Each country has its own currency and currency strengths fluctuate in relation to one another for a variety of reasons, such as relative interest rates and relative inflation.
When different countries do business together, there must be currency conversion. The foreign exchange market exists because of this need to move currencies between countries. Features of the foreign exchange market include:
- the organizational structure of the foreign exchange market
- three types of exchange rates
- currency derivatives—what they are and the different types to choose from.
The organizational structure of the foreign exchange market
The foreign exchange market exists on two levels. One is the retail level at which banks convert currencies for their customers. The other is the interbank level where banks trade currencies between themselves at wholesale prices.
The foreign exchange market exists on two levels. One is the retail level at which banks convert currencies for their customers. The other is the interbank level where banks trade currencies between themselves at wholesale prices.
At the retail level there is a spread between the purchase and sell rate for currencies. Better rates are given for larger volumes. At the interbank level, banks buy and sell from one another, profiting by selling money back to the customer or to other banks at a higher rate.
Exchange rates are expressed either as direct or indirect. They appear either in terms of the U.S. dollar equivalent of the other currency, or how many units of other currency you could buy with $1. In working with rates, it helps to be familiar with relative currency strengths.
You must invert a rate, whether it is direct or indirect, to find out its counterpart. For example, if you know the direct rate, you divide it into 1 to find the indirect rate: 1/1.6537 = .6047.
Three types of exchange rates
There are three commonly used types of exchange rates. The first is the spot rate which indicates the present value of a currency. The second is the forward rate which is an expectation of the future spot rate of a currency. Finally, cross rates are used to compare the values of non-U.S. dollar currencies.
There are three commonly used types of exchange rates. The first is the spot rate which indicates the present value of a currency. The second is the forward rate which is an expectation of the future spot rate of a currency. Finally, cross rates are used to compare the values of non-U.S. dollar currencies.
Spot rates are used for on the spot transactions. This is the rate you will be charged at your bank or by your dealer for same-day transactions. Spot rates for any one currency can change several times during a business day.
If you need to buy or sell Swiss Francs in the future and have reason to believe it will be fluctuating unfavorably, lock in a future purchase today at a forward rate. Forward rates are quoted for 1-, 3-, 6-, 9-, and 12-month settlements.
Foreign exchange rates are always quoted relative to the U.S. dollar. You need to use a cross rate to convert two currencies if neither is the dollar. You could use either direct or indirect rates in your calculations.
Currency derivatives
The foreign exchange market allows you to protect yourself against fluctuating foreign exchange rates. It is also used by speculators who find ways to profit from interest rate differentials in other countries. This market uses instruments called derivative contracts whereby an individual or corporation agrees to make a future purchase or sale of foreign currency. The value of the contract is derived from the value of the underlying foreign currency; hence, the name derivative.
The foreign exchange market allows you to protect yourself against fluctuating foreign exchange rates. It is also used by speculators who find ways to profit from interest rate differentials in other countries. This market uses instruments called derivative contracts whereby an individual or corporation agrees to make a future purchase or sale of foreign currency. The value of the contract is derived from the value of the underlying foreign currency; hence, the name derivative.
Futures and forward contracts have distinguishing characteristics. Futures provide a secure way to exchange large amounts of foreign currency and can easily be traded on a public exchange when the owner wants out. Forwards are private, locked-in contracts that are only accessible to those with high credit standings.
Options contracts are particularly useful when a corporation is bidding on a project. You may know the volume of currency that you will need if a contract is won, but not know for certain that it will be won. A currency option allows a company to buy the currency if needed, but also allows the option of letting the opportunity pass if the bid is not accepted. This type of contract could also be used to protect against the cancellation of orders by customers.
A simple currency swap involves the exchange of currencies between two companies in different countries. Swap contracts guarantee each party a set exchange rate over the term of the contract. When the swap also services debt you owe in the other country, it is called an interest rate swap.
An understanding of the foreign exchange market as a framework for trading foreign currencies is crucial for financial managers of corporations involved in international business. You need to use this market to trade currencies on the spot at a bank, trade currencies at future settlement dates, purchase options to buy or sell currencies, and make agreements to swap currencies or interest rates.Related link.
0 comments:
Post a Comment