Contents

I. Introduction 2

II. The structure of the foreign exchange market 3

1. What is the foreign exchange? 3

2. The participants of the foreign exchange markets 4

3. Instruments of the foreign exchange markets 5

III. Foreign exchange rates 6

1. Determining foreign exchange rates 6

2. Supply and Demand for foreign exchange 7

3. Factors affecting foreign exchange rates 11

IV. Conclusion 13

V. Recommendations 14

VI. Literature used 16

Introduction

Trade and payments across national borders require that one of the
parties to the transaction contract to pay or receive funds in a foreign
currency. At some stage, one party must convert domestic money into foreign
money. Moreover, knowledgeable investors based in each country are aware of
the opportunities of buying assets or selling debts denominated in foreign
currencies when the anticipated returns are higher abroad or when the
interest costs are lower. These investors also must use the foreign
exchange market whenever they invest or borrow abroad.
I’d like to add that the foreign exchange market is the largest market
in the world in terms of the volume of transactions. That the volume of
foreign exchange trading is many times larger than the volume of
international trade and investment reflects that a distinction should be
made between transactions that involve only banks and those that involve
banks, individuals, and firms involved in international trade and
investment.
The phenomenal explosion of activity and interest in foreign exchange
markets reflects in large measure a desire for self-preservation by
businesses, governments, and individuals. As the international financial
system has moved increasingly toward freely floating exchange rates,
currency prices have become significantly more volatile. The risks of
buying and selling dollars and other currencies have increased markedly in
recent years. Moreover, fluctuations in the prices of foreign currencies
affect domestic economic conditions, international investment, and the
success or failure of government economic policies. Governments,
businesses, and individuals involved in international affairs find it is
more important today than ever before to understand how foreign currencies
are traded and what affects their relative values.
In this work, we examine the structure, instruments, and price-
determining forces of the world's currency markets.

The structure of the foreign exchange market

What is the foreign exchange?

The foreign exchange markets are among the largest markets in the
world, with annual trading volume in excess of $160 trillion. The purpose
of the foreign exchange markets is to bring buyers and sellers of
currencies together. It is an over-the-counter market, with no central
trading location and no set hours of trading. Prices and other terms of
trade are determined by negotiation over the telephone or by wire,
satellite, or telex. The foreign exchange market is informal in its
operations: there are no special requirements for market participants, and
trading conforms to an unwritten code of rules.
You know that almost every country has its own currency for domestic
transactions. Trading among the residents of different countries requires
an efficient exchange of national currencies. This is usually accomplished
on a large scale through foreign exchange markets, located in financial
centers such as London, New York, or Paris—in order of importance—where
exchange rates for convertible currencies are determined. The instruments
used to effect international monetary payments or transfers are called
foreign exchange. Foreign exchange is the monetary means of making payments
from one currency area to another. The funds available as foreign exchange
include foreign coin and currency, deposits in foreign banks, and other
short-term, liquid financial claims payable in foreign currencies. An
international exchange rate is the price of one (foreign) currency measured
in terms of another (domestic) currency. More accurately, it is the price
of foreign exchange. Since exchange rates are the vehicle that translates
prices measured in one currency into prices measured in another currency,
changes in exchange rates affect the price and, therefore, the volume of
imports and exports exchanged. In turn the domestic rate of inflation and
the value of assets and liabilities of international borrowers and lenders
is influenced. The exchange rate rises (falls) when the quantity demanded
exceeds (is less than) the quantity supplied. Broadly speaking, the
quantity of U.S. dollars supplied to foreign exchange markets is composed
of the dollars spent on imports, plus the amount of funds spent or invested
by U.S. residents outside the United States. The demand for U.S. dollars
arises from the reverse of these transactions.
Many newspapers keep a daily record of the exchange rates in the
highly organized foreign exchange market, where currencies of different
nations are bought and sold. For instance, the Wall Street Journal shows
the price of a currency in two ways: first the price of the other currency
is given in U.S. dollars, and second the price of the U.S. dollar is quoted
in units of the other currency. Pairs of prices represent reciprocals of
each other. These rates refer to trading among banks, the primary
marketplace for foreign currencies.

2. The participants of the foreign exchange markets

The foreign exchange market is extremely competitive so there are many
participants, none of whom is large relative to the market.
The central institution in modern foreign exchange markets is the
commercial bank. Most transactions of any size in foreign currencies
represent merely an exchange of the deposits of one bank for the deposits
of another bank. If an individual or business firm needs foreign currency,
it contacts a bank, which in turn secures a deposit denominated in foreign
money or actually takes delivery of foreign currency if the customer
requires it. If the bank is a large money center institution, it may hold
inventories of foreign currency just to accommodate its customers. Small
banks typically do not, hold foreign currency or foreign currency-
denominated deposits. Rather, they contact large correspondent banks, which
in turn contact foreign exchange dealers.
The major international commercial banks act as both dealers and
brokers. In their dealer role, banks maintain a net long or short position
in a currency, and seek to profit from an anticipated change in the
exchange rate. (A long position means their holdings of assets denominated
in one currency exceed their liabilities denominated in this same
currency.) In their broker function, banks compete to obtain buy and sell
orders from commercial customers, such as the multinational oil companies,
both to profit from the spread between the rates at which they buy foreign
exchange from some customers and the rates at which they sell foreign
exchange to other customers, and to sell other types of banking services to
these customers.
Frequently, currency-trading banks do not deal directly with each
other but rely on foreign exchange brokers. These firms are in constant
communication with the exchange trading rooms of the world's major banks.
Their principal function is to bring currency buyers and sellers together.
Security brokerage firms, commodity traders, insurance companies, and
scores of other nonbank companies have come to play a growing role in the
foreign exchange markets today. These Nonbank Financial Institutions have
entered in the wake of deregulation of the financial marketplace and the
lifting of some foreign controls on international investment, especially by
Japan and the United Kingdom. Nonbank traders now offer a wide range of
services to international investors and export-import firms, including
assistance with foreign mergers, currency swaps and options, hedging
foreign security offerings against exchange rate fluctuations, and
providing currencies needed for purchases abroad.
In main all participants of an exchange market are usually divided on
two groups. The first group of participants is called speculators; by
definition, they seek to profit from anticipated changes in exchange rates.
The second group of participants is known as arbitragers. Arbitrage refers
to the purchase of one currency in a certain market and the sale of that
currency in another market in response to differences in price between the
two markets. The force of arbitrage generally keeps foreign exchange rates
from getting too far out of line in different markets.

3. Instruments of the foreign exchange markets

. Cable and Mail Transfers
Several financial instruments are used to facilitate foreign exchange
trading. One of the most important is the cable transfer, an execute order
sent by cable to a foreign bank holding a currency seller's account. The
cable directs the bank to debit the seller's account and credit the account
of a buyer or someone the buyer designates.
The essential advantage of the cable transfer is speed because the
transaction can be carried out the same day or within one or two business
days. Business firms selling their goods in international markets can avoid
tying up substantial sums of money in foreign exchange by using cable
transfers.
When speed is not a critical factor, a mail transfer of foreign
exchange may be used. Such transfers are written orders from the holder of
a foreign exchange deposit to a bank to pay a designated individual or
institution on presentation of a draft. A mail transfer may require days to
execute, depending on the speed of mail deliveries.
. Bills of Exchange
One of the most important of all international financial instruments
is the Bill of Exchange. Frequently today the word draft is used instead of
bill. Either way, a draft or bill of exchange is a written order requiring
a person, business firm, or bank to pay a specified sum of money to the
bearer of the bill.
We may distinguish sight bills, which are payable on demand, from time
bills, which mature at a future date and are payable only at that time.
There are also documentary hills, which typically accompany the
international shipment of goods. A documentary bill must be accompanied by
shipping papers allowing importers to pick up their merchandise. In
contrast, a clean hill has no accompanying documents and is simply an order
to a bank to pay a certain sum of money. The most common example arises
when an importer requests its bank to send a letter of credit to an
exporter in another country. The letter authorizes the exporter to draw
bills for payment, either against the importer's bank or against one of its
correspondent banks.
. Foreign Currency and Coin
Foreign currency and coin itself (as opposed to bank deposits) is an
important instrument for payment in the foreign exchange markets. This is
especially true for tourists who require pocket money to pay for lodging,
meals, and transportation. Usually this money winds up in the hands of
merchants accepting it in payment for purchases and is deposited in
domestic banks. For example, U.S. banks operating along the Canadian and
Mexican borders receive a substantial volume of Canadian dollars and
Mexican pesos each day. These funds normally are routed through the banking
system back to banks in the country of issue, and the U.S. banks receive
credit in the form of a deposit denominated in a foreign currency. This
deposit may then be loaned to a customer or to another bank.
. Other Foreign Exchange Instruments
A wide variety of other financial instruments are denominated in
foreign currencies, most of this small in amount. For example, traveler's
checks denominated in dollars and other convertible currencies may be spent
directly or converted into the currency of the country where purchases are
being made. International investors frequently receive interest coupons or
dividend warrants denominated in foreign currencies. These documents
normally are sold to a domestic bank at the current exchange rate.

Foreign exchange rates

1. Determining foreign exchange rates

As I’ve already mentioned the prices of foreign currencies expressed
in terms of other currencies are called foreign exchange rates. There are
today three markets for foreign exchange: the spot market, which deals in
currency for immediate delivery; the forward market, which involves the
future delivery of foreign currency; and the currency futures and options
market, which deals in contracts to hedge against future changes in foreign
exchange rates. Immediate delivery is defined as one or two business days
for most transactions. Future delivery typically means one, three, or six
months from today.
Dealers and brokers in foreign exchange actually set not one, but two,
exchange rates for each pair of currencies. That is, each trader sets a bid
(buy) price and an asked (sell) price. The dealer makes a profit on the
spread between the bid and asked price, although that spread is normally
very small.

2. Supply and Demand for foreign exchange

The underlying forces that determine the exchange rate between two
currencies are the supply and demand resulting from commercial and
financial transactions (including speculation). Foreign-exchange supply and
demand schedules relate to the price, or exchange rate. This is illustrated
in Figure 1, which assumes free-market or flexible exchange rates.

Figure 1

[pic]
Before examining this figure, we need to define two terms.
Depreciation (appreciation) of a domestic currency is a decline (rise)
brought about by market forces in the price of a domestic currency in terms
of a foreign currency. In contrast, devaluation (revaluation) of a domestic
currency is a decline (rise) brought about by government intervention in
the official price of a domestic currency in terms of a foreign currency.
Depreciation or appreciation is the appropriate concept to deal with
floating, or flexible, exchange rates, whereas devaluation or revaluation
is appropriate when dealing with fixed exchange rates.
In the dollar-pound exchange market, the demand schedule for pounds
represents the demands of U.S. buyers of British goods, U.S. travelers to
Britain, currency speculators, and those who wish to purchase British
stocks and securities. It slopes downward because the dollar price to U.S.
residents of British goods and services declines as the exchange rate
declines. An item selling for Ј1 in Britain would cost $2.00 in the U.S. if
the exchange rate were Ј1/$2.00 U.S. If this exchange rate declined to
Ј1/$1.50 U.S., the same item is $.50 cheaper in the United States,
increasing the demand for British goods and thus the demand for pounds. The
supply schedule of pounds represents the pounds supplied by British buyers
of U.S. goods, British travelers, currency speculators, and those who wish
to purchase U.S. stocks and securities. It slopes upward because the pound
price to British residents of U.S. goods and services rises as the $ price
of the Ј falls. Assuming an exchange rate of Ј1 /$2.00 U.S., a $2.00 item
in the U.S. costs Ј1 in Britain. If this exchange rate declined to Ј1/$1.50
U.S., the same item is 33 percent more expensive in Britain, decreasing the
demand for dollars to buy U.S. goods and thus reducing the supply of
pounds. The equilibrium exchange rate in Figure 1 is Ј1/$2.00 U.S. The
amounts supplied and demanded by the market participants are in balance.

Figure 2

[pic]

To understand better the schedules, several of the factors that might
cause these curves to shift are discussed next. If there is a decrease in
national income and output in one country relative to others, that nation's
currency tends to appreciate relative to others. The domestic income level
of any country is a major determinant of the demand for imported goods in
that country (and hence a determinant of the demand for foreign
currencies). Figure 2 shows the effects of a decline in national income in
Britain (assuming all other factors remain constant). The decrease in
British income implies a decrease in demand for goods and services (both
domestic and foreign) by British people. This reduction in demand for
imported goods leads to a reduction in the supply of pounds, which is shown
by a leftward shift of the supply curve in Figure 2 (from S[pic] to
S[pic]). If the exchange rate floats freely, the British pound appreciates
against the U.S. dollar. If the exchange rate is artificially maintained at
the old equilibrium of Ј1/$2.00 U.S., however, a balance-of-payments
surplus (for Britain) likely results.

Figure 3

[pic]

In Figure 3, an initial exchange-rate equilibrium of Ј1/$2.00 U.S. is
assumed. Now presume the rate of price inflation in Britain is higher than
in the United States. British products become less attractive to U.S.
buyers (because their prices are increasing faster), which causes the
demand schedule for pounds to shift leftward (D[pic] to D[pic]). On the
other hand, because prices in Britain are rising faster than prices in the
U.S., U.S. products become more attractive to British buyers, which causes
the supply schedule of pounds to shift to the right (S[pic] to S[pic]). In
other words, there is an increased demand for U.S. dollars in Britain. The
reduced demand for pounds and the increased supply (resulting from British
purchases of U.S. goods) mandates a newer, lower, equilibrium exchange
rate. Furthermore, as long as the inflation rate in Britain exceeded that
in the United States, the British pound would continually depreciate
against the U.S. dollar.
Differences in yields on various short-term and long-term securities
can influence portfolio investments among different countries and also the
flow of funds of large banks and multinational corporations. If British
yields rise relative to others, an investor wishing to take advantage of
these higher interest rates must first obtain British pounds to buy the
securities. This increases the demand for British pounds shift the demand
schedule in Figure 4 to the right (D[pic] to D[pic]). British investors are
also less inclined to purchase U.S. securities, moving the supply schedule
of pounds to the left (S[pic] to S[pic]). Both activities raise the
equilibrium exchange rate of the British pound in terms of U.S. dollars.

Figure 4

[pic]

3. Factors affecting foreign exchange rates

. Balance-of-Payments Position
The exchange rate for any foreign currency depends on a multitude of
factors reflecting economic and financial conditions in the country issuing
the currency. One of the most important factors is the status of a nation's
balance-of-payments position. When a country experiences a deficit in its
balance of payments, it becomes a net demander of foreign currencies and is
forced to sell substantial amounts of its own currency to pay for imports
of goods and services. Therefore, balance-of-payments deficits often lead
to price depreciation of a nation's currency relative to the prices of
other currencies. For example, during most of the 1970s, 1980s, and into
the 1990s, when the United States was experiencing deep balance-of-payments
deficits and owed substantial amounts abroad for imported oil, the value of
the dollar fell.
. Speculation
Exchange rates also are profoundly affected by speculation over future
currency values. Dealers and investors in foreign exchange monitor the
currency markets daily, looking for profitable trading opportunities. A
currency viewed as temporarily undervalued quickly brings forth buy orders,
driving its price higher vis-a-vis other currencies. A currency considered
to be overvalued is greeted by a rash of sell orders, depressing its price.
Today, the international financial system is so efficient and finely tuned
that billions of dollars can flow across national boundaries in a matter of
hours in response to speculative fever. These massive unregulated flows can
wreak havoc with the plans of policymakers because currency trading affects
interest rates and ultimately the entire economy.
. Domestic Economic and Political Conditions
The market for a national currency is, of course, influenced by
domestic conditions. Wars, revolutions, the death of a political leader,
inflation, recession, and labor strikes have all been observed to have
adverse effects on the currency of a nation experiencing these problems. On
the other hand, signs of rapid economic growth, improving government
finances, rising stock and bond prices, and successful economic policies to
control inflation and unemployment usually lead to a stronger currency in
the exchange markets.
Inflation has a particularly potent impact on exchange rates, as do
differences in real interest rates between nations. When one nation's
inflation rate rises relative to others, its currency tends to fall in
value. Similarly, a nation that reduces its inflation rate usually
experiences a rise in the value of its currency. Moreover, countries with
higher real interest rates generally experience an increase in the exchange
value of their currencies, and countries with low real interest rates
usually face relatively low currency prices.
. Government Intervention
It is known that each national government has its own system or policy
of exchange-rate changes. Two of the most important are floating and fixed
exchange-rate systems. In the floating system, a nation's monetary
authorities, usually the central bank, do not attempt to prevent
fundamental changes in the rate of exchange between its own currency and
any other currency. In the fixed-rate system, a currency is kept fixed
within a narrow range of values relative to some reference (or key)
currency by governmental action.
National policymakers can influence exchange rates directly by buying
or selling foreign currency in the market, and indirectly with policy
actions that influence the volume of private transactions. A third method
of influencing exchange rates is exchange control—i.e., direct control of
foreign-exchange transactions.

Intervention of a central bank involves purchases or sales of the
national money against a foreign money, most frequently the U.S. dollar. A
central bank is obliged to prevent its currency from depreciating below its
lower support limit. The central bank should buy its own currency from
commercial banks operating in the exchange market and sell them dollars in
exchange. These transactions are effectively an open-market sale using
dollar demand deposits rather than domestic bonds. Such transactions reduce
the central bank's domestic liabilities in the hands of the public. The
ability of a foreign central bank to prevent its currency from depreciating
depends upon its holdings of dollars, together with dollars that might be
obtained by borrowing. Even if a national monetary authority has the
foreign exchange necessary for intervention, its need to support its
currency in the exchange market might be inconsistent with its efforts to
undertake a more expansive monetary policy to achieve its domestic economic
objectives.
Also I’d like to say a few words about currency sterilization. A
decision by a central bank to intervene in the foreign currency markets
will have both currency market and money supply effects unless an operation
known as currency sterilization is carried out. Any increase in reserves
and deposits that results from a central bank currency purchase can be
«sterilized» by using monetary policy tools that absorb reserves. There is
currently a great debate among economists as to whether sterilized central
bank intervention can significantly affect exchange rates, in either the
short term or the long term, with most research studies finding little
impact on relative currency prices.

Conclusion

A market in national monies is a necessity in a world of national
currencies; this market is the foreign-exchange market. The assets traded
in this market are demand deposits denominated in the different currencies.
Individuals who wish to buy goods or securities in a foreign country must
first obtain that country's currency in the foreign-exchange market. If
these individuals pay in their own currency, then the sellers of the goods
or securities, use the foreign-exchange market to convert receipts into
their own currency.
One from the most important participants of an exchange market is a
business bank, which act as the intermediaries between the buyers and
sellers. As already it is known they can execute a role speculators and
arbitragers.
Most foreign-exchange transactions entail trades involving the U.S.
dollar and individual foreign currencies. The exchange rate between any two
foreign currencies can be inferred as the ratio of the price of the U.S.
dollar in terms of each of their currencies.
The exchange rates are prices that equalize the demand and supply of
foreign exchange. In recent years, exchange rates have moved sharply, more
sharply than is suggested by the change in the relationship between
domestic price level and foreign price level. Exchange rates do not
accurately reflect the relationship between the domestic price level and
foreign price levels. Rather, exchange rates change so that the anticipated
rates of return from holding domestic securities and foreign securities are
the same after adjustment for any anticipated change in the exchange rate.
The major factor influencing to the rate of exchange, is interference
of government in the person of central bank in currency policy of the
country. The value of a nation's currency in the international markets has
long been a source of concern to governments around the world. National
pride plays a significant role in this case because a strong currency,
avidly sought by traders and investors in the international marketplace,
implies the existence of a vigorous and well-managed economy at home. A
strong and stable currency encourages investment in the home country,
stimulating its economic development. Moreover, changes in currency values
affect a nation's balance-of-payments position. A weak and declining
currency makes foreign imports more expensive, lowering the standard of
living at home. And a nation whose currency is not well regarded in the
international marketplace will have difficulty selling its goods and
services abroad, giving rise to unemployment at home. This explains why
Russia made such strenuous efforts in the early 1990s to make the Russian
ruble fully convertible into other global currencies, hoping that ruble
convertibility will attract large-scale foreign investment.

Recommendations

The problem of “laundering” money is essential with regard to the
exchange market. I’d like to add that the Russian exchange market comes
first in this respect.
The origin of this problem directly is connected with activity of the
organized crime: funds obtained in a criminal way are presented as legal
capital to introduce them in economic and financial structures of the
state. Therefore struggle against “laundering” money is recognized in all
countries as one from major means of a counteraction of the organized
crime. The sources of “dirty” money are as follows:
international drugs traffic;
mafia’s activity;
illegal trade of weapon.
The use of exchange markets for “laundering” money is not a
contingency. This process is promoted by absence of restrictions concerning
foreign exchange.
Unfortunately today participation of Russia in international struggle
against outline problem is limited by signing of the Viennese convention on
struggle against an international drugs trafficking and entering Interpol.
The work on struggle against “laundering” money in Russia should start from
the very beginning. The process of developing legislation and mechanisms of
its application is supposed to give instructions aimed at lawful struggle
against “laundering” money, developing bilateral cooperation with
countries of European Union, USA and Japan.

Literature used

1. “Money, banking and the economy” T. Mayer, J.S. Duesenberry, R.Z.
Aliber
W.W. Norton & company New York, London 1981
2. “Principles of international finance” Daniel R. Kane
Croom Helm 1988
3. “Money and banking” David R. Kamerschen
College Division South-western Publishing Co. 1992
4. “Money and capital markets: the financial system in a increasingly
global economy” fifth edition Peter S. Rose
IRWIN 1994