• OTC - Over The Counter market
• commercial banks
• investment banks
• exchange traded market
stock exchanges that trade futures and options

• Convert the currency of one country into another currency
• for companies receiving payments from exports
• for companies making payments for imports
• when companies have spare cash (from profits)
• currency speculation
• taking advantage of guessing a currency will move down, compared to the currency you hold
• Protect and mitigate against "foreign exchange risk"
• "a second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates" 

         p. 300 Global Business Today, 2nd Ed.
• see RBC comments on the importance of understanding risk factors

• Relative inflation rates
• Relative interest rates
• Relative income levels
• Government controls
• Expectations
• Events

• Relative inflation rates
• changes in inflation rates can affect international trade activity, which influences the demand and supply of currencies
• if inflation is high, price of products is rising fast and the economy will have a lot of money to buy foreign products
• if they buy foreign products, there is need for currencies other than the currency they have, so demand is high
• affects supply and demand for currency
• impacts international trade
• e.g., British inflation rises against US inflation
• British goods become more expensive relative to US
• decrease of US demand for pound sterling
• increase in British demand for “cheaper” US goods
• increase in British demand for $US
• increase in supply of pounds on sale for $US
• British pound declines in value against the $US

• Relative interest rates
• changes in relative interest rates affect investment in foreign securities, which influence the demand and supply of currencies
• simply put, this means the exchange rate is effected by the interest rates in order countries, effecting other currencies

• Relative income levels
• if personal income in a country increases, globalization will increase demand for foreign products because consumers will want to import more - this is a consequence of changes in the "Economic Environment" 
• demand for foreign products will increase demand for the currency of the countries where those products come from
• in the late 1980’s and early 1990’s, income levels in North America caused massive imports of Japanese consumer products, making the Japanese yen rise very high

• Government controls
• foreign exchange barriers
• repatriation restrictions
• sometimes a national government will not let currency leave the country
• foreign trade barriers
• central bank intervention
• sometimes a central bank will buy the currency of its own country to artificially prop up demand
• intervention may affect inflation, interest rates and income levels

• Expectations
• e.g., news of potential increase in British inflation
• market expects decline in value of pound
• institutional traders sell pound sterling
• value of pound declines against the $US

• Events
• Tsunami
• War in Iraq
• Hurricanes in the Caribbean
• political scandal (Ottawa - sponsorship scandal hurt the Cdn $ )

"Canada has a floating exchange rate. .. The exchange rate is affected by supply and demand for Canadian dollars in international exchange markets. If demand exceeds supply, the value of the dollar will go up. If the supply exceeds demand, its value will go down. On an average day, CAN$37 billion is bought and sold on the international exchange markets.  Several factors influence the supply of and demand for Canadian dollars. If interest rates are higher in Canada than in other countries, investors may choose to invest in Canada, increasing demand for the dollar, providing that the expected rate of  inflation is not higher in Canada than among our trading partners. If our inflation rate is higher, investors are less likely to prefer Canada — even with higher interest rates — because of the expectation that the value of the dollar will be eroded by  inflation. "

In the case of RBC - they have a portion of their site devoted to a short glossary of Foreign Exchange terms, start at  www.royalbank.com/

RBC also had a helpful page which has a good lead in to the topic of
Foreign Exchange Risk, saying

"The globalization of business and interdependence of world markets has increased the chances of severe and unpredictable currency fluctuations. These trends open a category of risk for all Canadian businesses that can be new and unfamiliar. What's more, foreign exchange losses come straight out of your profits, often without tax deductibility and the possibility of recovery. When your profit margins are already slim, foreign exchange losses can make or break your business in any given financial period."

this was posted previously at www.royalbank.com/sme/guides/foreign_exchange/risk.html
 

• identify your exposure to foreign exchange fluctuations; 
• quantify your exposure 
• meaning try to determine the amount of money at risk
• draft a possible foreign exchange exposure management strategy;
• meaning think about what you will do if the key currencies start to move up or down, will you buy forward contracts, will you change your pricing, you have to have a plan of action
• review the financial products available to support your strategy and what they cost
• meaning - the different banks have different things they can help you with, and it all costs money
• if the costs justify the rewards, implement your strategy; and
• monitor and evaluate the performance of your foreign exchange risk management strategy. 

"Your Exposure to Foreign Exchange Risk"

• Sales and inventory 
• what accounts in what currencies are outstanding
• what will we have to pay for, in what currencies, in the future
• Capital equipment 
• Supplies and services
• Debt / lease costs
• Payroll 
• overseas salaries
• Payments to shareholders 
• Transfer payments 

Spot refers to the price of one currency in terms of another.
if the price is in X country dollars = $1.00 US it is called a direct quote
if the price is 1 unit of xx country currency = amount in USD it is an indirect quote
nn

Scotiabanks's website explains the term Spot Price

"A spot price is quoted as a spread between the BID (level where the bank buys the underlying currency) and the OFFER (level where the bank sells the underlying currency). The underlying currency is the first one in the currency pair. For example, if USD/CAD is 1.5000 - 1.5010, Scotiabank buys USDs at 1.5000 against CAD and sells USDs at 1.5010."
 old link www.scotiafx.com/HedgingStrategies.htm#spot.

Spot Price - Advantages & Disadvantages

"Advantages 

• Exporters benefit from domestic currency devaluation. 
• Importers benefit from domestic currency appreciation. 
• No transaction cost. 
• Simple/Easy to monitor changes in the market.

Disadvantages

• Exporters are vulnerable to domestic currency appreciation.
• Importers are vulnerable to domestic currency depreciation. 
• Monitoring is required in order to transact at a favorable rate"

"Although the spot market lets your company buy or sell currency as you need it, spot exchange rate movements are highly unpredictable, even during a single trading day. Relying on the spot market for future foreign exchange is highly speculative. It can expose your company's cash flow to the risk of unfavourable changes in foreign currency values." was posted at www.tdbank.ca/business/foreign/management/spot.html (link dead)

So if you are nervous about the Spot Market and want to lock in a currency, you can execute a forward contract. One states the  amount of a currency to be exchanged on a specific day - you may employ individually tailored contracts

Long (Short):  Bought (Sold) a futures contract to receive (deliver) foreign exchange.  A Long is similar to a forward  contract to buy foreign exchange while a Short is similar to a forward contract to sell foreign exchange.
 

Scotiabank says "A forward outright is the price of one currency in terms of another for settlement on a date other than spot. In other words, the spot rate is adjusted by accounting for the interest rate differential between two currencies. "

old link www.scotiafx.com/HedgingStrategies.htm

"Advantages

• Complete protection from adverse currency moves
• No transaction costs 
• Simple to monitor 
• Simple to unwind (very liquid). 
• meaning you could sell this position to someone else 
• that would be termed a "Currency Swap" if they traded you for a position they held in another currency

Disadvantages 

• Loss of opportunity gains resulting from favorable currency moves. 
• Liability from both parties to transact."

TD banks's web site says similarly
formerly posted at www.tdbank.ca/business/foreign/management/forward.html link dead in 2007

"A Forward Contract lets your company buy or sell one currency against another, for settlement on the day the contract expires. Unlike spot contracts, a forward contract eliminates the risk of fluctuating exchange rates by locking in a price today for a transaction that will take place in the future. This is called hedging (or insuring) your expected foreign currency transactions. By protecting your future cash flow against negative currency
  fluctuations, it can eliminate some of the uncertainty of doing business abroad. "

Forward Contract does not reflect market predictions of future spot exchange rates. Rather, it reflects the difference in interest rates between countries.

If the currency is popular, and a lot of volume on both "sell" and "buy" side is required, the spread will be small because the bank does not have to worry about the risk of buying a currency because it can soon sell it.

If the currency is not popular, or the volume on both "sell" and "buy" side is low, the bank will charge more for the transaction because it wants to cover any risk in holding the currency to long

The Bid / Ask Spread can be calculated = (ask price minus bid price)/ ask price

• direct quotes: number of domestic-currency units received for each foreign-currency unit
• example - direct quote for Cdn dollar re: US
• 1 $ USD = 1.5 $ CDN 

• Indirect quotes: number of foreign-currency units received for each domestic-currency unit
• example - indirect quote for Cdn dollar re: US

1 $ CDN = .75 USD 

"The purchase of securities in one market for immediate resale in another to profit from price discrepancy"
p. 304 Global Business Today, 2nd Ed.

A simple explanation would be that Arbitrage is taking advantage of the fact that one thing has two different prices - you can then buy it at the low price, and sell it for a profit to the person who is paying the higher price. This usually only works for very large quantities and is usually applied to terms of millions or tens of millions of dollars. It is the type of business in which you have to make decisions very quickly and employ all the advantages of the "Technological Environment".

The noun for people who do this ia "arbitrageur" - an individual or bank that monitors the commodity markets and makes the play.

WTGR 

• Commercial banks facilitate the Spot exchanges so that the currency can be moved between the seller and buyer
• 20 large banks in the world handle 50% of the global volume
• six currencies comprise 90% of the volume
• Japanese Yen
• German Mark
• British Pound
• Canadian Dollar
• French Franc
• Swiss France
• The exchange rate, between two currencies, offered by various banks, is always very similar
• if the difference was too large, banks themselves would start trading currencies (and in fact some merchant banks do)
• If a bank begins to experience a shortage of a particular foreign currency, it can purchase this from other banks
• this trading is called the Interbank Market

www.scotiafx.com/HedgingStrategies.htm#swaps "Definition: A contract to exchange two currencies at one time (T1), in order to exchange back to each investor's original position at some future date  (T2), for a predetermined price.

Settlement: 
Swaps settle at the near date and the far date. However, if the near end matches the maturity of a previous contract, it is only the resulting gain or loss that is cash settled. 

Implied View: 
A swap provides an investor with the opportunity to borrow money in one currency and lend it in another through the FX market (and hence, defer settlement of a contract)." 

similar to Forward Contracts, BUT, they are NOT negotiated like Forward Contracts
Currency Futures are traded in an Exchange

• Currency Futures trade through a broker
• Forward Contracts are arranged directly with the lender (the 4X banks and commercial banks)

Barchart.com was launched in December 1995 as an Internet web site designed for commodity and index traders.

Prof. Richardson has created a Powerpoint specifically on Currency Futures and Options
- it can be downloaded at

 www.witiger.com/powerpoints/intl~banking/INTL303chpt5currencyfutures.ppt

essentially currency futures and options contracts are used
to hedge or speculate based upon anticipated exchange rate changes

Futures contracts
state amount of a currency to be exchanged on a specific day - employ standardized contracts (which can be traded - and the trading takes place within an exchange) 

In "real life", hedging is like a contingency plan

I want to get a ride to the airport for a business trip, I’ll book an airline limo
Just in case the limo doesn’t come on time, I’ll hedge my risk by having my neighbour agree to drive me

• Buy a futures contract for a currency you need
• It is done when you need to spend money in the future, and want to lock in the price because you are concerned it might rise to your disadvantage
• If you don’t need it,   your broker can sell it on the exchange
• Sell a futures contract for a currency you DO NOT need
• Done when you need to get rid of money in the future, and want to lock in the price because you are concerned it might rise to your disadvantage
• Again, if you don’t need it,   your broker can sell it on the exchange

• hedging by buying 90 day contracts
• e.g., a US firm orders Swiss products
• must pay SF750,000 upon delivery in 90 days
• US firm buys 90 day contract today
• locks in price to be paid for francs in 90 days 

"An option gives the holder the right but not the obligation, to buy or sell an underlying asset at a predetermined price at or until a certain time. It differs from a forward contract in that it is not an obligation to transact.  An option provides insurance from adverse currency movements."

"A Foreign Currency Option is like an insurance policy. It is a "hedging tool" that lets you exchange one currency for another on a given date, at a prearranged exchange rate (strike price), without obliging you to do so. Like forward contracts, foreign currency options eliminate the spot market risk for future transactions. Unlike forward contracts, they do not oblige you to deal if the spot  rate is more favourable than your option's strike price. As the   name implies, you have the option to deal or not."
from www.tdcommercialbanking.com/foreignx/products/foreign_c.jsp(link works Feb 2009)

• Call: The holder has the right, but not the obligation to  purchase the underlying asset at the strike price.
• Put: The holder has the right, but not the obligation to sell the underlying asset at the strike price. "

Contract grants the right to sell a specific currency 

• at a specific price
• within a specific time period

• “in the money”: spot rate < strike price
• “out of the money”:  spot rate > strike price