1. FOREX market defination
• Foreign exchange markets are markets on which
individuals, firms and banks buy and sell foreign
currencies:
– foreign exchange trading occurs with the help of the
telecommunication net between buyers and sellers of
foreign exchange that are located all over the world
– can actually talk about a single international foreign
exchange market for every single currency
– foreign exchange trading takes place at least in some of
the world financial centers in every moment
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• Clearing of currencies:
– service of exchanging one currency for another
• Provision of Credit:
– trader that bought a certain good from the manufacturer,
needs time to sell this good to the final customer and to pay
the manufacturer with the money he received from the
customer
2. Foreign Exchange Market Functions
Clearing of Currencies and Provision of Credit
3. Forward Contracts
• Agreement to buy or sell an asset at a certain time in
the future for a predetermined price
• Over-the-counter product that do not trade on any
organized exchange
• Delivery date can be any date that is mutually
convenient to both the parties to the contract
• Size can be customized
• Not marked-to-market daily
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4. The Forward Market
• A forward contract is an agreement to buy or
sell an asset in the future at prices agreed
upon today.
• If you have ever had to order an out-of-stock
textbook, then you have entered into a
forward contract.
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5. Forward Rate Quotations
• The forward market for FOREX involves
agreements to buy and sell foreign currencies
in the future at prices agreed upon today.
• Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
• Longer-term swaps are available.
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6. Futures Contracts
• A futures contract is an agreement to buy or sell a
specified quantity of a specified asset at a certain
point in the future at a price agreed upon today
• In the case of currencies, it is an agreement to
buy/sell a specified quantity of a specific currency at
a pre agreed upon exchange rate at a certain time in
the future
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7. • cross exchange rate:
– can be calculated with the help of the relationship
of two currencies with a third currency
• hedging:
– activities with which the foreign exchange market
participants avoid exchange rate risk or activities
with which they are closing their open foreign
exchange position
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8. • arbitragers:
– they want to earn a profit without taking any kind
of risk (usually commercial banks):
• try to profit from simultaneous exchange rate
differences in different markets
• making use of the interest rate differences that exist in
national financial markets of two countries along with
transactions on spot and forward foreign exchange
market at the same time (covered interest parity)
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9. hedgers and speculators:
hedgers do not want to take risk while participating in the
market, they want to insure themselves against the
exchange rate changes
speculators think they know what the future exchange
rate of a particular currency will be, and they are willing to
accept exchange rate risk with the goal of making profit
every foreign exchange market participant can behave
either as a hedger or as a speculator in the context of a
particular transaction
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5. Types of Foreign Exchange Market Transactions
almost immediate delivery of foreign exchange
buyer and seller establish the exchange rate at the time of
the agreement, payment and delivery are not required
until maturity
forward exchange rates:
1, 3, 6, 9 months, one year
2. Outright Forward Transactions
1. SPOT Transactions
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Options
• basic characteristics of options:
– financial instrument that gives the buyer the right, but
not the obligation, to buy or sell a standardized
amount of a foreign currency, that is traded, at a fixed
price at a particular time, or until a particular time in
the future
– call option and put option
– American and European options
– three different prices:
• exercise/strike price
• cost, price or value of the option
• underlying or actual spot exchange rate
“at-the-money”
“in-the-money”
“out-of-money”
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Options
• types of options trading:
– in organized markets:
• standardized contracts with given strike prices, standardized
durations (1, 3, 6, 9, 12 months) and expirations
• only certain currencies, contract amounts are standardized
– over-the-counter trading:
• expiration date, strike price and contract amount depend on
the individual needs of the client
• counterparty risk!
• retail and interbank market
• information about options trading
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• Usage of options:
– when the economic agent expects that the exchange
rate trend of a particular currency could change
drastically
– when the economic agent does not know for sure that
a certain foreign exchange flow will occur in the future
– advantages:
• fixed option costs
• options do not need to be executed
Options
14. Bid & Ask Quotes
Foreign currency dealers provide two quotes:
Bid Price: Price at which the dealer is willing to buy
foreign currency from you.
Ask Price: Price at which the dealer is willing to sell
foreign currency to you.
It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread.
The less traded and more volatile a currency, the
greater is the spread.
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