The Functions of the Foreign Exchange Market

1. The foreign exchange market serves two functions: converting currencies and reducing risk. There are four major reasons firms need to convert currencies.

2. First, the payments firms receive from exports, foreign investments, foreign profits, or licensing agreements may all be in a foreign currency. In order to use these funds in its home country, an international firm has to convert funds from foreign to domestic currencies.

3. Second, a firm may purchase supplies from firms in foreign countries, and pay these suppliers in their domestic currency.

4. Third, a firm may want to invest in a different country from that in which it currently holds underused funds.

5. Fourth, a firm may want to speculate on exchange rate movements, and earn profits on the changes it expects. If it expects a foreign currency to appreciate relative to its domestic currency, it will convert its domestic funds into the foreign currency. Alternately stated, it expects its domestic currency to depreciate relative to the foreign currency. An example similar to the one in the book can help illustrate how money can be made on exchange rate speculation. The management focus on George Soros shows how one fund has benefited from currency speculation.

6. Exchange rates change on a daily basis. The price at any given time is called the spot rate, and is the rate for currency exchanges at that particular time. One can obtain the current exchange rates from a newspaper or online.

7. The fact that exchange rates can change on a daily basis depending upon the relative supply and demand for different currencies increases the risks for firms entering into contracts where they must be paid or pay in a foreign currency at some time in the future.

8. Forward exchange rates allow a firm to lock in a future exchange rate for the time when it needs to convert currencies. Forward exchange occurs when two parties agree to exchange currency and execute a deal at some specific date in the future. The book presents an example of a laptop computer purchase where using the forward market helps assure the firm that will won’t lose money on what it feels is a good deal. It can be good to point out that from a firm’s perspective, while it can set prices and agree to pay certain costs, and can reasonably plan to earn a profit; it has virtually no control over the exchange rate. When spot exchange rate changes entirely wipe out the profits on what appear to be profitable deals, the firm has no recourse.

9. When a currency is worth less with the forward rate than it is with the spot rate, it is selling at forward discount. Likewise, when a currency is worth more in the future than it is on the spot market, it is said to be selling at a forward premium, and is hence expected to appreciate. These points can be illustrated with several of the currencies.

10. A currency swap is the simultaneous purchase and sale of a given amount of currency at two different dates and values.