Foreign Exchange Market Mechanisms (FOREX) Homework Help, Tutoring
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Foreign Exchange Market Mechanisms & Conventions:
Foreign exchange market provides a forum or a meeting point where the currency of
one country can be traded for the currency of another country. This kind of market
is essential because different countries around the globe have different currencies
for trading and that import and export of goods and services between countries is
inevitable. If the trading is only within a country, local currency dealings are
preferable. For example if Thailand imports aircrafts from the United States, it
has to pay by U.S.Dollar currency and not by Thai bahts. From where will Thailand
get U.S.Dollar currency unless there is a market for foreign exchange? So, the payment
in a particular currency depends upon the exporting country or the currency preferred
by the exporter. There are cases when the exporter also accepts payment in other
currencies provided they fall under the "major/hard currencies" being popularly
and widely traded around the globe. Examples of such currencies are U.S.Dollars,
British Pounds, Euros, Japanese Yen, French Franc, Deutsche Mark and Swiss Franc.
Foreign currencies are also used for direct investment in foreign countries investment
options and lendings apart from export and import. The world's largest financial
markets can be traced to foreign currency markets. The major participants in a foreign
currency market are large commercial banks and central banks of countries.
Various aspects in Foreign Exchange Dealings
- Spot exchange rate
- Forward exchange rate
- Cross exchange rate
- Direct quotation
- Indirect quotation
- Spread
- Arbitrage process
A note about direct and indirect quotations:
A foreign exchange quotation can either be a direct quotation or indirect quotation.
A direct quotation is otherwise called as European quotation. It is expressed in
a way that reflects the exchange of a specified number of domestic currencies vis-à-vis
one unit of foreign currency.
Example: 1.43020595 NZD = USD 1 is a direct quotation
for US dollars in New Zealand.
An indirect quotation is otherwise called as American quotation. It is expressed
in a way that reflects the exchange of a specified number of foreign currencies
vis-à-vis one unit of local currency.
Example: NZD 1 = 0.6973 USD is an indirect quotation
for US dollars in New Zealand.
Two way quotations: The foreign exchange quotation typically consists of two quotations
or rates: buying rate (bid price) and selling rate (ask price). Both the prices
will be different because the foreign exchange dealers obviously want a profit out
of each transaction. Suppose if a dealer bank quotes British pound sterling 1 =
1.50 USD – 1.57 USD; this means that the dealer bank is ready to purchase British
pound sterling at $1.50 and sell at $1.57.
A note about Spread and Arbitrage Process:
Spread is the difference between the ask price (which is the sale price) and the
purchase price (which is the bid price). The factors affecting Spread are the currencies
involved in trading, the volume of business transactions during the day and the
sentiments and rumours in the foreign exchange market. The size of the Spread will
be directly related to the volatility of the currency. If the involved currency
is subject to high volatility, the Spread will be higher to compensate for the higher
risk involved and vice versa.
Arbitrage refers to an act of purchasing a currency in one foreign exchange market
at a lower price and selling it in another market at a higher price. This results
in equilibrium in the exchange rates of different currencies. In spot markets, the
arbitrage can take the type of geographical arbitrage or triangular arbitrage. In
forward markets, the arbitrage can take the form of covered interest arbitrage.
Factors influencing the variation in exchange rates of currencies:
- Inflation rates
- Interest rates
- Balance of Payment position
- Volume of international reserves and
- Level of activity and employment.
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