Foreign exchange markets and transactions

Date: May 31, 2006 Pham Thi Thuy Ha

Foreign Exchange Market:

Started in 1970s, the foreign exchange market first enables the conversion of other currencies to US dollars at fixed exchange rate. This market has grown over time due to the expansion of international trade and became the largest market in the world with 1.2 trillion average daily turnover in 2001. The largest trading center is in UK with 16% of US dollars, 9% of Japanese Yen. OTC is the most popular trading method and transactions include spot transactions, outright forwards and swaps. Euro and world-wide consolidation of in the financial sector have reduced traded volume of the market. There was a trend toward fewer banks with larger market share in the exchange market. Electronic brokering systems account for increasing share of turnover in spot market.

What is an exchange rate?

An exchange rate is the rate at which one currency can be exchanged for another. On other words, it is the price of a currency in the exchange market. Direct quotes are exchange rates listed in the form of US $ Equivalent and give the price of a unit of foreign currency in US dollars. Indirect quotes are rates listed in the form of Currency per U.S. $ and give the number of units of foreign currency required to buy 1 U.S.$. Cross exchange rate are exchange rates in terms of two non-U.S. dollar currencies. For instance, the cross rate between RMB and Euro. Bid/ask spread is the service fees that banks or brokers charge for each currency transaction. A quote is a bank’s buy price and an ask quote is a bank’s sell price. The spread is the difference between these two prices. Therefore, bank currency quotes are usually given in pairs with the first rate being the bid quote and the second being the ask quote.

Exchange rate movements:

Prices of currencies fluctuate quite often in the exchange market like the prices of goods fluctuate in the good market.
Currency appreciation is the increase in the value of a currency relative to other currencies. When the value is decrease, currency is depreciated. When a currency is appreciated, its purchasing power increases.
Exchange rate fluctuations are measured in percentage relative to some reference currency, for example Euro could appreciate 10% relative to US dollars. Three steps to calculate percentage of fluctuation: 1) convert exchange rates into a standard form; 2) determine whether the studied currency is depreciated or appreciated; 3) calculate the percentage of changes of the original exchange rate.

There are 2 reasons why exchange rates fluctuate: 1) according to purchasing power parity theory, exchange rate fluctuate because of the changes of purchasing power of a currency to another currency; 2) according to interest parity theory, exchange rates fluctuate because of the fluctuation of interest rates. In other words, potential holders of foreign currency deposits should not be different between two currencies.

5 types of foreign exchange transactions:
- Spot transactions are foreign exchange transactions based on spot rates, daily exchange rates quoted in the Wall Street Journal and other news sources.

- Forwards are transactions made sometime in the future at forward rates and forward contracts, an agreement between buyer and seller to trade a particular currency on a date in the future for a fixed price regardless of the changes in spot rates. If the currency is expected to appreciate in the future, forward rates will contain a premium. If the currency is expected to depreciate in the future, forward rates will contain a discount. Forwards end with the purchase of currencies.

- Swaps are a series of forwards under a contract that hedges long-term, sustained foreign exchange exposure. It differs from forwards in the sense that swaps cover multiple future transactions until the mature date while forwards deal with one transaction. Swaps are arranged by brokers and banks in favor of two parties who have complementary foreign exchange to pair up and trade their currencies.

- Futures are contracts that specify a standard volume of a currency to be exchanged on a settlement date some time in the future. Futures are similar to forwards except the fact that futures are standardized for trading on markets like Chicago Mercantile Exchange. They are often used as a tool for currency speculation rather than a hedging tool. Future contracts are traded on the market and the holder can have gains or losses depending on the movement of spot rate over time and changing expectation about the spot rate’s value on the settlement date.

- Options are contracts that allow their owners to buy or sell a currency at a designated price within specific period of time. A currency call option is a contract that allows its owner the right to buy a specific currency. A currency put option is a contract that allows its owner the right to sell a specific currency. Exercising an option is to take the right to buy or sell the currency. Options are sold in standard volumes.

Lessons drawn from the case

1. Companies using foreign currency should have different strategies of foreign currency against unfavorable movements of exchange rates before making decisions on any transaction relating to foreign currency.

2. Corporations conducting international business should consider currency options to cover the risks of unfavorable exchange movements.

3. Call options are suitable for companies that need future foreign currency and want to hedge against currency appreciation

4. Put options are suitable for companies who hold a large amount of foreign currency and want to hedge against currency depreciation