5.2 Foreign Exchange Markets and Exchange Rate Determination

The foreign exchange market is a global network where currencies are traded. It's a 24-hour system connecting banks, corporations, and investors worldwide. This market enables international trade, investment, and currency risk management through various transaction types.

Exchange rates are determined by complex economic factors and market forces. These include inflation, GDP growth, trade balances, and interest rates. Supply and demand dynamics, influenced by trade flows and speculation, drive currency values in different exchange rate regimes.

Foreign Exchange Market Structure and Transactions

Structure of foreign exchange market

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• Decentralized over-the-counter (OTC) market connects global participants electronically
• Major participants trade currencies banks (JPMorgan Chase), corporations (Apple), investment firms (BlackRock), central banks (Federal Reserve)
• Interbank market facilitates large-volume trades between financial institutions
• Retail market serves individuals and small businesses through banks or online platforms (Forex.com)
• Electronic trading platforms (Reuters Dealing) and voice brokers execute trades
• 24-hour trading across global financial centers (New York, London, Tokyo) ensures continuous market operation

Functions of foreign exchange market

• Currency conversion enables transactions between different currencies
• Facilitates international trade by allowing businesses to pay foreign suppliers
• Enables investment and speculation in currency markets
• Hedging against currency risk protects businesses from exchange rate fluctuations
• Provides liquidity for global financial markets
• Supports monetary policy implementation by central banks

Types of forex transactions

• Spot transactions involve immediate exchange of currencies settled within two business days
• Forward transactions agree to exchange currencies at future date with pre-determined rate
• Outright forwards physically deliver currency at maturity
• Non-deliverable forwards (NDFs) settle in cash for restricted currencies (Chinese Yuan)
• Swap transactions combine spot and forward trades simultaneously purchasing and selling currency
• Foreign exchange swaps involve two parties swapping principal and interest payments
• Currency swaps exchange principal and interest payments in different currencies

Exchange Rate Determination and Analysis

Factors in exchange rate determination

• Economic fundamentals influence long-term currency values
• Inflation rates affect purchasing power (higher inflation typically weakens currency)
• GDP growth indicates economic health (stronger growth often strengthens currency)
• Balance of trade impacts currency demand (trade surplus generally strengthens currency)
• Government debt levels affect investor confidence (high debt may weaken currency)
• Interest rates influence capital flows (higher rates attract foreign investment)
• Central bank monetary policy decisions shape interest rate expectations
• Real interest rates account for inflation when comparing rates between countries
• Market expectations drive short-term currency movements
• Political stability and geopolitical events impact investor sentiment (elections, conflicts)
• Economic forecasts and analyst reports shape market perceptions
• Market sentiment and risk appetite influence currency demand (risk-on vs risk-off)
• Capital flows and foreign direct investment affect currency demand
• Commodity prices impact resource-dependent economies (oil prices for Russian Ruble)
• Speculation and carry trades can cause short-term volatility

Supply and demand in forex

• Supply represents sellers of a currency while demand represents buyers
• Trade flows impact supply and demand (exports increase demand, imports increase supply)
• Capital flows affect currency movements (foreign investment increases demand)
• Speculation can cause short-term fluctuations in supply and demand
• Exchange rate equilibrium occurs where supply meets demand
• Appreciation results from rightward shift in demand or leftward shift in supply
• Depreciation caused by leftward shift in demand or rightward shift in supply
• Exchange rate regimes influence market dynamics:
  1. Floating rates allow free market determination
  2. Fixed rates peg currency to another currency or basket
  3. Managed float (dirty float) involves periodic central bank intervention
• Central bank intervention through currency purchases or sales influences exchange rates
• Exchange rate overshooting causes short-term volatility due to rapid expectation adjustments