MODULE 8 The Foreign Exchange Market

Introduction
The role of the Foreign Exchange (FX) Market in the international capital market will be elaborated
upon in this Module, coupled with an example of how the exchange rate determines the price of
commodities. The risks that international bankers are taking in this market will be discussed,
especially settlement risk. The role of the central bankers in the FX Market will be elaborated upon.
And finally, the role of the Internet in the FX Market will be discussed.
Objectives
Upon successful completion of this module, the student should be able to:
Identify the role of the FX Market in international trade.
Calculate a simple example of commodity prices in relation to currency values.
List a series of potential risks the FX Market poses to the operation of international
banking.
Examine the role of the central bankers in the FX Market.
Examine the role of Eurocurrency in the FX Market.

With

the globalization of economic and financial activity, and advancement in the

telecommunication sector, the planet became a neighborhood in a short period of time.
International trade, which encompasses economic and financial activity, coupled with the
interdependencies in economic resources among nations, requires a payment system that
facilitates and brings efficiency to these reciprocities.
The FX market facilitates international trade and payment systems among nations by altering
their currencies. Nations macroeconomic stability is heavily dependent upon the value of their
currency in relation to others with whom they trade. Various financial securities are utilized by
nations to satisfy debt incurred through international trade or other economic interaction. The
rate by which the two currencies are valued is determined by the amount of the currencies
exchanged as a result of export and import, transactions in the international bond market, and
exchange of goods and services between countries. In the international capital market, the term
arbitrage refers to transacting in foreign currencies to take advantage of fluctuations that occur in
the value of currencies as a result of macroeconomic instability. For further information, please
see Footnote #1.
The various instances in which people use the FX market include traveling to another nation that
requires purchasing that countrys currency. If both nations are experiencing economic and
financial stability, then the exchange rate between the countries is stable and normal. On the
other hand, if either nation is experiencing macroeconomic instability, it can impact the other
nations economic system through contagion.
Like every other market, the FX market is also subject to an equilibrium resulting from how
much currency of each nation is supplied and demanded. This equilibrium is determined through
trade and tourism, and purchasing and selling financial securities. If the currency value of one
nation is superior to another, then its currency is demanded more than the other, and vise-versa.

The focal point of the FX market is international trade. For example, an American importer of a
French commodity can purchase that good from France cheaper if the US dollar can purchase
more French Francs, since there will be less dollars needed for that purpose. This would also
apply to a French importer of US goods if the French Franc can purchase more US dollars. In
this way, the FX market facilitates trade among nations. The notion of comparative advantage
among nations for producing goods and services at lower opportunity cost is worth mentioning,
since the basis of international trade and the terms of trade are established on this foundation.
Average consumers who purchase goods are not directly involved in the FX market, since that
task has already been undertaken by importers or exporters of the said goods.
The rate of exchange determines the true cost when purchasing a foreign good. For example, if
an American would like to purchase a BMW from Germany, and lets say the price of the BMW
is 40,000 (Euros) and the exchange rate is 1 US Dollar = 0.67467 Euro, we would need
$59,326.80 US dollars to purchase the BMW. If one US dollar can purchase more Euros, the
price of a BMW will be cheaper for a US importer, and hence demand for this automobile will
increase and manufactures will supply more of this automobile. However, if the US dollar can
purchase fewer Euros, the price of a BMW will become more expensive, demand for it in the US
will decline, and BMW manufacturers will produce less. Therefore, volatility between the Euro
and US dollar can change the price of the BMW drastically for a US purchaser.
If foreigners produce goods that Americans need, and they are capable of producing them with
lower opportunity cost, there is a tendency for dumping this commodity into the US market. In
this case, the US may impose a tariff on foreign goods in order to nurture infant domestic
industries and also protect our national security. The imposition of a tariff makes a foreign good
more expensive in the US; hence demand for that good will decline. This results in a stronger
US dollar capable of purchasing more foreign currency. On the other hand, the US dollar
becomes more expensive for foreigners to purchase, therefore American goods become more
expensive to foreigners and US exports will decline. Unless there are special provisions made
for US exporters by removing some monetary value to counteract the effect of US currency
becoming more expensive, US exports will suffer.
Like every other operation of international banks, FX activities are not without risk. Though
profitable, speculating on foreign currency movement is a risky venture, since variables that can
impact this market ranging from political, economic and financial to weather and culture
cannot be controlled and forecasted by speculators. Since the FX market is an international
economic and financial activity, its trading activities are also done through an international
telecommunications system that connects different parts of the planet instantly, so speculators
can determine their speculative motive, based upon the information they are continuously
receiving on the FX market and currency valuation from the other side of the globe. All trading
activity is done via the Internet. Major centers for these activities are located in large
metropolitan areas such as New York and London.
Central banks play an important role in the FX market. Though they are reluctant to intervene in
manipulating the value of their currency, they are actively seeking stability of their currency and
thus its value. We can summarize that the FX market is largely unregulated, and is determined
mainly by market forces. For further information, please see Footnotes #2 and #3.

Unlike most other sectors of the international financial market, the FX market is not regulated by
domestic nor international entities. The FX market lacks a supervising institution to set
guidelines for maintaining checks and balances in order to avoid exchange rate volatility. As it
was mentioned before, under special circumstances central bankers may involve themselves in
purchasing and selling their currency in order to maintain stability in the FX market, even though
their involvement historically has not always resulted in a satisfactory outcome. One could
argue that instability in the FX market may also be the result of speculative inconsistencies,
which causes drastic changes in exchange rates.
In some instances, central bankers cooperatively intervene in the FX market to correct the
deviations that occur in the macroeconomic indexes which cause instability in this market. This
concerted involvement may be the result of unusual economic and financial circumstances, such
as political instability, that require action on the part of central bankers. In the US, the US
Treasury and Federal Reserve are responsible for ensuring a sound economic posture for the US
dollar. They maintain a sufficient amount of foreign currency in case their intervention is
needed.
The level of central bankers intervention in buying and selling foreign currency to bring
equilibrium into the FX market is insignificant in comparison to the overall FX market. But this
action may be perceived by investors as an eventual intervention by central bankers, and
influence their decisions on currency speculation. Historically, the intervention by central
bankers has declined in the past two decades, including the US Federal Reserve System.
Currency fluctuations in the FX market create an economic disadvantage in developing nations
with soft currencies, creating economic instability, especially in the areas of import and export.
Some developing nations have resorted to pegging their currency to more stable currencies, such
as the US dollar. For example, Ecuador, Panama and El Salvador have pegged their currencies
to the US dollar, thus avoiding further devaluation of their currency. In the case of the European
Union, all member nations pegged their currencies to the Euro which brought universal stability
throughout the European Union. Thus the old currencies of the member nations no longer have
any influence in the FX market. Though central bankers are reluctant to intervene in the FX
market, in some instances it may be the only tool to bring stability to this market, since persistent
instability in the FX market may have harmful effects on international interest rates.
Rapid globalization and the Internet caused sudden growth in international economic activity
such as trade and investment. This process necessitated the need for hard currencies to satisfy
such a rapid rate of growth. The market for hard currency outside of ones domestic boundaries
is known as Eurocurrency. For example, US dollars deposited in any bank outside of the US are
called Eurodollars. This currency is not subject to the rules and regulations of the Federal
Reserve, such as those governing reserve requirements and the currencys movement in the
international capital market. Since all parties in the international financial market, especially
banks, wish to hold Eurocurrency for future speculative purposes, they may infringe on the
attempts of less developed nations to control the flight of capital.

Overall, the FX market and international trade have brought a certain level of economic growth,
thus improving the living standards in many areas of the planet.
As I implied before, the central banks of industrial nations are reluctant to intervene in correcting
their currencies valuations due to anomalies of the financial market, though their actions could
be powerful enough to correct whatever deviation may exist. Even so, the central bankers can be
overwhelmed by financial market forces.
As we know, central bankers are responsible for maintaining economic stability, such as full
employment output, stable prices and sustained economic growth. In order to achieve these three
goals, the Federal Reserve System in the US implements monetary policies. To fight recession,
the Federal Reserve lowers interest rates, increases the money supply and promotes investment
activity, thus unemployment is reduced. This is known as expansionary monetary policy. To
fight inflationary forces, the Federal Reserve increases interest rates, decreases the money supply
and discourages investment activity. This is known as contractionary monetary policy. These
processes are conducted through open market operations by buying and selling US securities
respectively in the financial market. They can also change the reserve requirement to achieve the
same goal by manipulating the level of the money supply; or they can manipulate the discount
rate to reach the said goals. By achieving a certain level of equilibrium in the money supply, the
Federal Reserve can also bring stability to the FX market since, as we mentioned before, central
bankers maintain a large amount of foreign currency at their disposal. Also, by achieving
stability in the FX market through a stable money supply, the Federal Reserve can fight
inflationary forces and avoid devaluation of the US dollar. For further information, please see
Footnote #4.
Currency movement forecasting and cross-border capital flow are important variables for
currency speculators positioning. Also, the dynamism of the FX market requires analysis of
other variables and trends, such as political and economic issues, mergers and consolidations,
and financial crises by speculators to take advantage of the new opportunities in this market.
As I mentioned, the FX market is a dynamic market and, based upon many diverse variables
whether predictable or unpredictable the attractiveness of the market fluctuates among
speculators. This phenomenon occurred especially in the decade of the 80s. Consequently, the
profit taking ability of speculators and international banks experienced volatility in that era.
Since then, with central bankings prudent intervention, the relative stability of major currencies
and the advent of new technology (Internet), the FX market and international banks are
experiencing growth, profitability and lower operational costs.
The other important players in the FX market other than central bankers are fund and wealth
managers and commodity traders which can impact this growing market with their speculative
ventures. The FX market is going through rapid growth, especially in the area concentrated by
many powerful emerging markets such as the Asian Tigers; in this case, southeast Asia and
eastern Asia, such as China and South Korea. Due to this rapid growth, many financial
instruments have been invented to facilitate payment for trade through the FX market. These
newly developed securities are known as derivatives. Derivatives protect speculators from risk

caused by volatility in interest rates and currency valuation. For further information, please see
Footnote #5.
The advent of the Internet advanced and facilitated the FX market tremendously. Todays
investors and speculators in the FX market demand immediate actions and responses when
dealing in currency transactions. The FX market provides that opportunity through electronic
transmission of information worldwide at any time.
The growth of the FX market and the role of international banks intensified with the entry of
non-banking financial intermediaries into this market, such as pension funds (institutional and
non-institutional), insurance companies and hedge fund speculators. Though there is a major
debate that the entry of these new financial entities into the FX market may cause instability in
the FX market and cause currency devaluation, the other side of the argument indicates that it
may be a source of stability by making speculative decisions more prudent, especially in
emerging markets. The universality of financial, economic and international trade activities, as a
result of an increase in human interaction and interdependencies, could be considered a catalyst
for the expansion of the FX market.
Like every other activity in the financial market, the FX market is subject to risk, especially in
the derivatives market. Therefore, speculative prudence must play a role in making the decision
to transact into the currency exchange market by international banks.
There are a number of risks that pose a threat to the operation of the FX market, such as
settlement risk (also known as Herstatt Risk), which occurs when funds are not transferred on a
timely basis across international borders, therefore the contract or agreement is nullified. This
may adversely impact the creditworthiness (credit risk) and liquidity (liquidity risk) of the parties
involved. The settlement risk can be resolved if all parties agree to abide by an international set
of standards. For further information, please see Footnotes #6 and #7.
Conclusion
In this module, you have learned the operation of the Foreign Exchange Market in the global
theater. Furthermore, you learned to calculate simple exchange rates in relation to commodity
prices. The risks that the Foreign Exchange Market poses to international trade activity were
discussed, and the central banking policy on intervention was analyzed.

FOOTNOTES
(1) The Foreign Exchange Market for Beginners. (2012). Retrieved from
http://www.gocurrency.com/articles/forex-for-beginners
(2) Foreign exchange market. (2012). Retrieved from
http://en.wikipedia.org/wiki/Foreign_exchange_market
(3) GoForex-Central Banks. (2004-2012). Retrieved from http://www.goforex.net/foreignexchange-market.htm#Central_Banks
(4) Federal Reserve Bank of New York - U.S. Foreign Exchange Intervention (2007). Retrieved
from http://www.ny.frb.org/aboutthefed/fedpoint/fed44.html
(5) Derivatives market (2012). Retrieved from http://en.wikipedia.org/wiki/Derivative_market
(6) Overview: Settlement Risk. (2000). Retrieved from http://riskinstitute.ch/134710.htm
(7) Settlement risk. (2011). Retrieved from http://en.wikipedia.org/wiki/Settlement_Risk