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CH05sguide - 5 TheForeignExchange ChapterObjectives 1 To...

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Chapter Objectives 1. To describe the size of the foreign exchange market. 2. To list major participants in the foreign exchange market and their functions. 3. To distinguish between the spot and forward markets. 4. To explain how to read foreign-currency quotations as they appear in The Wall Street Journal. 5. To discuss five theories of exchange rate determination and their relationships: purchasing power parity, Fisher Effect, International Fisher Effect, interest-rate parity, and forward rate as a predictor of the future spot rate. 6. To explain different types of arbitrage and how to take advantage of covered interest arbitrage opportunities. Chapter Outline I. The Foreign Exchange Market A. The foreign exchange market is a market where one country’s currency can be exchanged for another country’s. It has three tiers of operations: i. Individuals and corporations buy and sell foreign exchange through their commercial banks. ii. Commercial banks trade in foreign exchange with other commercial banks in the same financial center. iii. Commercial banks trade in foreign exchange with commercial banks in other financial centers. 1. The first is the retail market; the last two are the interbank market. The Foreign Exchange Market and Parity Conditions 58 5 The Foreign Exchange  Market and Parity Conditions
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B. Major Participants i. Commercial Banks 1. They operate the payment mechanism meaning a collection system that transfers money by drafts, notes, etc. 2. They extend credit both secured and unsecured. 3. Help to reduce risk by using a letter of credit. a. A letter of credit is a document issued by a bank at the request of an importer and in the document the bank guarantees to honor a draft drawn on the importer. 4. Most banks do not have a large amount of currency trading, the market is dominated by a few large banks. ii. Global and National Market 1. Banks throughout the world serve as market makers in foreign exchange. 2. All foreign exchange banks are linked together using telecommunication. 3. Local banks may have an advantage trading their specific currency (e.g. Sterling in London), but all foreign exchange banks have global level activities. 4. The foreign exchange market is 24 hour. iii. Central Banks 1. They attempt to control the growth of the money supply within their jurisdictions. 2. They also attempt to control the value of their own currency against any foreign currency. a. For fixed exchange rates, this involves absorbing the difference between supply of and demand for foreign exchange to maintain the par value. b. For flexible exchange rates, this involves intervening to maintain orderly trading conditions. 3. Central bank activities include transaction with other central banks, various international organizations, and exchange rate intervention.
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