🏦Financial Institutions and Markets Unit 9 – Foreign Exchange Markets

What's This Unit About?

• Explores the global market for exchanging currencies known as the foreign exchange market or forex market
• Examines how exchange rates between different currencies are determined and fluctuate over time
• Discusses the various participants in the forex market including central banks, commercial banks, and individual traders
• Covers different exchange rate systems used by countries to manage their currencies such as floating, fixed, and pegged rates
• Analyzes the economic and political factors that can influence exchange rates and currency values
• Introduces common forex trading strategies employed by market participants to profit from exchange rate movements
• Highlights real-world applications and examples of forex markets in international trade, investment, and financial transactions

Key Concepts and Terminology

• Exchange rate: The price of one currency in terms of another currency (USD/EUR = 1.20)
• Appreciation: When a currency increases in value relative to another currency
• Depreciation: When a currency decreases in value relative to another currency
• Floating exchange rate: A system where currency values are determined by supply and demand in the market
• Fixed exchange rate: A system where a currency's value is pegged to another currency or asset at a predetermined rate
• Forex spot market: The market for immediate currency transactions at the current exchange rate
• Forex forward market: The market for currency transactions to be settled at a future date and predetermined rate
• Forex futures: Standardized contracts to buy or sell a specific amount of currency at a future date and price
• Forex options: Contracts giving the right but not the obligation to buy or sell currency at a specific price and date
• Bid-ask spread: The difference between the buying price (bid) and selling price (ask) for a currency pair

How Forex Markets Work

• Forex markets operate 24 hours a day, 5 days a week across multiple time zones
• Currency transactions occur in pairs with one currency being bought and another sold simultaneously (EUR/USD)
• Exchange rates constantly fluctuate based on supply and demand dynamics in the market
  • Higher demand for a currency relative to supply leads to appreciation
  • Lower demand for a currency relative to supply results in depreciation
• Forex transactions can be executed in the spot market for immediate settlement or in forward/futures markets for future settlement
• Market participants can take long positions (buying a currency expecting it to rise) or short positions (selling a currency expecting it to fall)
• Forex markets are decentralized and primarily traded over-the-counter (OTC) through electronic platforms
• Central banks play a key role in forex markets through monetary policy actions and currency interventions to manage exchange rates

Major Players in Forex

• Commercial and investment banks: Facilitate currency transactions for clients and engage in proprietary trading
• Central banks: Manage domestic money supply, set interest rates, and intervene in forex markets to influence exchange rates
• Hedge funds and asset managers: Trade currencies as part of investment strategies and to manage portfolio risk
• Multinational corporations: Engage in forex transactions to facilitate international trade and manage currency exposure
• Individual retail traders: Speculate on currency movements using online trading platforms and leverage
• Brokers: Act as intermediaries between buyers and sellers in the forex market and provide trading services

Exchange Rate Systems

• Floating exchange rates: Currency values are determined by market forces of supply and demand (USD, EUR, JPY)
  • Advantages: Automatic adjustment to economic conditions, monetary policy flexibility
  • Disadvantages: Exchange rate volatility, uncertainty for international trade and investment
• Fixed exchange rates: Currency values are pegged to another currency or asset at a predetermined rate (Saudi riyal pegged to USD)
  • Advantages: Exchange rate stability, encourages trade and investment
  • Disadvantages: Requires central bank intervention, loss of monetary policy autonomy
• Managed float systems: Mix of market-determined rates with central bank intervention to keep rates within a desired range (Singapore dollar)
• Currency boards: Strict form of a fixed exchange rate where domestic currency is backed by foreign reserves (Hong Kong dollar)
• Dollarization: Adopting a foreign currency (usually USD) as the official domestic currency (Ecuador, Panama)

Factors Influencing Exchange Rates

• Interest rates: Higher interest rates tend to attract foreign capital, leading to currency appreciation
• Inflation rates: Higher inflation erodes the purchasing power of a currency, leading to depreciation
• Economic growth and stability: Stronger economic performance and political stability boost currency demand and value
• Balance of payments: Trade surpluses increase currency demand while deficits increase currency supply
• Government debt: High debt levels can undermine confidence in a currency and lead to depreciation
• Political events and geopolitical risks: Elections, policy changes, and global tensions can impact currency markets
• Speculation and market sentiment: Traders' expectations and positioning can exacerbate currency movements

Forex Trading Strategies

• Fundamental analysis: Trading based on economic indicators, financial data, and political developments
• Technical analysis: Using price charts, patterns, and indicators to identify trading opportunities and trends
• Carry trade: Borrowing in a low-interest currency to invest in a higher-yielding currency
• Momentum trading: Following the prevailing trend and buying currencies showing strength or selling those showing weakness
• Range trading: Identifying currencies trading within a defined price range and buying at the bottom and selling at the top
• Breakout trading: Entering positions when a currency breaks out of a previous trading range in anticipation of a new trend
• Position sizing and risk management: Allocating appropriate capital to trades and using stop-losses to limit downside risk

Real-World Applications and Examples

• International trade: Exporters and importers use forex markets to convert revenues and payments into their domestic currency (US company buying goods from Europe)
• Foreign investment: Investors use forex markets to purchase foreign assets and repatriate returns (European investor buying US stocks)
• Currency hedging: Corporations and investors use forex derivatives to manage currency risk and protect against adverse exchange rate movements
• Central bank intervention: Central banks buy or sell currencies in the market to influence exchange rates and manage domestic economic conditions (Bank of Japan weakening the yen)
• Remittances: Migrant workers use forex markets to send money back to their home countries (Indian worker in Dubai sending funds back to India)
• Travel and tourism: Individuals exchange currencies when traveling abroad for business or leisure (American tourist exchanging dollars for euros in France)
• Global capital flows: Forex markets facilitate the flow of capital across borders for investment and financing purposes (Chinese company issuing US dollar-denominated bonds)