International foreign exchange market is one of the main components which is coming under the international financial market. Foreign exchange market is the market in which the currencies are exchanged. In this article I am going to cover four major parts under the international foreign exchange market. They are;
- History of Foreign Exchange
- Foreign Exchange Transactions
- Foreign Exchange Quotations
- Interpreting the Foreign Exchange Quotation
1.0 History of foreign exchange
System of currency exchanging was evolved as follows.
Under gold standards each currency was able to be converted into gold at a specific rate and the exchange rate between countries was determined based on the relative convertibility of the rates per ounce of gold.
After that, the exchange rate system shifted to fixed exchange rate system. Under the fixed exchange rates the government intervenes to the process of exchanging currencies in order to make sure that the established exchange rates between currencies are not deviated from the established exchange rates. Two agreements naming Bretton Woods agreement, Smithsonian Agreements were formed to execute this exchange rate system.
Finally the floating exchanging rate system was introduced by eliminating the boundaries introduced by the Smithsonian Agreement.
2.0 Foreign exchange transactions
Usually to conduct the foreign exchange transactions, there are no specific building or locations where traders can come together and exchange currencies. This exchange of currencies happens via Commercial banks over a network of telecommunications and mainly through the Over The Counter (OTC) market.
Most of the foreign currency transactions happen for immediate exchange and the market in which these transactions occur is known as the spot market and the rate at which the currencies are exchanged in the spot market is known as the spot rate.
2.1 Spot market structure
The transactions in the spot market usually are done by the banks electronically. When executing such transactions banks do not just execute those transactions but also act as foreign exchange dealers. Foreign exchange dealers are the ones who serve as intermediaries in the foreign exchange market by facilitating the process of exchanging currencies between countries.
When acting as an intermediary in the process of exchanging currencies; the banks sometimes will experience shortages in currencies. In that case they can purchase that particular currency for which the shortage is prevailing from another bank and this market where the trading between and among banks occurs is known as the Inter-bank market.
2.2 Spot market liquidity
The liquidity of a spot market depends on the number of buyers and the sellers in the market. Larger the number of buyers and the sellers in the market that market is said to be a liquid market and vise versa.
3.0 Foreign exchange quotations
Foreign exchange rates can be quoted in two ways. They are as follows.
- Direct quotation
- Indirect quotation
3.1 Direct quotation
Under this method we states the number of units of home currencies per unit of a foreign currency.
In Sri Lanka we use this direct quotation method.
And when you are given the value of a dollar in terms of rupees you can convert this value into the value of a rupee in terms of Dollars as follows.
3.2 Indirect quotation
Stating the number of units of foreign currencies per unit of home currency is known as the indirect method.
When you are given the value of a rupee in terms of dollars you can convert that into a value of dollar in terms of rupees as follows.
Bid ask spread
Banks charge a fee for conducting foreign exchange transactions in the foreign exchange market and due to this fee, the ask quote ( selling price of a particular currency ) is always higher than the bid quote ( buying price of a particular currency ) .
There fore the bid ask spread is the difference between the ask quote and the bid quote of a particular currency and that can be calculated as follows.
Bid ask spread =( ask quote-bid quote)/ ask quote
Factors that affect the spread
1. Order cost
Order cost is the cost that the banks should incur in order to process the transactions and it includes costs such as clearing cost and the cost of recording transactions.
2. Inventory cost
This cost includes the opportunity cost of holding an inventory of a particular currency.
3. Competition and the volume
If the market is liquid competition is high and the volume of the transactions are large. So higher the competition lower the spread and larger the volume lower the spread.
4. Currency risk
If a particular currency is subjected to frequent fluctuations it exhibits a currency risk and when the currency risk Is higher the spread will be higher too.
4.0 Interpretation of foreign exchange quotations
An upward movement of a direct exchange rate of a dollar is known as an appreciation.
A downward movement of a direct exchange rate of a dollar is known as a depreciation.
When there is an upward movement in the direct exchange quotation method there is a downward movement in the indirect quotation method and vice versa.
Cross exchange rates
Exchange rate between two non-dollar currencies is known as the cross exchange rates.
In this article we mainly focused on international forex market which is one of the main components of the international financial markets and we mainly touched four areas starting from history. There we discussed about gold standards, fixed exchange rate agreements and floating rate systems too.
We gained a little knowledge on spot market under the foreign exchange transactions and under the foreign exchange quotations we talked about the two ways in which the exchange rates can be quoted. They are direct quotation and the indirect quotation. Finally we discussed about the ways in which the quotation methods are interpreted. Additionally we talked about the bid ask spread and how it is calculated too. At the same time this article made a platform to discuss about the factors that affect on the spread as well.