Key Concepts of Foreign Exchange Markets

Why This Matters

Foreign exchange markets form the backbone of international finance, and understanding them is essential for analyzing how money flows across borders. You're being tested on more than just definitions—exams expect you to connect market structures, pricing theories, and risk management strategies to real-world scenarios involving trade, investment, and monetary policy. These concepts appear repeatedly in questions about financial institutions, international trade, and macroeconomic policy.

Don't just memorize what each market type does—know why it exists and how it relates to hedging, speculation, and exchange rate determination. When you understand the underlying mechanisms, you can tackle any FRQ asking you to compare instruments, explain currency movements, or evaluate central bank interventions. Master the connections between interest rates, purchasing power, and balance of payments, and you'll have the toolkit to analyze virtually any forex scenario.

---

Market Types and Trading Venues

Different forex markets serve distinct purposes, from immediate transactions to complex risk management. The key distinction is timing and customization—some markets handle spot needs while others let participants lock in future rates or manage long-term exposures.

Spot Market

• Immediate settlement at current rates—transactions typically complete within two business days, making this the most straightforward forex market
• Primary venue for urgent currency needs—businesses converting export revenues or tourists exchanging cash operate here
• Benchmark for all other forex instruments—forward rates, futures prices, and options premiums all derive from spot rates

Forward Market

• Customized contracts for future delivery—parties agree today on an exchange rate for a transaction occurring weeks or months ahead
• Over-the-counter (OTC) trading means contracts are negotiated directly between parties, offering flexibility but introducing counterparty risk
• Essential hedging tool for importers and exporters—a U.S. company expecting €1 million in 90 days can lock in today's rate to eliminate uncertainty

Currency Futures Market

• Standardized, exchange-traded contracts—unlike forwards, futures have set contract sizes, expiration dates, and are cleared through exchanges
• Reduced counterparty risk through margin requirements and daily mark-to-market settlement by clearinghouses
• Attracts both hedgers and speculators—standardization makes these instruments highly liquid and accessible to smaller participants

Currency Options Market

• Right without obligation to buy (call) or sell (put) currency at a specified strike price before expiration
• Asymmetric payoff structure—limits downside risk while preserving upside potential, unlike forwards which lock in a rate regardless of market movement
• Premium cost reflects flexibility—buyers pay upfront for the protection, making options more expensive but more versatile than forwards

Currency Swaps Market

• Exchange of principal and interest payments across currencies over time—not just a single future transaction but an ongoing arrangement
• Manages both currency and interest rate exposure—a company can convert floating-rate dollar debt into fixed-rate euro debt
• Used by multinationals and governments to access favorable borrowing terms in foreign markets without direct exposure

Interbank Foreign Exchange Market

• Decentralized network of major banks trading directly with each other—this is where the bulk of global forex volume occurs
• Sets benchmark rates that flow through to retail markets, corporate treasuries, and derivative pricing
• Operates 24 hours across global financial centers (London, New York, Tokyo, Singapore), ensuring continuous liquidity

Retail Foreign Exchange Market

• Individual traders and small businesses access forex through brokers and online platforms
• Wider bid-ask spreads compared to interbank rates—retail participants pay more for the convenience and smaller transaction sizes
• Lower liquidity and higher costs reflect the intermediation required to connect small traders to wholesale markets

---

Exchange Rate Systems

How a country manages its currency's value shapes everything from inflation to trade competitiveness. The spectrum runs from complete government control to pure market determination.

Exchange Rate Systems (Fixed, Floating, Managed Float)

• Fixed (pegged) systems tie currency value to another currency or basket—provides stability but requires large foreign reserves to defend the peg
• Floating systems let supply and demand determine rates—offers monetary policy independence but introduces volatility for businesses
• Managed float (dirty float) combines elements—markets generally set rates, but central banks intervene during extreme movements to prevent destabilization

---

Theories of Exchange Rate Determination

Exchange rates don't move randomly—economic theories explain why currencies appreciate or depreciate over time. These frameworks are heavily tested because they connect forex to inflation, interest rates, and trade flows.

Purchasing Power Parity Theory

• Law of one price extended to currencies—identical goods should cost the same across countries when converted at the exchange rate
• Explains long-term currency movements—if U.S. inflation exceeds European inflation, the dollar should depreciate against the euro over time
• Real-world limitations include trade barriers, transportation costs, and non-tradable goods that prevent perfect price equalization

Interest Rate Parity Theory

• Links interest rate differentials to forward rates—if U.S. rates exceed U.K. rates, the forward dollar should trade at a discount to prevent arbitrage
• Covered interest parity holds almost exactly due to arbitrage; uncovered interest parity involves expectations and holds less precisely
• Critical for understanding carry trades—investors borrowing in low-rate currencies to invest in high-rate currencies face exchange rate risk

Balance of Payments and Its Impact on Exchange Rates

• Comprehensive record of international transactions—current account (trade) plus capital/financial account (investment flows) should theoretically balance
• Persistent deficits pressure currencies downward—a country importing more than it exports creates excess supply of its currency
• Affects foreign exchange reserves—central banks may deplete reserves defending a currency against balance of payments pressures

Factors Affecting Exchange Rates

• Economic fundamentals drive expectations—GDP growth, inflation rates, and employment data signal currency strength or weakness
• Interest rate differentials attract capital flows—higher rates draw foreign investment, increasing demand for the domestic currency
• Political stability and policy credibility influence investor confidence—uncertainty triggers capital flight and depreciation

---

Risk Management and Market Interventions

Currency volatility creates both opportunities and dangers. Understanding how participants manage risk and how authorities intervene is essential for analyzing market stability.

Foreign Exchange Risk and Hedging Strategies

• Three types of exposure—transaction risk (contractual cash flows), translation risk (accounting values), and economic risk (competitive position)
• Hedging instruments include forwards, futures, options, and swaps—each offers different trade-offs between cost, flexibility, and protection level
• Natural hedging through operational decisions (matching revenue and cost currencies) complements financial hedging

Central Bank Interventions in Forex Markets

• Direct intervention involves buying or selling currency in open markets to influence the exchange rate
• Indirect intervention through interest rate changes affects currency demand—raising rates typically strengthens the currency
• Sterilized vs. unsterilized intervention—sterilized operations offset the money supply impact, limiting effectiveness but avoiding inflation consequences

Currency Crises and Speculative Attacks

• Self-fulfilling dynamics can trigger crises—if traders believe a peg will break, their selling pressure can force the outcome they anticipated
• Warning signs include overvalued currencies, large current account deficits, and declining foreign reserves
• Severe economic consequences follow crises—inflation spikes, credit tightens, and recessions often result from rapid depreciation

---

Quick Reference Table

---

Self-Check Questions

1. Which two forex instruments both lock in future exchange rates, and what key feature distinguishes them in terms of counterparty risk?

2. A company expects to receive payment in a foreign currency in 60 days but wants protection against depreciation while preserving the ability to benefit if the currency appreciates. Which instrument should they use, and why?

3. Compare purchasing power parity and interest rate parity: which theory would you apply to explain why a country with persistently higher inflation sees its currency weaken over time?

4. If an FRQ describes a central bank selling foreign reserves to support its currency, what type of intervention is this, and what risk does the central bank face if the pressure continues?

5. How does the balance of payments connect to exchange rate movements, and why might a country with a large current account deficit experience currency depreciation?