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Forex Market Mechanisms

Foreign Exchange Market Mechanisms Assignment / Homework Help

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
The above equation is also called as the Foreign Exchange Market Mechanisms.

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--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--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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