CHAPTER 6: 3.

Government Debt
FOREIGN EXCHANGE MARKET Government debt is the amount of debt owed by a federal government. It impacts currency value
and exchange rates since a country with higher debt is less likely to acquire foreign capital, which, in
FOREIGN EXCHANGE MARKET turn, leads to inflation. It puts downward pressure on the domestic currency and decreases its value
• INTRODUCTION in exchange rates.
Most countries of the world have their own currencies. The United States has its dollars, France, the 4.Political Stability
euro; Brazil its real; India its rupee and in the Philippines its peso. The political state of a country influences the currency value and exchange rates since a country
The trading of currency and bank deposits dominated in particular currencies takes place in the with higher political turmoil is less likely to attract foreign investors. Political instability fosters more
Foreign Exchange Market. risk for investors, as they are unsure of whether they will see their investments protected via fair
market practices or a strong legal system.
Define Foreign Exchange Market 5. Export or Import Activities
• The foreign exchange market is over a counter (OTC) global marketplace that determines A country’s net exports or imports impact currency value and exchange rates. A domestic country
the exchange rate for currencies around the world. This foreign exchange market is also that exports more goods than it imports will experience a higher demand for its currency, and
known as Forex, FX, or even the currency market. The participants engaged in this market thereby, will see its exchange rate increase relative to other foreign currencies.
are able to buy, sell, exchange, and speculate on the currencies. 6. Speculation
• These foreign exchange markets are consisting of banks, forex dealers, commercial If a country’s currency is expected to rise for any reason, investors will demand more of the
companies, central banks, investment management firms, hedge funds, retail forex currency to realize a profit based on that expectation. It can cause immediate demand increases for
dealers, and investors. In our prevailing section, we will widen our discussion on the domestic currency relative to foreign currencies.
‘Foreign Exchange Market’.
Factors Affecting Exchange Rate
Functions of Foreign Exchange Market 1. INFLATION- Inflation tends to deflate the value of a currency because holding the currency results
The various functions of the Foreign Exchange Market are as follows: in reduced purchasing power.
1. Transfer Function: The basic and the most obvious function of the foreign exchange market is to Example :If inflation in the UK is relatively lower than elsewhere, then UK exports will become more
transfer the funds or the foreign currencies from one country to another for settling their payments. competitive, and there will be an increase in demand for Pound Sterling to buy UK goods. Also,
The market basically converts one’s currency to another. foreign goods will be less competitive and so UK citizens will buy fewer imports.
2. Credit Function: The FOREX provides short-term credit to the importers in order to facilitate the Therefore countries with lower inflation rates tend to see an appreciation in the value of their
smooth flow of goods and services from various countries. The importer can use his own credit to currency. For example, the long-term appreciation in the German D-Mark in the post-war period
finance foreign purchases. was related to the relatively lower inflation rate.
3. Hedging Function: The third function of a foreign exchange market is to hedge the foreign
exchange risks. The parties in the foreign exchange are often afraid of the fluctuations in the 2. INTEREST RATE- If interest returns in a particular country are hinger relative to other countries,
exchange rates, which means the price of one currency in terms of another currency. This might individuals and companies will be enticed to invest in that country. As a result, there will be an
result in a gain or loss to the party concerned. increased demand for the country’s currency.
Exchange Rate:Definition and its Importance Example: If UK interest rates rise relative to elsewhere, it will become more attractive to deposit
• An exchange rate is the rate at which one currency can be exchanged for another between money in the UK. You will get a better rate of return from saving in UK banks. Therefore demand for
nations or economic zones. It is used to determine the value of various currencies in Sterling will rise. This is known as “hot money flows” and is an important short-run factor in
relation to each other and is important in determining trade and capital flow dynamics. determining the value of a currency.
• Higher interest rates cause an appreciation.
Importance of Exchange Rates • Cutting interest rates tends to cause a depreciation
1. Interest Rates
Changes in interest rates impact currency value and exchange rates. All else being equal, a higher 3. BALANCE OF PAYMENT- Balance of payment is used to refer to a system of accounts that catalogs
interest rate in a domestic country will increase the demand for a domestic currency since more the flow of goods between the residents of two countries. For instance, if the Philippines is a net
foreign investors will seek to invest at the higher interest rate, thereby investing foreign capital exporter of goods and therefore has a surplus balance of trade, courtries purchasing the goods must
into the domestic currency. However, in practice, it is balanced out by inflationary pressures. use the country’s currency. This increases the demand for the currency and its relative value
2. Inflation Rates
Changes in inflation rates impact currency value and exchange rates. All else being equal, a higher 4. GOVERNMENT INTERVENTION- Through intervention(e.g.., buying or selling the currency in the
inflation rate in a domestic country will decrease the demand for the domestic currency since the foreign exchange markets), the central bank of a country may support or depress the value of its
value of the currency depreciates relatively faster over time than other foreign currencies. currency.
 PIP stands for "Percentage in Point" or "Price Interest Point". It refers to the smallest unit of
How is Foreign Exchange Rate traded? measurement used to express the change in value between two currencies. In the foreign exchange
1. Spot Market: market, PIP represents the minimum movement or fluctuation in the price of a currency pair. It is
• This is the primary forex market where currency pairs are swapped, and exchange rates typically measured as the fourth decimal place for most currency pairs, except for the Japanese Yen
are determined in real-time based on supply and demand. pairs where it is the second decimal place. PIPs are important for calculating profits and losses in
• Transactions in the spot market involve the immediate delivery of currencies at the forex trading and determining the spread or commission charged by brokers.
current market rate. A market order is an instruction given to a broker to buy or sell a security at the prevailing market
2. Forward Market: price. It is executed immediately and is not limited to a specific price.
• In the forward market, traders enter into binding private contracts to exchange currencies A LIMIT order is an order to buy or sell a security at a specific price or better. It allows the trader to
at a predetermined rate on a future date. set a maximum purchase price or a minimum selling price for the trade. This means that the order
• This allows traders to lock in an exchange rate for an agreed-upon amount of currency at a will only be executed if the market reaches the specified price or better. It provides traders with
specific future date. more control over the execution price of their trades, ensuring that they do not pay more or receive
3. Futures Market: less than their desired price.
• The futures market involves standardized contracts to buy or sell a predetermined The BID price refers to the price at which you can sell the base currency. In foreign exchange
amount of a currency at a specific exchange rate on a future date. trading, the base currency is the currency being sold or exchanged for another currency, known as
• These contracts are traded on an exchange rather than privately, as in the forward the counter currency. Therefore, the BID price represents the value at which you can sell the base
market. currency in order to obtain the counter currency.
Exchange Rate Transaction The FX Market constantly moves 24 hrs. everyday, and allows currency conversion. It is a place for
• An exchange rate transaction involves the buying and selling of currencies at the the central bank to intervene when it is necessary to adjust the exchange rate in a direction that
prevailing exchange rate. It includes transactions where one currency is exchanged for benefits the economy, provides services to customers wishing to conduct international commercial
another based on the current market rate. These transactions can occur in various forms, transactions, and helps rotate international investments, credit, other international financial
such as spot transactions for immediate delivery, forward transactions for future delivery, transactions as well as exchanges between countries.
or options contracts that provide the right but not the obligation to exchange currencies In the FX Market, the currency used to buy imported goods is the seller's home currency. As a
at a future date. Exchange rate transactions are essential for international trade, general rule, moreover, currencies bought and sold on the spot foreign exchange market are
investment, and financial activities, allowing businesses and individuals to manage available 48 hours after the conclusion of the transaction.
currency exposure, hedge risks, and capitalize on currency fluctuations.
• The exchange rate is the price of a unit of foreign currency in terms of the
domestic
• currency. In the Philippines, for instance, the exchange rate is conventionally expressed as
• the value of one US dollar in peso equivalent. For example, US$1 = P57.00.
• In every exchange rate quotation, therefore, there are always two currencies involved.

ADDITIONAL NOTES
The standard lot size refers to the standardized quantity of currency units that are traded in the
foreign exchange market. This means that when trading in the forex market, a standard lot size
corresponds to 100,000 units of the base currency. It is important to note that the lot size can vary
depending on the currency being traded.
If you have gone long in the FX market, it means that you have bought the base currency and expect
it to increase in value. Going long is a term used in trading, specifically in the foreign exchange
market to indicate that you have taken a bullish position on a currency pair. By buying the base
currency, you are essentially betting that its value will rise relative to the quote currency. This is
typically done with the expectation of making a profit from the price appreciation of the base
currency.
If you have a short position, it means that you have sold the base currency and bought the counter
currency. This means that you are betting on the base currency to decrease in value relative to the
counter currency. This is a common strategy used in forex trading to profit from falling currency
prices.