Article Instruments of the Foreign Exchange Market
Prof. Ian Giddy, New
York University
Key markets and terms
The foreign-exchange
market. This market links prices in different countries, and governments
waver between floating and fixing their exchange rates to manage this interdependence.
Spot and forward
contracts. Spot contracts are for delivery in two business days, while forward
contracts entail later excahnge of currencies.
The Eurocurrency
market, which permits the separation of currency of denomination from country
of jurisdiction.
Domestic financial
markets are today linked through the Euromarkets. National interest rates
each reflect the time value of their own money, and the forward foreign-exchange
market reflects the time value of the exchange rate between the two monies
The foreign-exchange
market links Eurocurrency interest rates, and national inflation rates
and monetary policies.
Currency swaps,
used in connection with international bond financing or investment, are the
long-term counterparts of the forward-exchange market. Both allow the separation
of the currency and interest-rate risks of an asset from the asset itself.
Eurobonds, which
may be the most innovative instruments of the global financial market—because
they are subject to fewer constraints than the new derivative instruments,
they are frequently packaged with future- and option-like features to match
investor and issuer needs in the international capital market. This exemplifies
a recurring theme of international finance—that because national markets
are constrained, international markets evolve to intermediate between them,
creating partial but not perfect linkages between them.
Some Questions and Answers
What markets are encompassed in the term "global financial markets?"
Markets for means of payments:
The foreign-exchange market: market for the exchange of one currency
for another
Markets for credit:
Markets for financial claims; markets where issuers and investors, borrowers
and savers meet.
• deposits and loans: domestic and Euro markets
• commercial paper and bonds: fixed claims: domestic
and Euro
• equity markets: variable claims: domestic and international.
Derivative markets:
Forward contracts, futures, options and swaps.
Commodity markets.
Markets for hybrid instruments:
• Many claims encompass two or more characteristics
of the above markets, such as Eurobonds with an equity linkage.
What considerations might lead a country to fix its exchange rates
rather than letting the currency's value be determined in free trading?
(a) Reduce uncertainty
in international trade and capital flows
(b) Raise confidence
in the country to appeal to foreign and domestic investors
(c) Want to link
domestic monetary policy to that of a foreign country; eg Bank of Finland
says "by linking the Finnmark to the ECU, we have chosen to adopt the monetary
policy of the Bundesbank." In doing so willing to give up domestic monetary
policy independence; can no longer influence domestic interest rates significantly.
(d) If the country
has a tendency to run a balance of payments deficit or surplus, the domestic
economy will adjust through prices and employment level, not through the
exchange rate.
What does the "efficient markets" theory say about the predictability
of exchange rates?
"You cannot beat the market." Actions taken by successful forecasters
eventually bring market prices to the forecasted level, so eliminating abnormal
profit opportunities. So cannot usually outforecast the market's forecast
as reflected, for example, in forward rates. Only new information will change
exchange rates and other financial market prices. Because new news is unpredictable
or random, exchange rates fluctuate randomly, too.
Through what instruments are interest rates linked to one another?
Through spot-and forward-exchange rates, which when traded simultaneously
are called "foreign-exchange swaps." The linkage arises via covered-interest
arbitrage, where banks borrow in one currency, exchange the money into
another currency where they invest it, and change the proceeds back by
means of a forward-exchange contract to repay the debt. Such arbitrage,
being free of exchange risk, ensures a close link between Eurocurrency interest
rates through the foreign-exchange market.
Is there an important distinction between foreign-exchange forward
contracts, futures and options?
(a) A forward-exchange contract is an agreement to
exchange two currencies at a future date; a commitment by each party.
(b) Futures are also contracts to exchange currencies
in the future, but the gain or loss is paid daily, eliminating most of the
default risk of the commitments.
(c) An option is not a symmetric commitment; one party
has the obligation, the other party the right to buy or sell.
Rates of Exchange and Foreign Exchange Contracts
A rate of exchange is the price of one currency in terms of another
currency. It is the means by which banks are able to trade foreign currencies
in exchange for CFA francs, for example.
Banks quote prices at which they will buy and sell foreign currency.
These are based on prices that are quoted in the major wholesale foreign
exchange markets and can change constantly throughout the day depending
on market forces.
Contracts of sale between importers and exporters for the supply
of goods or services should always specify the currency in which the payment
is to be made.
The Export Perspective
When an exporter sells goods to a buyer with payment in a foreign
currency, the foreign currency amount will be paid to the exporter. The
method of remittance of the foreign currency by the importer will depend
on the method of payment agreed to in the
contract of sale.
Once the exporter has been paid in foreign currency, they may then
sell that foreign currency to a bank in exchange for CFA francs, or another
currency. As rates of exchange are always quoted from a bank's point of view,
in this case the buying rate of exchange will apply, as the bank is buying
the foreign currency from the exporter.
The Import Perspective
An importer, who is required to make payment in foreign currency
to an exporter (based on contract of sale and agreed
method of payment ), will need to purchase foreign currency for
the payment of goods or services. The importer may purchase the foreign currency
from a bank, and as the bank is selling the importer the currency, the selling
rate of exchange will apply.
Forward Exchange Contracts
This is an agreement between a Bank and a customer. The bank agrees
to buy from, or sell to, the customer a fixed amount in foreign currency.
The contract is actioned on a fixed future date, or during a period expiring
on a fixed future date, at the rate of exchange quoted in the agreement.
This agreement may cover exchange risk between a foreign currency
and CFA francs, or between two foreign currencies. A bank can provide forward
exchange contracts, in most foreign currencies, for the protection of exporters
and importers who are subject to exchange risk in the course of their transactions.
Foreign Currency Options
These can allow you to take advantage of favourable exchange rate
movements while protecting you from the effects of adverse movements. A
foreign currency option enables you to buy or sell an amount of foreign
currency at an agreed rate for a certain delivery date. If rates move favorably,
there is no need to exercise the option. Exchange rate risk can be reduced,
or eliminated, for a known up front cost.
The fee, or 'premium' charged for a currency option varies according
to factors such as the strike price, the term, and the volatility of the
market.
Examples of Spot Rates of Exchange to the US Dollar [USD]
