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Foreign exchange market ( )

Foreign exchange market ( )

Contents

I. Introduction 2

II. The structure of the foreign exchange market 3

1. What is the foreign exchange? 3

2. The participants of the foreign exchange markets 4

3. Instruments of the foreign exchange markets 5

III. Foreign exchange rates 6

1. Determining foreign exchange rates 6

2. Supply and Demand for foreign exchange 7

3. Factors affecting foreign exchange rates 11

IV. Conclusion 13

V. Recommendations 14

VI. Literature used 16

Introduction

Trade and payments across national borders require that one of the

parties to the transaction contract to pay or receive funds in a foreign

currency. At some stage, one party must convert domestic money into foreign

money. Moreover, knowledgeable investors based in each country are aware of

the opportunities of buying assets or selling debts denominated in foreign

currencies when the anticipated returns are higher abroad or when the

interest costs are lower. These investors also must use the foreign

exchange market whenever they invest or borrow abroad.

Id like to add that the foreign exchange market is the largest market

in the world in terms of the volume of transactions. That the volume of

foreign exchange trading is many times larger than the volume of

international trade and investment reflects that a distinction should be

made between transactions that involve only banks and those that involve

banks, individuals, and firms involved in international trade and

investment.

The phenomenal explosion of activity and interest in foreign exchange

markets reflects in large measure a desire for self-preservation by

businesses, governments, and individuals. As the international financial

system has moved increasingly toward freely floating exchange rates,

currency prices have become significantly more volatile. The risks of

buying and selling dollars and other currencies have increased markedly in

recent years. Moreover, fluctuations in the prices of foreign currencies

affect domestic economic conditions, international investment, and the

success or failure of government economic policies. Governments,

businesses, and individuals involved in international affairs find it is

more important today than ever before to understand how foreign currencies

are traded and what affects their relative values.

In this work, we examine the structure, instruments, and price-

determining forces of the world's currency markets.

The structure of the foreign exchange market

What is the foreign exchange?

The foreign exchange markets are among the largest markets in the

world, with annual trading volume in excess of $160 trillion. The purpose

of the foreign exchange markets is to bring buyers and sellers of

currencies together. It is an over-the-counter market, with no central

trading location and no set hours of trading. Prices and other terms of

trade are determined by negotiation over the telephone or by wire,

satellite, or telex. The foreign exchange market is informal in its

operations: there are no special requirements for market participants, and

trading conforms to an unwritten code of rules.

You know that almost every country has its own currency for domestic

transactions. Trading among the residents of different countries requires

an efficient exchange of national currencies. This is usually accomplished

on a large scale through foreign exchange markets, located in financial

centers such as London, New York, or Parisin order of importancewhere

exchange rates for convertible currencies are determined. The instruments

used to effect international monetary payments or transfers are called

foreign exchange. Foreign exchange is the monetary means of making payments

from one currency area to another. The funds available as foreign exchange

include foreign coin and currency, deposits in foreign banks, and other

short-term, liquid financial claims payable in foreign currencies. An

international exchange rate is the price of one (foreign) currency measured

in terms of another (domestic) currency. More accurately, it is the price

of foreign exchange. Since exchange rates are the vehicle that translates

prices measured in one currency into prices measured in another currency,

changes in exchange rates affect the price and, therefore, the volume of

imports and exports exchanged. In turn the domestic rate of inflation and

the value of assets and liabilities of international borrowers and lenders

is influenced. The exchange rate rises (falls) when the quantity demanded

exceeds (is less than) the quantity supplied. Broadly speaking, the

quantity of U.S. dollars supplied to foreign exchange markets is composed

of the dollars spent on imports, plus the amount of funds spent or invested

by U.S. residents outside the United States. The demand for U.S. dollars

arises from the reverse of these transactions.

Many newspapers keep a daily record of the exchange rates in the

highly organized foreign exchange market, where currencies of different

nations are bought and sold. For instance, the Wall Street Journal shows

the price of a currency in two ways: first the price of the other currency

is given in U.S. dollars, and second the price of the U.S. dollar is quoted

in units of the other currency. Pairs of prices represent reciprocals of

each other. These rates refer to trading among banks, the primary

marketplace for foreign currencies.

2. The participants of the foreign exchange markets

The foreign exchange market is extremely competitive so there are many

participants, none of whom is large relative to the market.

The central institution in modern foreign exchange markets is the

commercial bank. Most transactions of any size in foreign currencies

represent merely an exchange of the deposits of one bank for the deposits

of another bank. If an individual or business firm needs foreign currency,

it contacts a bank, which in turn secures a deposit denominated in foreign

money or actually takes delivery of foreign currency if the customer

requires it. If the bank is a large money center institution, it may hold

inventories of foreign currency just to accommodate its customers. Small

banks typically do not, hold foreign currency or foreign currency-

denominated deposits. Rather, they contact large correspondent banks, which

in turn contact foreign exchange dealers.

The major international commercial banks act as both dealers and

brokers. In their dealer role, banks maintain a net long or short position

in a currency, and seek to profit from an anticipated change in the

exchange rate. (A long position means their holdings of assets denominated

in one currency exceed their liabilities denominated in this same

currency.) In their broker function, banks compete to obtain buy and sell

orders from commercial customers, such as the multinational oil companies,

both to profit from the spread between the rates at which they buy foreign

exchange from some customers and the rates at which they sell foreign

exchange to other customers, and to sell other types of banking services to

these customers.

Frequently, currency-trading banks do not deal directly with each

other but rely on foreign exchange brokers. These firms are in constant

communication with the exchange trading rooms of the world's major banks.

Their principal function is to bring currency buyers and sellers together.

Security brokerage firms, commodity traders, insurance companies, and

scores of other nonbank companies have come to play a growing role in the

foreign exchange markets today. These Nonbank Financial Institutions have

entered in the wake of deregulation of the financial marketplace and the

lifting of some foreign controls on international investment, especially by

Japan and the United Kingdom. Nonbank traders now offer a wide range of

services to international investors and export-import firms, including

assistance with foreign mergers, currency swaps and options, hedging

foreign security offerings against exchange rate fluctuations, and

providing currencies needed for purchases abroad.

In main all participants of an exchange market are usually divided on

two groups. The first group of participants is called speculators; by

definition, they seek to profit from anticipated changes in exchange rates.

The second group of participants is known as arbitragers. Arbitrage refers

to the purchase of one currency in a certain market and the sale of that

currency in another market in response to differences in price between the

two markets. The force of arbitrage generally keeps foreign exchange rates

from getting too far out of line in different markets.

3. Instruments of the foreign exchange markets

. Cable and Mail Transfers

Several financial instruments are used to facilitate foreign exchange

trading. One of the most important is the cable transfer, an execute order

sent by cable to a foreign bank holding a currency seller's account. The

cable directs the bank to debit the seller's account and credit the account

of a buyer or someone the buyer designates.

The essential advantage of the cable transfer is speed because the

transaction can be carried out the same day or within one or two business

days. Business firms selling their goods in international markets can avoid

tying up substantial sums of money in foreign exchange by using cable

transfers.

When speed is not a critical factor, a mail transfer of foreign

exchange may be used. Such transfers are written orders from the holder of

a foreign exchange deposit to a bank to pay a designated individual or

institution on presentation of a draft. A mail transfer may require days to

execute, depending on the speed of mail deliveries.

. Bills of Exchange

One of the most important of all international financial instruments

is the Bill of Exchange. Frequently today the word draft is used instead of

bill. Either way, a draft or bill of exchange is a written order requiring

a person, business firm, or bank to pay a specified sum of money to the

bearer of the bill.

We may distinguish sight bills, which are payable on demand, from time

bills, which mature at a future date and are payable only at that time.

There are also documentary hills, which typically accompany the

international shipment of goods. A documentary bill must be accompanied by

shipping papers allowing importers to pick up their merchandise. In

contrast, a clean hill has no accompanying documents and is simply an order

to a bank to pay a certain sum of money. The most common example arises

when an importer requests its bank to send a letter of credit to an

exporter in another country. The letter authorizes the exporter to draw

bills for payment, either against the importer's bank or against one of its

correspondent banks.

. Foreign Currency and Coin

Foreign currency and coin itself (as opposed to bank deposits) is an

important instrument for payment in the foreign exchange markets. This is

especially true for tourists who require pocket money to pay for lodging,

meals, and transportation. Usually this money winds up in the hands of

merchants accepting it in payment for purchases and is deposited in

domestic banks. For example, U.S. banks operating along the Canadian and

Mexican borders receive a substantial volume of Canadian dollars and

Mexican pesos each day. These funds normally are routed through the banking

system back to banks in the country of issue, and the U.S. banks receive

credit in the form of a deposit denominated in a foreign currency. This

deposit may then be loaned to a customer or to another bank.

. Other Foreign Exchange Instruments

A wide variety of other financial instruments are denominated in

foreign currencies, most of this small in amount. For example, traveler's

checks denominated in dollars and other convertible currencies may be spent

directly or converted into the currency of the country where purchases are

being made. International investors frequently receive interest coupons or

dividend warrants denominated in foreign currencies. These documents

normally are sold to a domestic bank at the current exchange rate.

Foreign exchange rates

1. Determining foreign exchange rates

As Ive already mentioned the prices of foreign currencies expressed

in terms of other currencies are called foreign exchange rates. There are

today three markets for foreign exchange: the spot market, which deals in

currency for immediate delivery; the forward market, which involves the

future delivery of foreign currency; and the currency futures and options

market, which deals in contracts to hedge against future changes in foreign

exchange rates. Immediate delivery is defined as one or two business days

for most transactions. Future delivery typically means one, three, or six

months from today.

Dealers and brokers in foreign exchange actually set not one, but two,

exchange rates for each pair of currencies. That is, each trader sets a bid

(buy) price and an asked (sell) price. The dealer makes a profit on the

spread between the bid and asked price, although that spread is normally

very small.

2. Supply and Demand for foreign exchange

The underlying forces that determine the exchange rate between two

currencies are the supply and demand resulting from commercial and

financial transactions (including speculation). Foreign-exchange supply and

demand schedules relate to the price, or exchange rate. This is illustrated

in Figure 1, which assumes free-market or flexible exchange rates.

Figure 1

[pic]

Before examining this figure, we need to define two terms.

Depreciation (appreciation) of a domestic currency is a decline (rise)

brought about by market forces in the price of a domestic currency in terms

of a foreign currency. In contrast, devaluation (revaluation) of a domestic

currency is a decline (rise) brought about by government intervention in

the official price of a domestic currency in terms of a foreign currency.

Depreciation or appreciation is the appropriate concept to deal with

floating, or flexible, exchange rates, whereas devaluation or revaluation

is appropriate when dealing with fixed exchange rates.

In the dollar-pound exchange market, the demand schedule for pounds

represents the demands of U.S. buyers of British goods, U.S. travelers to

Britain, currency speculators, and those who wish to purchase British

stocks and securities. It slopes downward because the dollar price to U.S.

residents of British goods and services declines as the exchange rate

declines. An item selling for 1 in Britain would cost $2.00 in the U.S. if

the exchange rate were 1/$2.00 U.S. If this exchange rate declined to

1/$1.50 U.S., the same item is $.50 cheaper in the United States,

increasing the demand for British goods and thus the demand for pounds. The

supply schedule of pounds represents the pounds supplied by British buyers

of U.S. goods, British travelers, currency speculators, and those who wish

to purchase U.S. stocks and securities. It slopes upward because the pound

price to British residents of U.S. goods and services rises as the $ price

of the falls. Assuming an exchange rate of 1 /$2.00 U.S., a $2.00 item

in the U.S. costs 1 in Britain. If this exchange rate declined to 1/$1.50

U.S., the same item is 33 percent more expensive in Britain, decreasing the

demand for dollars to buy U.S. goods and thus reducing the supply of

pounds. The equilibrium exchange rate in Figure 1 is 1/$2.00 U.S. The

amounts supplied and demanded by the market participants are in balance.

Figure 2

[pic]

To understand better the schedules, several of the factors that might

cause these curves to shift are discussed next. If there is a decrease in

national income and output in one country relative to others, that nation's

currency tends to appreciate relative to others. The domestic income level

of any country is a major determinant of the demand for imported goods in

that country (and hence a determinant of the demand for foreign

currencies). Figure 2 shows the effects of a decline in national income in

Britain (assuming all other factors remain constant). The decrease in

British income implies a decrease in demand for goods and services (both

domestic and foreign) by British people. This reduction in demand for

imported goods leads to a reduction in the supply of pounds, which is shown

by a leftward shift of the supply curve in Figure 2 (from S[pic] to

S[pic]). If the exchange rate floats freely, the British pound appreciates

against the U.S. dollar. If the exchange rate is artificially maintained at

the old equilibrium of 1/$2.00 U.S., however, a balance-of-payments

surplus (for Britain) likely results.

Figure 3

[pic]

In Figure 3, an initial exchange-rate equilibrium of 1/$2.00 U.S. is

assumed. Now presume the rate of price inflation in Britain is higher than

in the United States. British products become less attractive to U.S.

buyers (because their prices are increasing faster), which causes the

demand schedule for pounds to shift leftward (D[pic] to D[pic]). On the

other hand, because prices in Britain are rising faster than prices in the

U.S., U.S. products become more attractive to British buyers, which causes

the supply schedule of pounds to shift to the right (S[pic] to S[pic]). In

other words, there is an increased demand for U.S. dollars in Britain. The

reduced demand for pounds and the increased supply (resulting from British

purchases of U.S. goods) mandates a newer, lower, equilibrium exchange

rate. Furthermore, as long as the inflation rate in Britain exceeded that

in the United States, the British pound would continually depreciate

against the U.S. dollar.

Differences in yields on various short-term and long-term securities

can influence portfolio investments among different countries and also the

flow of funds of large banks and multinational corporations. If British

yields rise relative to others, an investor wishing to take advantage of

these higher interest rates must first obtain British pounds to buy the

securities. This increases the demand for British pounds shift the demand

schedule in Figure 4 to the right (D[pic] to D[pic]). British investors are

also less inclined to purchase U.S. securities, moving the supply schedule

of pounds to the left (S[pic] to S[pic]). Both activities raise the

equilibrium exchange rate of the British pound in terms of U.S. dollars.

Figure 4

[pic]

3. Factors affecting foreign exchange rates

. Balance-of-Payments Position

The exchange rate for any foreign currency depends on a multitude of

factors reflecting economic and financial conditions in the country issuing

the currency. One of the most important factors is the status of a nation's

balance-of-payments position. When a country experiences a deficit in its

balance of payments, it becomes a net demander of foreign currencies and is

forced to sell substantial amounts of its own currency to pay for imports

of goods and services. Therefore, balance-of-payments deficits often lead

to price depreciation of a nation's currency relative to the prices of

other currencies. For example, during most of the 1970s, 1980s, and into

the 1990s, when the United States was experiencing deep balance-of-payments

deficits and owed substantial amounts abroad for imported oil, the value of

the dollar fell.

. Speculation

Exchange rates also are profoundly affected by speculation over future

currency values. Dealers and investors in foreign exchange monitor the

currency markets daily, looking for profitable trading opportunities. A

currency viewed as temporarily undervalued quickly brings forth buy orders,

driving its price higher vis-a-vis other currencies. A currency considered

to be overvalued is greeted by a rash of sell orders, depressing its price.

Today, the international financial system is so efficient and finely tuned

that billions of dollars can flow across national boundaries in a matter of

hours in response to speculative fever. These massive unregulated flows can

wreak havoc with the plans of policymakers because currency trading affects

interest rates and ultimately the entire economy.

. Domestic Economic and Political Conditions

The market for a national currency is, of course, influenced by

domestic conditions. Wars, revolutions, the death of a political leader,

inflation, recession, and labor strikes have all been observed to have

adverse effects on the currency of a nation experiencing these problems. On

the other hand, signs of rapid economic growth, improving government

finances, rising stock and bond prices, and successful economic policies to

control inflation and unemployment usually lead to a stronger currency in

the exchange markets.

Inflation has a particularly potent impact on exchange rates, as do

differences in real interest rates between nations. When one nation's

inflation rate rises relative to others, its currency tends to fall in

value. Similarly, a nation that reduces its inflation rate usually

experiences a rise in the value of its currency. Moreover, countries with

higher real interest rates generally experience an increase in the exchange

value of their currencies, and countries with low real interest rates

usually face relatively low currency prices.

. Government Intervention

It is known that each national government has its own system or policy

of exchange-rate changes. Two of the most important are floating and fixed

exchange-rate systems. In the floating system, a nation's monetary

authorities, usually the central bank, do not attempt to prevent

fundamental changes in the rate of exchange between its own currency and

any other currency. In the fixed-rate system, a currency is kept fixed

within a narrow range of values relative to some reference (or key)

currency by governmental action.

National policymakers can influence exchange rates directly by buying

or selling foreign currency in the market, and indirectly with policy

actions that influence the volume of private transactions. A third method

of influencing exchange rates is exchange controli.e., direct control of

foreign-exchange transactions.

Intervention of a central bank involves purchases or sales of the

national money against a foreign money, most frequently the U.S. dollar. A

central bank is obliged to prevent its currency from depreciating below its

lower support limit. The central bank should buy its own currency from

commercial banks operating in the exchange market and sell them dollars in

exchange. These transactions are effectively an open-market sale using

dollar demand deposits rather than domestic bonds. Such transactions reduce

the central bank's domestic liabilities in the hands of the public. The

ability of a foreign central bank to prevent its currency from depreciating

depends upon its holdings of dollars, together with dollars that might be

obtained by borrowing. Even if a national monetary authority has the

foreign exchange necessary for intervention, its need to support its

currency in the exchange market might be inconsistent with its efforts to

undertake a more expansive monetary policy to achieve its domestic economic

objectives.

Also Id like to say a few words about currency sterilization. A

decision by a central bank to intervene in the foreign currency markets

will have both currency market and money supply effects unless an operation

known as currency sterilization is carried out. Any increase in reserves

and deposits that results from a central bank currency purchase can be

"sterilized" by using monetary policy tools that absorb reserves. There is

currently a great debate among economists as to whether sterilized central

bank intervention can significantly affect exchange rates, in either the

short term or the long term, with most research studies finding little

impact on relative currency prices.

Conclusion

A market in national monies is a necessity in a world of national

currencies; this market is the foreign-exchange market. The assets traded

in this market are demand deposits denominated in the different currencies.

Individuals who wish to buy goods or securities in a foreign country must

first obtain that country's currency in the foreign-exchange market. If

these individuals pay in their own currency, then the sellers of the goods

or securities, use the foreign-exchange market to convert receipts into

their own currency.

One from the most important participants of an exchange market is a

business bank, which act as the intermediaries between the buyers and

sellers. As already it is known they can execute a role speculators and

arbitragers.

Most foreign-exchange transactions entail trades involving the U.S.

dollar and individual foreign currencies. The exchange rate between any two

foreign currencies can be inferred as the ratio of the price of the U.S.

dollar in terms of each of their currencies.

The exchange rates are prices that equalize the demand and supply of

foreign exchange. In recent years, exchange rates have moved sharply, more

sharply than is suggested by the change in the relationship between

domestic price level and foreign price level. Exchange rates do not

accurately reflect the relationship between the domestic price level and

foreign price levels. Rather, exchange rates change so that the anticipated

rates of return from holding domestic securities and foreign securities are

the same after adjustment for any anticipated change in the exchange rate.

The major factor influencing to the rate of exchange, is interference

of government in the person of central bank in currency policy of the

country. The value of a nation's currency in the international markets has

long been a source of concern to governments around the world. National

pride plays a significant role in this case because a strong currency,

avidly sought by traders and investors in the international marketplace,

implies the existence of a vigorous and well-managed economy at home. A

strong and stable currency encourages investment in the home country,

stimulating its economic development. Moreover, changes in currency values

affect a nation's balance-of-payments position. A weak and declining

currency makes foreign imports more expensive, lowering the standard of

living at home. And a nation whose currency is not well regarded in the

international marketplace will have difficulty selling its goods and

services abroad, giving rise to unemployment at home. This explains why

Russia made such strenuous efforts in the early 1990s to make the Russian

ruble fully convertible into other global currencies, hoping that ruble

convertibility will attract large-scale foreign investment.

Recommendations

The problem of laundering money is essential with regard to the

exchange market. Id like to add that the Russian exchange market comes

first in this respect.

The origin of this problem directly is connected with activity of the

organized crime: funds obtained in a criminal way are presented as legal

capital to introduce them in economic and financial structures of the

state. Therefore struggle against laundering money is recognized in all

countries as one from major means of a counteraction of the organized

crime. The sources of dirty money are as follows:

international drugs traffic;

mafias activity;

illegal trade of weapon.

The use of exchange markets for laundering money is not a

contingency. This process is promoted by absence of restrictions concerning

foreign exchange.

Unfortunately today participation of Russia in international struggle

against outline problem is limited by signing of the Viennese convention on

struggle against an international drugs trafficking and entering Interpol.

The work on struggle against laundering money in Russia should start from

the very beginning. The process of developing legislation and mechanisms of

its application is supposed to give instructions aimed at lawful struggle

against laundering money, developing bilateral cooperation with

countries of European Union, USA and Japan.

Literature used

1. Money, banking and the economy T. Mayer, J.S. Duesenberry, R.Z.

Aliber

W.W. Norton & company New York, London 1981

2. Principles of international finance Daniel R. Kane

Croom Helm 1988

3. Money and banking David R. Kamerschen

College Division South-western Publishing Co. 1992

4. Money and capital markets: the financial system in a increasingly

global economy fifth edition Peter S. Rose

IRWIN 1994

 
 

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