Foreign Currency Markets

Introduction

The purchase and sales of foreign exchange take place not solely on spot, but also on a forward basis that allows delivery on a specified future date. In the case of no government intervention, demand and supply govern forward currency markets and forward market rates provide valuable information on future rates. In case the future and forward currency exchange rates are the same, the clients do not expect reasonable fluctuations in currency rates within a particular period. Option, forward and future currency are all derived contracts and all derive their standards from primary assets and trade of a currency pair. In all the forms of the currencies, a client makes money only when long currency grows against short currency due to price disparities. Consequently, future, forward and option foreign exchange markets create price disparities that cause arbitrage issues which affect international finance negatively.

Description of Forward Foreign Currency Markets

Forward currency markets refer to foreign exchange markets where purchase or sales become agreed on up front, however, the sales or purchase takes place in the future. Therefore, in this type of market, fixed exchange rates become fixed in current date for future exchange of currencies. Therefore, forward foreign currency markets run on the basis of forward exchange contracts. According to Hodrick, forward cover or forward exchange contract refers to a legal agreement between customers and their bank where foreign exchange rate become fixed immediately for purchasing and sales of one currency for the other upon agreed future dates. Forward currency markets protect traders and clients to a bank from negative financial exchange rate fluctuations that occur from the period of the contract and payment date. Therefore, forward currency market prevents currency fluctuations within a set period before a contract execution.

There exist three types of forward exchange contracts namely fixed, partly optional and fully optional contracts. In fixed contacts, the clients only deliver at maturity. However, in case the customer wishes to deliver before the stipulated date, partly optional and fully optional contracts apply. In the partly optional forward contracts, the terms of the contract become put in place during the initial period from the formulation to option start date followed by fully optional from the final payment date. Therefore, in such contract, clients are allowed to make the foreign exchange at any time during the optional period. This is because the partly optional contracts have two dates and cover both fully optional and fixed optional contracts. In fully optional contact, the delivery of the contract takes place within the set dates between the establishment of the contract and the final date. Fully optional contracts become used when a client wishes to make multiple transactions or is not sure of his or her date of commitment to making the foreign exchange. Therefore, the choice of a type of forward cover depends on the needs of the client and the bank.

Description of Futures Foreign Currency Markets

Future currency markets refer to exchange markets that consist of transferable future contracts in which the prices of currency become specified for sales or purchase in the future. According to Busch, Christensen and Nielsen, currency futures enable investors to hedge against risks that arise from fluctuations in foreign exchange rates. Futures foreign currency markets mark currency futures on a daily basis. Therefore, the investors can exit their responsibilities of purchasing or selling the currency prior to the formulated delivery date of the contract. As a result, most currency future contracts do not last until the established delivery date because most future market participants are spectators who frequently close down their positions prior to the established delivery date. Consequently, future foreign currency markets become affected significantly in case there exist substantial fluctuations in the spot rates. For instance, increase in spot rates result in an upsurge in currency futures while a significant decrease in the spot rates translates to possible substantial reductions in future currency rates. Therefore, currency futures allow investors to archive linear payoffs or asymmetric payoffs.

Futures foreign currency markets became introduced during the period of rapid innovations and alterations in foreign exchange trading. Currency futures cause high volatility of currency rates interbank markets. Currency futures become applied in hedging and speculations. In hedging, in a situation where an investor predicts the likelihood of receiving cash flow that is denominated in the overseas currency within a set future date, he or she uses currency futures to lock the present exchange rate by taking part in a currency future contract that pass away when the cash flow terminates. In the case of speculations, investors use currency futures to gain profits from falling or rising currency exchange rates. Speculators use incurring risks to predict the profits they receive from currency futures. For instance, in case of a price drop, an investor may sell first and purchase later to collect profit from the falling exchange rates. Future foreign currency market base their exchange rate on the currency pair. The feature of currency futures permits traders to conduct trade over their foreign allocation in a highly liquid market. Therefore, currency future obliges a client to purchase a long currency but make payments using a short currency.

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Description of Options Foreign Currency Markets

Option foreign currency markets refer to currency markets where the buyer become grated the right and not the obligation in a contract to purchase or sell a particular currency before or on a specific date. Clark state that similar to currency futures and forward markets, options currency markets aid investor to hedge against adverse movements in currency exchange rates. The clients are able to hedge exchange risks through buying currency call or put. When a buyer purchase currency put, he receives a right and not an obligation that allows him or her to sell a specific currency by a particular date and at a stipulated rate. On the other hand, a call provided the buyer with the right to buy a currency. A call option refers to the contract that allows an investor to possess the right and not the obligation to by bond, stock or commodity. The call options are used by investors in the option foreign currency markets for the purpose of income generation, tax management and speculation.

The strike price in option foreign currency market refers to the price at which foreign currency become sold or purchased. The strike price denotes the foreign exchange ratio for a currency pair. Consequently, a call holder gets to sell the sell the currency option when the strike price is less than the actual price of the currency pair. The difference between currency futures and option currency is that in option currency, clients are not obligated to actual sales or purchase long currency while future currency traders are obligated. Therefore, option currency traders can either purchase or sell underlying assets if options foreign currency markets go against their demands. Currency futures contracts offer higher than the required premium margin while option markets offer premiums that are lower than the recommended margin. Therefore, option and future currency differ in terms of premiums.

How Each Foreign Currency Market Demonstrate Arbitrage Problem in International Finance

Currency arbitrage issues refer to risks that require purchasing and sales of two or more currencies to occur simultaneously. Arbitrage issues occur due to the existence of financial market inefficiencies. Arbitrage provide a mechanism that enables controlling market inefficiencies through ensuring prices do not deviate significantly from their fair values, especially within long periods. Market inefficiencies exist in option, forward and future foreign currency market due to the existence of information asymmetry, frictions and non-synchronous trading.

Connection between Forward Foreign Currency Markets with Potential Arbitrage Issues

Forward rates become determined based on supply and demand of currencies. Technical, political and economic factors cause upheaval in forward foreign exchange markets that hamper international trade through making foreign exchange highly volatile. Money supply in different nations causes arbitrage issues when forward rates are used. When the money supply increases significantly in a country faster than its economy, its value becomes less when compared to the currencies of other nations. Forward rates cause triangular arbitrage issues that occur due to market inefficiency as well as the effects of supply and demand. Triangular arbitrage occurs due to pricing disparities that make buyers to purchase currencies using either partly or fully optional forward exchange contracts and selling them to other banks at the same time. In return, the bank selling stock at lower prices lose stock while the buyer gains profit instantly. The arbitrageur received yield at zero-risk. Arbitrage happens in forward foreign currency markets as soon as banks estimate exchange forward rates that are different to the market's implicit cross exchange rate.

Connection between Futures Foreign Currency Markets With Potential Arbitrage Issues

Similar to forward currency markets, rates in futures foreign currency markets become determined by demand and supply. Potential arbitrage issues exist in currency futures due to the possibility of existence in rate disparities that allow buyers and sellers to take part in currency exchange at the same time. The participants of currency futures include spectators who close their position if the contract is unfavorable prior to the established date. Therefore, the spectators take advantages of arbitrage issues to gain profits because the only leave their position opened until the established date when they are not at risk. Therefore, currency futures affect interbank markets as well as international finance.

Connections between Options Foreign Currency Markets With Potential Arbitrage Issues

Options foreign currency markets enhance arbitrage through creating price disparities. Considering that arbitrage is risk-free, call option in options foreign currency enable the buyer to purchase or sell when the actual price of the currency pair is more than the strike price. Similar to currency future, option currency has spectators as the major participants. Option currency allows spectators to sell or purchase currencies when a trade goes against their needs. Considering that options foreign currency markets are demand and supply driven, economic factors affect option currency that causes possible arbitrage issues. Call option holders can choose to sell their assets and purchase new call or put options in other banks with at any time with the aim of gaining profit instantly or maintaining zero risks. As a result, one bank may lose inventory while the call holders gain profit. As a result, option currency affects international finance.

Conclusion

Future, forward and option foreign exchange markets cause arbitrage issues due to the creation of price disparities that allow clients, especially the spectators to purchase and sell currencies at the same time. The factors that cause arbitrage issues in all the currency markets comprise economic factors and supply as well as demand. Currency futures markets differ from option currency market because they allow purchasing long currency and short currency respectively. All the currency markets allow investors to avoid the financial risk that arises from currency fluctuations. Also, all the currency markets allow spectators to gain profits without undergoing any risk from the market, especially in the case of market inefficiencies. Therefore, arbitrage issues that result from price disparities affect international finance negatively.