CH15+solutions

CH15+solutions - Chapter 15 Foreign exchange: the structure...

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Chapter 15 Foreign exchange: the structure and operation of the FX market The foreign exchange markets operate through a highly sophisticated network of telecommunications systems that link the numerous FX dealers and brokers located in all of the major cities of the world. Participants in the FX markets also include those who have underlying commercial and financial transactions denominated in foreign currencies. This includes importers and exporters, and those investing or borrowing overseas in a currency other than their home currency. In addition, there are speculators who buy and sell foreign currencies in the expectation of making profits from favourable exchange rate movements, and there are those who arbitrage exchange rate and/or international interest rate differentials across the different international markets. Central banks also enter the FX markets as buyers and sellers of foreign currency. A central bank may enter the FX market in order to meet its government’s foreign currency requirements or, from time to time, in an attempt to influence the value of a currency in the market. The FX markets operate somewhere around the globe twenty-four hours a day. The markets are dynamic, with exchange rates changing in response to the continuous flow of economic, political, financial and social news and information into the markets. It is estimated that around USD2 trillion pass through the FX markets each day, facilitated by FX dealing rooms that use sophisticated, technology-based computer and communication systems. The contracts that are traded in the FX markets are distinguished by their maturity or delivery dates. Spot and forward contracts are the most common contracts traded. Spot transactions have a value date that is two business days from today; that is, they require delivery of the foreign currency and financial settlement two business days from the contract date. Forward contracts specify a value date more than two business days from today. Because of the technology-based nature of the trade in foreign currencies, universal conventions are adopted in the markets. The first-named currency in an FX quote is called the unit of the quotation, or the base currency. The base currency represents one unit of the currency. The second-named currency is known as the terms currency. FX dealers, or price-makers, quote two- way rates: the first and lower rate is the one at which the dealer buys the base currency; the second and higher rate is the one at which the dealer sells the base currency. FX dealers will often quote only the final two points, as it is presumed that market participants are aware of the big numbers that precede them. A point is the final decimal place in a quote. The spread is the difference between the bid and offer rates. It is possible to derive a range of additional exchange rates on the basis of existing published
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CH15+solutions - Chapter 15 Foreign exchange: the structure...

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