Unit 3:
Foreign Exchange Trading
1. Foreign Exchange Market
Foreign exchange market: Market in which currencies are bought and sold and in which currency
prices are determined.
2. The Gold standard
- Advantages of using gold as a medium of exchange:
+Its limited supply made it a highly demanded commodity.
+Gold is highly resistant to corrosion, so it can be traded and stored for hundreds of years.
+It can be melted into either small coins or large bars, so gold is a good medium of exchange for
both small and large purchases.
3. The Gold standard
- Disadvantages of using as a medium of exchange:
+Its weight made transporting it expensive.
+When a transport ship sank at sea, the gold sank to the ocean floor and was lost.
Gold standard: International monetary system in which nations linked the value of their paper
currencies to specific values of gold.
- A monetary system used in the nineteenth and early twentieth centuries whereby the value of
currencies could, on request of the owner (holder), be converted in to gold at a country’s central
bank. As all currencies had a gold value, they also had a certain value in relation to each other.
This was the beginning of a foreign exchange system.
- Advantages of the gold standard:
+ Reduce exchange rate risk
+ Impose strict monetary policies
+ Correct trade imbalances
4. Bretton Woods Agreement
- Bretton Woods Agreement: Agreement (1944) among nations to create a new international
monetary system based on the value of the U.S dollar.
- Its features: Fixed exchange rates, built-in flexibility, funds for economic development, and an
enforcement mechanism.
- The Bretton Woods system of monetary management established the rules for commercial and
financial relations among the world's major industrial states in the mid 20th century. The Bretton
Woods system was the first example of a fully negotiated monetary order intended to govern
monetary relations among independent nation-states.
- World Bank (International Bank for Reconstruction and Development, or IBRD): Agency
to provide funding for national economic development efforts.
+ Purposes:
Promote international monetary cooperation.
Facilitate expansion and balanced growth of international trade.
Promote exchange stability, maintain orderly exchange arrangements and avoiding
competitive exchange devaluation.
Make the resources of the Fund temporarily available to members
Shorten the duration and lessen the degree of disequilibrium in the international balance
of payments of member nations.
5. Central Bank
- A country’s chief bank, which is government owned. It regulates the commercial banks and
holds gold and foreign currency reserves. It actively intervenes by buying and selling its own
currency in the foreign exchange markets so that the currency will keep a certain value.
6. Functions of Central Bank
- implementing monetary policy
- Controlling the nation's entire money supply
- The Government's banker and the bankers' bank ("lender of last resort")
- Managing the country's foreign exchange and gold reserves and the Government's stock register
- Regulating and supervising the banking industry
- Setting the official interest rate – used to manage both inflation and the country's exchange rate
– and ensuring that this rate takes effect via a variety of policy mechanisms
7. Exchange rates
- The exchange rates (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. It is the value of a
foreign nation’s currency in terms of the home nation’s currency.
- For example an exchange rate of 102 Japanese yen (JPY, ¥) to the United States dollar (USD, $)
means that JPY 102 is worth the same as USD 1. The foreign exchange market is one of the
largest markets in the world. By some estimates, about 3.2 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.
8. Fixed exchange rate
- A fixed exchange rate, sometimes called 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.
- A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency
it is pegged to. This facilitates trade and investments between the two countries, and is especially
useful for small economies where external trade forms a large part of their GDP.
- It is also used as a means to control It is also used as a means to control inflation. However, as
the reference value rises and falls, so does the currency pegged to it. In addition, a fixed
exchange rate prevents a government from using domestic monetary policy in order to achieve
macroeconomic stability.
9. Floating exchange rate
- A system in which currencies have no specific par value; value is normally determined by
supply and demand. Central bank are not required to intervene, but they often do to avoid wild
fluctuations
10. Factors determine exchange rates
- The law of one price stipulates that when price is expressed in a common denominator
currency, an identical product must have an identical price in all countries and must be entirely
produced within each particular country.
- The purchasing power parity (PPP)concept helps determine the relative ability of two countries’
currencies to buy the same “basket” of goods in those two countries.
11. Inflation and Interest rates
- Inflation erodes purchasing power.
- Interest rates affect inflation because they affect the cost of borrowing money.
- Exchange rates adjust to reflect changes in interest rates
12. Spot transaction
- Currency bought or sold today with delivery two business days later
13. Forward transaction
- To buy or sell a currency in the future, with payment and delivery at that future date
14. Hedging
- To offset a “buy” contract with a “sell” contract and vice versa, matching the amounts and the
time span exactly.
15. Speculation
- When dealers do not offset a “buy” contract with a “sell” contract. This means that their
position is left open.
16. Arbitrage
- The transfer of funds from one currency to another to benefit from currency differentials or
disparities in interest rates. In arbitraging, at least two market are enter.
17. Premium
- The additional amount it will cost to buy or sell a currency at a given future date (relative to the
spot or today’s price)
18. Discount
- The lesser amount it will cost to buy or sell a currency at a given future date (relative to the
spot or today’s price).
II. International monetary system
- International monetary system: Collection of agreements and institutions governing
exchange rates.
* The Gold standard
1. Fixed exchange rate system: System in which the exchange rate for converting one currency
into another is fixed by international agreement.
2. Exchange rates
- Exchange rate: Rate at which one currency is exchanged for another.
- Rates depend on
+The size of the transaction
+The trader conducting it
+General economic conditions
+Government mandate
- Exchange rates influence:
+Production and marketing decisions of companies.
+Financial decisions of companies
- Forecast exchange rates
Forward exchange rate: By the rate agree upon for foreign exchange payment at a future
date.
+Efficient market view: View that prices of financial instruments reflect all publicly
available information at any given time.
+Inefficient market view: View that prices of financial instruments do not reflect all
publicly available information.
- Forecasting techniques:
+Technical analysis: A technique using charts of past trends in currency prices and other factors
to forecast exchange rates.
+Fundamental analysis: Technique using statistical models based on fundamental economic
indicators to forecast exchange rates.
