Foreign Exchange Market
Introduction
The foreign exchange market is a market where foreign
currencies are bought and sold.
Different countries have different currencies and the
settlement of all business transactions with in a country is
done in the local currency.
The foreign exchange market provides a forum where the
currency of one country is traded for the currency of another
country.
Example, suppose an Ethiopian importer import goods from
the USA and has to make payments in US Dollars. To do so,
an Ethiopian importer has to purchase US Dollars in the
foreign exchange market and pay to US firm.
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Major Participants
The participants in the foreign exchange market are:
1. Individuals: are normally the tourists who exchange
the currencies, as also migrants sending a part of
their income to their family members living in their
home countries.
2. The firms: are generally the importers and
exporters. An exporter prefers to get the payment in
its own currencies or in a strong convertible
currency.
• Importers need foreign exchange for making
payments for their import.
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Cont’
3. Banks: When firms and individual approaches the local branch
of a bank, the local branch in turn approaches the foreign
exchange department in its head office.
4. Government: Though it is a fact that commercial banks
dominate, the government or monetary authorities too participate
in the foreign exchange market but to help stabilize the value of
domestic currencies.
5. International agencies: They buy and sell foreign currencies in
the foreign exchange market, but that is not a routine
affairs._____ They are limited in number 3
Foreign Exchange Rates
An exchange rate is the amount of one currency that
can be exchanged per unit of another currency or the
price of one currency in terms of another currency.
For example, consider the exchange rate between the
US Dollar and Ethiopian Birr. The exchange rate
could be quoted in one of two ways:
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Cont’d
1. The amount of US dollars necessary to acquire one
Ethiopian Birr, or the dollar price of one Ethiopian
Birr. (Dollar/One Birr). It is an indirect quotation.
$0.036/Birr 1.
• Indirect quote is the number of units of a foreign
currency that can be exchanged for one unit of a
local currency.
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Cont’d
2. The amount of Ethiopian Birr necessary to acquire
one US dollar, or the Ethiopian Birr price of one
dollar. (Birr/ One USD). It is a direct quotation. Birr
27.5/$1.
• Direct quote is the number of units of a local
currency exchangeable for one unit of a foreign
currency
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Foreign Exchange Risk
From the perspective of an Ethiopian investor, the cash
flows of assets denominated in a foreign currency expose
the investor to uncertainty as to the cash flow in Ethiopian
Birr.
The actual Ethiopian Birr that the investor gets depend on
the exchange rate between Ethiopian Birr and foreign
currency, if there is a direct conversion. Otherwise between
foreign currency and hard currency and again between hard
currency and Ethiopian Birr.
Therefore, if the foreign currency depreciates (declines in
value) relative to hard currency, the birr value of the cash
flows will be proportionately less. This referred to as
foreign exchange risk.
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Spot Market Vs Forward market
The foreign exchange market is classified either as
spot market or as forward market.
It is the timing of actual delivery of foreign exchange
that distinguishes between spot and forward market
transactions.
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Spot Market
In the spot market, currencies are traded for
immediate delivery at a rate existing on the day of
transaction.
The spot rate is applicable to the purchase and sell of
foreign exchange on an immediate delivery basis.
Example. Suppose that Ethiopia Airlines has bought
an air craft from USA. It is to convert Ethiopian Birr
in to USD. In case the terms of payment are
immediate, Ethiopia airlines is to arrange the
spontaneous purchase of the required sum of USD at
the spot rate from the spot market.
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Currency arbitrage in the spot market
With fast development in the telecommunication system,
rates are expected to be uniform in different foreign
exchange markets.
Nevertheless, inconsistency exists at times. As a result, the
arbitrage takes advantage of the inconsistency and garner
profits by buying and selling of currencies.
That means, they buy a particular currency at a cheaper rate
in one market and sell it at higher rate in the other market.
This process is known as currency arbitrage.
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Cont’d
The process influences the demand for, and supply of,
the particular currency in the two markets which
leads ultimately to removal of inconsistency in the
value of currencies in two markets.
Suppose, in New York: $1.96/£ and in London
$1.98/£. The arbitrage will buy the dollar in New
York and sell it in London making a profit of $1.98 -
$1.96 = $0.02 per pound sterling.
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Speculation in Spot market
Speculation occurs when the speculator anticipates a
change in the value of a currency, especially an
appreciation in the value of foreign currency.
Example: suppose that the exchange rate today is Birr 27.5/1USD.
The speculator anticipates this rate to become Birr 28.25/1USD
with in the coming two months. As a result, he will buy and hold a
USD for two months. When the target exchange rate is reached, he
will sell the USD and earn a profit of Birr 0.75/USD.
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Forward Market
In the forward market, contracts are made to
buy and sell currencies for future delivery, say
after a fortnight, one month, two months and
so on.
It is an agreement to buy or sell a currency at a
certain future time for a certain price.
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One of the parties to a forward contact assumes a
long position and agrees to buy the underlying asset
on a certain specified future date for a certain
specified price.
[
The other party assumes a short position and agrees
to sell the asset on the same date for the same price.
That is, forward exchange rates are applicable for the
delivery of foreign exchange at a future date.
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• Example, assume that, on August 16, 2014 G.C., an
Ethiopian airline purchases an aircraft $10 million from
US firm and agrees to make payment after 90 days, as
per the credit terms from the US firm. Ethiopian Airline
has two options:
1. On the due date of payment (after 3 months), make
purchase of the due sum of USD from the spot market, at
the spot rate prevailing at the point of time, and then
remit the payment of the US firm.
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2. In order to avoid the uncertainty of the exchange
rate three months from now, Ethiopian airline is to
purchase the required USD in the forward market at
the forward exchange rate that is decided at the time
of the agreement.
The agreed forward rate is valid for settlement
irrespective of the actual spot rate on the date of
maturity of the forward contract (i.e., 90 days from
today).
In this case, the delivery of USD and the payment
of Ethiopian Birr will be taken place 90 days latter,
on the date of settlement.
Thus, Ethiopian airline has eliminated exchange
risk by entering in to a forward contract.
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Spot and forward quotes for Birr/USD, exchange rate on
August 16, 2014 G.C.
Bid rate Offer rate
Spot rate 19.25 19.92
1 Month forward 19.52 20.21
3 Months forward 19.80 20.45
6 Months forward 19.97 20.55
• What would be the amount of Birr required to settle the
obligation according to the contact?
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The amount of Birr required by Ethiopian
Airline = $10 million × Birr 20.45/USD = Birr
204.5 million
Thus, Ethiopian Airlines is sure that it will
require Birr 204.5 million in order to settle its
transaction with US firm.
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Thank you!
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