Foreign Exchange Market

1. Def : market for converting the currency of one country into another country

1.1. Ex Rate: the rate at which currency is converted into another

1.1.1. determined by the supply and demand of a currency relative to another

2. Foreign Exchange Risk: the adverse consequences of unpredictable change in exchange rates

3. Use of FEM:

3.1. 1. To convert foreign currency received from exports, FDI and licensing to home country currency

3.2. 2. To pay a foreign company for its products/ services

3.3. 3. Invest spare cash in short term money markets

4. Currency Speculation: short term movement of funds form one currency to for profiting from the shift of exchange rates

5. Carry Trade: borrowing in one currency where interest rates are low and investing in other currency where interest rates are high

6. Spot Exchange rate: rate at which a foreign exchange dealer converts one currency into another on a particular day

7. Forward Exchange Rate: two parties agree to exchange currency and deal at some specific date in future

7.1. Forward Ex Rate: the exchange rate generally quoted fro 30, 90 and 180 days

8. Currency Swaps: simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

9. Nature of FEM: Global network of banks, FEx dealers , brokers connected with e communication systems

9.1. 1. never sleeps

9.2. 2. integration of various trading centers

9.3. London's dominance : history and geography

10. Arbitrage: buying currency low and selling it high

11. Law of one price: In competitive markets free of transportation cost and barriers to trade identical products should trade at the same price

12. Purchasing Power Parity: (PPP)In efficient market- the price of basket of goods should be roughly equivalent in each country

12.1. Changes in relative prices will result in a change in exchange rates

13. Inflation: Monetary Phenomenon

13.1. when the quantity of money in circulation rises faster than the stock of goods and services

13.2. Price inflation high --currency depreciation

13.3. Fisher effect: A country's nominal interest rate is the sum of required real rate of interest and the expected rate of inflation

13.4. International Fisher Effect: For any two countries, the sport exchange rate should change in equal amount, but in opposite direction

14. Investor psychology and bandwagon effect

14.1. Traders moving as a herd in the same direction at the same time

15. International Monetary system: the institutional arrangements that govern exchange rates

15.1. FLOATING EXCHANGE RATE : a country allows the foreign exchange market to determine the relative value of a currency

15.2. FIXED EXCHANGE RATE:A fixed exchange rate system exists when countries fix their currencies against each other at some mutually agreed on exchange rate

15.3. PEGGED EXCHANGE RATE: a country fixes the value of its currency relative to a reference currency

15.4. DIRTY FLOAT:a country tries to hold the value of its currency within some range of a reference currency such as the U.S. dollar

16. Currency convertibility

16.1. Freely convertible; Govt allow bot residents and non residents to purchase unlimited amount of foreign currency

16.2. Externally convertible: when only non residents can convert it into foreign currency

16.3. Nonconvertible: neither residents nor no residents are allowed to convert it into foreign currency