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.

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.

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.

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.

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.

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).

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

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.

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.

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.