CHAPTER 6: FOREIGN EXCHANGE MARKET The market basically converts one’s domestic currency since more foreign investors

rency since more foreign investors will

currency to another. seek to invest at the higher interest rate, thereby
INTRODUCTION investing foreign capital into the domestic currency.
 Most countries of the world have their own 2. Credit Function: The FOREX provides However, in practice, it is balanced out by
currencies. The United States has its dollars, short-term credit to the importers in order inflationary pressures.
France, the euro; Brazil its real; India its rupee to facilitate the smooth flow of goods and
and in the Philippines its peso. services from various countries. The 2. Inflation Rates
 The trading of currency and bank deposits importer can use his own credit to finance Changes in inflation rates impact currency value
dominated in particular currencies takes place foreign purchases. and exchange rates. All else being equal, a higher
in the Foreign Exchange Market. inflation rate in a domestic country will decrease
3. Hedging Function: The third function of a the demand for the domestic currency since the
DEFINE FOREIGN EXCHANGE MARKET foreign exchange market is to hedge the value of the currency depreciates relatively faster
 The foreign exchange market is over a counter foreign exchange risks. The parties in the over time than other foreign currencies.
(OTC) global marketplace that determines the foreign exchange are often afraid of the
exchange rate for currencies around the world. fluctuations in the exchange rates, which 3. Government Debt
This foreign exchange market is also known as means the price of one currency in terms of Government debt is the amount of debt owed by a
Forex, FX, or even the currency market. The another currency. This might result in a gain federal government. It impacts currency value and
participants engaged in this market are able to or loss to the party concerned. exchange rates since a country with higher debt is
buy, sell, exchange, and speculate on the less likely to acquire foreign capital, which, in turn,
currencies. EXCHANGE RATE: DEFINITION AND ITS leads to inflation. It puts downward pressure on the
 These foreign exchange markets are consisting IMPORTANCE domestic currency and decreases its value in
of banks, forex dealers, commercial companies,  An exchange rate is the rate at which exchange rates.
central banks, investment management firms, one currency can be exchanged for
hedge funds, retail forex dealers, and investors. another between nations or economic 4.Political Stability
In our prevailing section, we will widen our zones. It is used to determine the value The political state of a country influences the
discussion on the ‘Foreign Exchange Market’. of various currencies in relation to each currency value and exchange rates since a country
other and is important in determining with higher political turmoil is less likely to attract
FUNCTIONS OF FOREIGN EXCHANGE MARKET trade and capital flow dynamics. foreign investors. Political instability fosters more
The various functions of the Foreign Exchange risk for investors, as they are unsure of whether
Market are as follows: IMPORTANCE OF EXCHANGE RATES they will see their investments protected via fair
1. Interest Rates market practices or a strong legal system.
1. Transfer Function: The basic and the most Changes in interest rates impact currency
obvious function of the foreign exchange market is value and exchange rates. All else being 5. Export or Import Activities
to transfer the funds or the foreign currencies from equal, a higher interest rate in a domestic A country’s net exports or imports impact currency
one country to another for settling their payments. country will increase the demand for a value and exchange rates. A domestic country that
exports more goods than it imports will experience Example: If UK interest rates rise relative to rates are determined in real-time based on supply
a higher demand for its currency, and thereby, will elsewhere, it will become more attractive to and demand.
see its exchange rate increase relative to other deposit money in the UK. You will get a Transactions in the spot market involve the
foreign currencies. better rate of return from saving in UK immediate delivery of currencies at the current
banks. Therefore demand for Sterling will market rate.
6. Speculation rise. This is known as “hot money flows” 2. Forward Market:
If a country’s currency is expected to rise for any and is an important short-run factor in In the forward market, traders enter into binding
reason, investors will demand more of the currency determining the value of a currency. private contracts to exchange currencies at a
to realize a profit based on that expectation. It can predetermined rate on a future date.
cause immediate demand increases for domestic Higher interest rates cause an appreciation. This allows traders to lock in an exchange rate for
currency relative to foreign currencies. Cutting interest rates tends to cause a an agreed-upon amount of currency at a specific
depreciation future date.
FACTORS AFFECTING EXCHANGE RATE 3. Futures Market:
3. BALANCE OF PAYMENTS - Balance of The futures market involves standardized contracts
1. INFLATION - Inflation tends to deflate the value payment is used to refer to a system of to buy or sell a predetermined amount of a
of a currency because holding the currency results accounts that catalogs the flow of goods currency at a specific exchange rate on a future
in reduced purchasing power. between the residents of two countries. For date.
instance, if the Philippines is a net exporter These contracts are traded on an exchange rather
Example :If inflation in the UK is relatively lower of goods and therefore has a surplus than privately, as in the forward market.
than elsewhere, then UK exports will become more balance of trade, courtries purchasing the
competitive, and there will be an increase in goods must use the country’s currency. This EXCHANGE RATE TRANSACTION
demand for Pound Sterling to buy UK goods. Also, increases the demand for the currency and  An exchange rate transaction involves the
foreign goods will be less competitive and so UK its relative value buying and selling of currencies at the
citizens will buy fewer imports. prevailing exchange rate. It includes
Therefore countries with lower inflation rates tend 4. GOVERNMENT INTERVENTION- Through transactions where one currency is exchanged
to see an appreciation in the value of their currency. intervention(e.g.., buying or selling the for another based on the current market rate.
For example, the long-term appreciation in the currency in the foreign exchange markets), These transactions can occur in various forms,
German D-Mark in the post-war period was related the central bank of a country may support such as spot transactions for immediate
to the relatively lower inflation rate. or depress the value of its currency. delivery, forward transactions for future
delivery, or options contracts that provide the
2. INTEREST RATE- If interest returns in a particular HOW IS FOREIGN EXCHANGE RATE TRADED? right but not the obligation to exchange
country are hinger relative to other countries, 1. Spot Market: currencies at a future date. Exchange rate
individuals and companies will be enticed to invest This is the primary forex market where transactions are essential for international
in that country. As a result, there will be an currency pairs are swapped, and exchange trade, investment, and financial activities,
increased demand for the country’s currency. allowing businesses and individuals to manage
 currency exposure, hedge risks, and capitalize counter currency. This means that you market reaches the specified price or better. It
on currency fluctuations. are betting on the base currency to provides traders with more control over the
 The exchange rate is the price of a unit of decrease in value relative to the counter execution price of their trades, ensuring that
foreign currency in terms of the domestic currency. This is a common strategy they do not pay more or receive less than their
currency. In the Philippines, for instance, the used in forex trading to profit from desired price.
exchange rate is conventionally expressed as falling currency prices.
the value of one US dollar in peso equivalent.  The BID price refers to the price at which you
For example, US$1 = P57.00. In every exchange  PIP stands for "Percentage in Point" or can sell the base currency. In foreign exchange
rate quotation, therefore, there are always two "Price Interest Point". It refers to the trading, the base currency is the currency being
currencies involved. smallest unit of measurement used to sold or exchanged for another currency, known
express the change in value between as the counter currency. Therefore, the BID
ADDITIONAL NOTES two currencies. In the foreign exchange price represents the value at which you can sell
 The standard lot size refers to the standardized market, PIP represents the minimum the base currency in order to obtain the
quantity of currency units that are traded in the movement or fluctuation in the price of counter currency.
foreign exchange market. This means that a currency pair. It is typically measured
when trading in the forex market, a standard as the fourth decimal place for most  The FX Market constantly moves 24 hrs.
lot size corresponds to 100,000 units of the currency pairs, except for the Japanese everyday, and allows currency conversion. It is
base currency. It is important to note that the Yen pairs where it is the second decimal a place for the central bank to intervene when
lot size can vary depending on the currency place. PIPs are important for calculating it is necessary to adjust the exchange rate in a
being traded. profits and losses in forex trading and direction that benefits the economy, provides
determining the spread or commission services to customers wishing to conduct
 If you have gone long in the FX market, it charged by brokers. international commercial transactions, and
means that you have bought the base currency helps rotate international investments, credit,
and expect it to increase in value. Going long is  A market order is an instruction given to other international financial transactions as
a term used in trading, specifically in the a broker to buy or sell a security at the well as exchanges between countries.
foreign exchange market to indicate that you prevailing market price. It is executed
have taken a bullish position on a currency pair. immediately and is not limited to a  In the FX Market, the currency used to buy
By buying the base currency, you are essentially specific price. imported goods is the seller's home currency.
betting that its value will rise relative to the As a general rule, moreover, currencies bought
quote currency. This is typically done with the  A LIMIT order is an order to buy or sell a and sold on the spot foreign exchange market
expectation of making a profit from the price security at a specific price or better. It are available 48 hours after the conclusion of
appreciation of the base currency. allows the trader to set a maximum the transaction.
purchase price or a minimum selling
 If you have a short position, it means that you price for the trade. This means that the
have sold the base currency and bought the order will only be executed if the