Understanding Exchange Markets: Participants and Functions

1. Exchange market as a part of international financial markets, participants and functions of exchange markets Andrea Ubrežiová Jana Zentková MPA, 2007/2008

2. Exchange market (EM) • A place, where the supply of foreign currencies meets the demand for them and where the price of particular currencies is created – the exchange rate • A mechanism, which enables access to foreign currencies in international trade and international financial transactions • It is the biggest and most liquid market in the world, belongs to the oldest markets • The most important EMs are situated in the large financial world centres, e.g. London, New York, Paris, Frankfurt, Tokyo and create one global international EM

3. Exchange transaction – exchange of financial means, short-term receivables and obligations in one currency on the other one • EM from time point of view: • Prompt EM • Term EM - forwards - swap - financial futurities - option From territorial point of view: • EM of particular states • International markets

4. Trading on EM • Over the counter trade • in the form of freely accessible secondary market • Exchange operations are informal • Unorganized way of trading • 90 % of all transactions • Stock exchange • Trading conditions are set by stock exchange regulations • In the public place • Participants must be members of the stock exchange • It’s necessary that EM trades 24 hours/day, because exchange rates and market conditions can vary anytime and are influenced by current events in the world

5. EM is a system of these components: • Market forces (market mechanism) • Financial bank and non-bank institutions and other participants of EM • Financial tools in foreign currencies • Types of exchange trade and their techniques • The national EMs are connected and have global character • The integration process is a result of free exchange of national currencies and progressive development of the world-wide currency market • EM is connected also through off-shore banking centres, the tax breaks which provide investors with many advantages, but are risky as well. (Singapore, Hong Kong, Panama, etc.)

6. Liquidity of EM depends on: • the amount of potential participants in the worldwide scale, who are available • EM trades the most intensively when 2 basic world markets are opened – the american and main markets in Europe • On the currency of trade • Exchange rate – is the price of one currency expressed in other currency, it’s the relative price of two national currencies • Quotation of exchange rates: • Direct exchange list • Indirect exchange list – mostly used We use 2 currencies in exchange transactions - basic (usually USD) and variable.

7. Exchange rates can be divided according to: • financial tools: -valutove - devizove • time point of view: - prompt - term • types of trade: -prompt - forward - futures - option • Basic types of exchange trade: • Prompt– immediate, spot trading (arbitrage) • Term– forwards, futures, option trades • Combined prompt and term trades – swap operations.

8. Participants of International Exchange Market = each economic subject that offers or purchases foreign currency • Main subjects (financial institutions): • Commercial banks and their exchange brokers (dealers) • Central banks • Hedge funds, insurance companies, mutual funds and others • Non-financial institutions: • Export and import companies • citizens

9. Commercial banks – offer a number of services associated with EM (trading among banks, on behalf of their customers) • Market makers – buy or sell foreign exchange /FE/(help of brokers) • Trade among them can be direct or indirect, they quote bid and offer • difference between these two prices is bid-offerspread (bid-offer/bid)*100 • Central banks • Main goal: to stabilize (influence)the exchange rate of domestic currency due toits : • Appreciation • Depreciation

10. Bid/Offer of Foreign Exchange Figure 1: EUR/SKK Figure 2: USD/SKK • EUR/SKKBid/Offer 32.506/32.549 • USD/SKK Bid/Offer 21.380/21.420

11. Hedge funds – provide aggressive currency speculations since 1990 (Soros Fund Management) • control billions of dollars of equity • volumes of these operations are high - speculations are backed by loans • Brokers – agents/mediators among market makers • do not have an open position on EM • trade on behalf of customers for a fee/percentage from the value of a contract • security of information and liquidity of EMs • Insurance companies, mutual funds – wide range of services for international investors (export/import)

12. 2 types of trading on EMs: • Trading on interbank market /commercial, central banks, non-bank institutions • Trading on retail market /export and import companies – sell/buy FE in liabilities, insure their assets, try to find optimal structure of their FE accounts • Non-financial participants • position of export and import companies on EM: • Opened • Closed • Citizens (tourists, foreign investors…)

13. Functions of EM • Basic function – to shift financial funds from one country to another and to identify the price of FE / FE rate • There are 4 main functions of EM: • Security of foreign currencies • Hedging • Exchange speculations • Exchange arbitrage • Security of foreign currencies –opportunity to change sum of money in one currency for another sum in a different currency

14. Hedging – risk occurs when supply and demand of foreign exchange change in time - Insurance against adverse change of exchange rate during purchasing or financial contracting • Exchange speculations – are operations, which are based on prediction of future development of exchange rate • Opposite of hedging • Speculations can be divided: • Stable speculations • Unstable speculations

15. Exchange arbitrage – purchase of one currency in one financial EM and its selling in other • Aim: reach profit from the price difference in two or three financial exchange markets • Arbitrage can be divided into: • Direct arbitrage (two-side) • Indirect arbitrage (triangular, three-side)

16. Thank you for your attention!