Foreign exchange market (Èíîñòðàííûé îáìåííûé ðûíîê)
Foreign exchange market (Èíîñòðàííûé îáìåííûé ðûíîê)
I. Introduction 2
II. The structure of the foreign exchange market 3
1. What is the foreign exchange? 3
2. The participants of the foreign exchange
3. Instruments of the foreign exchange markets 5
III. Foreign exchange rates 6
1. Determining foreign exchange rates 6
2. Supply and Demand for foreign exchange 7
affecting foreign exchange rates 11
IV. Conclusion 13
V. Recommendations 14
VI. Literature used 16
Trade and payments across national borders require that one
of the parties to the transaction contract to pay or receive funds in a foreign
currency. At some stage, one party must convert domestic money into foreign
money. Moreover, knowledgeable investors based in each country are aware of the
opportunities of buying assets or selling debts denominated in foreign currencies
when the anticipated returns are higher abroad or when the interest costs are
lower. These investors also must use the foreign exchange market whenever they
invest or borrow abroad.
I’d like to
add that the foreign exchange market is the largest market in the world in
terms of the volume of transactions. That the volume of foreign exchange
trading is many times larger than the volume of international trade and
investment reflects that a distinction should be made between transactions that
involve only banks and those that involve banks, individuals, and firms
involved in international trade and investment.
phenomenal explosion of activity and interest in foreign exchange markets reflects
in large measure a desire for self-preservation by businesses, governments, and
individuals. As the international financial system has moved increasingly
toward freely floating exchange rates, currency prices have become
significantly more volatile. The risks of buying and selling dollars and other
currencies have increased markedly in recent years. Moreover, fluctuations in
the prices of foreign currencies affect domestic economic conditions,
international investment, and the success or failure of government economic policies.
Governments, businesses, and individuals involved in international affairs find
it is more important today than ever before to understand how foreign
currencies are traded and what affects their relative values.
this work, we examine the structure, instruments, and price-determining forces
of the world's currency markets.
The foreign exchange markets are among the largest
markets in the world, with annual trading volume in excess of $160 trillion.
The purpose of the foreign exchange markets is to bring buyers and sellers of
currencies together. It is an over-the-counter market, with no central trading
location and no set hours of trading. Prices and other terms of trade are determined
by negotiation over the telephone or by wire, satellite, or telex. The foreign
exchange market is informal in its operations: there are no special
requirements for market participants, and trading conforms to an unwritten code
You know that almost every country has its own currency for domestic transactions.
Trading among the residents of different countries requires an efficient exchange
of national currencies. This is usually accomplished on a large scale through
foreign exchange markets, located in financial centers such as London, New
York, or Paris—in order of importance—where exchange rates for convertible
currencies are determined. The instruments used to effect
international monetary payments or transfers are called foreign exchange.
Foreign exchange is the monetary means of making payments from one currency
area to another. The funds available as foreign exchange include foreign coin
and currency, deposits in foreign banks, and other short-term, liquid financial
claims payable in foreign currencies. An international exchange rate is
the price of one (foreign) currency measured in terms of another (domestic) currency.
More accurately, it is the price of foreign exchange. Since exchange rates are
the vehicle that translates prices measured in one currency into prices
measured in another currency, changes in exchange rates affect the price and,
therefore, the volume of imports and exports exchanged. In turn the domestic
rate of inflation and the value of assets and liabilities of international
borrowers and lenders is influenced. The exchange rate rises (falls) when the
quantity demanded exceeds (is less than) the quantity supplied. Broadly
speaking, the quantity of U.S. dollars supplied to foreign exchange markets is
composed of the dollars spent on imports, plus the amount of funds spent or
invested by U.S. residents outside the United States. The demand for U.S.
dollars arises from the reverse of these transactions.
newspapers keep a daily record of the exchange rates in the highly organized
foreign exchange market, where currencies of different nations are bought and
sold. For instance, the Wall Street Journal shows the price of a
currency in two ways: first the price of the other currency is given in U.S.
dollars, and second the price of the U.S. dollar is quoted in units of the
other currency. Pairs of prices represent reciprocals of each other. These
rates refer to trading among banks, the primary marketplace for foreign
The foreign exchange
market is extremely competitive so there are many participants, none of whom is
large relative to the market.
The central institution in
modern foreign exchange markets is the commercial bank. Most
transactions of any size in foreign currencies represent merely an exchange of
the deposits of one bank for the deposits of another bank. If an individual or
business firm needs foreign currency, it contacts a bank, which in turn secures
a deposit denominated in foreign money or actually takes delivery of foreign
currency if the customer requires it. If the bank is a large money center
institution, it may hold inventories of foreign currency just to accommodate
its customers. Small banks typically do not, hold foreign currency or foreign
currency-denominated deposits. Rather, they contact large correspondent banks,
which in turn contact foreign exchange dealers.
The major international
commercial banks act as both dealers and brokers. In their dealer role, banks
maintain a net long or short position in a currency, and seek to profit from an
anticipated change in the exchange rate. (A long position means their holdings
of assets denominated in one currency exceed their liabilities denominated in
this same currency.) In their broker function, banks compete to obtain buy and
sell orders from commercial customers, such as the multinational oil companies,
both to profit from the spread between the rates at which they buy foreign
exchange from some customers and the rates at which they sell foreign exchange
to other customers, and to sell other types of banking services to these customers.
currency-trading banks do not deal directly with each other but rely on foreign
exchange brokers. These firms are in constant communication with the
exchange trading rooms of the world's major banks. Their principal function is
to bring currency buyers and sellers together.
brokerage firms, commodity traders, insurance companies, and scores of other
nonbank companies have come to play a growing role in the foreign exchange
markets today. These Nonbank Financial Institutions have entered in the
wake of deregulation of the financial marketplace and the lifting of some
foreign controls on international investment, especially by Japan and the
United Kingdom. Nonbank traders now offer a wide range of services to
international investors and export-import firms, including assistance with
foreign mergers, currency swaps and options, hedging foreign security offerings
against exchange rate fluctuations, and providing currencies needed for purchases
main all participants of an exchange market are usually divided on two groups.
The first group of participants is called speculators; by definition,
they seek to profit from anticipated changes in exchange rates. The second
group of participants is known as arbitragers. Arbitrage refers to the
purchase of one currency in a certain market and the sale of that currency in
another market in response to differences in price between the two markets. The
force of arbitrage generally keeps foreign exchange rates from getting too far
out of line in different markets.
Cable and Mail Transfers
Several financial instruments are used to facilitate foreign exchange
trading. One of the most important is the cable transfer, an execute order sent
by cable to a foreign bank holding a currency seller's account. The cable
directs the bank to debit the seller's account and credit the account of a
buyer or someone the buyer designates.
The essential advantage of the cable transfer is speed because the
transaction can be carried out the same day or within one or two business days.
Business firms selling their goods in international markets can avoid tying up
substantial sums of money in foreign exchange by using cable
When speed is not a critical factor, a mail transfer of foreign exchange
may be used. Such transfers are written orders from the holder of a foreign
exchange deposit to a bank to pay a designated individual or institution on
presentation of a draft. A mail transfer may require days to execute, depending
on the speed of mail deliveries.
Bills of Exchange
One of the most important of all international financial instruments is
the Bill of Exchange. Frequently today the word draft is used instead of bill.
Either way, a draft or bill of exchange is a written order requiring a person,
business firm, or bank to pay a specified sum of money to the bearer of the
We may distinguish sight bills, which are payable on demand, from time
bills, which mature at a future date and are payable only at that time. There
are also documentary hills, which typically accompany the international shipment
of goods. A documentary bill must be accompanied by shipping papers allowing
importers to pick up their merchandise. In contrast, a clean hill has no
accompanying documents and is simply an order to a bank to pay a certain sum of
money. The most common example arises when an importer requests its bank to
send a letter of credit to an exporter in another country. The letter
authorizes the exporter to draw bills for payment, either against the
importer's bank or against one of its correspondent banks.
Foreign Currency and Coin
Foreign currency and coin itself (as opposed to bank deposits) is an
important instrument for payment in the foreign exchange markets. This is
especially true for tourists who require pocket money to pay for lodging,
meals, and transportation. Usually this money winds up in the hands of
merchants accepting it in payment for purchases and is deposited in domestic
banks. For example, U.S. banks operating along the Canadian and Mexican borders
receive a substantial volume of Canadian dollars and Mexican pesos each day.
These funds normally are routed through the banking system back to banks in the
country of issue, and the U.S. banks receive credit in the form of a deposit
denominated in a foreign currency. This deposit may then be loaned to a customer
or to another bank.
Other Foreign Exchange Instruments
A wide variety of other financial instruments are denominated in foreign
currencies, most of this small in amount. For example, traveler's checks
denominated in dollars and other convertible currencies may be spent directly
or converted into the currency of the country where purchases are being made.
International investors frequently receive interest coupons or dividend
warrants denominated in foreign currencies. These documents normally are sold
to a domestic bank at the current exchange rate.
already mentioned the prices of foreign currencies expressed in
terms of other currencies are called foreign exchange rates. There are
today three markets for foreign exchange: the spot market, which deals in
currency for immediate delivery; the forward market, which involves the future
delivery of foreign currency; and the currency futures and options market,
which deals in contracts to hedge against future changes in foreign exchange
rates. Immediate delivery is defined as one or two business days for most
transactions. Future delivery typically means one, three, or six months from
Dealers and brokers in foreign exchange actually set not
one, but two, exchange rates for each pair of currencies. That is, each trader
sets a bid (buy) price and an asked (sell) price. The dealer makes a profit on
the spread between the bid and asked price, although that spread is normally
The underlying forces that determine the exchange rate between two currencies
are the supply and demand resulting from commercial and financial transactions
(including speculation). Foreign-exchange supply and demand schedules relate to
the price, or exchange rate. This is illustrated in Figure 1, which
assumes free-market or flexible exchange rates.
Before examining this figure, we need to define two terms. Depreciation
(appreciation) of a domestic currency is a decline (rise) brought about by
market forces in the price of a domestic currency in terms of a foreign
currency. In contrast, devaluation (revaluation) of a domestic currency is a
decline (rise) brought about by government intervention in the official price
of a domestic currency in terms of a foreign currency. Depreciation or
appreciation is the appropriate concept to deal with floating, or flexible,
exchange rates, whereas devaluation or revaluation is appropriate when dealing
with fixed exchange rates.
In the dollar-pound exchange market, the demand schedule for pounds represents
the demands of U.S. buyers of British goods, U.S. travelers to Britain,
currency speculators, and those who wish to purchase British stocks and securities.
It slopes downward because the dollar price to U.S. residents of British goods
and services declines as the exchange rate declines. An item selling for
£1 in Britain would cost $2.00 in the U.S. if the exchange rate were
£1/$2.00 U.S. If this exchange rate declined to £1/$1.50 U.S., the
same item is $.50 cheaper in the United States, increasing the demand for
British goods and thus the demand for pounds. The supply schedule of pounds
represents the pounds supplied by British buyers of U.S. goods, British travelers,
currency speculators, and those who wish to purchase U.S. stocks and
securities. It slopes upward because the pound price to British residents of
U.S. goods and services rises as the $ price of the £ falls. Assuming an
exchange rate of £1 /$2.00 U.S., a $2.00 item in the U.S. costs £1
in Britain. If this exchange rate declined to £1/$1.50 U.S., the same
item is 33 percent more expensive in Britain, decreasing the demand for dollars
to buy U.S. goods and thus reducing the supply of pounds. The equilibrium
exchange rate in Figure 1 is £1/$2.00 U.S. The amounts supplied and demanded
by the market participants are in balance.
To understand better the schedules, several of the factors that might
cause these curves to shift are discussed next. If there is a decrease in
national income and output in one country relative to others, that nation's
currency tends to appreciate relative to others. The domestic income level of
any country is a major determinant of the demand for imported goods in that
country (and hence a determinant of the demand for foreign currencies). Figure
2 shows the effects of a decline in national income in Britain (assuming
all other factors remain constant). The decrease in British income implies a
decrease in demand for goods and services (both domestic and foreign) by
British people. This reduction in demand for imported goods leads to a reduction
in the supply of pounds, which is shown by a leftward shift of the supply curve
in Figure 2 (from S
to S). If the
exchange rate floats freely, the British pound appreciates against the U.S.
dollar. If the exchange rate is artificially maintained at the old equilibrium
of £1/$2.00 U.S., however, a balance-of-payments surplus (for Britain)
In Figure 3, an initial exchange-rate equilibrium of
£1/$2.00 U.S. is assumed. Now presume the rate of price inflation in
Britain is higher than in the United States. British products become less
attractive to U.S. buyers (because their prices are increasing faster), which
causes the demand schedule for pounds to shift leftward (D to D). On the other hand, because prices in
Britain are rising faster than prices in the U.S., U.S. products become more
attractive to British buyers, which causes the supply schedule of pounds to
shift to the right (S
to S). In other
words, there is an increased demand for U.S. dollars in Britain. The reduced
demand for pounds and the increased supply (resulting from British purchases of
U.S. goods) mandates a newer, lower, equilibrium exchange rate. Furthermore,
as long as the inflation rate in Britain exceeded that in the United States,
the British pound would continually depreciate against the U.S. dollar.
Differences in yields on various short-term and long-term securities can
influence portfolio investments among different countries and also the flow of
funds of large banks and multinational corporations. If British yields rise
relative to others, an investor wishing to take advantage of these higher
interest rates must first obtain British pounds to buy the securities. This
increases the demand for British pounds shift the demand schedule in Figure
4 to the right (D
to D). British
investors are also less inclined to purchase U.S. securities, moving the
supply schedule of pounds to the left (S to S). Both activities raise the equilibrium
exchange rate of the British pound in terms of U.S. dollars.
3. Factors affecting foreign exchange rates
The exchange rate for any foreign currency depends on a multitude of
factors reflecting economic and financial conditions in the country issuing the
currency. One of the most important factors is the status of a nation's
balance-of-payments position. When a country experiences a deficit in its
balance of payments, it becomes a net demander of foreign currencies and is
forced to sell substantial amounts of its own currency to pay for imports of
goods and services. Therefore, balance-of-payments deficits often lead to price
depreciation of a nation's currency relative to the prices of other currencies.
For example, during most of the 1970s, 1980s, and into the 1990s, when the
United States was experiencing deep balance-of-payments deficits and owed
substantial amounts abroad for imported oil, the value of the dollar fell.
Exchange rates also are profoundly affected by speculation over future currency
values. Dealers and investors in foreign exchange monitor the currency markets
daily, looking for profitable trading opportunities. A currency viewed as temporarily
undervalued quickly brings forth buy orders, driving its price higher vis-a-vis
other currencies. A currency considered to be overvalued is greeted by a rash
of sell orders, depressing its price. Today, the international financial system
is so efficient and finely tuned that billions of dollars can flow across
national boundaries in a matter of hours in response to speculative fever.
These massive unregulated flows can wreak havoc with the plans of policymakers
because currency trading affects interest rates and ultimately the entire
Domestic Economic and Political Conditions
The market for a national currency is, of course, influenced by domestic
conditions. Wars, revolutions, the death of a political leader, inflation,
recession, and labor strikes have all been observed to have adverse effects on
the currency of a nation experiencing these problems. On the other hand, signs
of rapid economic growth, improving government finances, rising stock and bond
prices, and successful economic policies to control inflation and unemployment
usually lead to a stronger currency in the exchange markets.
Inflation has a particularly potent impact on exchange rates, as do
differences in real interest rates between nations. When one nation's inflation
rate rises relative to others, its currency tends to fall in value. Similarly,
a nation that reduces its inflation rate usually experiences a rise in the
value of its currency. Moreover, countries with higher real interest rates generally
experience an increase in the exchange value of their currencies, and countries
with low real interest rates usually face relatively low currency prices.
It is known that each national government has its own system or policy of
exchange-rate changes. Two of the most important are floating and fixed
exchange-rate systems. In the floating system, a nation's monetary authorities,
usually the central bank, do not attempt to prevent fundamental changes in the
rate of exchange between its own currency and any other currency. In the
fixed-rate system, a currency is kept fixed within a narrow range of values
relative to some reference (or key) currency by governmental action.
National policymakers can influence exchange rates directly by buying or
selling foreign currency in the market, and indirectly with policy actions that
influence the volume of private transactions. A third method of influencing
exchange rates is exchange control—i.e., direct control of foreign-exchange
Intervention of a central bank involves purchases or sales of the
national money against a foreign money, most frequently the U.S. dollar. A
central bank is obliged to prevent its currency from depreciating below its
lower support limit. The central bank should buy its own currency from
commercial banks operating in the exchange market and sell them dollars in
exchange. These transactions are effectively an open-market sale using dollar
demand deposits rather than domestic bonds. Such transactions reduce the
central bank's domestic liabilities in the hands of the public. The ability of
a foreign central bank to prevent its currency from depreciating depends upon
its holdings of dollars, together with dollars that might be obtained by borrowing.
Even if a national monetary authority has the foreign exchange necessary for intervention,
its need to support its currency in the exchange market might be inconsistent
with its efforts to undertake a more expansive monetary policy to achieve its
domestic economic objectives.
Also I’d like to say a few words about currency sterilization. A
decision by a central bank to intervene in the foreign currency markets will
have both currency market and money supply effects unless an operation known as
currency sterilization is carried out. Any increase in reserves and deposits
that results from a central bank currency purchase can be "sterilized"
by using monetary policy tools that absorb reserves. There is currently a great
debate among economists as to whether sterilized central bank intervention can
significantly affect exchange rates, in either the short term or the long term,
with most research studies finding little impact on relative currency prices.
A market in national monies is a necessity in a world of national
currencies; this market is the foreign-exchange market. The assets traded in
this market are demand deposits denominated in the different currencies.
Individuals who wish to buy goods or securities in a foreign country must first
obtain that country's currency in the foreign-exchange market. If these
individuals pay in their own currency, then the sellers of the goods or
securities, use the foreign-exchange market to convert receipts into their own
One from the most important participants of an exchange market is a
business bank, which act as the intermediaries between the buyers and sellers.
As already it is known they can execute a role speculators and arbitragers.
Most foreign-exchange transactions entail trades involving the U.S. dollar
and individual foreign currencies. The exchange rate between any two foreign
currencies can be inferred as the ratio of the price of the U.S. dollar in
terms of each of their currencies.
The exchange rates are prices that equalize the demand and supply of
foreign exchange. In recent years, exchange rates have moved sharply, more
sharply than is suggested by the change in the relationship between domestic
price level and foreign price level. Exchange rates do not accurately reflect
the relationship between the domestic price level and foreign price levels.
Rather, exchange rates change so that the anticipated rates of return from
holding domestic securities and foreign securities are the same after
adjustment for any anticipated change in the exchange rate.
The major factor influencing to the rate of exchange, is interference of
government in the person of central bank in currency policy of the country.
The value of a nation's currency in the international markets has long been a
source of concern to governments around the world. National pride plays a
significant role in this case because a strong currency, avidly sought by
traders and investors in the international marketplace, implies the existence
of a vigorous and well-managed economy at home. A strong and stable currency
encourages investment in the home country, stimulating its economic development.
Moreover, changes in currency values affect a nation's balance-of-payments
position. A weak and declining currency makes foreign imports more expensive,
lowering the standard of living at home. And a nation whose currency is not
well regarded in the international marketplace will have difficulty selling its
goods and services abroad, giving rise to unemployment at home. This explains
why Russia made such strenuous efforts in the early 1990s to make the Russian
ruble fully convertible into other global currencies, hoping that ruble
convertibility will attract large-scale foreign investment.
The problem of “laundering” money is essential with regard to the
exchange market. I’d like to add that the Russian exchange market comes first
in this respect.
The origin of this problem directly is connected with activity of the
organized crime: funds obtained in a criminal way are presented as legal
capital to introduce them in economic and financial structures of the state.
Therefore struggle against “laundering” money is recognized in all countries
as one from major means of a counteraction of the organized crime. The sources
of “dirty” money are as follows:
international drugs traffic;
illegal trade of weapon.
The use of exchange markets for “laundering” money is not a contingency.
This process is promoted by absence of restrictions concerning foreign
Unfortunately today participation of Russia in international struggle
against outline problem is limited by signing of the Viennese convention on
struggle against an international drugs trafficking and entering Interpol. The
work on struggle against “laundering” money in Russia should start from the
very beginning. The process of developing legislation and mechanisms of its
application is supposed to give instructions aimed at lawful struggle against
“laundering” money, developing bilateral cooperation with countries of
European Union, USA and Japan.
“Money, banking and the economy” T. Mayer, J.S.
Duesenberry, R.Z. Aliber
W.W. Norton & company New York, London 1981
“Principles of international finance” Daniel R. Kane
Croom Helm 1988
“Money and banking” David R. Kamerschen
College Division South-western Publishing Co. 1992
“Money and capital markets: the financial system in a
increasingly global economy” fifth edition Peter S. Rose