Definition of foreign exchange market

Foreign exchange is the system or process of converting one national currency into another, and of transferring money from one country to another. The term foreign exchange is also used to refer to foreign currencies. That is, foreign exchange is the foreign currency and includes all deposits, credits and balance payable in any foreign currency and any drafts, traveler’s deposits, letters of credits and bill of exchange, expressed or drawn in domestic currency, but payable in any foreign currency.

7.1 Functions of foreign exchange market
The foreign exchange market is a market in which foreign exchange transactions take place. In other words, it is a market in which national currencies are bought and sold against one another.

A foreign exchange market performs three important functions:-

  • Transferring of purchasing power – The primary function of a foreign exchange market is the transfer of purchasing power from one country to another and from one currency to another. The international clearing function performed by foreign exchange markets plays a very important role in facilitating international trade and capital market.
  • Provision of credit – International trade depends to a great extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit facilities are available also for exporters. The Euro-dollar Market has emerged as a major international credit market.
  • Provision of hedging facilities – Foreign exchange market provide hedging facilities. Hedging refers to covering of export risks, and it provides a mechanism to exporters and importers to protect themselves against losses from fluctuation in exchange rates.

7.2. Determinants of demand and supply of foreign currency

The demand for foreign currency is fixed by the supply and demand curve (just like any other commodity in an open market). The demand for foreign currency arises from the traders who have to make up payments for imported goods i.e. demand for a currency in the foreign exchange market is a derived demand. The supply arises from those who have exported goods and services abroad. This depends largely on how much foreigners are willing to buy goods and services from a particular country.

7.2.1. Foreign exchange is demanded

  1. to buy things denominated in it (goods, services, or assets)
  2. to hold interest-bearing accounts in that currency
  3. greater quantity demanded at lower price/exchange rate

7.2.2. Non-price Determinants of Demand.
increased (decreased) demand for foreign goods and services

  • increased (decreased) domestic income
  • lower (higher) relative price levels for goods and services denominated in currency

Increased (decreased) relative return on assets denominated in foreign currency
Supply of foreign exchange: wanting to sell a currency greater quantity supplied at higher price/exchange rate
People wanting to sell more (less) of a currency at any given exchange rate is an increase (decrease) in supply

  • change in foreign income
  • change in relative price levels
  • change in relative rate of return on domestic assets

7.3. Exchange rate

Exchange rate: – this is simply the price of one currency in terms of another.

There are two methods of expressing exchange rate:-
1. Foreign exchange units per unit of the domestic currency. For example, taking the Kenya shilling as the domestic currency, we can have approximately Kshs. 85.6 required to purchase one US dollar (Kshs. 85.6/$1)
2. Foreign units per unit of domestic currency. Again taking Kenya Shillings as a domestic currency, we can have approximately
$0.01162/Kshs.1 required to obtain one pound.


  • The second method is a reciprocal of the first method
  • It is necessary to be careful when talking about a rise or a fall in the exchange rate because the meaning will be very different depending upon which expression used. A rise in the Kshs per dollar exchange rate from say Kshs. 85.6/$1 to Kshs. 90.0/$1 means that more Kshs. Have to be give to obtain a dollar. This means that the Kshs has depreciated in value or equivalently the dollar has appreciated in value.

If the second definition is employed, a rise in the exchange rate from $0.01162/Kshs.1 to $0. 01262/Kshs.1 would mean that more dollars are obtained per Kshs, so that the Kshs has appreciated or equivalently the dollar has depreciated.

7.4. Factors affecting exchange rates

1. Export/Imports
If a country exports more goods, the importing country will have a higher demand for the currency of the exporting country so as to meet its obligation. The value of the currency of the exporting country will therefore appreciate. The opposite is the case if a country imports more goods than exports.

2.  Political environment
Unsuitable political climate will make the citizens lose confidence in their currency. They would therefore wish to invest or just buy the currency of the other countries they deem to be stable. In so doing, the demand for currency of more political stable countries will appreciate as compared to those of politically unstable countries.

3. Inflation rate differential (purchasing power parity theorem)
Parity between the purchasing powers of two currencies establishes the rate of exchange between the two currencies. When inflation rate differential between two countries changes, the exchange rate also adjusts to correspond to the relative purchasing powers of the currencies. The purchasing power theorem states that the:
% E(f) = I (h) – I (f) x 100
I (f) + 1
% E (f) = the percentage change in the direct quote
I (h) = the inflation rate in the home market
I (f) = the inflation rate in the foreign market.

4.  Interest Rate Parity (International Fisher Effect)
This theory states that differences in interest rate in different market can cause a flow of funds from markets with low interest rate to markets with high interest rates. The international fisher effect can be explained as follows:
%E (f) = I (h) – I (f) x 100
1+ I (f)
% E (f) = is the % change in direct quote.
I (h) = is the interest rate in the home market.
I (f) = is the interest rate in the foreign market.

5.  Balance of Payment
The term balance of payment refers to a system of government accounts that catalogues the flow of economic transactions between the residents of one country and the residents of other countries. It is therefore the fund flow statement. Continuous deficit in the balance of payments is expected to depress the value of a currency because such deficit would increase the supply of that currency relative to its demand.

6. Government Policies
A national government may through its Central Bank intervene in the foreign exchange market, buying and selling its currency as it sees fit to support its currency relative to others. In order to promote cheap export, a country may maintain a policy of undervaluing its currency.

7.5 Spot Exchange and Forward Exchange

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. Spot exchange rate is the quotation between two currencies for immediate delivery. In other word, the spot exchange rate is the current exchange of two currencies vis-à-vis each other. The market for spot exchange transaction is known as the spot market. In addition to the spot exchange rate it is
possible for economic agents to agree today to exchange currencies to some specified time in the future, most commonly for 1 month, 3 month, 6 month, 9 month and 1 year.

Forward transaction is an agreement between two parties, requiring the delivery at some specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contact is called the forward exchange rate and the market for forward transaction is known as the forward market. Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risk arising out
of exchange rate fluctuations by entering into an appropriate forward exchange contract.

With reference to forward rate relationship with the spot rate, the forward rate may be at par, discount or premium.

  • At par – The forward exchange rate is said to be at par if the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract.
  • At premium – The forward rate for a currency, say the Kshs, is said to be at premium with respect to the spot rate when Kshs 1 buys more units of another currency say Uganda shillings, in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis.
  • At discount – the forward rate for a currency, say Kshs, is said to be at discount with respect to the spot rate when Kshs. 1 buys fewer Uganda shillings in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on per annum basis. The forward exchange rate is determined mostly by the demand for and supply of forward exchange. When the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and, conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par.

Economic agents involved in the forward exchange market are divided into three groups where classifications are distinguished by their motives for participation in the foreign exchange market.

These agents are:-
1. Hedgers – these are agent, usually firms, which enter the forward exchange market to protect themselves against exchange-rate
fluctuations which entail exchange-rate risk. By exchange rate risk we mean the risk of loss due to diverse exchange rate movement.
2. Arbitrageurs – these are agents (usually banks) that aim to make a risk less profit out of discrepancies between interest-rate differentials and what is known as the forward discount or forward premium. A currency is said to be forward premium if the forward exchange rate quotation for that currency represents an appreciation of that currency compared to the spot quotation. A currency is said to be forward discount if the forward exchange-rate quotation for that currency represents depreciation of that currency compared to the spot quotation. The forward discount or premium is usually expressed as a percentage of the spot exchange rate.
3. Speculators – Speculators are agents that hope to make a profit by accepting exchange-rate risk. They engage in the forward exchange market because they believe that future spot rate corresponding to the date of the quoted forward exchange rate will be different from the quoted forward rate. Consider the situation where the one year forward rate is quoted at $1.55/£1, and a speculator feels that the pound will be $1.40/£1 in one year’s time. In this instance he may sell £1000 forward at $1.55/£1 so as to obtain $1550 one year hence and hope to change them back into pounds in one year’s time at $1.40/£1, and so obtain £1107.14 making £107.14 profit. Of course the speculator maybe wrong and find that in one year’s time the spot exchange rate is above $1.55/£1 which lead to a loss.

7. 6 Currency Derivatives (Futures, options and swaps)

1. The growth of derivatives markets
The phenomenal growth of trading in these derivative instruments has been one of the most important developments in international financial markets over the last three decades. The 1980s witnessed an astonishing growth of futures and options markets and this trend has continued into the 1990s.

2. Reasons for rapid growth of futures and options markets

  • The volatility of foreign exchange markets following the collapse of Bretton Wood System of fixed exchange rates, combined with greater freedom o movement of capital internationally, has created a large demand on part of companies, investors, fund manager and the like for a means to cope the greater volatility and risk of exchange rate.
  • Futures and options market enables traders to take speculative position on price movements for a low initial cash payment, known as the initial margin
  • Futures and options contrasts enable traders to take short positions, that is sell something they do not own with considerable ease. This means that taking a position on currency depreciation is as easy as taking position on currency appreciation.
  • Unlike forward contracts, where there is a degree of counterparty risk, all futures and options contracts are guaranteed by the exchange on which they traded.

7.6.1 Currency futures and currency forwards
A currency futures contract is an agreement between two counterparties to exchange a specified amount of two currencies at a given date in the future at a pre determined exchange-rate. Currency futures are basically standardized forward contracts. For example, a currency futures contract may specify that £62500 per contract is being bought or sold. With forward contract, the amount to be exchange is negotiable between the two parties; For example, the two parties might agree to buy/sell, say £ 64272 forward.

Currency futures contract specifies:-

  • the amount of currency to be exchanged,
  • the Exchange on which on which the contract is traded
  • the delivery and the process for delivery.

One party agree to sell the currency (go short), and the other to purchase it (go long). Despite their high degree of similarity there are some practical differences between currency forward and futures contracts.

7.6.2 The main differences are:-

  • a currency futures contract is a standardized notional agreement between two counterparties to exchange a specified amount of a currency at a fixed future date for a predetermined price, while in a forward contract the amount of currencies to be exchanged is determined by the mutual agreement of the two parties.
  • Futures contracts are traded on an Exchange while forward contracts are over-the counter instruments with the exchange being made directly between two parties
  • Futures contracts are guaranteed by the Exchange whereas forward contracts are not, which removes the counterparty risk inherent in forward contracts. With forward contact, each of counterparty needs to carefully consider what will happen and whether the other is capable of seeing their commitment which may involve quite substantial losses. This credit risk tends to limit the forward market to only very high grade financial and commercial institutions.
  • Futures contracts are generally regarded as having greater liquidity than forward contracts. Their standardized nature means that they can easily be sold to other party at any time up until maturity at the prevailing futures prices; with the trader being credited with a profit or loss. Since forward contracts obligations cannot be transferred to a third party, the only way for a trader to get out of a forward contract is to take out a new offsetting forward position. For example. If a trader is committed to buying £ 1 million of sterling forward at $1.50, then the only way out of the forward contract is to take out another forward contract to sell £ 1 million sterling with another party. There are two problems with this:-

1. The trade is now exposed to two counterparties (double his counterparty risk)
2. The maturity date of the second forward contract may not be perfectly match with that of the first forward contract. For example, if the origin forward contract is for 90 days and 20 days later the trader tries to take an offsetting position, the nearest available forward contract is 60 days leaving 10 days of open exposure.

7.7 Currency options

A currency option is a contract that gives the purchase the right, but not the obligations to buy or sell a currency at a predetermined price sometimes in the future. The currency in which the option is granted is known as the underlying currency. The currency to be exchanged for the underlying currency is known as the counter currency. For example, if the contact specifies the right to buy £31250 at $ 1.65/£1, then the pound is the underlying currency and the dollar is the counter currency. An option contract involves two parties, the writer who sells the option and the holder who purchases it. If the option contract gives the holder the right to purchase the
underlying currency at a predetermined price from the other party, the contract is known as a call option. If it gives the owner the right to sell the underlying currency at a predetermined exchange rate from the other party, it is known as a put option.

The price at which the underlying currency can be bought or sold is known as the strike price exercise price and the date at which the current express is known as expiry date or maturity date.

7.7.1 Differences between options and future contracts
Options are futures are both examples of derivatives instruments in that their price is derived in relation to the spot price, and they can also both be used for hedging and speculative purposes. However, there are some significant differences in the two contracts. The differences are:-

  • With an option contract the buyer of the option is not obliged to transact, whereas both parties to a futures contract are obliged to transact.
  • With a futures contracts, for every cent the future spot prices is above the futures rate on expiry of the contract the buyer makes a cent and the seller lose a cent on the contract. This is not the case with an option contract. The maximum loss of the option holder is limited to the premium paid for the option, which is the maximum possible gain for the option writer. However, there is a limited potential profit for an option holder and likewise unlimited potential loss for the writer.

7.8 The swaps market

A swap is an agreement between two parties to exchange two differing forms of payment obligations. They are basically of two kinds:- Interest rate swaps – this is the exchange which involves payments denominated in same currency. Currency swaps – the exchange involves two different currencies.

The first well-documented currency swap involved the World-Bank and International Business Machines (IBM) in 1981, whereby the World Bank committed itself to financing some of IBM’s deutschmark/ Swiss franc debt in return for a commitment by IBM to finance some of the World Bank’s dollar debt. Like many other financial instruments, swap agreements are used to manage risk exposure; however, one of the main reasons for the rapid growth of the swap market has been that they enable parties to raise fund more cheaply than would otherwise be the case. Swap markets are used extensively by major corporations, international financial institutions and
governments and are important part of the international bond market

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