. Foreign Exchange
Part A What are the two major segments of the foreign-exchange market? What types of foreign-exchange instruments are traded within these markets?
Part B How is foreign exchange traded? What methods are available?
Part C Using Internet research, discuss the exchange rate arrangements used in the EU, Hong Kong, China, and the U.S.
ANSWER
Part A
The two major segments of the foreign exchange market are the over-the-counter market (OTC) and the exchange-traded market. The OTC comprises commercial banks, investment banks and other financial institutions where the most foreign-exchange activity takes place. On the other hand, the exchange-traded market comprises security exchange, for example, the Chicago Mercantile Exchange and the Philadelphia Stock Exchange. Certain types of instruments are used in foreign exchange such as exchange-traded options and futures. Traditionally, instruments in the bulk of foreign exchange trading comprised spot transactions, FX swaps and outright forwards.
In the spot market currencies are exchanged on the spot. It is used when a company intends to exchange one currency to another instantly. The process is basic and could be handled by a banker where within a few short minutes the company has information on how many units of one currency are to be paid or received and for what units of the other currency. The forward market came to be to avoid uncertainties in the foreign exchange. Companies utilise a forward contract that in it includes what currencies to be traded, when an exchange is to happen, how many units of each currency is involved and which side of the contract each party is. The risk avoided in this exchange in comparison to the spot market is that the involved parties are aware of what they receive or pay in future. Lastly, in an FX swap, one currency is exchanged for another on one date and then changed back on a future date (Sager 2006). An FX swap can either be a spot or forward transaction.
Part B
Foreign exchange was initially traded during travel when people needed to exchange their currencies to the one that belonged to the countries they were visiting. Today, the foreign exchange refers to some form of investment trading also referred to as forex. Just like the stock exchange, the fluctuations of values in the forex market can be speculated and be used for profits. Today, the currency market is the largest investment market in the world and is still growing where “in April 2010, the forex market reached $4 trillion in daily turnover” (Lettau 2018). The New York Stock Exchange (NYSE) has a daily volume of about $25 billion (Lettau 2018). Additionally, the exchange allows 24 hours trading every day of the week making it the largest liquid asset market.
Currencies are traded against each other in pairs, for example, EUR/USD and each pair is quoted in percentage in points (pips). Fluctuations are expected throughout based on the economic situation of countries, geopolitical risk, instability and trade and financial flows (Lettau 2018). Currency is traded in lots which are of various sizes. A micro-lot is a thousand units of currency. Trading in the forex exchange is done in pairs, unlike the stock exchange. A single transaction consists of buying of one currency and selling of another currency. It is common for stock traders to take interest in the foreign currency market because most of the market forces affect both of them. Two factors move the currency markets, one is the natural supply and demand of any market and the second is interest rates. There other minor factors such as economic data and geopolitical tensions.
Part C
The International Monetary Fund (IMF) ranks foreign exchange arrangements based on the degree of flexibility and the existence of formal or informal commitments to the exchange rate paths (IMF.org). This brings about what is referred to as exchange rate regimes by the IMF. These exchange rate regimes can be one with no separate legal tender where the currency of another country is used as the sole legal tender or the country belongs to a union such as the European Union where a common legal tender is used or a currency board arrangement where “domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets” (IMF.org).
The European Union had a monetary system referred to as EMS (European Monetary System) which links all the member country currencies. The goal of this arrangement was to avoid negative inflation and stabilise the region by stopping large exchange rate fluctuations. It also enabled member countries to trade goods and services easily with each other. Hong Kong applies the Linked Exchange Rate System (LERS) SINCE 1983. The system aims to ensure that Hong Kong’s exchange rate remains stable and within a band of HK 7.75-7.85to one USD. China pegs its yuan currency to the U.S. dollar since it does not have a floating exchange rate determined by market forces. The yuan is pegged to the USD at 8.28. Lastly, the U.S dollar is a floating currency which means its value changes with regards to how the currency trades on the foreign markets. The USD is the most traded currency with other popular ones being the Euro, the Swiss Franc, the Indian Rupee, the Sterling Pound, the Japanese Yen and the Australian Dollar.
References
International Monetary Fund. Classification of Exchange Rate Arrangements and Monetary Policy Frameworks. Retrieved on 30th July 2020 from https://www.imf.org/external/np/mfd/er/2004/eng/0604.htm
Lettau, M., & Madhavan, A. (2018). Exchange-traded funds 101 for economists. Journal of Economic Perspectives, 32(1), 135-54.
Sager, M. J., & Taylor, M. P. (2006). Under the microscope: the structure of the foreign exchange market. International Journal of Finance & Economics, 11(1), 81-95.
