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FX 102 FOREX INTRODUCTION FOREING EXCHANGE MARKETS STUDY GUIDE LATEST UPDATED.
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FX 102 FOREX INTRODUCTION FOREING EXCHANGE MARKETS STUDY GUIDE LATEST UPDATED.
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FX 102 FOREX INTRODUCTION FOREINGEXCHANGE MARKETS STUDY GUIDE LATEST
UPDATED.
,CHAPTER I
FOREIGN EXCHANGE MARKETS
The international business context requires trading and investing in assets denominated in different
currencies. Foreign assets and liabilities add a new dimension to the risk profile of a firm or an
investor's portfolio: foreign exchange risk. This chapter has two goals. First, this chapter introduces
the terminology used in foreign exchange markets. Second, this chapter presents the instruments
used in currency markets.
I. Introduction to the Foreign Exchange Market
1.A An Exchange Rate is Just a Price
The foreign exchange (FX or FOREX) market is the market where exchange rates are determined.
Exchange rates are the mechanisms by which world currencies are tied together in the global
marketplace, providing the price of one currency in terms of another.
An exchange rate is a price, specifically the relative price of two currencies.
For example, the U.S. dollar/Mexican peso exchange rate is the price of a peso expressed in U.S.
dollars. On March 23, 2015, this exchange rate was USD 1.0945 per EUR, or, in market notation,
1.0945 USD/EUR.
The Price of Milk and the Price of Foreign Currency
An exchange rate is another price in the economy. Let’s compare an exchange rate to the price of
milk. Suppose that the price of a gallon of milk is USD 2.50, or 2.50 USD/milk, using the above
exchange rate market notation.
When we price milk, the denominator refers to one unit of the good that it is being bought –a
gallon of milk. When we price exchange rates, the denominator refers specifically to one unit of a
currency. Therefore, think of the currency in the denominator as the currency you are buying.
The exchange rate is just a price, but it is an important one: S t plays a very important role in the
economy since it directly influences imports, exports, & cross-border investments. It has an indirect
effect on other economic variables, such as the domestic price level, Pd, and real wages.
For example: when St increases, foreign imports become more expensive in USD. Then, the
domestic price level Pd increases and, thus, real wages decrease (through a reduction in purchasing
power). Also, when St increases, USD-denominated goods and assets are more affordable to
foreigners. Foreigners buy more goods and assets in the U.S. (exports, real estate, bonds, companies,
etc.). These factors drive aggregate demand up and, thus, GDP increases.
1.A.1 Equilibrium Exchange Rates and Foreign Exchange Risk
I.1
, Like in any other market, demand and supply determine the price of a currency. At any point in
time, in a given country, the exchange rate is determined by the interaction of the demand for
foreign currency and the corresponding supply of foreign currency. Thus, the exchange rate is an
equilibrium price (St E) determined by supply and demand considerations, as shown by Exhibit I.1.
Exhibit I.1
Demand and Supply determine the price of foreign currency (S tE).
St Supply of FC (S)
E
St
Demand of FC (D)
Quantity of FC
What are the determinants of currency supply and demand in the foreign exchange market? The
supply of foreign currency derives from foreign residents purchasing domestic goods and services
–i.e. domestic export--, foreign investors purchasing domestic assets, and foreign tourists traveling
to the domestic country. These foreign residents need domestic currency to pay for their domestic
purchases. Thus, the foreign residents buy the domestic currency with foreign currency in the
foreign exchange market. Similarly, the demand for foreign currency derives from domestic
residents purchasing foreign goods and services –i.e. domestic imports--, domestic investors
purchasing foreign assets, and domestic tourists traveling abroad.
Over time, the many variables that affect foreign trade, international investments and international
tourism will change, forcing exchange rates to adjust to new equilibrium levels. For example,
suppose interest rates in the domestic country increase, ceteris paribus, relative to interest rates in
the foreign country. The domestic demand for foreign bonds will decrease, reducing the demand
for foreign currency in the foreign exchange rate. The foreign demand for domestic bonds will
increase, increasing the supply of foreign currency in the foreign exchange rate. As a result of these
movements of the supply and the demand curves in the foreign exchange market, the price of the
foreign currency in terms of domestic currency will decrease. Exhibit I.2 shows the effect of these
changes in the equilibrium exchange rate.
I.2
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