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CHAPTER ONE
1. THE FOREIGN EXCHANGE MARKET
1.1. What is a Foreign Exchange Market? Definition of foreign exchange market
Foreign exchange is the trading of currencies. The foreign exchange market is not a single place like the NY Stock Exchange (NYSE). Instead, the foreign exchange market refers to the activities of major international banks that engage in currency trading. These banks act as intermediaries between the true buyers and sellers of currencies (i.e., government, business, and individuals). These banks will hold foreign currency deposits and stand ready to exchange these for domestic currency upon demand. It is a widely decentralized 24-hour-a-day market, made up of banks and traders communicating electronically. The retail market is b/n individuals, nonfinancial companies, nonbank financial institutions includes investment banks, mortgage lenders, money market funds, insurance companies, etc., and other customers of banks. The wholesale or interbank market is the trading between banks. This accounts for 60% or more of the total trading. The foreign exchange markets are thus the market in w/c individuals, firms and buys and sell foreign currency.
A given money (currency), in addition to buying goods and services, can buy another money (currency). It may also be sold by itself for yet another currency. This implies that there is market (a place or an arrangement) in which currencies of different countries are purchased and sold.
The foreign exchange market refers to the organizational setting with in which individuals businesses, governments and banks buy and sell foreign currencies. Unlike commodity or stock exchanges, the foreign exchanges market: Is not an organized structure Has no centralized meeting place and no formal requirements for participation Is not limited to any one country. For any currency, such as the Ethiopian Birr, the foreign exchange market consists of all locations where birr‟s are exchanged for other national currencies. The birr can be exchanged for any other currency everywhere in the world if the participants agree to do so.
Although, it could be operated anywhere else, three of the largest foreign exchange markets in the world are located in London, New York and Tokyo. However like other markets, the exchange market is very competitive because foreign exchange dealers are in constant telephone and computer contact. 1.2. Characteristics and Participants of the Foreign Exchange Market 1.2.1 Characteristics of the Foreign Exchange Market The following points highlight the top seven characteristics of foreign exchange market. The characteristics are:
- Most liquid market in the world
- Most dynamic market in the world.
- Twenty-four hour market
- Market transparency,
- International network of dealers
- Most widely traded currency is the dollar
- Over-the-counter market with an exchange traded segment. 1. Most liquid market in the world Currency spot trading is the most popular FX instrument around the world, comprising more than 1/3 of the total activity. It is estimated that spot FX trading generates about $1.5 trillion a day in volume, making it the largest most liquid market in the world. Liquidity has its advantages, the primary one being no manipulation of the market. Thin stock and futures markets can easily be pushed up or down by specialists, market makers, commercials, and locals. Spot FX on the other hand takes real buying/selling by banks and institutions to move the market. Any attempted manipulation of the spot FX market usually becomes an exercise in futility. 2. Most dynamic market Foreign exchange market is the most dynamic market in the world regardless of which instrument you are trading like stocks, government bonds, Ethiopian government treasuries, foreign exchange, or any of the countless others the attributes that determine the viability of a market as an investment opportunity remain the same. 3. It is a twenty-four hour market The twenty-four hour market means that exchanges rates and market conditions can change at any time in response to developments that can take place at any time. It also means that
7. Over-the-counter market with an exchange traded segment. Over-the-Counter (OTC) trades for securities are transacted via a dealer network as opposed to on a centralized exchange such as NYSE. 1.2.2 Participants in the Foreign Exchange Market
The main participants in the foreign exchange market can be categorized as follows. Retail Clients: - These are made up of business investors, multi-national corporations and so on. These need foreign exchange for the purpose of operating their business. Commonly they do not directly purchase or sell foreign currency themselves; rather they operate by placing buy/sell orders with the commercial banks. Commercial Banks:- The commercial banks carry out buy/sell orders from their retail clients and buy/sell currencies on their own account so as to alter the structure of their assets and liabilities in different currencies. Banks may deal either directly with other banks or through foreign exchange brokers. Foreign exchange brokers: - Commonly banks do not trade directly with one another, rather they offer to buy and sell currencies via foreign exchange brokers. Brokers intermediate the exchange currencies between different clients. The benefits of brokers is that, they collect, buy and sell order for most currencies from different banks around the world thereby the most favorable quotation can be obtained quickly and at lower cost. Central banks (monetary authority)- The monetary authority of a country cannot be indifferent to change in the external value of its currency, even if exchange rates of the major industrial nations have been left to fluctuate freely since 1973. Central banks frequently
intervene by buying /selling their currencies to influence the rate at which their currency is traded. Under a fixed exchange rate system the authorities are obliged to purchase their currencies when there is excess supply and sell the currency when there is excess demand 1.3. The functions of foreign exchange market The following are the main functions of foreign exchange market, which are actually the outcomes of its working; To facilitate currency conversion Provide instruments to manage foreign exchange risk such as foreign exchange Allow investors to speculate in the market for profit It transfer funds or purchasing power from one nation & currency to another Other functions The principal function of foreign exchange market is the transfer of funds from one nation to another. The role of commercial banks as clearing houses for the foreign exchange demanded and supplied in the course of foreign transactions by the nations residents. Credit function : credit is usually needed when goods are in transit and also to allow the buyer to resell the goods and make payment. Most commonly, exporter allows 90 days for importer to pay. However, the exporter usually discounts the importers‟ obligation to pay at the foreign department of his commercial bank. As a result, the exporter receives payment right away, and the bank will eventually collect the payment from the importer when due. The other most important function of foreign exchange market is to provide the facilities for hedging (exchange risk avoidance) and speculation (exchange risk taking). Minimizing Foreign Exchange Risk : The foreign exchange market provides "risk transfer" facilities to third parties through Forward, Futures, Options, and Swaps markets.
1.4. The Demand for and the Supply of Foreign Exchange The exchange rate of the foreign exchange (dollar) will be determined by the intersection of the supply & demand for dollar on the foreign exchange market in the world financial markets.
The Demand for foreign exchange ; It originates from domestic citizen‟s purchases for foreign goods, services, and assets (real or financial). In other words, a nation‟s demand for foreign
Note that any factor that affects the demand for US export affects the demand for dollar. Such as: change in ETH income, change in the price of ETH goods (which can substitute imports from US) change in ETH tastes in favor of US goods .All the above factors cause shift in demand for dollar. Supply of foreign exchange: It originates from sales of goods, services, and assets from domestic economy to foreigners. The supply of pounds, for instance, is generated by the desire of US residents and businesses to import Ethiopian goods and services, to lend funds and make investments in Ethiopia, and to extend transfer payments to Ethiopian residents. If dollar appreciates, the US export become expensive to the Ethiopian importers, on the other hand, Ethiopian export becomes cheap to the US residents. This leads to increase in demand for Birr, leading to rise in supply of USD. This shows an upward sloping supply schedule for USD. Consider the following table. Table 1.3. The Supply of dollar Price of ETH export goods in birr (1)
Exchange rate birr/USD (2)
Price of ETH export in USD (3)=(1/2 )
Quantity of ETH export (4)
Demand for birr (5) (1)x(4)
Supply of USD (6) =(5/2 )
100 9.20 10.9 300 30000 3260. 100 9.30 10.75 500 50000 5376. 100 9.40 10.64 700 70000 7446. 100 9.50 10.53 947.7 94770 9975.
100 9.60 10.42 1200 120000 12500.
100 9.80 10.21 1350 135000 13775.
100 10.00 10 1500 150000 15000.
Supply curve of foreign exchange slope upwards due to positive relationship between supply for foreign exchange and foreign exchange rate. In Fig. 1.2, supply of foreign exchange (US Dollar) and rate of foreign exchange have been shown on the X-axis and Y-axis respectively.
The Supply of and Demand for Dollar
Supply of foreign currency is created by: Ethiopian. Exports of goods and services and its capital inflows for Ethiopia. Demand for foreign currency is created by: Ethiopian. Imports of goods and services and which is capital outflows for Ethiopia Supply of U.S. dollars is created by U.S. imports of goods and services and there are capital outflows from U.S. Demand for U.S. dollars is created by U.S. exports of goods and services which results capital inflow to U.S. Causes of shift in demand for dollar
Forward transactions differ from spot transactions in that their maturity date is more than
two business days in the future. A forward exchange contact‟s maturity date can be a few months, or even years, in the future. The exchange rate is fixed when the contact is initially made. Swap transactions: entail the conversion of one currency to another currency at one point, with an agreement to reconvert it back to the original currency at some point in the future. The rates of both exchanges are also agreed to in advance. Swaps provide an efficient mechanism through which banks can meet their foreign exchange needs over a period of time. Banks are able to use a currency for a period in exchange for another currency that is not needed during that time. As an example for a swap transaction, consider Dashen Bank with excess balances of birrs but a shortage of dollars to meet the requirements of its client. At the same time, Bank of Abyssinia may have excess balances of dollars and insufficient amounts of birr. The two banks could negotiate a swap agreement in which Dashen Bank agrees to exchange birrs for dollars today and dollars for birr in the future. The key aspect is that the two banks arrange the swap as a single transaction in which they agree to pay and receive stipulated amounts of currencies at specified rates.
1.5.3. Nominal, Real and Effective Exchange Rates
Nominal exchange rate : most people are familiar with the nominal exchange rate, the price of one currency in terms of another. It's usually expressed as the domestic price of the foreign currency. So if it costs a U.S. dollar holder $1.36 to buy one euro, from a euroholder's perspective the nominal rate is 0.735 euros per dollar.
Real Exchange Rate : The real exchange rate (RER) between two currencies is the product of the nominal exchange rate (the dollar cost of a euro, for example) and the ratio of prices between the two countries.
Effective exchange rate
Over time, a given currency may appreciate with respect to some currencies and depreciate against others. Such events may leave the general public confused as to the actual value of that
given currency. Throughout the day, the value of the birr may change relative to the values of any number of currencies under market determined exchange rates. Direct comparison of the birr‟s exchange rate over time thus requires a weighted average of all the bilateral changes. Suppose the Ethiopian birr appreciates 3 percent relative to the Japanese yen and depreciates 5 percent against the German mark. The change in the birr‟s international value is some weighted average of the changes of these two bilateral exchange rates. This average is referred to as the birr’s effective exchange rate****.
- The effective exchange rate is a weighted average of the exchange rates between the domestic currency and the nation‟s most important trading partners. The effective exchange rate may be: nominal or real. The nominal effective exchange rate: is one that does not take in to account differences between domestic and foreign inflation rates. An increase in the birr‟s nominal effective exchange rate, for instance, indicates an appreciation of the birr relative to other currencies of trading partners. This is a loss of price competitiveness for Ethiopia. Conversely, a decrease in the birr‟s nominal effective exchange rate implies birr depreciation relative to the other currencies and an improvement in Ethiopia‟s international price competitiveness. The real effective exchange rate of the Ethiopian birr is thus derived by adjusting the nominal exchange rate for the differential between Ethiopian inflation rate and the weighted average of the inflation rates in the important trade partners of Ethiopia. If this real value rises, the birr appreciates relative to other currencies, and vice versa.
1.6 Exchange rate regimes
1.6.1 Exchange rate regimes, Spot versus forward foreign exchange rate markets
Exchange rate „regime‟: is the type of criterion that a country chooses to set the value of its exchange rate, whether flexible (i.e. determined by market forces) or fixed or any other form between these two extremes. Exchange Rate „System‟: refers to an agreement by which some countries, in a region or at the global level, set their (reciprocal) exchange rates according to a given mechanism (e.g. the Bretton Woods System of exchange rates 1944-1973).
There are three main types of exchange rate regime:
Flexible rates; Fixed-rate and, Pegged exchange rates.
Flexible exchange Rate Regimes: Under a flexible rate system , the exchange rate is determined by supply and demand for foreign exchange. Here there is no intervention by the national bank rather the forces of demand for and supply of both foreign and domestic currencies determine the level of the ongoing exchange rate. Fixed-rate: In fixed exchange rate regime, exchange rate is fixed by the authorities and cannot adjust in response to the change in supply and demand for currency. Figure 1.5 illustrates the mechanism of fixing exchange rate. In figure 1.2a below, the exchange rate is assumed to be fixed by monetary authorities at the point where demand intersect the supply curve at birr 9.50. If there is an increased demand for dollar which shifts the demand curve from D 1 to D 2 , there is a resulting pressure for the dollar to be revaluated. To control the appreciation of dollar, the National Bank of Ethiopia will sell Q 1 Q 2 amount of dollar to purchase birr with dollars in the foreign exchange market. This save of dollar by National Bank of Ethiopia shifts the supply curve of dollar from S 1 to S2. Such intervention eliminate the excess demand for dollar so that exchange rate will remain fixed at birr 9.5. This intervention will decrease the amount of birr in circulation and decreases the National Bank‟s dollar reserve. Similarly figure 1.2 (b) presents a situation
where the exchange rate is pegged by the National Bank at the point where S 1 intersects D 1 at birr 9.50 per dollar.
If there is an increase in demand for Ethiopian export, there will be an increased demand for birr and increased supply of dollar which shifts the supply curve to S 2. That is excess supply of dollar at the prevailing exchange rates and there will be a pressure on the dollar to be devaluated or domestic currency to be revalued. To avoid this, the National (Central) Bank of Ethiopia has to intervene in the foreign exchange market by purchasing Q 1 Q 2 amount of dollar to keep the exchange rate fixed at birr 9.50 per dollar. This intervention is shown by a right ward shit of the demand curve from D 1 to D 2. Such intervention removes the excess supply of dollar so that the exchange rate remain pegged at birr 9.50 per pound and it leads to an increase in the Ethiopian National Bank‟s reserves of dollar and in the amount of birr in circulation. Pegged exchange rate system : a system where the country commits to using monetary and fiscal policy to maintain the exchange-rate value of the domestic currency at a fixed rate or within a narrow band relative to another currency (or bundle of currencies). Unlike the case of a currency board, however, countries with a pegged exchange rate continue to conduct monetary policy.
investments. Without hedging, there could be smaller international capital flows, less trade and specialization in production, and smaller benefits from trade.
C. Speculation
Speculation is the attempt to profit by trading on expectations about prices of currencies in the future. Speculators (financial institutions, firms or individuals) buy currencies that they expect to go up in value and sell currencies that they expect to go down in value. Speculation is the opposite of hedging. Whereas a hedger seeks to cover a foreign exchange risk, a speculator accepts and even seeks out a foreign exchange risk. If the speculator correctly anticipates future changes in spot rates, he makes a profit, otherwise incurs a loss.
Note the difference between arbitrage and speculation. With arbitrage, a currency trader simultaneously buys a currency at a low price and sells that currency at a higher price, thus making a risk-less profit. A speculator‟s goal however is to buy a currency at one moment (such as today) and sell that currency at a higher price in the future (such as 3 months from today). Speculation thus implies a deliberate assumption of exchange risk.
1.8. Appreciation / Revaluation and Depreciation / Devaluation of Currencies Devaluation and revaluation are equivalent to depreciation and appreciation, except that the first group refers to changes in a currency's value under a fixed exchange rate system. Devaluation is a decline in the value of a currency under a fixed exchange rate system, while depreciation is a decline under a flexible system. Revaluation is an increase in the value of currency under a fixed exchange rate system while an appreciation is an increase in the value of currency under a flexible exchange rate.
