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Investment - The Foreign Exchange Market
The foreign exchange market is where currencies are traded. It is incredibly active and liquid, with an average of USD6.6 trillion moved globally every day. It is not situated in one area but is a highly integrated decentralized electronic network that connects buyers and vendors.
Foreign Exchange Rate Quotes
If you have ever converted currency, maybe at the airport, you are already aware that a bank or currency dealer always displays two conversion rates for a certain currency.
Bid Exchange Rate
The bid exchange rate, or bid rate, is the exchange rate at which the bank or currency dealer will buy the foreign currency.
Offer Exchange Rate
The offer exchange rate, or offer rate, also termed the ask exchange rate (or ask rate), is the exchange rate at which the bank or dealer will sell the foreign currency.
The difference between the bid and offer (ask) rates is known as the bid–offer spread, or bid–ask spread. The bid–offer spread is how the bank or currency dealer makes money, profiting by buying a unit of currency for less than they sell it.
The bid–offer spread will fluctuate from bank to bank, from currency to currency, and according to market conditions. The more a currency is traded, which implies better liquidity, the tighter the bid–offer spread.
Spot and Forward Markets
Foreign exchange transactions may take place in the spot market or in the future market.
Spot market
The spot market is where currencies are traded now and delivered instantly. An example of a spot market transaction would be an individual trading currency at an airport, like in the case above. The exchange rate for the transaction is termed the spot exchange rate, or spot rate.
Forward market
In contrast, the forward market is where currencies are traded at agreed on exchange rates today but are delivered at some future period, such as in one month or in two months. The exchange rate for the transaction is termed the forward exchange rate, or forward rate.
In many circumstances, investors or organizations desire to lock in an exchange rate today for a currency transaction that will occur at a later date. The objective for doing so is to eliminate currency rate risk between now and the transaction date.
Let us return to the example of the French grocery chain buying dairy products from the United Kingdom for GBP100,000. If the French supermarket needs to make the payment now and convert euros into pounds quickly, the transaction will occur in the spot market at the spot rate.
In the commercial world, however, many suppliers grant credit to their clients, allowing payment for today’s transactions at some point in the future.
Assume that the French grocery company has two months to pay its UK dairy producers. By waiting until the end of the two months to trade, the French grocery chain confronts uncertainty regarding the exchange rate that will exist at that time. In other words, the French supermarket chain is exposed to currency risk because of potential adverse movements in the EUR/GBP exchange rate.
Alternatively, the French retail chain can enter the forward market and can lock in the currency rate at which it will pay the invoice in two months. By doing so, it eliminates the currency risk, no matter how much the euro changes compared to the pound in the next two months.
For example, if the prevailing two-month forward rate for delivery in two months is EUR1.21/GBP1, the French grocery chain can lock in that exchange rate and know with certainty that it will require EUR121,000 to acquire the GBP100,000 necessary to pay its UK dairy farmers.
Gaining assurance enables organizations to assure that they can meet future cash expenditures, such as operating expenses and interest payments. Could it be the fact that the French retail company could have secured a more favourable exchange rate by waiting two months? Sure, but it could have also received a less favourable one. Locking in currency rates in the forward market assures the predictability of cash flows and profitability.
The foreign exchange market is where currencies are traded. It is incredibly active and liquid, with an average of USD6.6 trillion moved globally every day. It is not situated in one area but is a highly integrated decentralized electronic network that connects buyers and vendors.
Foreign Exchange Rate Quotes
If you have ever converted currency, maybe at the airport, you are already aware that a bank or currency dealer always displays two conversion rates for a certain currency.
Bid Exchange Rate
The bid exchange rate, or bid rate, is the exchange rate at which the bank or currency dealer will buy the foreign currency.
Offer Exchange Rate
The offer exchange rate, or offer rate, also termed the ask exchange rate (or ask rate), is the exchange rate at which the bank or dealer will sell the foreign currency.
The difference between the bid and offer (ask) rates is known as the bid–offer spread, or bid–ask spread. The bid–offer spread is how the bank or currency dealer makes money, profiting by buying a unit of currency for less than they sell it.
The bid–offer spread will fluctuate from bank to bank, from currency to currency, and according to market conditions. The more a currency is traded, which implies better liquidity, the tighter the bid–offer spread.
Spot and Forward Markets
Foreign exchange transactions may take place in the spot market or in the future market.
Spot market
The spot market is where currencies are traded now and delivered instantly. An example of a spot market transaction would be an individual trading currency at an airport, like in the case above. The exchange rate for the transaction is termed the spot exchange rate, or spot rate.
Forward market
In contrast, the forward market is where currencies are traded at agreed on exchange rates today but are delivered at some future period, such as in one month or in two months. The exchange rate for the transaction is termed the forward exchange rate, or forward rate.
In many circumstances, investors or organizations desire to lock in an exchange rate today for a currency transaction that will occur at a later date. The objective for doing so is to eliminate currency rate risk between now and the transaction date.
Let us return to the example of the French grocery chain buying dairy products from the United Kingdom for GBP100,000. If the French supermarket needs to make the payment now and convert euros into pounds quickly, the transaction will occur in the spot market at the spot rate.
In the commercial world, however, many suppliers grant credit to their clients, allowing payment for today’s transactions at some point in the future.
Assume that the French grocery company has two months to pay its UK dairy producers. By waiting until the end of the two months to trade, the French grocery chain confronts uncertainty regarding the exchange rate that will exist at that time. In other words, the French supermarket chain is exposed to currency risk because of potential adverse movements in the EUR/GBP exchange rate.
Alternatively, the French retail chain can enter the forward market and can lock in the currency rate at which it will pay the invoice in two months. By doing so, it eliminates the currency risk, no matter how much the euro changes compared to the pound in the next two months.
For example, if the prevailing two-month forward rate for delivery in two months is EUR1.21/GBP1, the French grocery chain can lock in that exchange rate and know with certainty that it will require EUR121,000 to acquire the GBP100,000 necessary to pay its UK dairy farmers.
Gaining assurance enables organizations to assure that they can meet future cash expenditures, such as operating expenses and interest payments. Could it be the fact that the French retail company could have secured a more favourable exchange rate by waiting two months? Sure, but it could have also received a less favourable one. Locking in currency rates in the forward market assures the predictability of cash flows and profitability.
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