Foreign Exchange Markets

Overview of Foreign Exchange Markets

• Foreign Exchange (FX) Markets: Markets where cash flows from the sale of products, services, or assets in foreign currencies are transacted.
• Foreign Exchange Rate: The price at which one currency can be exchanged for another.
• Currency Depreciation/Appreciation: Refers to a country's currency falling (depreciation) or rising (appreciation) in value relative to other currencies.

History of Foreign Exchange Markets

• Gold Standard System (1800s): Currencies were backed by gold, with issuers guaranteeing redemption.
• Bretton Woods Agreement (1944-1971): Established fixed exchange rates with government intervention.
• Smithsonian Agreement (1971): Allowed for devaluation of the dollar and an increase in exchange rate fluctuation boundaries to 2.25%.
• Free-Floating System (1973): Eliminated fixed boundaries, leading to the current partially free-floating FX system. Central governments can still intervene when necessary.
• Introduction of Euro (1999): Unified currencies across European nations, impacting global finance, while the U.S. dollar remained dominant in FX transactions.

Dollarization

• Definition: The use of a foreign currency alongside or instead of the local currency.
• Advantages: Promotes fiscal discipline, financial stability, and lower inflation.
• Examples: Panama, Ecuador, and El Salvador are major economies that have officially dollarized.

Free-Floating Yuan

• Managed Float (2005): China moved away from a fixed exchange rate to a managed float based on a basket of currencies.
• Internationalization: Efforts to make the yuan tradeable internationally began in 2009, culminating in its designation as an IMF reserve currency in 2015.

Foreign Exchange Rates

• Types of Quotes:
  • Direct Quote (IN US$): U.S. dollars received per foreign currency unit.
  • Indirect Quote (PER US$): Foreign currency received per U.S. dollar exchanged.

Types of Foreign Exchange Transactions

• Spot FX Transactions: Immediate exchange of currencies at the current exchange rate (30.1% of the $6.6 trillion daily FX trade).
• Forward FX Transactions: Agreements to exchange currencies at specified rates in the future (69.9% of transactions).

Measuring Risk and Return

• FX Risk: Potential loss due to changes in currency value; heightened when using foreign currency assets and liabilities.

Hedging Foreign Exchange Risk

• Purpose of Hedging: Manage exposure to currency risks without eliminating potential gains.
• Methods:
  • On-balance-sheet Hedging: Aligning foreign assets and liabilities on balance sheets.
  • Off-balance-sheet Hedging: Using derivatives like forwards, options, and swaps.

Role of Financial Institutions in FX Transactions

• Interbank Market: Conducted mainly OTC (over-the-counter); significant shift towards electronic brokerage.
• Types of Activities:
  • Facilitating international trade transactions.
  • Enabling investments in foreign markets.
  • Offering hedging solutions for exposure.
  • Speculation based on future FX rate movements.

Economic Theories Related to FX Transactions

• Fisher Effect: Relationship between nominal interest rates, real interest rates, and expected inflation.
• International Fisher Effect: Expected spot rate calculations based on foreign and domestic interest rates.
• Purchasing Power Parity (PPP): Exchange rate change driven by inflation rate differences.
• Law of One Price: Identical goods should have the same price in different markets.
• Interest Rate Parity (IRPT): Equating domestic interest rates with foreign rates adjusted for expected currency appreciation/depreciation.