Foreign Exchange Markets
The foreign exchange market is an institution that provides the institutional and the physical structures through which the currency of one country is exchanged with that of another country. The exchange rates between currencies of different countries are determined by the market forces present in this market, and it also completes the foreign exchange transactions physically.
Foreign exchange transactions are agreements between sellers and buyers that a given specific amount of one currency should be delivered at a specified rate for other currency.
The foreign exchange is a global over the counter market which is conducted through the use of electronic platforms or by telephone in trading desks. It is also called the Forex market. The OTC also referred to as the spot or off exchange Forex market exchanges the currencies at the prevailing market rate.
The future and future options of different currencies are traded on centralized boards of exchanges. The OTC is not a market in the traditional meaning, since there is no central trading location or exchange. Rather, it is an interconnection of telephone and electronic networks of dealers, brokers, bank traders and fund managers for electronic money transfer from one account to another on different currencies. The interbank connections market is one where huge insurance companies, banks, corporations and other financial institutions manage the risks related to currency fluctuation by trading in large quantities.
Over time, secondary markets have emerged allowing retail investors to participate in the Forex market. The over the counter market has more of similar characteristics of the interbank markets, but it does not provide similar prices as the trade size and volumes are low. Trading in the foreign exchange market involves buying one currency while at the same time selling a different one.
Foreign exchange fixing is a daily fixation of monetary exchange rates by the central bank of each country. The concept is that central bank uses the fixing time, and the current exchange rate to evaluate the trend of their currencies. Fixing of these exchange rates reflect the real-time value of market equilibrium where banks, traders and dealers use fixing rates as the value indicators.
Reasons for trading in the foreign exchange market
Some multinational companies who do business in different countries use the foreign exchange data to convert profits from overseas sales to their preferred domestic currencies. Other reasons for trading in the foreign exchange market include speculation of profits or hedging against currency fluctuation.
The foreign exchange market supports international traders and investors by providing an enabling environment of currency conversion. For instance, it permits a business in Australia to import goods from the members of the European Union and pay in euros even though different currencies are used in Australia. The market also supports in direct speculation in the value of currency based on interest rates between two or more currencies.
Primary institutions and organizations comprising the foreign exchange market
I) Retail foreign exchange traders
This consists of individual retail traders in a growing market segment with an advent in the retail foreign exchange platform both in their size and significance. They currently participate through the banks or brokers. They are largely regulated and controlled by the Commodity Future Trading commission in the USA and the National Futures Association who have previously been subjected to periodical foreign exchange frauds. Some foreign exchange brokers operate in the UK under the regulations and control of Financial Services Authority. In this economy, using margin in the foreign exchange trading is part of wider OTC derivatives.
II) Non-banks foreign exchange companies
This offers exchange of currencies and international payments to companies and individuals. They are also known as foreign exchange brokers; however, they are different in that they do not provide speculative trading but rather exchange of currencies with payments.
III) Money transfer companies
They perform high volume transfers generally by economic immigrants back to their home country. The largest and well renowned provider of this service is the Western Union with over 300,000 agents in the world.
IV) Bureau de change
They are also referred as currency transfer companies. They provide low value foreign exchange services to tourists and travellers. They are typically located at tourist destinations locations, airports, and allow exchange of physical notes from one currency to another. They obtain access to exchange markets through banks and non-bank foreign exchange organizations (Blundell-Wignall, & Browne, January 01, 1991.
Geographical extent of foreign market
Geographically, the foreign market spans the whole world, with prices moving up and down as currencies trade in different places daily. The market is the deepest and the most liquid especially on early afternoons when the Europe and the US East markets are trading. The market is the thinnest as the day ends in California when the traders in Hong Kong and Tokyo are just rising up for the next day business.
In some countries, a proportion of foreign exchange trading is conducted on an informal trading floor by open bidders. Closing prices are published as the day’s official price and fixing of the day and certain commercials and transactions are based on this official price.
Function of the foreign exchange market
Foreign exchange market is a mechanism by which a person or corporation transfers the purchasing power from one country to another. It also provide or obtain credit for international trade transactions thus minimizing the exposure to foreign exchange risks.
1) Transfer of purchasing power
This is necessary because international transactions usually involve parties from different countries with different forms of currencies. Each party normally want to deal with his own currency but the transaction can only be invoiced by the other currency. This is where the foreign exchange market comes in and simplifies the problem of currency exchange between the traders, hence facilitating trade.
2) Provision of credit facilities
Since the movement of goods from different countries takes time, financing of inventory in transit must be done. Foreign exchange market whether primary or the derivative markets offers soft loans to international traders, which is secured by the goods in transit and paid back on arrival of the goods.
3) Reduction of the foreign exchange risks
The foreign market provides hedging facilities in transferring of foreign exchange risks to someone else. Hedging is the act of making an investment reduces its risks of adverse price movement in an asset. The trader states a future price in the contract of sales and thus avoids the market fluctuation risks.
Purchasing power parity theory
This principle is based on a common idea that money is valued by what it can buy. If a basket of items cost $2000 in the US, and the same cost £1000 in the UK, then the purchasing power parity (PPP) between the dollar and the pound is $2=£1. This type of exchange rate is called the absolute purchasing power parity pertaining to a certain time period. The absolute purchasing power parity (absolute PPP) model states that the equilibrium exchange rate is indeed the absolute PPP, and the actual rate of exchange is the equilibrium rate (although this may take time to arrive at, the economists says that this might only hold in the long run).
The other version of the PPP theory considers the movement of prices and the exchange rates over time. Consider the exchange rate of a past year which is considered to be the “base period” with an equilibrium value. Therefore, relative PPP may thus be considered to be US inflation divided by the UK inflation and multiplied by the base year’s exchange rate.
I.e. x exchange rate of base year
Relative PPP theory asserts that the actual current exchange rate or at least the present equilibrium exchange rate is truly relative as it’s defined.
Relationship between interest rates and the exchange rates
The relationship between the interest rates and the exchange rates have developed special interests in both the developing and the advanced countries. This is mainly due to the role they play in determining the in real and nominal sides of the economy. These characteristics include the behavior of the domestic inflation, real outputs, imports and exports. In the emerging economies, the interest is further increased by the increase by recently introduced changes in the exchange and monetary policies, shifting to inflations that target operations in flexible markets. The backward exchange rate is a type of property exchange where, the property replacement is first acquired and then the current property is traded away. These reverse exchanges were created to help buyers trade before they can acquire their current property (Christiansen & Pigott, January 01, 1997).
A concise theoretical and econometric analysis of factors that determine the real exchange rate of UK Japan, Canada France and Germany with respect to the USA was conducted. The result is that exchange rates are almost determined by real factors relating to technological growth such as oil and commodity prices. Other factors are international allocation of global investments across countries and the underlying terms of exchange in trading partners. An anticipated money supply shock calculated in five years has no virtual effect. A Blanchard-Quah variance analysis also indicates that the real shock effect predominate over the monetary shock by a bigger margin. This implies that the conducts of monetary policies in countries outside the United States are explored to avoid overshooting of the exchange rates. This has seen them follow the monetary policies set in the United States.