This PPT provides an in-depth exploration of the foreign exchange market, which serves as the backbone of international trade and finance. It delves into the nature, structure, and participants of the foreign exchange market, along with various types of exchange rate quotations and regimes. Additionally, the unit examines the intricate relationship between nominal, real, and effective exchange rates, offering insights into exchange rate determination theories and phenomena such as exchange rate overshooting and the J curve effect. Topics Covered: Nature of the Foreign Exchange Market: This section elucidates the fundamental characteristics of the foreign exchange market, including its high liquidity, market transparency, and dynamic nature, along with its operation 24/7 and the range of currencies traded. Structure of the Foreign Exchange Market: Here, the unit explores the organizational framework of the foreign exchange market, encompassing the roles of various participants such as banks, financial institutions, corporations, and individual traders. Participants in the Foreign Exchange Market: This section provides an overview of the diverse participants involved in the foreign exchange market, including commercial banks, central banks, brokers and retail traders. Types of Exchange Rate Quotations: The unit examines different types of exchange rate quotations, including direct and indirect quotations. Exchange Rate Regimes: This section delves into the different exchange rate regimes employed by countries, ranging from fixed and floating exchange rate systems to managed floats, currency boards, and crawling pegs. Nominal, Real, and Effective Exchange Rates: The unit explores the intricate interplay between nominal, real, and effective exchange rates, elucidating their definitions, determinants, and implications for international trade and finance.

1. FOREIGN EXCHANGE
MARKET
BY GOLDY SINGH

2. TOPICS
1. INTRODUCTION
2. Nature of foreign exchange market
3. Structure of foreign exchange market
4. Participants in foreign exchange market
5. Types of exchange rate quotations
6. cross currency rates
7. spot rate
8. Forward rates
9. Bid ask spread
10. official exchange rate
11. free market rates
12. Nominal exchange rates
13. Real exchange rates
14. Effective exchange rates
15. Exchange rate regimes.
2

3. INTRODUCTION
The foreign exchange (forex) market is a global decentralized or over-the-
counter (OTC) market for the trading of currencies. It determines the relative
values of different currencies and facilitates the exchange of one currency for
another. Participants in the forex market include banks, financial institutions,
corporations, governments, and individual traders. Transactions in the forex
market occur electronically over-the-counter through computer networks
between traders around the world, allowing for 24-hour trading during
weekdays. The forex market is crucial for international trade and investment,
as well as for speculation and hedging against currency risk.
3

4. NATURE OF FOREIGN EXCHANGE
MARKET
 High Liquidity: The foreign exchange market is highly liquid, meaning that there is a high
volume of trading activity, allowing traders to buy and sell currencies quickly without
significantly affecting their prices.
 Market Transparency: The forex market is relatively transparent, with price quotes readily
available to market participants. This transparency helps ensure fair pricing and efficient market
operations.
 Dynamic Market: The forex market is dynamic, with exchange rates constantly fluctuating in
response to various factors such as economic indicators, geopolitical events, and market
sentiment. This dynamism provides opportunities for traders to profit from price movements.
 Operates 24/7 Hours: Unlike stock markets that have specific trading hours, the forex market
operates 24 hours a day, five days a week, across different time zones. This continuous
operation allows traders to participate in the market at any time, increasing flexibility and
accessibility.
4

5.  Currencies Traded: The primary function of the forex market is to facilitate the exchange of
one currency for another. Major currencies such as the US dollar, euro, Japanese yen,
British pound, and Swiss franc are actively traded, along with numerous minor and exotic
currencies.
 Decentralization: The forex market is decentralized, meaning that there is no central
exchange or clearinghouse. Instead, trading takes place electronically over-the-counter
(OTC) through a network of banks, brokers, and other financial institutions.
 Price Determination: Exchange rates in the forex market are determined by supply and
demand forces, with prices constantly adjusting to reflect market conditions. Factors
influencing exchange rates include interest rates, inflation, economic growth, geopolitical
events, and central bank policies.
 Risk Management: Risk management is essential in the forex market due to the inherent
volatility and uncertainty. Traders use various tools and strategies to manage risks, such as
stop-loss orders, hedging, diversification, and position sizing, to protect their capital from
adverse market movements.
5

6. 6

7. PARTICIPANTS IN FOREIGN EXCHANGE
MARKET
Central Banks
Brokers
Commercial Banks
Exporters, Importers, Tourists,
investors and immigrants
7

8. TYPES OF EXCHANGE RATE
QUOTATIONS
8
Direct Exchange Rate Quotation:
In a direct quotation, the domestic
currency is expressed in terms of a
foreign currency. This means stating
how much of the foreign currency is
needed to buy one unit of the domestic
currency. Direct exchange rate
quotations are more commonly used in
countries where the domestic currency
is not the US dollar.
Example: If the exchange rate between
the US dollar (USD) and the euro
(EUR) is 0.85, it means that 1 USD is
equal to 0.85 EUR. This is a direct
quotation expressed in terms of the
euro.
Indirect Exchange Rate Quotation:
In an indirect quotation, the foreign
currency is expressed in terms of the
domestic currency. This means stating
how much of the domestic currency is
needed to buy one unit of the foreign
currency. Indirect exchange rate
quotations are more commonly used
in countries where the domestic
currency is the US dollar.
Example: If the exchange rate
between the US dollar (USD) and the
British pound (GBP) is 0.72, it means
that 1 GBP is equal to 0.72 USD. This
is an indirect quotation expressed in
terms of the US dollar.

9. CROSS CURRENCY RATES
 Cross currency rates, also known as cross rates, refer to the
exchange rates between two currencies that do not involve the US
dollar. In other words, cross currency rates are exchange rates for
currency pairs that are not directly quoted in the foreign exchange
market.
 Cross currency rates are calculated using the exchange rates of
each currency pair against a common third currency. This process
is known as triangulation. The most common method for
calculating cross currency rates is through the use of the bid and
ask prices of the two currency pairs involved.
9

10. SPOT RATE
 The spot rate, also known as the spot exchange rate, is the current exchange rate at
which currencies can be bought or sold for immediate delivery or settlement. It reflects
the current market price of a currency pair.
 Spot rates are used for immediate transactions, such as converting currency for travel
expenses, international trade settlements, and financial transactions requiring
immediate currency exchange.
 Spot rates are determined by supply and demand forces in the foreign exchange
market, influenced by factors such as interest rates, inflation, economic indicators,
geopolitical events, and market sentiment.
 Spot rates are quoted with a bid price (the price at which buyers are willing to purchase
the currency) and an ask price (the price at which sellers are willing to sell the currency).
10

11. FORWARD RATES
 Forward rates represent the exchange rates agreed upon today for the future
delivery or settlement of a currency pair at a specified date in the future.
 Forward rates are used for hedging against future exchange rate fluctuations,
managing currency risk, and executing long-term financial transactions, such as
forward contracts and future payments.
 Forward rates are determined by the spot rate and the interest rate differentials
between the two currencies involved in the transaction. Specifically, they are
calculated using the concept of interest rate parity (IRP).
 Forward rates may trade at a premium (forward premium) or a discount (forward
discount) relative to the spot rate, depending on whether the domestic currency has a
higher or lower interest rate than the foreign currency.
 Forward contracts are agreements between two parties to exchange currencies at a
specified future date (maturity date) and at a predetermined exchange rate (the
forward rate) agreed upon today.
11

12. BID ASK SPREAD
The bid-ask spread is a fundamental concept
in financial markets, including the foreign
exchange market, and it represents the
difference between the prices at which a
market maker or broker is willing to buy (bid)
and sell (ask) a financial instrument, such as a
currency pair.
12

13. OFFICIAL EXCHANGE RATE
 The official exchange rate, also known as the nominal exchange rate, is a
rate set by the government or central bank of a country.
 Governments or central banks typically use the official exchange rate for
official transactions, such as international trade, government expenditures,
and foreign exchange reserves management.
 Official exchange rates are often fixed or pegged to a specific value, such
as another currency (e.g., US dollar), a basket of currencies, or a
commodity (e.g., gold).
 Governments may intervene in the foreign exchange market to maintain the
official exchange rate within a certain range by buying or selling currencies.
13

14. FREE MARKET RATES
 Free market rates, also known as market-determined rates or floating exchange
rates, are determined by supply and demand forces in the foreign exchange market.
 In a free market system, currency prices are determined by the interaction of buyers
and sellers without government intervention.
 Market participants, including banks, financial institutions, corporations, and
individual traders, buy and sell currencies based on factors such as economic
indicators, interest rates, inflation, geopolitical events, and market sentiment.
 Free market rates fluctuate continuously in response to changes in market
conditions, reflecting the relative strength or weakness of a country's economy and
currency.
 Countries with free market rates allow their currencies to float freely against other
currencies, adjusting to market forces without fixed exchange rate regimes.
14

15. NOMINAL EXCHANGE RATES
 The nominal exchange rate is the rate at which one currency
can be exchanged for another, typically expressed as the price
of one currency in terms of another.
 It represents the relative value of two currencies in the foreign
exchange market.
 The nominal exchange rate reflects changes in supply and
demand for currencies, as well as government policies such
as exchange rate interventions.
 Example: If 1 US dollar (USD) can be exchanged for 0.85
euros (EUR), the nominal exchange rate is 0.85 USD/EUR.
15

16. REAL EXCHANGE RATE
 The real exchange rate adjusts the nominal exchange rate for differences in price
levels (inflation) between two countries.
 It represents the relative purchasing power of two currencies, accounting for
differences in the cost of goods and services between countries.
 The real exchange rate is calculated as the nominal exchange rate multiplied by the
ratio of the price levels (inflation rates) between the two countries.
 A higher real exchange rate indicates that a country's goods and services are
relatively cheaper compared to its trading partners, making its exports more
competitive.
 Example: If the nominal exchange rate is 0.85 USD/EUR and the US inflation rate is
2% while the Eurozone inflation rate is 1.5%, the real exchange rate can be calculated
as (0.85 * (1 + 0.02)) / (1 + 0.015).
16

17. EFFECTIVE EXCHANGE
RATE
 The effective exchange rate, also known as the trade-weighted exchange
rate, is a measure of the value of a country's currency relative to a basket of
other currencies, weighted by the importance of each currency in the
country's international trade.
 It provides a broader and more comprehensive view of a country's currency
performance compared to a single nominal exchange rate..
 Changes in the effective exchange rate reflect changes in a country's overall
competitiveness in international trade.
 Example: If a country trades with multiple partners such as the US,
Eurozone, China, and Japan, the effective exchange rate would consider the
trade weights of these currencies in calculating the overall value of the
country's currency.
17

18. EXCHANGE RATE REGIMES
 Free Float
 Managed Float
 Fixed-but-adjustable Exchange Rate
 Currency Board
 Full ‘dollarization’
18