Foreign exchange market (Иностранный обменный рынок)

Foreign exchange market (Иностранный обменный рынок)

Contents

I.    Introduction                                                                                                             2

II.   The structure of the foreign exchange
market                                                      3

1.    What is the foreign exchange?                                                                              3

2. The participants of the foreign exchange markets                                                  4

3. Instruments of the foreign exchange markets                                                         5

III. Foreign exchange rates                                                                                           6

1. Determining foreign exchange rates                                                                       6

2. Supply and Demand for foreign exchange                                                              7

3. Factors affecting
foreign exchange rates                                                              11

IV.  Conclusion                                                                                                             13

V.   Recommendations                                                                                                 14

VI.  Literature used                                                                                                      16

   

    

      

    

     

    

    

   

   

  

   

   

   

   

   

    

    

   

   

   

   

   

  

  

          

I.  
Introduction

Trade and payments across national borders
require that one of the parties to the transaction contract to pay or receive
funds in a foreign currency. At some stage, one party must convert domestic
money into foreign money. Moreover, knowledgeable investors based in each
country are aware of the opportunities of buying assets or selling debts
denominated in foreign cur­rencies when the anticipated returns are higher
abroad or when the interest costs are lower. These investors also must use the
foreign exchange market whenever they invest or borrow abroad.

I’d
like to add that the foreign exchange market is the largest market in the world
in terms of the volume of transactions. That the volume of foreign exchange
trading is many times larger than the volume of international trade and
investment reflects that a distinction should be made between transactions that
involve only banks and those that involve banks, individuals, and firms
involved in international trade and investment.

The
phenomenal explosion of activity and interest in foreign exchange markets reflects
in large measure a desire for self-preservation by businesses, governments, and
individuals. As the international financial system has moved increasingly
toward freely floating exchange rates, currency prices have become
significantly more volatile. The risks of buying and selling dollars and other
currencies have increased markedly in recent years. Moreover, fluctuations in
the prices of foreign currencies affect domestic economic conditions,
international investment, and the success or failure of government economic policies.
Governments, businesses, and individuals involved in international affairs find
it is more important today than ever before to understand how foreign
currencies are traded and what affects their relative values.

In this work, we examine the structure,
instruments, and price-determining forces of the world’s currency markets.

 

 

 

II.  
The structure of the foreign
exchange market

1.  
What is the foreign exchange?

The foreign exchange markets are among
the largest markets in the world, with annual trading volume in excess of $160
trillion. The purpose of the foreign exchange markets is to bring buyers and
sellers of currencies together. It is an over-the-counter market, with no
central trading location and no set hours of trading. Prices and other terms of
trade are determined by negotiation over the telephone or by wire, satellite,
or telex. The foreign exchange market is informal in its operations: there are
no special requirements for market participants, and trading conforms to an unwritten
code of rules.

You know that almost every country has its own currency
for domestic transactions. Trading among the residents of different countries
requires an efficient exchange of national currencies. This is usually
accomplished on a large scale through foreign exchange markets, located in
financial centers such as London, New York, or Paris—in order of
importance—where exchange rates for convertible currencies are determined. The instruments used to effect international monetary payments or
transfers are called foreign exchange. Foreign exchange is the monetary means
of making payments from one currency area to another. The funds available as
foreign exchange include foreign coin and currency, deposits in foreign banks,
and other short-term, liquid financial claims payable in foreign currencies. An
international exchange rate is the price of one (foreign) currency
measured in terms of another (domestic) currency. More accurately, it is the
price of foreign exchange. Since exchange rates are the vehicle that translates
prices measured in one currency into prices measured in another currency,
changes in exchange rates affect the price and, therefore, the volume of
imports and exports ex­changed. In turn the domestic rate of inflation and the
value of assets and liabilities of international borrowers and lenders is
influenced. The exchange rate rises (falls) when the quantity demanded exceeds
(is less than) the quantity supplied. Broadly speaking, the quantity of U.S.
dollars supplied to foreign exchange markets is composed of the dollars spent
on imports, plus the amount of funds spent or invested by U.S. residents
outside the United States. The demand for U.S. dollars arises from the reverse
of these transactions.

Many
newspapers keep a daily record of the exchange rates in the highly organized
foreign exchange market, where currencies of different nations are bought and
sold. For instance, the Wall Street Journal shows the price of a
currency in two ways: first the price of the other currency is given in U.S.
dollars, and second the price of the U.S. dollar is quoted in units of the
other currency. Pairs of prices represent reciprocals of each other. These
rates refer to trading among banks, the primary marketplace for foreign
currencies.

2. The participants of the foreign
exchange markets

The foreign
exchange market is extremely competitive so there are many participants, none
of whom is large relative to the market.

The central
institution in modern foreign exchange markets is the commercial bank. Most
transactions of any size in foreign currencies represent merely an exchange of
the deposits of one bank for the deposits of another bank. If an individual or
business firm needs foreign currency, it contacts a bank, which in turn secures
a deposit denominated in foreign money or actually takes delivery of foreign
currency if the customer requires it. If the bank is a large money center
institution, it may hold inventories of foreign currency just to accommodate
its customers. Small banks typically do not, hold foreign currency or foreign
currency-denominated deposits. Rather, they contact large correspondent banks,
which in turn contact foreign exchange dealers.

The major
international commercial banks act as both dealers and brokers. In their dealer
role, banks maintain a net long or short position in a currency, and seek to
profit from an anticipated change in the exchange rate. (A long position means
their holdings of assets denominated in one currency exceed their liabilities
denominated in this same currency.) In their broker function, banks compete to
obtain buy and sell orders from commercial customers, such as the multinational
oil com­panies, both to profit from the spread between the rates at which they
buy foreign exchange from some customers and the rates at which they sell
foreign exchange to other customers, and to sell other types of banking
services to these customers.

Frequently, currency-trading banks do not deal directly with each other
but rely on foreign exchange brokers. These firms are in constant
communication with the exchange trading rooms of the world’s major banks. Their
principal function is to bring currency buyers and sellers together.

Security brokerage firms, commodity traders, insurance companies, and
scores of other nonbank companies have come to play a growing role in the
foreign exchange markets today. These Nonbank Financial Institutions
have entered in the wake of deregulation of the financial marketplace and the
lifting of some foreign controls on international investment, especially by
Japan and the United Kingdom. Nonbank traders now offer a wide range of
services to international investors and export-import firms, including
assistance with foreign mergers, currency swaps and options, hedging foreign
security offerings against exchange rate fluctuations, and providing currencies
needed for purchases abroad.

In main all participants of an exchange market are usually divided on two
groups. The first group of participants is called speculators; by
definition, they seek to profit from anticipated changes in exchange rates. The
second group of participants is known as arbitragers. Arbitrage refers
to the purchase of one currency in a certain market and the sale of that
currency in another market in response to differences in price between the two
markets. The force of arbitrage generally keeps foreign exchange rates from
getting too far out of line in different markets.

 

3. Instruments of the foreign
exchange markets

·  
Cable and Mail Transfers

Several financial instruments are used to facilitate
foreign exchange trading. One of the most important is the cable transfer, an
execute order sent by cable to a foreign bank holding a currency seller’s
account. The cable directs the bank to debit the seller’s account and credit
the account of a buyer or someone the buyer designates.

The essential advantage of the cable transfer is speed
because the transaction can be carried out the same day or within one or two
business days. Business firms selling their goods in international markets can
avoid tying up substantial sums of money in foreign exchange by using cable
transfers.                                         

When speed is not a critical factor, a mail transfer of
foreign exchange may be used. Such transfers are written orders from the holder
of a foreign exchange deposit to a bank to pay a designated individual or
institution on presentation of a draft. A mail transfer may require days to
execute, depending on the speed of mail deliveries.

·  
Bills of Exchange

One of the most important of all international financial
instruments is the Bill of Exchange. Frequently today the word draft is used
instead of bill. Either way, a draft or bill of exchange is a written order
requiring a person, business firm, or bank to pay a specified sum of money to
the bearer of the bill.

We may distinguish sight bills, which are payable on
demand, from time bills, which mature at a future date and are payable only at
that time. There are also documentary hills, which typically accompany the
international shipment of goods. A documentary bill must be accompanied by
shipping papers allowing importers to pick up their merchandise. In contrast, a
clean hill has no accompanying documents and is simply an order to a bank to
pay a certain sum of money. The most common example arises when an importer
requests its bank to send a letter of credit to an exporter in another country.
The letter authorizes the exporter to draw bills for payment, either against
the importer’s bank or against one of its correspondent banks.

·  
Foreign Currency and Coin

Foreign currency and coin itself (as opposed to bank
deposits) is an important instrument for payment in the foreign exchange
markets. This is especially true for tourists who require pocket money to pay
for lodging, meals, and transportation. Usually this money winds up in the
hands of merchants accepting it in payment for purchases and is deposited in
domestic banks. For example, U.S. banks operating along the Canadian and
Mexican borders receive a substantial volume of Canadian dollars and Mexican
pesos each day. These funds normally are routed through the banking system back
to banks in the country of issue, and the U.S. banks receive credit in the form
of a deposit denominated in a foreign currency. This deposit may then be loaned
to a customer or to another bank.

·  
Other Foreign Exchange Instruments

A wide variety of other financial instruments are
denominated in foreign currencies, most of this small in amount. For example,
traveler’s checks denominated in dollars and other convertible currencies may
be spent directly or converted into the currency of the country where purchases
are being made. International investors frequently receive interest coupons or
dividend warrants denominated in foreign currencies. These documents normally
are sold to a domestic bank at the current exchange rate.

III.
Foreign exchange rates

1. Determining foreign exchange
rates

As
I’ve already mentioned the prices of
foreign currencies expressed in terms of other currencies are called foreign
exchange rates
. There are today three markets for foreign exchange: the
spot market, which deals in currency for immediate delivery; the forward
market, which involves the future delivery of foreign currency; and the
currency futures and options market, which deals in contracts to hedge against
future changes in foreign exchange rates. Immediate delivery is defined as one
or two business days for most transactions. Future delivery typically means
one, three, or six months from today.

Dealers and brokers in foreign exchange
actually set not one, but two, exchange rates for each pair of currencies. That
is, each trader sets a bid (buy) price and an asked (sell) price. The dealer
makes a profit on the spread between the bid and asked price, although that
spread is normally very small.

2. Supply and Demand for foreign
exchange

The underlying forces that determine the exchange rate
between two currencies are the supply and demand resulting from commercial and
financial transactions (including speculation). Foreign-exchange supply and
demand schedules relate to the price, or exchange rate. This is illustrated in Figure
1
, which assumes free-market or flexible exchange rates.

Figure 1

Before examining this figure, we need to define two
terms. Depreciation (appreciation) of a domestic currency is a decline (rise)
brought about by market forces in the price of a domestic currency in terms of
a foreign currency. In contrast, devaluation (revaluation) of a domestic
currency is a decline (rise) brought about by government intervention in the
official price of a domestic currency in terms of a foreign currency.
Depreciation or appreciation is the appropriate concept to deal with floating,
or flexible, exchange rates, whereas devaluation or revaluation is appropriate
when dealing with fixed exchange rates.

In the dollar-pound exchange market, the demand schedule
for pounds represents the demands of U.S. buyers of British goods, U.S.
travelers to Britain, currency speculators, and those who wish to purchase
British stocks and securi­ties. It slopes downward because the dollar price to
U.S. residents of British goods and services declines as the exchange rate
declines. An item selling for £1 in Britain would cost $2.00 in the U.S.
if the exchange rate were £1/$2.00 U.S. If this exchange rate declined to
£1/$1.50 U.S., the same item is $.50 cheaper in the United States,
increasing the demand for British goods and thus the demand for pounds. The
supply schedule of pounds represents the pounds supplied by British buyers of
U.S. goods, British travelers, currency speculators, and those who wish to
purchase U.S. stocks and securities. It slopes upward because the pound price
to British residents of U.S. goods and services rises as the $ price of the
£ falls. Assuming an exchange rate of £1 /$2.00 U.S., a $2.00 item
in the U.S. costs £1 in Britain. If this exchange rate declined to
£1/$1.50 U.S., the same item is 33 percent more expensive in Britain,
decreasing the demand for dollars to buy U.S. goods and thus reducing the
supply of pounds. The equilibrium exchange rate in Figure 1 is £1/$2.00
U.S. The amounts supplied and demanded by the market participants are in
balance.

To understand better the schedules, several of the
factors that might cause these curves to shift are discussed next. If there is
a decrease in national income and output in one country relative to others,
that nation’s currency tends to appreciate relative to others. The domestic
income level of any country is a major determinant of the demand for imported
goods in that country (and hence a determinant of the demand for foreign
currencies). Figure 2 shows the effects of a decline in national income
in Britain (assuming all other factors remain constant). The decrease in
British income implies a decrease in demand for goods and services (both
domestic and foreign) by British people. This reduction in demand for imported
goods leads to a reduction in the supply of pounds, which is shown by a
leftward shift of the supply curve in Figure 2 (from S to
S). If the exchange rate floats freely,
the British pound appreciates against the U.S. dollar. If the exchange rate is
artifi­cially maintained at the old equilibrium of £1/$2.00 U.S.,
however, a balance-of-payments surplus (for Britain) likely results.

Figure 3

In Figure 3, an initial exchange-rate equilibrium
of £1/$2.00 U.S. is assumed. Now presume the rate of price inflation in
Britain is higher than in the United States. British products become less
attractive to U.S. buyers (because their prices are increasing faster), which
causes the demand schedule for pounds to shift leftward (D to D). On
the other hand, because prices in Britain are rising faster than prices in the
U.S., U.S. products become more attractive to British buyers, which causes the
supply schedule of pounds to shift to the right (S to S). In other words, there is an increased
demand for U.S. dollars in Britain. The reduced demand for pounds and the
increased supply (resulting from British purchases of U.S. goods) man­dates a
newer, lower, equilibrium exchange rate. Furthermore, as long as the inflation
rate in Britain exceeded that in the United States, the British pound would
continually depreciate against the U.S. dollar.

Differences in yields on various short-term and
long-term securities can influence portfolio investments among different
countries and also the flow of funds of large banks and multinational
corporations. If British yields rise relative to others, an investor wishing to
take advantage of these higher interest rates must first obtain British pounds
to buy the securities. This increases the demand for British pounds shift the
demand schedule in Figure 4 to the right (D to D). British investors are also less
inclined to purchase U.S. securi­ties, moving the supply schedule of pounds to
the left (S to S).
Both activities raise the equilibrium exchange rate of the British pound in
terms of U.S. dollars.

Figure 4

 

3. Factors affecting foreign exchange
rates

·  
Balance-of-Payments Position

The exchange rate for any foreign currency depends on a
multitude of factors reflecting economic and financial conditions in the
country issuing the currency. One of the most important factors is the status
of a nation’s balance-of-payments position. When a country experiences a
deficit in its balance of payments, it becomes a net demander of foreign
currencies and is forced to sell substantial amounts of its own currency to pay
for imports of goods and services. Therefore, balance-of-payments deficits
often lead to price depreciation of a nation’s currency relative to the prices
of other currencies. For example, during most of the 1970s, 1980s, and into the
1990s, when the United States was experiencing deep balance-of-payments
deficits and owed substantial amounts abroad for imported oil, the value of the
dollar fell.

·  
Speculation

Exchange rates also are profoundly affected by
speculation over future currency values. Dealers and investors in foreign
exchange monitor the currency markets daily, looking for profitable trading
opportunities. A currency viewed as temporarily undervalued quickly brings
forth buy orders, driving its price higher vis-a-vis other currencies. A
currency considered to be overvalued is greeted by a rash of sell orders,
depressing its price. Today, the international financial system is so efficient
and finely tuned that billions of dollars can flow across national boundaries
in a matter of hours in response to speculative fever. These massive
unregulated flows can wreak havoc with the plans of policymakers because
currency trading affects interest rates and ultimately the entire economy.

·  
Domestic Economic and Political Conditions

The market for a national currency is, of course,
influenced by domestic conditions. Wars, revolutions, the death of a political
leader, inflation, recession, and labor strikes have all been observed to have
adverse effects on the currency of a nation experiencing these problems. On the
other hand, signs of rapid economic growth, improving government finances, rising
stock and bond prices, and successful economic policies to control inflation
and unemployment usually lead to a stronger currency in the exchange markets.

Inflation has a particularly potent impact on exchange
rates, as do differences in real interest rates between nations. When one
nation’s inflation rate rises relative to others, its currency tends to fall in
value. Similarly, a nation that reduces its inflation rate usually experiences
a rise in the value of its currency. Moreover, countries with higher real
interest rates generally experience an increase in the exchange value of their
currencies, and countries with low real interest rates usually face relatively
low currency prices.

·  
Government Intervention

It is known that each national government has its own
system or policy of exchange-rate changes. Two of the most important are floating
and fixed exchange-rate systems. In the floating system, a nation’s monetary
authorities, usually the central bank, do not attempt to prevent fundamental
changes in the rate of exchange between its own currency and any other
currency. In the fixed-rate system, a currency is kept fixed within a narrow
range of values relative to some reference (or key) currency by governmental
action.

National policymakers can influence exchange rates
directly by buying or selling foreign currency in the market, and indirectly
with policy actions that influence the volume of private transactions. A third
method of influencing exchange rates is exchange control—i.e., direct control
of foreign-exchange transactions.

Intervention of a central bank involves purchases or sales
of the national money against a foreign money, most frequently the U.S. dollar.
A central bank is obliged to prevent its currency from depreciating below its
lower support limit. The central bank should buy its own currency from
commercial banks oper­ating in the exchange market and sell them dollars in
exchange. These trans­actions are effectively an open-market sale using dollar
demand deposits rather than domestic bonds. Such transactions reduce the
central bank’s domestic liabilities in the hands of the public. The ability of
a foreign cen­tral bank to prevent its currency from depreciating depends upon
its hold­ings of dollars, together with dollars that might be obtained by borrowing.
Even if a national monetary authority has the foreign exchange necessary for intervention,
its need to support its currency in the exchange market might be inconsistent
with its efforts to undertake a more expansive mone­tary policy to achieve its
domestic economic objectives.

Also I’d like to say a few words about currency
sterilization. A
decision by a central bank to intervene in the foreign
currency markets will have both currency market and money supply effects unless
an operation known as currency sterilization is carried out. Any increase in
reserves and deposits that results from a central bank currency purchase can be
"sterilized" by using monetary policy tools that absorb reserves.
There is currently a great debate among economists as to whether sterilized
central bank intervention can significantly affect exchange rates, in either
the short term or the long term, with most research studies finding little
impact on relative currency prices.

  

IV.  
Conclusion

A market in national monies is a necessity in a world of
national currencies; this market is the foreign-exchange market. The assets
traded in this market are demand deposits denominated in the different
currencies. Individuals who wish to buy goods or securities in a foreign
country must first obtain that country’s currency in the foreign-exchange
market. If these individuals pay in their own currency, then the sellers of the
goods or securities, use the foreign-exchange market to convert receipts into
their own currency.

One from the most important participants of an exchange
market is a business bank, which act as the intermediaries between the buyers
and sellers. As already it is known they can execute a role speculators and
arbitragers.

Most foreign-exchange transactions entail trades
involving the U.S. dol­lar and individual foreign currencies. The exchange rate
between any two foreign currencies can be inferred as the ratio of the price of
the U.S. dollar in terms of each of their currencies.

The exchange rates are prices that equalize the demand
and supply of foreign exchange. In recent years, exchange rates have moved
sharply, more sharply than is suggested by the change in the relationship
between do­mestic price level and foreign price level. Exchange rates do not
accurately reflect the relationship between the domestic price level and
foreign price levels. Rather, exchange rates change so that the anticipated
rates of return from holding domestic securities and foreign securities are the
same after adjustment for any anticipated change in the exchange rate.

The major factor influencing to the rate of exchange, is
interference of government in the person of central bank in currency policy of
the country.  The value of a nation’s currency in the international markets has
long been a source of concern to governments around the world. National pride
plays a significant role in this case because a strong currency, avidly sought
by traders and investors in the international marketplace, implies the
existence of a vigorous and well-managed economy at home. A strong and stable
currency encourages investment in the home country, stimulating its economic
development. Moreover, changes in currency values affect a nation’s
balance-of-payments position. A weak and declining currency makes foreign
imports more expen­sive, lowering the standard of living at home. And a nation
whose currency is not well regarded in the international marketplace will have
difficulty selling its goods and services abroad, giving rise to unemployment
at home. This explains why Russia made such stren­uous efforts in the early
1990s to make the Russian ruble fully convertible into other glob­al
currencies, hoping that ruble convertibility will attract large-scale foreign
investment.

V.
Recommendations

The problem of  “laundering” money  is essential with
regard to the exchange market. I’d like to add that the Russian exchange market
comes first in this respect.

The origin of this problem directly is connected with
activity of the organized crime: funds obtained in a criminal way are presented
as legal capital to introduce them in economic and financial structures of the
state. Therefore struggle against  “laundering” money is recognized in all
countries as one from major means of a counteraction of the organized crime.
The sources of “dirty” money are as follows:

international drugs traffic;

mafia’s  activity;

illegal trade of  weapon.

The use of exchange markets for “laundering” money is
not a contingency. This process is promoted by absence of restrictions
concerning  foreign exchange.

Unfortunately today participation of Russia in
international struggle against outline problem is limited by signing of the
Viennese convention on struggle against an international drugs trafficking and
entering Interpol. The work on struggle against “laundering” money in Russia
should start from the very beginning. The process of developing legislation and
mechanisms of its application is supposed to give instructions aimed at lawful
struggle against “laundering”  money, developing bilateral cooperation with
countries of European Union, USA and Japan. 

 

 

 

 

  

 

 

 

 

 

 

 

  

VI.  
Literature used

 

1.  
“Money, banking and the economy”  T. Mayer,
J.S. Duesenberry, R.Z. Aliber

W.W. Norton & company   New York, London 1981

2.  
“Principles of international finance” 
Daniel R. Kane

Croom Helm  1988

3.  
“Money and banking”  David R. Kamerschen

College Division South-western Publishing Co.  1992

4.  
“Money and capital markets: the financial
system in a increasingly global economy”  fifth edition    Peter S. Rose

IRWIN 1994

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