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Learning Goals: Understand the meaning and functions of the foreign exchange market Know what the spot, forward, cross, and effective exchange rates are Understand the meaning of foreign exchange risks, hedging, speculation, and interest arbitrage Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Introduction Foreign Exchange Market Where individuals, firms and banks buy and sell foreign currencies or foreign exchange. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Functions of the Foreign Exchange Markets 1. Transfer purchasing power from one nation and currency to another. Demand for currency arises when: Tourists visit another country Domestic firm wants to import from other countries Individual wants to invest abroad Supply of currency arises from: Foreign tourist expenditures Export earnings Receiving foreign investments Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Functions of the Foreign Exchange Markets 2. Provide credit for foreign transactions Credit is needed when goods are in transit, and to allow the buyer time to resell the goods to make the payment. 3. Provide the facilities for hedging and speculation. About 90% of foreign exchange trading reflects purely financial transactions, and only about 10% trade financing. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc. Functions of the Foreign Exchange Markets Participants Those needing currency to fund transactions Tourists, importers, exporters, investors, etc. Commercial banks Serve as the clearinghouses for currency exchange Foreign exchange brokers Clearinghouse for surpluses and shortages between the commercial banks Central banks Buyer or seller of last resort in the foreign exchange market Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
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