CORRESPONDENCE LEARNING MODULE
IBAT 1013-International Business and Trade
AY 2021-2022
Lesson 9: The Global Monetary System
Topic:
Learning Outcomes:
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 The Foreign Exchange Market
After reading this module, you are expected to:
Describe the functions of the Foreign Exchange Market.
Recognize the role that forward exchange rates play in insuring against foreign exchange risk.
Understand the different theories explaining how currency exchange rates are determined and their
relative merits.
Identify the merits of different approaches toward exchange rate forecasting.
LEARNING CONTENT
INTRODUCTION
In today’s world no economy is self-sufficient, so there is need for exchange of goods and services
amongst the different countries. So in this global village, unlike in the primitive age the exchange of
goods and services is no longer carried out on barter basis. Every sovereign country in the world has
a currency that is legal tender in its territory and this currency does not act as money outside its
boundaries. So whenever a country buys or sells goods and services from or to another country, the
residents of two countries have to exchange currencies. So we can imagine that if all countries have
the same currency then there is no need for foreign exchange.
With the globalization of economic and financial activity, and advancement in the telecommunication
sector, the planet became a neighborhood in a short period of time. International trade, which
encompasses economic and financial activity, coupled with the interdependencies in economic
resources among nations, requires a payment system that facilitates and brings efficiency to these
reciprocities.
LESSON PROPER
The Foreign Exchange Market or FOREX Market is one in which foreign currency or foreign exchange
is bought and sold, either Over the Counter (OTC) or through currency exchanges.
It is one of the important components of the International Financial Systems. The various commercial
and financial transactions as between countries result in receipts and payments as between them. Such
receipts and payments involve exchange of one currency for another.
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE
For example: Peso is a legal tender in the Philippines but an exporter in UK will have no use for these
pesos. He, therefore, wishes to receive from the importer in Philippines only in Pound sterling. Then
the Importer have to convert such pesos into pounds, in that transaction, Foreign Exchange Market
provides facilities for such operations. Any receipt and payment of foreign cash, coins, claims in
currencies or credit instruments involve a foreign exchange transaction.
The ForEx market facilitates international trade and payment systems among nations by altering their
currencies. Nations’ macroeconomic stability is heavily dependent upon the value of their currency in
relation to others with whom they trade. Various financial securities are utilized by nations to satisfy
debt incurred through international trade or other economic interaction. The rate by which the two
currencies are valued is determined by the amount of the currencies exchanged as a result of export
and import, transactions in the international bond market, and exchange of goods and services between
countries. In the international capital market, the term arbitrage refers to transacting in foreign
currencies to take advantage of fluctuations that occur in the value of currencies as a result of
macroeconomic instability.
HISTORY OF FOREIGN EXCHANGE MARKET
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Ancient Origins
 The barter system, where goods were exchanged for other goods, was introduced by
Mesopotamian tribes in 6000 BC.
 In the 6th century BC, the first gold coins were produced and widely accepted as a
medium of exchange.
13th-18th Century
 The first true forex market emerged in Amsterdam around 500 years ago, allowing
people to freely trade currencies to stabilize exchange rates.
 The Republic of Florence grew to be a significant European and Mediterranean power
in the 13th century.
The Gold Standard Era
 In 1875, the gold standard was implemented, requiring countries to print currency equal
to their gold reserves.
 By 1913, the number of forex trading companies in London increased from three to 71,
with the British pound sterling accounting for half of all forex transactions.
Bretton Woods System
 After World War II, the Bretton Woods system was established in 1944, pegging most
currencies to the U.S. dollar.
 The Bretton Woods agreement eventually failed, and in 1971, President Richard Nixon
ended the system, leading to the free floating of the U.S. dollar against other foreign
currencies.
The Rise of Electronic Trading
 In the 1980s, computer-based trading systems enabled financial institutions to trade
currencies electronically, laying the foundation for the digital revolution in forex trading.
 The 1990s saw the birth of retail forex trading, with online brokers offering individual
investors the opportunity to trade currencies through user-friendly platforms.
The Modern Forex Market
 Today, the forex market is the largest financial market in the world, with a global
network of financial centers transacting 24 hours a day, except on weekends.
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE
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The market continues to evolve, with the introduction of algorithmic trading, mobile
trading apps, and social trading platforms, making forex trading more accessible and
efficient than ever before
CHARATERISTICS OF FOREIGN EXCHANGE MARKET
Foreign Exchange Market is widespread throughout the globe, market participants are specialists,
transactions involve immense volume and involvement of variety of transactions.
 High Liquidity: The foreign exchange market is the most liquid financial market in the world, with trillions
of dollars traded daily. Traders can buy and sell currencies at any time.
 Market Transparency: The forex market is highly transparent, with traders having full access to real-time
market data and information.
 Dynamic Market: Currency exchange rates fluctuate constantly, changing every second and hour in the
forex market.
 24-Hour Operation: The foreign exchange market operates 24 hours a day, 5 days a week, across major
financial centers globally.
 Diverse Participants: Key participants include commercial banks, central banks, hedge funds,
corporations, and individual retail traders.
 Electronic Trading: The forex market is an over-the-counter (OTC) market without a central physical
exchange. Transactions are conducted electronically through a global network of banks and dealers.
 Geographical Dispersion: The forex market is not concentrated in one location, but spread across major
financial hubs around the world.
 High Trading Volume: Around 95% of forex trading involves cross-border capital flows, rather than traderelated transactions.
 Provision of Credit: The forex market provides specialized credit instruments like bankers' acceptances
and letters of credit to facilitate international trade and investment.
Functions of Foreign Exchange Market
The key functions of the foreign exchange market are:
 Transfer Function
o The primary function of the forex market is to facilitate the transfer of funds or
currencies between countries to settle international payments and trade.
o For example, a U.S. company importing goods from Japan would need to convert its
U.S. dollars into Japanese yen to pay the Japanese supplier.
 Credit Function
o The forex market provides short-term loans and credit instruments like bankers'
acceptances and letters of credit to importers to finance international trade. This helps
the smooth flow of goods and services across borders. For instance, an importer can
use these loans to pay for goods from another country.
 Hedging Function
o The forex market allows participants to hedge against foreign exchange risks arising
from fluctuations in currency exchange rates. Parties can use instruments like forwards,
futures, and options to manage their currency exposure.
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE
o For example, a U.S. company expecting to receive British pounds in 3 months can
hedge its position by selling pounds forward to lock in the exchange rate.
 Speculative Function
o The constantly fluctuating currency exchange rates in the dynamic forex market provide
regular trading opportunities for speculators seeking to profit from these price
movements. Speculators buy and sell currencies in anticipation of exchange rate
changes to make a profit.
In summary, the foreign exchange market serves the key functions of facilitating international
payments, providing trade financing, managing currency risks, and enabling speculative trading
activities. The market's high liquidity, transparency, and 24-hour global operation make it a vital part
of the international financial system.
FINANCIAL INSTRUMENTS USED IN EXCHANGE MARKET
The main financial instruments used in the foreign exchange market are:
 Foreign Exchange Instruments
 Represent financial instruments traded on the foreign exchange market
 Used for hedging foreign exchange risk and currency speculation
 Primarily consist of currency agreements like spot transactions, forwards, swaps
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Spot transactions: Currency exchange where the exchange takes place no later
than the second business day after the transaction is concluded.
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Outright Forwards: Currencies are exchanged at a predetermined exchange rate
and a point in time after the spot date, protecting investors from high exchange rate
fluctuations.
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Currency swaps: Two parties simultaneously exchange the same monetary value
with each other in different currencies, swapping back at a predetermined maturity
date and exchange rate.
 Derivative Instruments
 Financial instruments whose value is derived from an underlying asset like
currencies, stocks, bonds, commodities, etc.
 Used for hedging, speculation, and arbitrage
 Examples include futures and options
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Futures: A contract between two parties that involves customizable derivatives in
which the exchange occurs at the end of the contract at a specific price.
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Options: An agreement between two parties in which the seller grants the buyer the
right to purchase or sell a certain number of derivatives at a predetermined price for
a specific period of time.
 Cash Instruments
 Financial instruments whose value can be determined directly from the markets
 Represent direct ownership or debt obligations
 Includes securities (stocks, bonds), loans, and deposits
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Securities: Financial instruments traded on the stock exchange, where the buyer
receives a share in the issuing company. Examples include stocks and bonds.
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Loans: Contracts between lender and borrower specifying interest instalments and
rates. Loans are considered cash instruments.
 Other examples of financial instruments used in the forex market include:
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Synthetic Agreements for Foreign Exchange (SAFE): An over-the-counter
agreement guaranteeing a specified exchange rate during an agreed period.
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Interest Rate Swaps: A derivative agreement between two parties involving the
swapping of interest rates on loans in different currencies.
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE
 In summary, the foreign exchange market utilizes a range of financial instruments including
spot transactions, forwards, swaps, futures, options, securities, and loans to facilitate currency
trading and risk management. The choice of instrument depends on the specific needs and
objectives of the market participants.
 All three types of instruments are used for risk management, speculation, and facilitating
transactions in the financial markets. The choice depends on the specific needs and objectives
of the market participants.
FACTORS AFFECTING IN DETERMINING EXCHANGE RATES
Inflation Rates
 Countries with lower inflation rates tend to have appreciating currencies, as the purchasing power of
their currency increases relative to countries with higher inflation. Lower inflation makes a country's
exports more competitive.
 For example, if the U.S. has lower inflation than the Eurozone, the U.S. dollar will likely appreciate against
the Euro.
Interest Rates
 Interest rates, inflation and exchange rates are closely correlated. Higher interest rates attract foreign
capital, increasing demand for the currency and causing it to appreciate. Central banks can influence
exchange rates by adjusting interest rates.
 For instance, if the Bank of England raises interest rates, the British pound will typically strengthen
against currencies of countries with lower rates.
Government Debt
 High government debt makes a country less attractive to foreign investors, leading to currency
depreciation. Investors may sell bonds denominated in that currency, further reducing demand. Printing
money to finance debt also causes inflation.
 A country like Japan with very high public debt has seen its currency, the yen, weaken over time.
Political Stability
 Politically stable countries attract more foreign investment, boosting demand for the currency.
Instability and policy uncertainty deter investment and cause the currency to weaken.
 The Swiss franc is considered a safe haven currency due to Switzerland's political and economic stability.
Economic Health
 Strong economic growth, low unemployment, and a positive trade balance increase demand for a
country's currency. Recessions typically lead to currency depreciation as money flows out to higheryielding assets.
 A country like China with robust economic growth has seen its currency, the renminbi, appreciate.
In summary, exchange rates are determined by a complex interplay of economic, political and psychological
factors. Investors must closely monitor these drivers to understand and anticipate currency movements.
*** END of LESSON ***
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE
LEARNING TASK 2
I.True/False. Write True if the statement is correct, write False if the statement is incorrect.
1. The Foreign Exchange Market or FOREX Market is one in which foreign currency or foreign exchange is
bought and sold, either Over the Counter (OTC) or through currency exchanges.
2. Forex first existed in ancient time. Money-changing people, people helping others to change money and also
taking a commission or charging a fee were living in the times of the Talmudic writings (Biblical times).
3. On January 1981 (as part of changes beginning during 1978) the Bank of China allowed certain domestic
"enterprises" to participate in foreign exchange trading.
4. Previously, the Forex market was traded primarily by banks, large financial institutions, and governments.
5. A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the
right but not the obligation to exchange money denominated in one currency into another currency at a preagreed exchange rate on a specified date.
II. Multiple Choice. Choose the letter of the correct answer.
1. The following are the factors affecting in determining exchange rates except?
a. International trade
b. Capital movements
c. Strength of the economy
d. None of the above
2. Which of the following refers to the most common type of forward transaction?
a. Swap
b. Spot
c. Forward
d. Future
3. In this transaction, money does not actually change hands until some agreed upon future date.
a. Forward
b. Swap
c. Spot
d. Future
4. Which of the following factors is affected in determining exchange rates when domestic inflation or
deflation affects the exchange rate by affecting the demand and supply of domestic currency in the
foreign exchange market?
a. Changes in prices
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE
b. Speculations
c. International Trade
d. Government policies
5. Which of the following refers to the measure of the change in the prices of consumer goods across
over 200 different categories?
a. Consumer Price Index
b. Gross Domestic Product
c. Capital movements
d. None of the above
IBAT 1013-INTERNATIONAL BUSINESS AND TRADE