Introduction to Foreign Exchange Markets

Why are Financial markets crucial to our economy?

1. Channel funds from investors, promoting economic efficiency

2. Market activity affects personal wealth, business firms, and economy

3. Well functioning financial markets are key factors in [producing high economic growth

What is the foreign exchange market

where international currencies trade and exchange rates are set

where you tried currencies - exchange rates are set in FX market

• daily volume around $5 trillion

Why do fluctuations in financial markets?

consumers have found that vacationing in Europe is expensive, due to a weakening dollar relative to the Euro

When the dollar strengthens, foreign purchase of domestic good falls

What are the 5 main sections of financial institutions that are covered?

1. Structure of Financial System - helps funds move from savers to investors, typically through financial intermediaries

2. Central Banks and the Conduit of Monetary Policy - the role of the Fed, and foreign counterparts, in the management of interest rates and the money supply

3. The International financial System - capital flows between countries impacts domestic economies - need to understand exchange rates, capital controls, and the role of agencies such as the IMF

4. Banks and Other Financial Institutions - inc the role of insurance companies, mutual funds, pension funds

5. Managing Risk in Financial Institutions - focusing on risk management in the financial institutions

What is the foreign exchange market?

where individuals, firms and banks buy and sell foreign currencies or foreign exchange

What are the functions of the foreign exchange markets?

1. Transfer purchasing power from one nation and currency to another

2. Provide credit for foreign transactions

3. Provide the facilities for hedging and speculation

When does demand for a currency arise?

tourists visit another country

domestic firm wants to import from other countries

individual wants to invest abroad

when does supply of currency arise

foreign tourist expenditures

export earnings

receiving foreign investments

when is credit needed

Credit is needed when goods are in transit and to allow the buyer time to resell the goods to make the payment

Who are the participants of the foreign exchange markets?

1. Those needing currency to fund transactions - buy/sell currency - tourists, importers, exporters, investors etc

2. Commercial banks - serve as the clearing houses for currency exchange - middle man

3. Foreign exchange brokers - clearinghouse for surpluses and shortages between the commercial banks

4. Central banks - buyer or seller of last resort in the foreign exchange market - step in if there is a financial crisis or problem

What is the exchange rate btw the dollar and the euro?

the number of dollars needed to purchase one euro

S = $/€

How is S determined in a flexible exchange system?

determined by the intersection of market demand and supply curves for euros

What is depreciation?

when the currency declines in value.

• if the dollar price of the eurp increases from $1 to $1.50, the dollar has depreciated

• you require more dollars to buy the same amount of euro

What is appreciation?

when currency increases in value

• if the dollar price of the euro decreases from $1 to $0.50, the dollar has appreciated

• value of money increases

What are the different classified routes of exchange rate systems?

• fixed

• freely floating

• managed float

• pegged

• currency board

• dollarisation

What are the fixed exchange rate system?

Rates are held constant or allowed to fluctuate within very narrow bands only.

What are the pros vs cons of a fixed exchange rate system?

Pros:

• future exchange rates are known

Cons:

• governments can revalue their currencies

• each country is also vulnerable to the economic conditions in other countries

What is a freely floating exchange rate system?

rates are determined by market forces without governmental intervention

What are the pros and cons of freely floating exchange rate system

Pros

• each country is more insulated from the economic problems of other countries

• central bank interventions just to control exchange rates are not needed

• governments are not constrained by the need to maintain exchange rates when setting new policies

• less capital flow restrictions are needed, therefore, enhancing market efficiency

Cons

• you may need to devote susbtaintial resources to managing their exposure to exchange rate fluctuations - costly

• the country that initially experienced economic problems - such as high inflation and inc unemp - may have its problems compounded

What is a managed float exchange rate system?

exchange rates can move freeky daily and no official boundaries exist

However, gov may intervene to prevent the rates from moving too much in a certain direction

What is the cons of a managed float exchange rate system?

a gov may manipulate its exchange rates such that its own country benefits at the expense of other countries

What is a pegged exchange rate system

the currency’s value is pegged to a foreign currency or to some unit of account and therefore moves in line with that currency or unit against other currencies