Principles of foreign exchange Chapter 4

Overview Trading one currency for another arises from the elements that make up a nation’s balance of payments: movement of international trade, transfers made and redeemed and tourist and immigrant movements etc. There are 150 currencies around the world.

Background Gold standard: a country needed to maintain the convertibility between banknotes and gold and to allow gold to flow freely in and out of the country.

The Foreign Exchange A foreign exchange rate is a numerical expression of the price of the currency of one country in terms of that of another. Ex. 1 U.S dollar ($) = 100 yen (European terms) 1 yen = U.S dollar (U.S. terms)

Continuing There is a rate for buying the currency and a rate for selling. The difference between the buying and selling price is called the spread. Changing the par value downward( in terms of gold) is devaluation: changing the par value upward is revaluation.

Fixed Rate of exchange To maintain a fixed rate of exchange requires extensive controls and regulation by the government and is as much a political decision as an economic one. After World war II people used to keep fixed rate, to increase trade between countries.

The floating rate of exchange A floating rate of exchange is one in which the rate is determined by supply and demand in a market. For example: Importers, investors, and others who need the currency will bid for it from those who have it – exporters and others. When the demand is greater than the supply, the price rises; when supply exceeds demand, the price falls.

Example Some countries uses to keep exchange rates fixed by central banks, so nation’s reserves could be affected directly, but if the rate is floating there is no direct impact.

Link to Strong currency Some smaller trading countries link their currency to major currency to determine its value for international transactions. The strongest way to establish a link is with the creation of a currency board. – The currency board must maintain holdings of that foreign currency at least equal to its monetary liabilities.

Foreign exchange Traders Each bank’s foreign exchange trading is the responsibility of a designated trader or dealer, who is responsible for meeting the needs of the bank’s customers. For example, a U.S. business purchasing a machine made in Sweden will need Swedish krona to pay for it. So, a bank’s foreign exchange trader will supply the krona in exchange for dollars from the U.S. company.

Operations in the foreign exchange market All activities that make up a nation’s balance of payments will influence trading in that country’s currency. Regardless of whether the currency used is one’s own currency or a foreign currency, almost every international transaction involves one party’s being exposed to exchange risk.

Payments for Imports and Exports In practice, many U.S. firms and individuals receive foreign exchange in payment for goods and services sold abroad. Others make payments to foreigners in their currency rather than in U.S. dollars. For example, A U.S. company selling in the United Kingdom may invoice its sales in pounds sterling.

Trading in foreign Currencies To satisfy the needs of their customers, commercial banks hold foreign exchange inventories in the form of working balances with foreign banks or have access to such balances through their major correspondent banks. In U.S. these are Due From accounts

Spot Trading Generally, spot trade is settled two business days hence to provide time for these messages to be sent and for the foreign banks to have time to pass their necessary entries, taking into account the difference in time zones.

Forward Trading A forward contract between two parties calls for delivery at a future date of a specified amount of one currency against payment of another, with the exchange rate fixed at the time the contract is made.

Continuing Although forward contracts are often for periods of time such as one, three, or six months, they can be arranged for any number of days. Forward trades are used to reduce price uncertainties in international business when an immediate decision must be made about completion and payment in future.

Some cases A forward is at a discount when the forward rate is lower than the spot rate; it is at premium when the forward rate is higher than the spot. The difference between the spot rate and the forward rate usually reflects the difference in short-term interest rates between the two countries.

Speculation Speculation is the purchase or sale of foreign exchange, usually on a spot or forward basis, for the sole purpose- or at least with the hope- of subsequently being able to cover the open position at a profit.

Example A form of speculation can occur when market participants anticipate that a country with fixed exchange rates is going to change the par value, or a country with floating exchange rates is going to support the rate in the market. If the expectation is that the rate will go down, anyone with payments to make for commercial transactions in that currency will delay payment as long as possible to benefit from the new, lower rate.

Risks The first external risk is credit: the customer on whose behalf the bank is initiating the trade will not be able to pay for the transaction. The second external risk is the potential exposure with counterparty to the trade- that is, the bank or company with which the bank has made the trade.

Continuing A third risk is referred to as Herstatt risk, taking its name from a private German bank, Bankhaus I.D. Herstatt, “whose closure[by the German banking authorities] in 1974 occurred after it had received deutsche marks due to it on foreign exchange trades but before the corresponding dollar amounts were paid in the United States.” The closure came before the New York market was open as the bank was in the middle of setting $620 million of uncompleted trade.

Summary Converting the money of one country into that of another country is a service banks provide for their customers through foreign exchange trading. This is a continuation of the concept outlined in the previous chapter in which money is moved from one country to another through accounts maintained by banks with each other.