13.1 Foreign Exchange Market

The foreign exchange market is a global playground where currencies dance to the tune of supply and demand. It's a 24/7 party with banks, corporations, and even regular folks joining in. This market is huge, with trillions of dollars changing hands daily.

Exchange rates are like price tags for currencies, telling us how much one is worth compared to another. There are different ways to quote these rates, and the difference between buying and selling prices is called the spread. Spot deals happen now, while forward contracts let you lock in future rates.

The Foreign Exchange Market

Key Participants and Market Characteristics

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• The foreign exchange market is a global decentralized marketplace that facilitates the buying, selling, and exchanging of currencies
• Key participants in the foreign exchange market include:
  • Commercial banks
  • Central banks
  • Multinational corporations
  • Hedge funds
  • Individual investors
• The foreign exchange market operates 24 hours a day, five days a week, across major financial centers worldwide (London, New York, Tokyo, Singapore)
• The foreign exchange market is the largest financial market in the world, with a daily trading volume exceeding $6 trillion

Exchange Rate Quotations

Types of Quotations

• Exchange rate quotations express the value of one currency in terms of another currency
• Direct quotation expresses the domestic currency price of one unit of foreign currency
  • Example: USD/EUR = 0.85, meaning 1 EUR costs 0.85 USD
• Indirect quotation expresses the foreign currency price of one unit of domestic currency
  • Example: EUR/USD = 1.18, meaning 1 USD costs 1.18 EUR
• Cross rates are exchange rates between two currencies, neither of which is the official currency of the country in which the quote is given
  • Example: EUR/JPY in the U.S.

Bid-Ask Spread

• Bid-ask spread represents the difference between the price at which a market maker is willing to buy (bid) and sell (ask) a currency
• The bid price is always lower than the ask price
• The size of the bid-ask spread reflects the liquidity and transaction costs in the market

Spot vs Forward Markets

Spot Market

• The spot market is where currencies are bought and sold at the current market price for immediate delivery (usually within two business days)
• Spot transactions are settled in cash at the prevailing exchange rate
• The spot market is used for immediate currency needs, such as for international trade or travel

Forward Market

• The forward market involves contracts to buy or sell currencies at a predetermined price on a future date, typically ranging from a few days to several months
• Forward contracts are used by market participants to hedge against exchange rate fluctuations and manage currency risk
• The forward exchange rate is determined by the interest rate differential between the two currencies, as per the interest rate parity theory
• Forward contracts are customizable and can be tailored to specific amounts and maturities

Factors Influencing Exchange Rates

Economic Factors

• Differences in interest rates between countries can affect exchange rates, as higher interest rates tend to attract foreign capital, increasing demand for the domestic currency
• Inflation differentials between countries impact exchange rates, as currencies of countries with lower inflation rates tend to appreciate against those with higher inflation
• Economic growth and stability influence exchange rates, with stronger economies generally associated with appreciating currencies
• Balance of payments, which includes trade balance and capital flows, affects the supply and demand of currencies in the foreign exchange market

Political and Market Factors

• Political stability and government policies, such as fiscal and monetary measures, can impact currency values
  • Examples: tax reforms, government spending, central bank interventions
• Market sentiment, speculation, and geopolitical events can lead to short-term volatility in exchange rates
  • Examples: elections, trade disputes, natural disasters, terrorism
• Changes in risk appetite and investor confidence can trigger capital flows and influence currency demand