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The Foreign Exchange Market

The Foreign Exchange Market. B 645. Outline. Meaning of the Foreign Exchange Market Rationale for the Foreign Exchange Market Characteristics of the Foreign Exchange Market Price Quotation in the Foreign Exchange Market Types of Trade in the Foreign Exchange Market. Meaning.

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The Foreign Exchange Market

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  1. The Foreign Exchange Market B 645

  2. Outline • Meaning of the Foreign Exchange Market • Rationale for the Foreign Exchange Market • Characteristics of the Foreign Exchange Market • Price Quotation in the Foreign Exchange Market • Types of Trade in the Foreign Exchange Market

  3. Meaning • A place where purchasing power in one currency can be converted into purchasing power into another currency • A place where units of one currency can be exchanged for units of another currency

  4. Rationale • Growth of Global Commerce • Guarantee to the participants that cash flows can be converted into the currency of their desire

  5. The Foreign Exchange Market • 24 Hour Global OTC Market • Principal Centers • London New York Tokyo • Volume: $1.3 trillion daily, up from $100 billion in the 1980s • Main Participants Users Market Makers

  6. Participants • Users • Multinationals • Institutional Investors • Trading Companies • Individuals • Speculators • 92% of the daily market activity driven by speculation • Market Makers • Commercial Banks • Investment Banks • Central Banks • Exchanges

  7. Major Trading Centers Percentage of Market London 32% New York 18% Tokyo 8% Singapore 7% Europe 55% Asia 26% North America 19%

  8. Types of Trade • Spot Trade • Forward Trade

  9. Types of Foreign Exchange Trades • Spot Trade--The Standard Trade • For delivery of currency bought and sold two business days from trade date • Also know as cash market

  10. Exchange Rate Quotations • “Direct,” “American,” or “Normal Quotations • ¥1 = $0.007547 • THB1 = $0.02265 Price of domestic currency per unit of foreign currency • “Indirect,” “European,” “Reciprocal”, or “Volume” Quoatations • $1 = ¥132.50 • $1= THB44.15 Effectively quotes the volume of foreign currency purchased by fixed quantity of domestic currency

  11. Currency Prices Spot • Agree on price today, settle two business days later Bid Offer Yen per US $ 134.42 134.60 Trader Buys US $ Sells US $ Client Sells US $ Buys US $ Thai Baht/$ 44.15 44.19 Trader Buys US $ Sells US $ Client Sells US $ Buys US $

  12. Currency Prices Bid Offer U.S. Dollar/¥ 0.007541 0.007547 Trader Buys ¥ Sells ¥ Client Sells ¥ Buys ¥ U.S. Dollar/THB 0.02263 0.02265 Trader Buys THB Sells THB Client Sells THB Buys THB

  13. Forward Trade • Forward Trade • For delivery of both currencies more than two business days from trade date • Used for hedging of exchange rate risk • If you have foreign currency cash inflows, hedge by selling that currency in the forward market • If you have foreign currency cash outflows, hedge by buying that currency in the forward market

  14. Forward Trade • Forward Premiums/Discount • Forward rate may be more or less than the spot rate • If forward rate is higher than the spot rate, the currency is trading at a forward premium in the foreign exchange market • If forward rate is lower than the spot rate, the currency is trading at a forward discount in the foreign exchange market • Annualized forward premium/discount

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