Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 11 - The Foreign Exchange Market

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter eleven.

Chapter Introduction

The foreign exchange market is where the various national currencies are bought and sold. In this chapter we examine the various participants in the market and the basic forces that operate within it. We examine the basic determinants of exchange rate behaviour and in particular look at the crucial role played by exchange rate expectations in the determination of exchange rates. We then look at the operational differences between fixed and floating exchange rate regimes, concluding with an examination of the relationship between the spot and forward exchange rates.

One of the most fascinating things about the foreign exchange market is the huge sums of money that are exchanged on a daily basis, and Table 11.1 shows the result of surveys carried out by the Bank for International Settlements (BIS). The main centre for foreign exchange trading is London with some $1,359 billion worth of foreign exchange traded on a daily basis in 2007, which is quite a lot when one considers that the annual gross domestic product of the UK is less than twice that amount. The global total is nearly $4 trillion per day.

Learning Objectives

In this chapter you will learn about:
  • The difference between the spot and forward exchange rate
  • How arbitrageurs, speculators and hedgers use the foreign exchange market
  • The difference between fixed and floating exchange rate regimes
  • How to calculate the forward exchange rate using the covered interest rate parity formula
  • How to calculate and interpret the nominal and real exchange rate index
  • How to calculate and interpret the nominal and real effective exchange rate indices

Further Reading

Chen, J. (2009) Essentials of Foreign Exchange Trading, Wiley.

Shamah, S.A. (2008) Foreign Exchange Primer, Wiley.

Walmsley, J. (2000) The Foreign Exchange and Money Markets Guide, 2nd edn, Wiley.

Multiple Choice Questions

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