Exchange Rates and the Foreign Exchange
Market
Exchange rates are quoted as foreign currency per unit of domestic currency
vice-versa.
Spread
Spread- the difference between buying and selling price of a currency (Higher
for low-volume traded currency / or high- riske).
Price and Exchange Rates
Purchasing Power Parity (PPP) holds when two currencies have the same
purchasing power in the two countries.
Depreciation and Appreciation
Depreciation is a decrease in the value of a currency relative to another
currency.
Appreciation is an increase in the value of a currency relative to another
currency.
Depreciated currency  will export more.
Appreciated currency  will import more.
AED and US dollare are PIGGED
Foreign Exchange Markets
The set of markets where foreign currencies and other assets are exchanged for
domestic ones Institutions buy and sell deposits of currencies or other assets
for investment purposes.
About 90% of transactions involved US dollars.
The participants:
1. *Commercial banks and other depository institutions: transactions involve
buying/selling of deposits in different currencies for investment purposes.
2. Non-bank financial institutions (mutual funds, hedge funds, securities
firms, insurance companies, pension funds) may buy/sell foreign assets
for investment.
3. Non-financial businesses conduct foreign currency transactions to
buy/sell goods, services and assets.
4. *Central banks: conduct official international reserves transactions.
Spot Rates and Forward Rates
Spot rates are exchange rates for currency exchanges “on the spot”, or when
trading is executed in the present.
Forward rates are exchange rates for currency exchanges that will occur at a
future (“forward”) date.
Rates are negotiated between two parties in the present, but the
exchange occurs in the future.
Central Bank Intervention
Central banks, such as the Federal Reserve, buy and sell foreign exchange to
influence the values of their currencies.
Suppose the U.S. demand for British goods increases, which causes the
demand for pounds to shift to the right. As a result, the dollar depreciates
and pound appreciates.
Either the Bank of England or the Fed may intervene to stop the pound
appreciation by selling pounds in the foreign exchange market.
Fixed Exchange Rate
Fixed Exchange Rate—where a central bank actively intervenes in the foreign
exchange market so as to keep the exchange rate from changing.
Flexible Exchange Rate
Flexible Exchange Rate—where the exchange rate is determined by freemarket forces of demand and supply.
Black Market
Black Market—an illegal market in foreign exchange. Usually a result of
restrictive government policies on foreign exchange transactions.