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From 1876 to 1913 each currency was convertible to gold at a specified rate & thus exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold. Suspended during World War-I during 1914.

In 1930s some countries pegged their currencies to the dollar or pound, but due to instability in FE market, system did not work.

In 1944, Bretton Woods Agreement called for fixed exchange rates between currencies, which lasted till 1971. During this period, governments would intervene to prevent exchange rates from moving more than 1 % above or below their initially established levels. In 1971, US $ was overvalued foreign demand was less than supply (to be exchanged for other currencies) Exchange rates were allowed to fluctuate by 2.25% in either direction from newly set rates.

Even after various efforts, governments still had difficulty maintaining exchange rates within stated boundaries. By March 1973, the more widely traded currencies were allowed to fluctuate in accordance with the market forces & the official boundaries were eliminated.

The foreign exchange market is the place where one currency is bought or sold for another currency.

Transfer of purchasing power. o Hedging facilities. o Reducing foreign exchange risks: the risk exist that the exchange values of national currency may fluctuate i.e. transaction exposure. o Obtain or provide credit for international trade transactions.
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Its trading volume. o The extreme liquidity of the market. o The large number & variety of, traders in the market. o Its geographical dispersion. o Its long trading hours-24hrs a day(except on weekends). o The variety of factors that affects exchange rate.
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A foreign exchange rate is the price of one currency expressed in terms of another currency.

A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency referring to Cross Exchange Rate. Both the Mexican Peso (Ps) and the Nepalese rupee(NPR) are commonly quoted against US $. Assume the following quotes .09760$=1MXN 0.01358$=1NPR:
Cross Rate =

Mexican Peso/ US Dollar Nepalese rupee/ US Dollar = 1MXN/.09760 $ 1NPR /.01358 $ = 0.1391 MXN/NPR

Foreign currency dealers provide two quotes: Bid Price: Price at which the dealer is willing to buy foreign currency. Ask Price: Price at which the dealer is willing to sell foreign currency.

Banks act as market makers and realise their profits from the spread which is the difference between the bank bid and ask quote called bid and ask spread:
Bid-Ask Spread = (Ask-Bid)/Ask

% spread

1.4484 1.4482
1.4484

100 1.38%

 Prices

of currencies can fluctuate just as prices of goods. Currency appreciations and depreciations Appreciation: when a currency increases in a value related to other currency. Depreciation: when a currency decreases in a value related to other currency.

 Currencies

are sometimes described as overvalued or undervalued that can be determined by:

Purchasing

Power Parity Interest Parity

 Goods

that are freely trade should cost same everywhere, when measured in the same currency. The exchange rate between currencies should be that currencies have equivalent purchasing power. Exchange rate change over the long term because power of one currency increase/ decrease related to other currency.

 Foreign

exchange market is in equilibrium when the rate of return on deposit of any two currencies measured in the same currency are equal.

 Five

main groups of transactions are covered : spot transactions, forwards, swaps, futures, and options. Forwards, swaps, futures, and options belong to the class of financial instruments called derivatives. Derivatives are contracts that derive their value from some underlying assetin this case, the asset is currency.

Spot Market
A market for the immediate purchase and delivery of currency

Spot Exchange Rates

Market prices of foreign exchanges in the spot market that are the rates pertaining to the trading of foreign-currency. o Participants of spot market are commercial banks , brokers and clients of commercial and central banks.

Forward Exchange Market

A market for contracts that ensures the future delivery of and payment for a foreign currency at a specified exchange rate.

Forward Exchange Rates

The prices of contracts traded in the forward exchange market. Premiums and discounts in forward contracts.

Purpose of a Forward:
exchange rate risk or hedging.

the act of reducing

 Series

of forward under one contract for long term. It enables two parties having complimentary foreign exchange obligations to pair up. They are customized for the needs of parties with predetermined date and rate.

 They

specify a standard volume of currency to be exchanged on a date in future. Basis elements: type of currency amt of currency, future rate and settlement date. Canadian dollar contract contains-1,00,000 CAD, Swiss franc -1,25,000CHF and British pound- 62,500 GBP.

 Allow

owners to buy or sell currency at specified price with in a specified time. Currency call option- contract granting owner right to buy a currency. Currency put option- contract granting owner right to sell a currency. Euro option- exercised only on date of expiration of contract and US option- any time during the contract period.

In order to exercise call and put option, spot rate must reach a threshold called strike price before option expires. Fee paid to buy an option-premium. Whether option exercised or not.