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4.6. Foreign exchange market

There is a market that is closely related to the money market: the foreign exchange market (from here on foreign exchange is termed forex). This market, strictly speaking, is not a financial market, because lending and/or borrowing does not take place in this market. The forex market merely makes it possible to buy and/or sell forex.

It is important to understand what is meant by forex and buying and selling forex. Forex means:

• Foreign notes and coins.

• Foreign deposits and investments.

Foreign notes and coins are bought for the purpose of spending in a foreign country14. However, this is a tiny part of the forex market. The forex market is comprised mainly of the buying and selling and foreign deposits. This may sound a bit odd, but consider the situation of a Local Country (LC) export company. It receives payment for exports in the form of a deposit made by the foreign importer in a foreign bank deposit account. The exporter then sells this (exchanges this foreign deposit) for a domestic deposit (in the forex market).

Conversely, a LC importer company buys a foreign deposit in order to pay for imports, and pays for this by a debit to its domestic deposit account. Assuming that the foreign country is the UK, there is one UK bank, one LC bank, an exchange rate of GBP/LCC 10.00, and the amount is LCC 100 million, the respective balance sheets change as is shown in boxes 1-4.

BOX 1: LC EXPORTER (LCC MILLIONS)

LC EXPORTER (LCC MILLIONS)

BOX 2: LC IMPORTER (LCC MILLIONS)

Assets

+ 100

Equity and liabilities

Goods (imported)

Deposit at LC bank (pay for UK imports)

-100

Deposit at UK bank (bought with LCC)

+ 100

Deposit at UK bank (pay for imports)

-100

Total

0

Total 0

BOX 3: UK BANK (GBP MILLIONS)

Assets

Equity and liabilities

LC exporter deposit (from exporting)

+10

LC exporter deposit (sells for LC deposit)

-10

LC importer deposit (buys for importing)

+ 10

LC importer deposit (pays for imports)

-10

Total

0

0

BOX 4: LC BANK (LCC MILLIONS)

Assets

Equity and liabilities

LC exporter deposit

+ 100

LC importer deposit

-100

Total

0

Total

0

In this example the forex market cleared perfectly, i.e. demand and supply matched and there was no influence of the exchange rate. Following from the above, it will be evident that the case of a foreign investing, a deposit is bought in the first instance, in order to pay for the foreign investment.

There are two types of transactions in the forex market: spot and forward (called forwards) transactions. Spot means pay now, which has a different meaning in different countries, and forward means at a date in the future other than spot. The forward market is a derivative market (from the spot market). In addition these are other forex derivative markets, such as futures, options, swaps, etc.

The above should make it clear that the forex market is not a financial market in the sense that borrowing and lending takes place. Rather it is a conduit for:

• Foreigners into the domestic goods and services markets (domestic notes and coin and travelers' cheques), to the domestic deposit market (receipts / payments for imports / exports), and to domestic financial markets (debt and share markets) (via the deposit market)

• Residents into the foreign goods and services markets (foreign notes and coin and travelers cheques), to the foreign deposit market(receipts / payments for imports / exports), and foreign financial markets (debt and share markets) (via the deposit market)

financial markets

Figure 6: financial markets

However, even though the forex market is not a financial market in the sense that borrowing and lending takes place, it is a conduit to these markets, and the derivatives of this market are financial. Thus we will give it the status of a financial market.

We are now able to expand our illustration (see Figure 6). We now have four financial markets and need to add the fifth: the derivative markets.

 
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