Forx Chapter Three

Chapter Three:
Foreign exchange market
Learning objectives
At end of the lesson student should be able
to ;
• Define foreign exchange market.
• Explain the functions of foreign exchange.
• Discuss structure of foreign exchange.
• Evaluate the transaction of foreign
exchange market
The Foreign Exchange Market is a market
where the buyers and sellers are involved
in the sale and purchase of foreign
currencies. In other words, a market where
the currencies of different countries are
bought and sold is called a foreign
exchange market.
The Foreign Exchange Market
• The Foreign Exchange Market provides:
– the physical and institutional structure through
which the money of one country is exchanged
for that of another country;
– the determination rate of exchange between
currencies; and
– is where foreign exchange transactions are
physically completed.
Functions of the Foreign Exchange
Market
The foreign exchange market is the
mechanism by which participants:
– transfer purchasing power between countries;
– obtain or provide credit for international trade
transactions; and.
– minimize exposure to the risks of exchange
rate changes.
• Transfer function: The basic and the most visible
function of foreign exchange market is the transfer of
funds (foreign currency) from one country to another for
the settlement of payments. It basically includes
the conversion of one currency to another, where in
the role of FOREX is to transfer the purchasing power
from one country to another.
For example, If the exporter of Somaliland import goods
from the UAE and the payment is to be made in dollars,
then the conversion of the s/land shillings to the dollar
will be facilitated by FOREX.
The transfer function is performed through a use of credit
instruments, such as bank drafts, bills of foreign
exchange, and telephone transfers.
Credit Function: FOREX provides a short-term
credit to the importers so as to facilitate the
smooth flow of goods and services from
country to country.
An importer can use credit to finance the foreign
purchases. Such as UAE company wants to
purchase the machinery from the USA, can
pay for the purchase by issuing a bill of
exchange in the foreign exchange market,
essentially with a three-month maturity.
• Hedging Function: the third function of a foreign
exchange market is to hedge foreign exchange risks.
The parties to the foreign exchange are often afraid of
the fluctuations in the exchange rates, i.e., the price of
one currency in terms of another.
• The change in the exchange rate may result in a gain or
loss to the party concerned. Thus, due to this reason the
FOREX provides the services for hedging the anticipated
or actual claims/liabilities in exchange for the forward
contracts.
• A forward contract is usually a three month contract to
buy or sell the foreign exchange for another currency at
a fixed date in the future at a price agreed upon today.
Thus, no money is exchanged at the time of the contract.
Structure of Foreign exchange
market
• The foreign exchange market consists of two tiers:
– the interbank or wholesale market.
– the client or retail market (specific, smaller amounts).
• Five broad categories of participants operate within

these two tiers; bank and nonbank foreign exchange
dealers, individuals and firms conducting commercial or
investment transactions, speculators and arbitragers,
central banks and treasuries, and foreign exchange
brokers.
1. Bank and Nonbank Foreign
Exchange Dealers
• Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
• The profit from buying foreign exchange at a “bid” price
and reselling it at a slightly higher “offer” or “ask” price.
• Dealers in the foreign exchange department of large
international banks often function as “market makers.”
• These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an “inventory” position in those currencies.
2.Individuals and Firms
• Individuals (such as tourists) and firms (such as
importers, exporters and multinational
Enterprises) conduct commercial and investment
transactions in the foreign exchange market.
• Their use of the foreign exchange market is
necessary but nevertheless incidental to their
underlying commercial or investment purpose.
• Some of the participants use the market to
“hedge” foreign exchange risk.
3. Speculators and Arbitragers
• Speculators and arbitragers seek to profit from
trading in the market itself.
• They operate in their own interest, without a
need or obligation to serve clients or ensure a
continuous market.
• While dealers seek the bid/ask spread,
speculators seek all the profit from exchange
rate changes and arbitragers try to profit from
simultaneous exchange rate differences in
different markets.
4. Central Banks and Treasuries
• Central banks and treasuries use the market to acquire
or spend their country’s foreign exchange reserves as
well as to influence the price at which their own currency
is traded.
• The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in
a manner that will benefit the interests of their citizens.
5. Foreign Exchange Brokers
• Foreign exchange brokers are agents who
facilitate trading between dealers without
themselves becoming principals in the
transaction.
• Dealers use brokers to expedite the
transaction and to remain anonymous,
since the identity of participants may
influence short-term quotes.
Transactions in the foreign
Exchange Market
very brief account of certain important types of
transactions conducted in the foreign exchange market
is given below.
Spot and Forward Exchanges
• Spot Market The term spot exchange refers to the class
of foreign exchange transaction which requires the
immediate delivery or exchange of currencies on the
spot. In practice the settlement takes place within two
days in most markets.
• The rate of exchange effective for the spot transaction is
known as the spot rate and the market for such
transactions is known as the spot market.
• Forward Market
The forward transactions is an agreement
between two parties, requiring the delivery at
some specified future date of a specified amount
of foreign currency by one of the parties, against
payment in domestic currency be the other
party, at the price agreed upon in the contract.
The rate of exchange applicable to the forward
contract is called the forward exchange rate and
the market for forward transactions is known as
the forward market.
Conti------
• The foreign exchange regulations of various
countries generally regulate the forward
exchange transactions with a view to curbing
speculation in the foreign exchanges market. In
India, for example, commercial banks are
permitted to offer forward cover only with respect
to genuine export and import transactions.
• Forward exchange facilities, obviously, are of
immense help to exporters and importers as
they can cover the risks arising out of exchange
rate fluctuations be entering into an appropriate
forward exchange contract.
Define of operational terms
• Exchange rate; price of one counry’s currency
expressed in terms of another country’s
currency .
• Spot rate ;rate for transactions for immediate
delivery, in the case of foreign exchange, the
spot rate is for settlement in 2 days.
• Forward rate; exchange rate that established
now but with payment and with payment and
delivery to occur at a specified future date.
• Forward Margin; difference between spot and
forward rates.
End of the lesson
Thank you.

Forx Chapter Three

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Chapter Three:

Foreign exchange market

• Five broad categories of participants operate within

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