The second is called the counter
currency. For example : EUR/USD = 1.33866, means EUR is the base and USD the
counter, so 1 EUR = 1.33866 USD.
Currency pairs are given with four decimal places, except JPY with two decimal places
(EUR/USD : 1.3386 - EUR/JPY : 165.29). In other words, quotes are given with 5 digits.
Where rates are below 1, quotes frequently include 5 decimal places.
 Free or pegged
Main article: Exchange rate regime
If a currency is free-floating, its exchange rate is allowed to vary against that of other
currencies and is determined by the market forces of supply and demand. Exchange rates
for such currencies are likely to change almost constantly as quoted on financial markets,
mainly by banks, around the world. A movable or adjustable peg system is a system of
fixed exchange rates, but with a provision for the devaluation of a currency. For example,
between 1994 and 2005, the Chinese yuan renminbi (RMB) was pegged to the United
States dollar at RMB 8.2768 to $1. China was not the only country to do this; from the
end of World War II until 1970, Western European countries all maintained fixed
exchange rates with the US dollar based on the Bretton Woods system. 
 Nominal and real exchange rates
The nominal exchange rate e is the price in domestic currency of one unit of a
The real exchange rate (RER) is defined as , where P is the domestic price level
and P * the foreign price level. P and P * must have the same arbitrary value in
some chosen base year. Hence in the base year, RER = e.
The RER is only a theoretical ideal. In practice, there are many foreign currencies and
price level values to take into consideration. Correspondingly, the model calculations
become increasingly more complex. Furthermore, the model is based on purchasing
power parity (PPP), which implies a constant RER. The empirical determination of a
constant RER value could never be realised, due to limitations on data collection. PPP
would imply that the RER is the rate at which an organization can trade goods and
services of one economy (e.g. country) for those of another. For example, if the price of a
good increases 10% in the UK, and the Japanese currency simultaneously appreciates
10% against the UK currency, then the price of the good remains constant for someone in
Japan. The people in the UK, however, would still have to deal with the 10% increase in
domestic prices. It is also worth mentioning that government-enacted tariffs can affect the
actual rate of exchange, helping to reduce price pressures. PPP appears to hold only in the
long term (3–5 years) when prices eventually correct towards parity.
More recent approaches in modelling the RER employ a set of macroeconomic variables,
such as relative productivity and the real interest rate differential.
 Uncovered interest rate parity
See also: Interest rate parity#Uncovered interest rate parity
Uncovered interest rate parity (UIRP) states that an appreciation or depreciation of one
currency against another currency might be neutralized by a change in the interest rate
differential. If US interest rates exceed Japanese interest rates then the US dollar should
depreciate against the Japanese yen by an amount that prevents arbitrage. The future
exchange rate is reflected into the forward exchange rate stated today. In our example, the
forward exchange rate of the dollar is said to be at a discount because it buys fewer
Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a
UIRP showed no proof of working after 1990s. Contrary to the theory, currencies with
high interest rates characteristically appreciated rather than depreciated on the reward of
the containment of inflation and a higher-yielding currency.
 Balance of payments model
This model holds that a foreign exchange rate must be at its equilibrium level - the rate
which produces a stable current account balance. A nation with a trade deficit will
experience reduction in its foreign exchange reserves which ultimately lowers
(depreciates) the value of its currency. The cheaper currency renders the nation's goods
(exports) more affordable in the global market place while making imports more
expensive. After an intermediate period, imports are forced down and exports rise, thus
stabilizing the trade balance and the currency towards equilibrium.
Like PPP, the balance of payments model focuses largely on tradable goods and services,
ignoring the increasing role of global capital flows. In other words, money is not only
chasing goods and services, but to a larger extent, financial assets such as stocks and
bonds. Their flows go into the capital account item of the balance of payments, thus,
balancing the deficit in the current account. The increase in capital flows has given rise to
the asset market model.
 Asset market model
See also: Capital asset pricing model
The explosion in trading of financial assets (stocks and bonds) has reshaped the way
analysts and traders look at currencies. Economic variables such as economic growth,
inflation and productivity are no longer the only drivers of currency movements. The
proportion of foreign exchange transactions stemming from cross border-trading of
financial assets has dwarfed the extent of currency transactions generated from trading in
goods and services.
The asset market approach views currencies as asset prices traded in an efficient financial
market. Consequently, currencies are increasingly demonstrating a strong correlation
with other markets, particularly equities.
Like the stock exchange, money can be made or lost on the foreign exchange market by
investors and speculators buying and selling at the right times. Currencies can be traded
at spot and foreign exchange options markets. The spot market represents current
exchange rates, whereas options are derivatives of exchange rates.
 Fluctuations in exchange rates
A market based exchange rate will change whenever the values of either of the two
component currencies change. A currency will tend to become more valuable whenever
demand for it is greater than the available supply. It will become less valuable whenever
demand is less than available supply (this does not mean people no longer want money, it
just means they prefer holding their wealth in some other form, possibly another
Increased demand for a currency is due to either an increased transaction demand for
money, or an increased speculative demand for money. The transaction demand for
money is highly correlated to the country's level of business activity, gross domestic
product (GDP), and employment levels. The more people there are unemployed, the less
the public as a whole will spend on goods and services. Central banks typically have little
difficulty adjusting the available money supply to accommodate changes in the demand
for money due to business transactions.
The speculative demand for money is much harder for a central bank to accommodate but
they try to do this by adjusting interest rates. An investor may choose to buy a currency if
the return (that is the interest rate) is high enough. The higher a country's interest rates,
the greater the demand for that currency. It has been argued that currency speculation can
undermine real economic growth, in particular since large currency speculators may
deliberately create downward pressure on a currency in order to force that central bank to
sell their currency to keep it stable (once this happens, the speculator can buy the
currency back from the bank at a lower price, close out their position, and thereby take a
In choosing what type of asset to hold, people are also concerned that the asset will retain
its value in the future. Most people will not be interested in a currency if they think it will
devalue. A currency will tend to lose value, relative to other currencies, if the country's
level of inflation is relatively higher, if the country's level of output is expected to
decline, or if a country is troubled by political uncertainty. For example, when Russian
President Vladimir Putin dismissed his Government on February 24, 2004, the price of
the ruble dropped. When China announced plans for its first manned space mission,
synthetic futures on Chinese yuan jumped (since China's currency is officially pegged,
synthetic markets have emerged that can behave as if the yuan were floating).
 Foreign exchange markets
Main article: Foreign exchange market
The foreign exchange markets are usually highly liquid as the world's main international
banks provide a market around-the-clock. The Bank for International Settlements
reported that global foreign exchange market turnover daily averages in April was $650
billion in 1998 (at constant exchange rates) and increased to $1.9 trillion in 2004 .
Trade in global currency markets has soared over the past three years and is now worth
more than $3.2 trillion a day. The biggest foreign exchange trading centre is London,
followed by New York and Tokyo.
 See also
Floating And Fixed Exchange Rates
by Reem Heakal (Email | Biography)
Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the
world? In fact, over $1 trillion is traded in the currency markets on a daily basis. This article is certainly not a
primer for currency trading, but it will help you understand exchange rates and why some fluctuate while
others do not.
What Is an Exchange Rate?
An exchange rate is the rate at which one currency
can be exchanged for another. In other words, it is the value of another country's currency compared to that
of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price
of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt,
for example, and the exchange rate for USD 1.00 is EGP 5.50, this means that for every U.S. dollar, you can
buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different
countries, because the exchange rate must maintain the inherent value of one currency against the other.
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a
rate the government (central bank) sets and maintains as the official exchange rate. A set price will be
determined against a major world currency (usually the U.S. dollar, but also other major currencies such as
the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank
buys and sells its own currency on the foreign exchange market in return for the currency to which it is
If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the
central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate,
the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency
held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This
ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and
ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and
demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will
automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is
low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for
local goods and services. This in turn will generate more jobs, and hence an auto-correction would occur in
the market. A floating exchange rate is constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence
changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its
pegged currency, a "black market" which is more reflective of actual supply and demand may develop. A
central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the
unofficial one, thereby halting the activity of the black market.
In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid
inflation; however, it is less often that the central bank of a floating regime will interfere.
The World Once Pegged
Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning
that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the
gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade;
however, with the start of World War I, the gold standard was abandoned.
At the end of World War II, the conference at Bretton Woods, in an effort to generate global economic
stability and increased volumes of global trade, established the basic rules and regulations governing
international exchange. As such, an international monetary system, embodied in the International Monetary
Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and
therefore that of the global economy.
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It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in
turn was pegged to gold at USD 35/ounce. What this meant was that the value of a currency was directly
linked with the value of the U.S. dollar. So if you needed to buy Japanese yen, the value of the yen would be
expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to
readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The
peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of
USD 35/ounce of gold.
From then on, major governments adopted a floating system, and all attempts to move back to a global peg
were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use
of gold as a peg has been completely abandoned.
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may
decide to peg its currency to create a stable atmosphere for foreign investment. With a peg the investor will
always know what his/her investment value is, and therefore will not have to worry about daily fluctuations. A
pegged currency can also help to lower inflation rates and generate demand, which results from greater
confidence in the stability of the currency.
Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the
long run. This was seen in the Mexican (1995), Asian and Russian (1997) financial crises: an attempt to
maintain a high value of the local currency to the peg resulted in the currencies eventually becoming
overvalued. This meant that the governments could no longer meet the demands to convert the local
currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get
out their money and convert it into foreign currency before the local currency was devalued against the peg;
foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to
devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by
the end of 1997, the bhat had lost its value by 50% as the market's demand and supply readjusted the value
of the local currency.
Countries with pegs are often associated with having unsophisticated capital markets and weak regulating
institutions. The peg is therefore there to help create stability in such an environment. It takes a stronger
system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is
also required to proceed with some form of economic reform, like implementing greater transparency, in an
effort to strengthen its financial institutions.
Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses
the value of the peg periodically and then changes the peg rate accordingly. Usually the change is
devaluation, but one that is controlled so that market panic is avoided. This method is often used in the
transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to
devalue in an uncontrollable crisis.
Although the peg has worked in creating global trade and monetary stability, it was used only at a time when
all the major economies were a part of it. And while a floating regime is not without its flaws, it has proven to
be a more efficient means of determining the long term value of a currency and creating equilibrium in the