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• 1 The foreign exchange market

• 1.3 Characteristics and participants of the foreign exchange market

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• Who are the main participants of the foreign exchange market?

  1. Retail clients - businesses, investors, corporations (do not directly purchase/sell currencies but place orders at banks) 
  
  2. Commercial banks: carry out the orders from their clients and buy/sell currencies on their own account to change the structure of their assets and liabilities in different currencies (proprietary trading) 
  
  3. Foreign exchange brokers: collect, buy and sell quotations for most currencies from banks (for a brokerage fee) 
  
  4. Central banks: intervene frequently to buy and sell their currencies in a bid to influence the exchange rate. (Under a fixed rate system they are supposed to intervene) 

• 1.4 Arbitrage in the foreign exchange market

• What are two kinds of arbitrage in the foreign exchange market? (Exploitation of price differences for riskless profit)

  1. Financial centre arbitrage: ensures that the dollar/ pound exchange rate in New York will be the same as in other financial centres
  
  2. Cross currency arbitrage: currency arbitrage implies that the exchange rate of the euro against the pound will be different

• 1.5 The spot and the forward exchange market

• What is the spot exchange rate?

  The quotation between two currencies for immediate delivery (S)

• What is the forward exchange rate?

  Price for a transaction later (forward contract), the possibility for economic agents to agree today on an exchange rate at a specific time in the future (F)

• 1.6 Nominal, real and effective exchange rates

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• What is the definition of nominal exchange rate?

  The exchange rate which prevails at a given date. 
  = merely the price of one currency in terms of another with no reference made to what this means in terms of purchasing power. 

• What is the definition of the real exchange rate?

  The real exchange rate is the nominal exchange rate adjusted for relative prices between countries.
  --> It monitors changes in a country's competitiveness. 

• What is the definition of the effective exchange rate?

  The effective exchange rate is a measure of whether or not the currency is appreciated or depreciated against a weighted basked of foreign currencies. (Nominal effective exchange rate does not take into account price movements)

• 1.8 Alternative exchange rate regimes

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• Why is appreciation/depreciation of the exchange rate undesirable for an economy?

  Appreciation: could hit the economy's exports
  Depreciation: could lead to a rise in the cost of imports and endanger the bank's inflation target

• 1.9 The determination of the forward exchange rate

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• What is the definition of the forward exchange market?

  Where buyers and sellers agree to exchange currencies at some specified date in the future.

• Which economic agents are involved in the forward exchange market?

  1. Hedgers: agents that enter the forward exchange market to protect themselves against fluctuations and exchange rate risk. The trader can be sure of the number of pounds they will receive
  
  2. Arbitrageurs: agents that aim to make riskless profit out of discrepancies between interest rate differentials and what is known as the forward discount or forward premium. 
  
  3. Speculators: agents that hope to make a profit by accepting exchange rate risk. They believe that the future spot rate corresponding to the date of the quoted forward exchange rate will be different from the quoted forward rate