Chapter 7 FI

CHAPTER SEVEN
Foreign Exchange Market (FX MKT)
To buy foreign goods or services or to invest in other country, first buy

the currency of the country with which they are doing business.
Generally, exporter paid on their country’s currency or in U.S. dollar,
which are accepted all over the world.
Example; When Ethiopia buy oil from Kenya, they pays in U.S dollars,
not by birr or shelling. However, USA is not involved in the transaction.
FX MKT is a market were buying and selling of different currencies take
places. The price of one currency in terms of another currency is known
as Exchange rate.
↔There are three main centers of trading, which handle the majority of
all foreign exchange transaction. This are;
United state
United kingdom and
Japan
No unified or centrally cleared market for the majority of foreign

exchange trades. Due to the Over the counter (OTC) nature of the
currency markets, there are a number of interconnected market places,
where different currency instruments are traded .This implies there is no
single dollar rate but rather a number of different rates (price), depend
on bank or market maker.
Foreign exchange consists of trading one type of currency for another.

Unlike other financial market, The FX MKT has no physical location and
no central exchange. It operates “over the counter” through the network
of the banks, corporation and individual trading one currency for
another. FX is the largest financial market in the world. It Operates 24
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hours a day. UN like other financial market, investor can respond to the
currency fluctuation caused by economic, political and social events.
→FX MKT is unique because of
 Largest trading volume

 Large number of, and variety of, traders in the market
 Cover high geographical location
 Trading 24 hours
 There are different factor affecting exchange rate
 Low profit compares with other market of fixed income, but profit
is high due to very large trading volumes.
FX MKT is denominated by four currency, dollar, Euro, Yen (Japan), and

pound in term of trading volume. Together these account for over 80% of
the market.
Exchange Rate
In finance exchange rate is known as FX Rate. Which implies between

two currencies specifies show much one currency is worth is in term of
the other.
Example-exchange rate of 17.4 cent Ethiopian birr to the USA one dollar
Quotations of exchange rate
An exchange rate quotation is given by stating the number of units of

“term currency” or “price currency” that can be bought in term of one
unit of currency (also called base currency).
Example: - In quotation Euro currency to USA, dollar Exchange rate is

1.3 (1.3 USD per EUR) that is
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EUR USD =1.3 USD
EUR
The term currency is USD were as Base currency is EUR.

→Quotes using a country home currency as the price currency
Example: Euro 1.00 = $ 1.45 US are known as direct quotation or price
quotation.
→Quotes using a countries home currency as a unit currency are known
as indirect quotation or quantity quotation.
↔ Direct quotation: 1 foreign currency unit = X home currency units

↔ Indirect quotation: 1 home currency unit = X foreign currency unit
Example
1. For Ethiopia 1 USA dollar = 12.4 birr is direct quotation
2. For Ethiopia 12.4 birr = is 1 USA dollar is indirect quotation
Note; using direct quotation, if the home currency is strengthening (that

is appreciating or becoming more valuable) the exchange rate decreases.
Example If 1 USD=10 birr rather than 1USD =12.4 birr it is exchange
rate decreases. In contrary if the foreign currency is strengthen, the
exchange rate increases and home currency depreciation.
Cross Rate
The theoretical exchange rate between two countries other than US

dollar can be inferred from the exchange rate with the US dollar. This is
called cross rate.
Quote in American in term of currency x

Quote in American in term of currency y
Example; The exchange rate for the two currencies in term of USA dollar
is 0.6234 for German mark and $ 0.009860 per Japanese Yen. Calculate
the cross rate between two country.
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↔ The number of Japan yen(y) per unit of German marks(x) is
=$0.6234/$0.009860=62.23 (yen/mark)
↔ The number of German marks(y) per unit of Japans yen (x) is=
$0.009860/$0.6234 = 0.01581(mark/yen)
Fluctuations in exchange rate
→ a market-based exchange rate will change whenever the value of either

the two-component currency change. The currency becomes more
valuable when demand is greater than supply. And inverse is true that is
the currency become less valuable when demand is less than supply of
currency.
→Increased demand for currency is due to either increased transaction
demand for money or increased speculative demand for money.
Participant of FOREX
 Banks
 Commercial companies
 Central banks
 Investment management firms
 Retail FOREX brokers
1. BANKS-the interbank market center for both the majority of
commercial turnover and large amount of speculative trading every
day
2. COMMERCIAL COMPANIES:-this market comes from the financial
activities of companies seeking foreign exchange to pay for goods and
service.
3. CENTRAL BANK-national or central banks control; the-
- Money supply
- Inflation
- Interest rate
Page 4
→Central banks do that to buy foreign exchange, when the exchange rate
is too low, and to sell when the rate is too high to get profit. The main
objective of central bank is to stabilize currency
4. Investment management firms:
Investment management firms (such as pension funds and endowment)

use the foreign exchange market to facilitate transaction in foreign
countries-
Example. An investment manager at an international equity portfolio will
need to buy and sell foreign currencies in the spot market in order to pay
for purchases of foreign equities.
5. Retail for ex brokers : there are two types of retail broker(brokers

speculative trading and offering physical delivery- bought currency is
delivered to a bank account)
FACTOR AFFECTING CURRENCY TRADING
Supply and demand for any given currency, and thus its value are not
influenced by any single element, rather by several. These elements
generally fall into three categories:
1. Economic factors-include balance of trade levels, inflation level-

economic growth
2. Political condition
3. Market psychology
Foreign exchange rates types’
A. Fixed FX rate (pegged)- is the rate the central bank set and
maintains as the official exchange rate. One country central bank set
fixed rate of FX for stabiles its own currency. In order to maintain local
exchange rate, the central bank buys and sells its own currency on the
foreign exchange market return for the currency to which it is pegged.
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B. Floating: - is determined by the private market depend on the supply
and demand. It is often termed “self correcting” as any difference in
supply and demand will automatically be corrected in the market.
↔If demand for a currency is low; its volume will be decreased, thus
making imported goods more expensive and thus stimulating demand for
local goods and services.
→ In floating, the central bank may also intervene when it is necessary to

ensure stability and to avoid the inflation.
Foreign exchange reserves
Is called foreign exchange reserves (also called FOREX reserves). It Is

only the foreign currency deposits held by central banks and monetary
authorities. Central bank held in different reserve currency issued, such
as dollar, pound, euro, yen
Purpose of foreign exchange reserves
In a non-fixed exchange rate system, reserves allow a central bank to

purchase the issued currency, exchanging its assets to reduce its
liability. The purpose of reserves is to allow central banks an additional
means to stabilize the issued currency from exchange volatility.
Costs, Benefits, and criticisms foreign exchange reserves
Large reserve of foreign currency allows the government to

manipulate exchange rates.
To stabilize the foreign exchange rates to provide a more favorable
economic environment.
There are cost in maintaining large currency reserves
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FINANCIAL INSTRUEMENTS OF FOREX
A. SPOT- is a two-day delivery transaction represents direct exchange

between two currencies. It involves shorter period as well as it
involves cash rather than contract. Has the largest share by volume in
FX transaction among all instruments. There is currency arbitrage in
spot market. That is buying a currency at cheaper rate in one market
& selling at higher rate in another market. It is either two currency
arbitrage, as well as triangular (three-currency) arbitrage.
B. Forward
In this transaction money does not actual change hands until some
agreed upon future data. Buyer and seller agree on an exchange rate
for any data in the future, the transaction occurs on that data.
C. swap
Most common type of forward transaction is the currency swap. In a

swap, two parties exchange currencies for a certain length of time and
agree the transaction at a later data. There is no standardized
contract.
→Swap transaction: how it works
Suppose a U.S company needs 15 million Japanese yen for a three-

month investment in Japan. It may agree to a rate of 150 yen to a
dollars and swap $100,000 with a company willing to swap 15 million
yen for three months, after three months the U.S company returns
the 15 million yen to the company and get backs $100,000.
D. Future
Foreign company futures are forward transaction with standard

contract safes and maturity
Page 7
EX: - 500,000 British pounds for next November at an agree rate.
Futures contracts are usually inclusive of any interesting amounts.
E. Option
a foreign exchange option (commonly shortened to just FX option) is a

deliberative were the owner has the right but not the obligation to
exchange money dominated in one currency into another currency.
FX option MKT is the deepest, largest and liquid mkt. Option
transaction is more flexible than swap or future. Option to BUY
currency called call option. Option to sell currency called put option.
→Option: how it works
Suppose a trader purchases a six-month call option on one million

Euros at 0.88 USD to a yen. During the six months, the trader can
either purchase the Euros at the 0.88 rate, or purchase them it at the
MKT rate.
↔If the number of unit a foreign currency that can obtain for one
dollar is large, the price of dollar or indirect quotation raised, the
dollar is said to be appreciate relative to the foreign currency, while
the foreign currency is said to be depreciate. Appreciation means
decline in the direct quotation.
Gold exchange standard
The value of all currency was fixed in terms of how much gold for
which they could be exchanged.
Example If one ounce of gold was worth12 British pounds or 35 USA

dollars, the exchange rate between dollars and pound remains constant
at just under 3 to 1.
Advantage of gold exchange system
Served as a common measure of value
Page 8
Helped to keep inflation
Page 9

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CHAPTER SEVEN

Foreign Exchange Market (FX MKT)

To buy foreign goods or services or to invest in other country, first buy

No unified or centrally cleared market for the majority of foreign

Foreign exchange consists of trading one type of currency for another.

→FX MKT is unique because of

 Largest trading volume

FX MKT is denominated by four currency, dollar, Euro, Yen (Japan), and

In finance exchange rate is known as FX Rate. Which implies between

Quotations of exchange rate

An exchange rate quotation is given by stating the number of units of

Example: - In quotation Euro currency to USA, dollar Exchange rate is

The term currency is USD were as Base currency is EUR.

↔ Direct quotation: 1 foreign currency unit = X home currency units

Note; using direct quotation, if the home currency is strengthening (that

The theoretical exchange rate between two countries other than US

Quote in American in term of currency x

Fluctuations in exchange rate

→ a market-based exchange rate will change whenever the value of either

4. Investment management firms:

Investment management firms (such as pension funds and endowment)

5. Retail for ex brokers : there are two types of retail broker(brokers

FACTOR AFFECTING CURRENCY TRADING

1. Economic factors-include balance of trade levels, inflation level-

Foreign exchange rates types’

→ In floating, the central bank may also intervene when it is necessary to

Foreign exchange reserves

Is called foreign exchange reserves (also called FOREX reserves). It Is

Purpose of foreign exchange reserves

In a non-fixed exchange rate system, reserves allow a central bank to

Costs, Benefits, and criticisms foreign exchange reserves

Large reserve of foreign currency allows the government to

A. SPOT- is a two-day delivery transaction represents direct exchange

Most common type of forward transaction is the currency swap. In a

Suppose a U.S company needs 15 million Japanese yen for a three-

Foreign company futures are forward transaction with standard

a foreign exchange option (commonly shortened to just FX option) is a

Suppose a trader purchases a six-month call option on one million

Gold exchange standard

Example If one ounce of gold was worth12 British pounds or 35 USA

Advantage of gold exchange system

Served as a common measure of value

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