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1. What is foreign exchange?
This is money or currency of a foreign country.
2. Explain how the gold standard represented the beginning of a foreign exchange system.
The value of the currencies could be converted to gold at a country’s central bank on request of the owner.
3. Name three functions of a country’s central bank. Who owns it?
Three functions of a country’s central bank are:
• Regulating the commercial banks
• Holding gold and foreign currencies reserves
• Intervening actively by selling and buying its own currency Government owns it.
4. Under a floating exchange rate system, what normally determined the value of currencies?
Supply and Demand determine the value of currencies.
5. Under what circumstances is an exchange rate system fixed?
• Buying the currency when it reaches its low point.
• Selling the currency when it reaches it high point. lOMoARcPSD|50713028
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6. What is a spot transaction? When does delivery take place?
A spot transaction is a currency bought or sold today with delivery two business days later.
7. On the forward transaction, when is the payment made? When is the delivery of funds made?
Payment and delivery are made at future date. 8. Define hedging
Hedging is to offset a ‘buy’ contract with a ‘sell’ contract and vice versa, matching the
amounts and the time span exactly.
9. What does premium mean? How is it determined? What is the opposite of premium?
• Premium means the additional amount it will cost to buy or sell a currency at a given future date.
• The opposite of premium is discount.
10.What is involved in arbitraging? How many markets are entered?
Arbitraging is the transfer of funds from one currency to another to benefit from
currency differentials or disparities in interest rates. In arbitraging, at least two markets are entered. B. Reading Reading
FOREIGN EXCHANGE TRADING lOMoARcPSD|50713028
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Without foreign exchange trading, international trade itself could not exist. In
former times trade was based on bartering - goods were exchanged for other goods.
The introduction of precious metals (i.e., gold and silver) to pay for goods can be
considered the forerunner of the foreign exchange market.
The Greeks and Romans commonly used gold as a medium of exchange. Most
world trade continued to be based on gold until the nineteenth century. By then
industrialization in Western Europe and the United States had boosted world trade to
such an extent that gold reserves were no longer adequate to meet the requirements.
Governments introduced a par value of their respective local currencies in gold. Thus,
the currencies were related to one another through a system called the gold standard.
The United States joined this system in 1879. The gold standard system determined the
value of all currencies based on gold. This meant the values of different currencies could
be compared in terms of one another.
The system worked well until World War I, when trade was interrupted. After the
war, currencies fluctuated widely in terms of gold and, thus, in relation to each other.
The value of currencies was meant to be regulated by supply and demand (the market
mechanism), buy speculators often interfered with this mechanism. So in an effort to
create more stable exchange markets, some countries, notably the United States,
England, and France, returned to the gold standard. Except for a brief period in the early
1930s the United States stayed on the gold standard. Buy 1971 it was the only country
whose currency remained convertible into gold, and so, by declaring the dollar
inconvertible, the gold standard was finally abolished. The meant the holders of United
States dollars could no longer exchange their dollars for gold at par value.
In 1944 toward the end of World War II, the Western industrialized nations realized
that foreign trade would be necessary to quickly and effectively heal the wounds of war.
To create a calm and stable foreign exchange market, the United States government
called for a conference in the summer of 1944. It was held in Breton Woods, New
Hampshire. At this conference, both the International Monetary Fund (IMF) and the
International Bank for Reconstruction and Development were established.
The Breton Woods Agreement stipulated that all member countries would express
the value of their currencies in gold. However, only the United States dollar was
convertible into gold, at the price of $35 an ounce.
Central banks of the member countries were required to intervene in the foreign
exchange markets to keep the value of their currencies within 1 percent of the par value. lOMoARcPSD|50713028
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This intervention was achieved by actively buying or selling foreign exchange or gold.
A given currency could, therefore, never rise above nor fall below fixed points, which
are called intervention points. There are the prices beyond which the central bank intervenes.
This is called the system of fixed exchange rates.
The system of fixed exchange rated worked well until the late 1960s and early
1970s. at that time a number of countries devalued their currencies. This meant that
their currencies were now worth less in terms of gold. England in 1967, France in 1969,
and the United States in 1971 and 1973, devalued their currencies. This caused an
almost unprecedented turbulence in the foreign exchange markets. In addition,
countries such as West Germany and Holland revalued their currencies (increased the
par value of their currencies in terms of gold). Intervention by central banks became
very costly. Foreign currency and gold reserves were drained. Countries had to buy their
own currency with gold and foreign exchange in order to keep its value above the
minimum intervention point, as agreed at Bretton Woods.
It is not surprising, then, that the world saw a return to a floating exchange rate
system. Central banks were no longer required to support their own currencies. England,
France (only temporarily), Italy, Japan, and the United States all floated their currencies.
Western Europe, united in the Common market, moved to preserve the fixed-rate
system but allowed a widening of the intervention points to within 2.25 percent of the
par value of the currencies. This system became known as the snake since these
currencies move up and down together against currencies outside the snake. The British
and the Italians, now members of the Common Market, are expected to eventually join
their currencies to the snake.
The foreign exchange market is the mechanism through which foreign currencies
are traded. It is not an actual marketplace but a system of telephone of telex
communications between banks, customers, and middlemen (foreign exchange brokers,
acting for a client vis-à-vis the bank).
Most banks have a special foreign exchange trading department, which consists of
foreign exchange dealers and an administrative staff. Customers trade with banks, banks
trade among themselves, and brokers often trade on behalf of banks or corporations.
Active participants in the foreign exchange market include tourists, investors, exporters
and importers, and governments, whose central banks intervened in the markets to
minimize fluctuations in the currencies. lOMoARcPSD|50713028
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The market consists of spot and forward transactions. When a French father
transfers money to his son in New York, a typical spot transaction occurs. The French
father buys the dollars spot – for immediate delivery – although business practice allows
two days for actual delivery. This permits sufficient time to consummate the transaction.
The French father, of course, pays for the dollars with his own currency, that is French francs.
A forward transaction means that delivery of a currency if specified to take place
at a future date. Japanese exporters of Toyota cars to the United States know from the
sales contracts that they will receive a specified United States dollar amount in six
months. In order to protect themselves against fluctuating exchange sales, they can sell
the dollars forward six months to their bank in Japan in return for yen. Payment and
delivery are not required until six months later. The rate of exchange is fixed, however,
on the date of the contract. Forward rates are usually quoted on a 30-, 90-, or 180-day
basis, but major currencies can have any maturity up to a year and sometimes longer.
Dealers, having concluded a forward contract, should always hedge with an
offsetting contract, so as not to leave the position open. For example, if they buy forward
thirty days, they should immediately sell forward thirty days for the same amount.
Obviously, traders try to realize a profit margin between the two transactions. If dealers
do not equalize their position, they are said to speculate. If they buy currency forward
without selling forward at the same time, this position is known as long; if they sell a
currency forward without buying forward at the same time, this is called short. Such
behavior can be disastrous if the exchange rates change rapidly. For instance, suppose
that a French company concludes a contract with an American importer, promising to
deliver a certain commodity in six months valued at 1,000,000 French francs. At the
exchange rate of 22 cents for one franc, the French company expects to receive
$220,000. If the franc rises to the dollar rate of 23 cents within six months, and the
French company does not sell dollars forward, only 956,521.72 francs will be obtained.
Since it cost 1,000,000 francs to deliver the original commodities, the French company would lose 43,478.28 francs.
Forward rates can be quoted either outright or in terms of a premium or discount
on the spot rate. The following table of British pounds on July 6, 1976, shows outright
quotations. A bid is the price dealers will pay to acquire pounds. An offer is the price
they will sell the pounds for. lOMoARcPSD|50713028
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………………………………………………………… July 6, 1976 Bid Offer Spot $1.8020 $1.8030 One month forward $1.7895 $1.7915 Two months forward $1.7795 $1.7815 Three months forward $1.7695 $1.7715 Six months forward $1.7445 $1.7465 One year forward $1.7010 $1.7030
Arbitrage is the practice of transferring funds from one currency to another to
benefit from rate differentials. For instance, local supply and demand factors may result
in a dollar spot rate in London that differs from the rate in New York. If the spot rate is
higher in London, an arbitrage dealer would quickly buy dollars with pounds in New
York and sell the dollars in London for pounds. Such arbitraging makes sense only if
transaction costs (cable, paperwork, etc.) are covered and a small profit if realized.
Opportunities to realized big profits do not exist in this type of arbitraging, since
communication systems today make the price, and therefore profit opportunities, available to everyone.
Another form of arbitrage is interest arbitrage. If interest rates in England are 2
percent higher than in the United States money market, a United States investor would
do well to change United States dollars into pounds sterling and then invest the sterling
at the English interest rate. However, the exchange rate discount of sterling is 1 percent.
The investor will have to buy back dollars at a 1 percent premium, thus losing 1 percent.
Still, the investor makes an overall gain of 1 percent. Of course, such transactions can
only be realized in the absence of foreign exchange regulations, such as capital transfer
limitations, which are sometimes imposed by governments. Such restrictions serve to
protect country’s foreign exchange and gold reserves and, therefore, its balance of payments .
The foreign exchange market is an extremely valuable mechanism for world trade.
Its main function is to reduce the risk of fluctuating exchange rates or of a change in
the parity of currencies (devaluation or revaluation). lOMoARcPSD|50713028
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Reading comprehension tasks
1. Name a payment mechanism used in earlier times. What was it later replaced by?
Gold standard – after that was replaced by Breton Wood Systems
2. Briefly describe the importance of the gold standard.
Determining the value of all currencies based on gold.
3. Under the gold standard, currencies were convertible into gold. This convertibility
was abolished for most currencies. Which currency remained convertible into gold until 1971? United States dollars.
4. What is the system of fixed exchange rates? Which conference agreed upon this system?
When central banks intervene in the foreign exchange markets at the intervention
points – Breton Wood Agreement.
5. What does devaluation mean? Name the countries in the Western industrialized
world that devalued their currencies between 1967 and 1973.
Devaluation means lowering the value of a currency in terms of gold. Three
countries are: England, France and United States.
6. Name two countries that revalued their currencies in the early 1970s. West Germany and Holland.
7. Are intervention points applicable in a system of floating exchange rates? Explain your answer.
No, because central banks were no longer required to support their own currencies.
8. What is the snake? Why is it called the snake and which Common Market members are outside it?
Snake is the system where a country can keep its fixed – rate system but allow a
widening of the intervention points to within 2.25% of the par value of the currencies. lOMoARcPSD|50713028
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9. Where and how does the foreign exchange market take place?
It is not an actual marketplace but a system of telephone of telex communications
between banks, customers and middlemen.
10. What is the function of a foreign exchange broker?
Acting for a client (customer) vis – a – vis the bank.
11. Name at least five active participants in the foreign exchange market. Tourists,
investors, exporters, importer, governments…
12. Briefly describe spot and forward transactions. Give an example of each.
Spot transaction in a transaction when currency is bought or sold today with delivery
two business days later.E.g: a French father transfer money to his son in New York.
Forwarding Transaction means buying or selling a currency in the future with payment
and delivery at that future date. E.g: Japanese exports on Toyota cars to the US from
the SC that they will receive a specified US dollar amount in 6 months.
13. When does delivery of the foreign exchange take place in a spot transaction and why?
2 days later – a sufficient time to consume the transaction.
14. When does payment and delivery of foreign exchange take place in a forward
transaction? At what point is the exchange rate determined?
Couples of month later – on the date of contract.
15. What causes an open position? A forward contract.
16. An open position is either long or short. Describe both types.
Long – open position is when a tracker buy currency forward without selling it forward
at the same time. Short – open position is when a trader sell currency forward at the same time.
17. What is the difference between a bid and an offer? lOMoARcPSD|50713028
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A bid is the price dealers will pay to acquire pounds (buying) while an offer is the price
they will sell the pounds for (sell price).
18. What is arbitrage? Is this usually a very profitable transaction for a bank?
Arbitrage is the practice of transfer funds from one currency to another to benefit from rate differentials.
19. Give an example of interest arbitrage. In which case is interest arbitrage not possible?
If Internet rates in England are 2% higher than in the US money market and a US
investor would do well to change USD into pounds sterling at the English interest rate
in present of foreign exchange regulation. D. Exercises
Complete the following statements with the appropriate word or phrase.
1. Bartering is based on the exchange of ……goods…………… for goods.
2. The Bretton Woods Agreement stipulated that all members would express their currencies in gold.
3. When central banks intervene in the foreign exchange markets at the intervention
points, this is called the system of ……fixed…………. exchange rates. The
opposite is called the system of …floating…………….. exchange rates. lOMoARcPSD|50713028
4. If dealers buy currencies forward but do not sell forward simultaneously, their
position is said to be ………long………...
5. Dealers using two foreign exchange markets to benefit from rate differentials are
said to engage in ……arbitrage……………..