The Foreign Exchange Market - Literature review Example

The foreign exchange market Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: Words: 2,658 Table of Contents Table of Contents ii Introduction 1 Significance of the Topic 1 Literature Review 1 Evidence and data sources 5 References: 8 THE FOREIGN EXCHANGE MARKET Introduction The foreign exchange market is a platform for which the currency of one country is exchanged for the currency of another country. The foreign exchange market provides a both a physical and institutional framework through which the rate of exchange for the different currencies are determined, and the actual foreign exchange transactions are physically carried out(Goodhart& Payne, 2000). According to Czinkota et al. (2009), foreign exchange transaction is an agreement between a buyer and a seller that one foreign currency will be delivered in exchange for another currency at a specified rate. The foreign exchange market is the largest market in the world, and it consists of about $2 trillion in volume a day, and its growth is very rapid. The value of a country’s currency is determined by comparing it to the value of another country’s currency using a specified exchange rate (Czinkota et al., 2009). The graph below shows average daily derivatives, equity and FX volume in the year 2000. Significance of the Topic It is fundamentally important for international finance students to study the topic about foreign exchange market and determination of foreign exchange rate. This topic is the core of international finance as every international transaction involves the use of foreign currencies that are obtained from the foreign exchange market (Brown, 2001). This topic equips the learner with expansive knowledge on currency quotations, estimation of currency appreciation and depreciation, computation of a currency’s bid and asks prices and the determination of foreign exchange rates. The foreign exchange market is also important in understanding bilateral and multilateral export and import transactions globally. Literature Review The most commonly traded currencies in the foreign exchange market include the United States dollar (USD), the Euro (EUR), the British Pound (GBP), the Japanese yen (JPY), and the Swiss franc (CHF). The major currency pairs are USD/JPY, EUR/USD, GBP/USD and USD/CHF(Sapp, 2002). In a pair of currencies, the first currency is referred to as the base currency while the second currency is known as the counter currency. The foreign exchange market is conducted over the counter (OTC). The decentralization of the market is important for the forex dealers as they can choose whom to trade with from a large number of traders. The exchange of currencies 24 hours a day in the foreign exchange market and no entity can influence the market. There exist charts and tools that guide the forex dealers in analysing the various currencies to make the right decision to buy or sell (Sapp, 2002). There are numerous participants in the foreign exchange market, and the market can be broadly categorized into two segments: interbank (wholesale market) and the retail or client market (Frenkel& Johnson, 2013). The interbank market involves the transaction of large sums of money in multiples of million USD or other currencies of equivalent values. On the other hand, the client market involves the transactions between a bank and its client, and the currencies involved are in specific amounts that can even be the smallest currency penny. Banks and other nonbank dealers in foreign exchange participate in both the interbank and client markets. They buy the exchange foreign currencies at a bid price and then resell them at a higher ask price, thereby making a profit. Then foreign exchange market is made efficient by the global competition among the dealers as the spread between ask and bid prices is considerably narrowed (Clark & Ghosh, 2004). Tourists, international portfolio investors, importers, and exporters rely on the foreign exchange market to enable them to execute their investment or commercial transactions. Arbitragers and speculators in the foreign exchange market make a profit from the market to serve their interest without the obligation to provide services to clients or to sustain the market. The profits of speculators come from changes in foreign exchange rates in the same market while the profits of arbitragers come from the existence of different exchange rates in different markets. National treasuries and central banks participate in the foreign exchange market to raise or spend foreign exchange reserves for their countries. In so doing, they essentially influence the trading price of their country. Thus, the central banks and treasuries differ significantly in behaviour and motive from other participants in the foreign exchange market. Within the market, there also exist foreign exchange brokers who act as agents who facilitate transactions between the dealers without themselves becoming active participants in the transactions. The brokers maintain a broad network of dealers was hence making it easy for the dealers to access the foreign exchange market. The business of the broker involves understanding then the particular moment that a client wants to buy or sell a currency and then finds a counterpart client promptly in the market to seal the deal without revealing the dealers until an agreement is reached. They earn by charging a commission for the services. There are three types of transactions in the foreign exchange market that include spot, forward and swap transactions. Spot transactions involve immediate delivery of the currencies being traded. A spot transaction in the interbank market involves the purchase of the foreign currency with the payment and delivery between the banks normally taking place on the second business day(Levi, 2007). The value date represents the day of settlement of a given transaction. Of the three types of transactions, occupying about 43% of all the transaction executed on the foreign exchange market. A forward transaction involves an agreement between two parties where one commits to deliver a specified amount of one currency at a future date in exchange for a specified amount of another currency (Levi, 2007). The exchange rate for the transaction is determined and specified at the time of making the agreement, but the actual payment and delivery are not required until the lapse of the maturity period. The quoted value dates for forward exchange rates are in common cases of one, two, three, six, or twelve months. The forward transactions take about 9% of all the transactions carried out in the foreign exchange market. Forward transactions are carried out by businesses and dealers in the foreign exchange market to hedge against foreign exchange rate risk and for speculation purposes so as to make profits. Swap transaction involves the purchase and sale of a given amount of currencies simultaneously for two different value dates. Commonly, it involves a spot against a forward, and both treated as a single transaction. In the case, for instance, a dealer purchases a currency in the spot market and then simultaneously sales it in the forward market in the same platform. This kind of transaction enables the dealer to avoid any unexpected foreign exchange risk. The swap transactions approximately account for about 48% of all the transactions done in the foreign exchange market (Goodhart, & Payne, 2000). A foreign exchange rate is defined as the specific price at which one currency is exchanged for another foreign currency. On the other hand, a foreign exchange quotation is a statement that shows the willingness of a dealer to buy or sell a particular currency at an announced rate (Levi, 2007). Professional brokers and dealers commonly state the foreign exchange quotations in a form known as the European rules. The European terms quotation expresses the number of units of a particular foreign currency required to purchase one unit of the USD. For example, CAD can be elaborated as 1.6772 per USD. The other alternative method of quoting the foreign exchange rate is the American terms (Goodhart, & Payne, 2000). The American terms quote indicates the number of USD units required to purchase a single unit of foreign currency. For example, USD can be exchanged at 0.5962 per CAD. It can be clearly noted that the two types of quotations are highly related to each other. The spot price of a USD can be defined in CAD to be S(CAD/USD) = CAD 1.6772/USD. Likewise, he price of a CAD can be defined in USD as S(USD/CAD) = USD O.5962/CAD. These rules for both the European and American terms apply to the forward rates as well. The outright forward quote can be denoted as F (CAD/USD). The Foreign exchange rate can be expressed as direct or indirect quotes. A direct quote refers to the home currency price of a unit of foreign currency, whereas an indirect quote refers to a foreign currency price of a unit of home currency (Frenkel& Johnson, 2013). For example, the direct quote for the CAD in the US is USD 0.5962/CAD. This quotation would be an indirect quote in Canada. In the interbank market, exchange rate quotations are given as bid and ask. A ‘bid’ refers to the exchange rate in a particular currency at which a deal will be willing to buy another currency while ‘ask’ refers to the exchange rate at which a dealer will be willing to sell a currency in exchange for another currency. The asking price is always greater than the bid price, and the difference between the two prices is known as the spread. Dealers in the foreign exchange market buy a currency at the bid price and then sell it at the asking price, therefore, making a profit from the spread between the bid and ask prices. It can, therefore, be pointed out that the bid for one currency is the ‘ask’ of the other currency used in the same transaction. For example, S(USD/CAD) = 1/ {S( CAD/USD)}, and S(USD/CAD) = 1/ {S(CAD/USD)}. A foreign exchange market dealer may provide a quotation such as USD 0.6333 - 0.6349/CAD. From this quotation, it can be noted that the bid price for the CAD is USD 0.6333/ CAD and that the asking price is USD 0.6349/ CAD. This quotation can be written in the indirect version to become CAD 1.5750 – 1.5790/ USD. A dealer who is willing to buy a CAD at the price of USD 0.6333/CAD is as well willing to sell a USD at a price of CAD 1.5790/ USD, which is a reciprocal of the former. The spread between the bid and ask prices serves two main reasons: the first being to cover the transaction cost of financial intermediaries like brokers, and the second reason is to create profits for the dealers in the market. The exchange rate for currency pairs that are inactively traded in the foreign exchange market is determined through a third currency with which their widely related, generally the USD. This is referred to as the cross rate quotation. For instance, an investor may be in Thailand and might want to buy some Barbados Dollars (BBD). Since the two currencies are quoted against the USD, the investor can work out the cross exchange price of the Thai Baht (THB) against the BBD. Let us assume that the current direct quotations of the both currencies regarding the USD are THB 41.6982/USD and BBD 2.0116/USD respectively. The cross rate can be expressed as (THB41.6982/USD)/ (BBD 2.0116/USD)=THB20.7289/BBD. From this illustration, we can determine how many THB are in a single unit of BBD and how many BBD units are in a single unit of THB. Therefore, the price of one BBD is THB20.7289 while the price of one THB, 1/ 20.7289 = BBD0.0482 (Brown, 2001) Two theories can explain the foreign exchange rate determination. These are the asset approach based on interest rate parity and the monetary approach based on the purchasing power parity. The asset approach treats foreign exchange holdings as assets since they are mostly held as bank deposits. The primary determinant of the demand for a financial asset is the interest rate which is the expected rate of return (Cheung & Marsh, 2004). The interest rate parity theory states that at equilibrium, the forward rate (F) differs from the spot rate by an amount that is equal to the interest tare differential (rh - rf), between the two countries. The premium or discount for the forward rate is equal to the interest rate differential, that is (F - S)/S = (rh – rf) where rh is the home interest rate, and rf is the foreign interest rate. In an equilibrium situation, the returns will have the same meaning that no profit will be obtained, and there exists interest rate parity. This can be represented as (1+rh)/ (1+rf)=F/S. If the forward premium or discount does not equal the interest rate differential, the money assets will move into the country with the more attractive interest rate. The market pressures result when one currency has a higher demand than the other, and it is therefore bought on the spot and sold in forwarding (Allayannis&Ofek, 2001). The inflow of currency assets into the country depresses the interest rates, hence restoring the state of equilibrium in the foreign exchange market. The interest rate parity puts forward that if a particular currency has a higher interest rate than the other, the condition is offset by forward discounts. On the other hand, lower interest rates on a currency are offset by forward premiums to achieve equilibrium in the foreign exchange market. The purchasing power parity (PPP) theory states that when the purchasing power of two currencies is the same, then the exchange rates between the currencies are in equilibrium. The theory comes into play to determine the foreign exchange rate due to the behaviour of importers and exporters of goods between two countries, and it is based on the law of one price. Individuals tend to buy goods in the market in which the prices are lower and resell then in a market with higher prices to make profits. Let us consider two markets, the US, and Mexico. The analysis using PPP theory shows that the exchange rate between the Mexican peso and the US dollar is expressed as Ep/$= Pp/P$, that is, the price of Mexican pesos divided by the price in US dollars. If the basket of goods in the US is cheaper than in Mexico, there will be an increased demand for US dollar in the foreign exchange market (Clark & Ghosh, 2004). This is because individuals will be buying goods in the US and then reselling them in Mexico. This will also lead to increased Mexican pesos from US exporters. The increase in USD demand is represented by an outward shift in the demand curve in graph 4. Similarly, the supply of US dollars will reduce due to the pricier Mexican goods as US consumers abandon them. This is represented by the downward shift to the left of the US dollar supply curve as shown in graph 4.The shifts in the demand and supply curves of the US dollar will lead to a rise in the US dollar value, and hence the exchange rate increases. This process will continue until the market cost of a basket of goods in the two markets equalizes, and thus the PPP theory holds. Evidence and data sources Graph 1. Source: BIS Aite Group, 2014. Graph 2. Source: Reserve Bank of Australia. This graph shows the Total Australian Forex Exchange Turnover between 1999 and 2015. April 2015 0.3771 May 2015 0.3768 June 2015 0.3770 July 2015 0.3771 August 2015 0.3776 September 2015 0.3775 November 2015 0.3776 December 2015 0.3771 January 2016 0.3766 February 2016 0.3765 March 2016 0.3768 April 2016 0.3770 Table 1. 365 Day History for US Dollar/Bahrain Dinar (2015-2016). Source: Frenkel & Johnson, (2016).  Graph 3. 365 Day History for US Dollar/Bahrain Dinar (2015-2016). Source: Frenkel& Johnson, (2016).  Graph 4. Source: Clark & Ghosh, (2004). Conclusions In conclusion, the foreign exchange market is growing rapidly, citing the globalization of businesses and thus the need for foreign currencies. The forex market is a very profitable venture and a successful dealer in the market demand for constant study and learns the operations of the market since the environment is very dynamic. Staying informed enables a forex trader to analyse timely the available information and make quick, informed decisions and also predict future movements in exchange rates. References: Allayannis, G., &Ofek, E. (2001). Exchange rate exposure, hedging, and the use of foreign currency derivatives. Journal of international money and finance, 20(2), 273-296. Brown, G. W. (2001). Managing foreign exchange risk with derivatives.Journal of Financial Economics, 60(2), 401-448. Cheung, Y. W., Chinn, M. D., & Marsh, I. W. (2004). How do UK‐based foreign exchange dealers think their market operates? International Journal of Finance & Economics, 9(4), 289-306. Clark, E. & Ghosh, D. (2004). Arbitrage, hedging, and speculation. Westport, Conn.: Praeger. Czinkota, M. R., Ronkainen, I. A., Moffett, M. H., Marinova, S., &Marinov, M. (2009). International business (Vol. 4). Dryden Press. Frenkel, J. A., & Johnson, H. G. (2016). The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge. Goodhart, C. & Payne, R. (2000). The foreign exchange market. Houndmills, Basingstoke, Hampshire: St. Martin's Press. Levi, M. D. (2007). International Finance: Contemporary Issues. Routledge. Sapp, S. G. (2002). Price leadership in the spot foreign exchange market.Journal of Financial and Quantitative Analysis, 37(03), 425-448. Read More