Deck 16: The Foreign Exchange Market

Question 1

What are the major types of transactions or activities that result in supply of foreign currency in the spot foreign exchange market

Answer 1

Spot foreign exchange markets are the ones that allow traders or investors to exchange the foreign currencies at the current exchange price within the time span of two days. In these types of markets once the exchange rate is agreed for the standard large transactions of foreign currencies then it takes maximum of one 2 days for the whole transactions of foreign currencies.
The major types of transactions or activities that result in supply of foreign currencies in the Spot Foreign Exchange Markets are usually in the forms of cash-in of travelers and transferring of money via banks and the transaction of currency notes.
European Forex Market is the major producer of Spot Forex transactions. London forex comprises of 50% Spot Foreign Exchange transactions.

Question 2

A U.S. firm must make a payment of 1 million yen to a Japanese firm that has sold the U.S. firm sets of Japanese baseball-player trading cards. The U.S. firm begins with a dollar checking account. Explain in detail how this payment would be made, including the use of the spot foreign exchange market and banks in both countries.

Answer 2

An US firm must make a payment of 1M Yen to a Japanese firm that has sold the US firm sets of Japanese basket ball-player trading cards. If the US firm is writing a check in US Dollars then the Japanese firm has no obligation in receiving the US Dollar check and must have US dollar bank deposits.
Or the Japanese firm must be paid in Japanese Yen. In such a case US firm must sell US Dollars to get Japanese Yen to make payments for Japanese baseball player trading cards. Thus the US firm must request its Bank for the quotation of the exchange rates of Japanese Yen and then Bank of US firm pays from its Japanese Yen fixed deposits.
In the Spot Forex Market anyone can acquire foreign moneys, whether they are any organization, business entity or an individual. In these markets foreign currencies are allowed to make payments for any imported or exported goods and services. Even in the Spot Forex Market people or businesses can sell foreign currencies which they have received in payments.

Question 3

A trader at a U.S. bank believes that the euro will strengthen substantially in exchange rate value during the next hour. How would the trader use the interbank market to attempt to profit from her belief

Answer 3

Interbank Foreign Exchange Markets are those markets which are used by financial institutions for the trading of currency among themselves. Interbank (or interdealer) trading is also done by traders at banks for their large number of customers. More than 40% of Forex trading is done among interbank trading.
Now a day's most of the interbank trading is done through technology or electronic platforms, which enables the traders to get in touch with exchange rates of the worldwide trading at all the times. It ultimately helps firms keeping their position strengthened quickly and that too at low price or value.
If a trader at a US bank believes that the Euro will strengthen in exchange rate value during the next hour then she uses her insights of trading and currency valuation. She deals with interbank traders of other firms as well then she gets continuous stream of information by interacting with different traders at different banks and by continuous observations of exchange rate quotations. Although it is a very hectic job as humongous amounts of demand deposit currency is exchanged and with the proper information dealers can earn profits for their customers or the entities for which they are working for.

Question 4

You have access to the following three spot exchange rates:
$0.01/yen
$0.20/krone
25 yen/krone
You start with dollars and want to end up with dollars.
a. How would you engage in arbitrage to profit from these three rates What is the profit for each dollar used initially
b. As a result of this arbitrage, what is the pressure on the cross-rate between yen and krone What must the value of the cross-rate be to eliminate the opportunity for triangular arbitrage

Question 5

Assume instead that the spot exchange rate between the dollar and Swiss franc is a fixed or pegged rate within a narrow band around a central rate. For each change shown in problem 9, assume that just before the change private (or nonofficial) supply and demand intersected at an equilibrium exchange rate within this narrow band. For each change shown in problem 9, what intervention is necessary by the monetary authorities to defend the fixed rate if the change shifts the intersection of private supply and demand outside the band