Foreign Exchange Fundamentals and Financial Instruments

Foreign Currency and Market Functions

What is Foreign Currency?

A foreign currency is defined as a deposit or bank balance held in a financial institution, denominated in a currency different from the national currency.

Functions of the Foreign Exchange Market

The foreign exchange market performs several crucial functions:

• Allows for the transfer of funds between countries.
• Provides instruments for financing international trade.
• Enables the management of investment risks, arbitration, and speculation.

Understanding Exchange Rates

Exchange Rate Definition

The exchange rate of a currency is its price expressed in units of another currency.

Bid and Ask Prices

Exchange rates are typically quoted with two prices: a bid price for the buyer and an ask price for the seller. Participants in the market can assume a bivalent position, acting as both buyers and sellers (e.g., selling their national currency to buy another).

• Bid Price: This is the price an intermediary will pay to acquire your money. From your perspective, it's the price at which you can sell a currency.
• Ask Price: This is the price it will cost you to buy a specific currency from the intermediary. From your perspective, it's the price at which you can buy a currency.

The bid price is always lower than the ask price, representing the intermediary's spread.

Exchange Rate Quotation Systems

• Direct System: This system indicates the number of national currency units required to obtain one foreign currency unit.
  Example: €0.7724 / USD (meaning 0.7724 Euros for 1 US Dollar).
• Indirect System: This system indicates the number of foreign currency units that can be obtained for one national currency unit.
  Example: $1.2946 / € (meaning 1.2946 US Dollars for 1 Euro).

Types of Exchange Rate Regimes

Flexible Exchange Rate

A flexible exchange rate is determined by the forces of supply and demand within the foreign exchange market, without significant government intervention.

Fixed Exchange Rate

In a fixed exchange rate regime, the central bank sets the exchange rate with other currencies and actively intervenes in the foreign exchange market to maintain this predetermined rate.

Intermediate Exchange Rate

An intermediate exchange rate regime involves central banks intervening to a greater or lesser extent, allowing for some flexibility while still managing the rate.

Foreign Exchange Operations

Spot Operations

Spot operations are agreements for the immediate exchange of one currency at a determined rate, with the delivery or value date typically set for two business days after the agreement.

Forward Operations

Forward operations involve an agreement to exchange currencies at a fixed price over a specified future period, with a value date greater than two business days (e.g., 1, 2, 3, or 6 months). A forward contract for the purchase and sale of foreign currencies is a binding agreement, and therefore, compliance is mandatory.

Syndicated Loans

Definition of Syndicated Loans

A syndicated loan is a loan derived from an agreement between two or more financial institutions to jointly grant a debtor a loan, adhering to standard debt rules. This arrangement effectively disperses the risk among the group of participating banks.