Currency exchange
Currency exchange refers to the process of trading one currency for another, primarily occurring in the foreign exchange (FX) market. The value of a currency compared to another is expressed through exchange rates, which are influenced by various factors including supply and demand dynamics, international trade, capital flows, and political events. These exchange rates can be categorized into fixed rates, where a currency is pegged to a major currency like the U.S. dollar, and floating rates, which are determined by market forces.
The FX market is one of the largest financial markets globally, featuring a diverse array of participants, including banks, investors, and governments. In this market, various financial products are traded, such as currency forward and futures contracts, options, and swaps. These products allow participants to hedge risk or speculate on currency movements. Understanding the complexities of currency exchange and the factors affecting exchange rates is crucial for businesses and investors engaging in international transactions or investments. This overview presents a fundamental insight into currency exchange, highlighting its importance in the global economy.
Currency exchange
Summary: Mathematical models seek to price financial products in the foreign exchange market.
The term “currency exchange” refers to the business transaction that trades one currency for another. Such a transaction happens in the foreign exchange (FX) market and is measured by foreign exchange rates, which are often called exchange rates. Exchange rates fluctuate all the time. There are many factors that influence the movements of exchange rates. After all, foreign exchange rates are largely determined by the supply and demand in the FX market. Numerous mathematical models have been proposed by financial mathematicians and financial engineers to price different financial products in the FX market. Some of them have been used successfully by practitioners.
Exchange Rate Definition
There are many different currencies in the world. A measurement of the value of one currency in terms of another is called a (foreign) “exchange rate” or a “currency rate.” In simple terms, an exchange rate of K currency X to currency Y means the value of K units of currency X is equivalent to the value of 1 unit of currency Y. It is often quoted as the price of currency X divided by currency Y is K. For example, the price of “euros/U.S. dollars is 1.3578” denotes an exchange rate of 1.3578 U.S. dollars to euros. In other words, it means the value of 1 euro is the same as that of 1.3578 U.S. dollars.
Types of Exchange Rates
A fixed exchange rate (also known as “pegged rate”) means one currency is pegged to a major currency such as the U.S. dollar. Usually, the government or the central bank of a country will intervene in the market to peg its currency to a major currency to maintain a fixed exchange rate.
In contrast, a floating exchange rate is determined by the market forces of demand and supply.
Exchange Rate Fluctuation
Fluctuation of exchange rates, like fluctuation of stock prices, interest rates, and many other economic indices, is a ubiquitous phenomenon. Many factors drive the exchange rates up and down. These factors include but are not limited to capital flows, international trades, speculation, political factors, government or central bank intervention, and interest rates. However, the fundamental driving force is the invisible hand—the demand and supply—of the market.
Besides those quantifiable drivers of the FX market, there are other nonquantifiable ones such as the expectation of the investors. Attempts have been made by economists to account for those driving forces as well. Some economists have put the theory of exchange rate into a behavioral finance framework. Others used information theory and game theory.
FX Markets and FX Financial Products
The FX market is where the currency exchange happens, and is one of the largest financial markets in the world. Its major participants include commercial banks, investment banks, companies, investors, hedgers, speculators, traders, governments, and central banks. A variety of financial instruments are traded in the FX market, including currencies, currency forward contracts (also known as “FX forward contracts”), currency futures contracts (also known as “FX futures contracts”), currency options (also known as “FX options”) and currency swaps (also known as “FX swaps”). Thus, the FX market has several important submarkets: the FX spot market, the FX forward market, the FX futures market, the FX options market, and the FX swaps market.
Although hundreds of financial products exist in the FX market, the basic ones are currencies, currency forward contracts, currency futures contracts, currency options, and currency swaps. Currencies are priced by the exchange rates. Both currency forward contracts and currency futures contracts are agreements made between two parties to exchange a specified amount of currency for a specified price at a specific future date. The main difference is that a currency forward contract is traded over the counter, whereas a currency futures contract is traded on an exchange. They both are financial derivatives. Their prices can be determined using simple algebra and are expressed in terms of exponential functions. Currency options and currency swaps are also financial derivatives. A currency call/put option gives one party the right—but not the obligation—to buy or sell a specific amount of the currency at a price (called “strike price”) at a specific time in the future.
A European option can be exercised only at maturity, whereas an American option can be exercised at any time up to maturity. The cash flows of currency options are more complicated than those of the currency forward and currency futures contracts. The pricing requires sophisticated mathematical tools from stochastic calculus. Fisher Black, Myron Scholes, and Robert C. Merton made fundamental contributions in option pricing by giving the basic pricing formulas of European options. Scholes and Merton were awarded the Nobel Prize in Economics for this accomplishment in 1997 (Black was not awarded the prize because he had passed away).
A currency swap is an agreement between two parties to exchange the principal and interests of one currency at an interest rate for the principal and interests of another currency at another interest rate for a certain period of time. For example, suppose party A enters into a currency swap contract with party B today. For the next five years, party A will pay party B the interest of a principal of $1 million at an annual interest rate of 5%. In return, party B will pay party A the interest of a principal of 95 million Japanese yen at an annual interest rate of 4.5%. The two parties will also exchange the principals at the end of the fifth year. Like currency forward and currency futures contracts, the currency swap can also be priced using simple algebra.
Bibliography
De Grauwe, Paul. The Exchange Rate in a Behavioral Finance Framework. Princeton, NJ: Princeton University Press, 2006.
Driver, Rebecca, Peter Sinclair, and Christoph Thoenissen. Exchange Rates, Capital Flows and Policy. New York: Routledge, 2005.
Hull, John C. Options, Futures and other Derivatives. 7th ed. Upper Saddle River, NJ: Pearson Education, 2008.
McDonald, Robert L. Derivatives Markets. 2nd ed. Upper Saddle River, NJ: Pearson Education, 2006.
Rosenberg, Michael R. Exchange Rate Determination: Models and Strategies for Exchange-Rate Forecasting. New York: McGraw-Hill, 2003.
Weithers, Tim. Foreign Exchange. Hoboken, NJ: Wiley, 2006.