The term "foreign exchange" has three principal meanings.
In the first place, it means the system utilized in financing international payments. Or it may refer to the subject which is studied to obtain knowledge as to the financial operations conducted to discharge international obligations.
In the second place, it means the media used to discharge international obligations. For the purpose of international finance and exchange, the principal kinds of media are telegraphic transfers, mail transfers, bills, demand drafts, cheques, banker's drafts, foreign bonds, coupons, dividend checks, pension checks, commercial and personal letters of credit, traveller's cheques, foreign notes and coins, etc.
The third meaning of the term "foreign exchange" is that it covers, in a general way, the rates at which foreign exchange is quoted.
The overwhelming majority of international payments are made through the media of foreign exchange traded in foreign markets. The foreign exchange market is not an organized market in the same as a stock exchange or commodity exchange. In other words, there is no single, physical where purchases and sales are executed. While markets are organized in various ways in different countries of the world, most foreign exchange transactions are simply arranged by two parties and executed by telephone or telex. The most important dealers in foreign exchange transactions are large commercial banks, which maintain foreign exchange "dealing rooms" and execute foreign exchange transactions between themselves or on behalf of their corporate customers. Foreign exchange markets perform four major functions: (1) transfer of payments, (2) the provision of credit, (3) payment at a distance, and (4) allowing hedging against exchange risks.
The method of quoting the prices or rates of exchange for different currencies takes one of two forms, the direct quotation method and the indirect quotation method. Under the direct quotation method, the rates are quoted in terms of a variable number of home currency per fixed foreign currency unit, and China adopts this method. Under the indirect quotation method, the rates are quoted in terms of a variable number of foreign currency units to the fixed unit of home currency, the exchange market in London practices this method.
An exchange dealer always quotes two rates, at one of which he will buy and at the other of which he will sell the foreign currency. For direct rates then, on the standpoint of the exchange dealer, the maxim is "buy low, sell high", for indirect rates, the maxim is "buy high, sell low". A distinction must be drawn between rates quoted by a dealer to his customers and the so-called "market rates". The market rates are those ruling between the dealers themselves as members of the market. For direct rates, the selling rate to his customers will be higher than that of the market rate, while the buying rate will be lower than that of the market rate. There are many other exchange expressions, but those who are not well versed in exchange terminology would do well to confine themselves to the use of the expressions "favorable" and "unfavorable" when describing movements in exchange from the point of view of their countries, or to the use of "appreciate" and "depreciate" when describing a movement in the value of any particular currency. In the case of direct rates, "low rates are for us" (favorable from a national viewpoint) and "high rates are against us" (unfavorable from a national viewpoint); or vise versa in the case of indirect rates.
Foreign exchange market transactions mainly consist of (1) spot transactions, (2) forward transactions, (3) option forward transactions, and (4) swap transactions.
Spot Transactions (即期业务)
The spot transactions hold a key position in the exchange market. The main weight of business falls on spot, and other rates are quoted by reference to the spot.
In a spot transaction, the settlement and delivery of currencies take place within two business days from the transaction date of the deal. Using a normal definition of two business days, one can see that a Friday deal will be settled on the following Tuesday if the day is a business day of banks. The spot rate, as a rule, consists of five numerical figures, for example, on April 19,1992 closing rates of Japanese Yen and Deutsche mark against one U.S. dollar in the New York exchange market were 133. 70/133. 90 and 1. 664 5/1. 66 5 respectively. The first rate is the buying rate and the second rate is the selling rate. Again for example, Japanese Yen 133. 70 is the buying rate (bid rate) of the exchange dealer (usually a bank) for one U. S. dollar or the selling rate for Yen. Japanese Yen 133. 90 is the selling rate (offered rate) for one U. S. dollar or the buying rate for Yen. The difference between the rates, 20 points in this case, is known as the "spread " or "margin " which represents the profit of a bank in buying and selling foreign exchange. The points are usually the first two places to the right of the decimal in the quotation, but they can be carried to three or four places.
Forward Transactions (远期业务)
A forward transaction is one that is transacted for delivery of currencies at some date beyond spot date. The delivery date and price are agreed upon at the time the contract is made. Purchases and sales for delivery three months and six months hence are common. Longer terms of one year or more are usually feasible.
The forward price for a currency can, at time be identical (at par) with the spot price. Almost always, however, the forward price of a currency is at a "premium " or at a "discount " in terms of another. Remembering that "premium " is synonymous with "dearer " and "discount" with "cheaper", we can see that such expressions mean that the first currency is dearer or cheaper in terms of the second currency than the ratio established between them in the spot rate. Exchange dealers only work with these differences, i. e. with the premium and discount, expressed in decimal points, between the spot and forward prices. The outright forward rate is obtained by adding the premium to, or subtracting the discount from the spot rate under the direct quotation method, or vice versa under the indirect quotation method. Forward transactions can serve a number of purposes. They can be used to cover or hedge otherwise existing exchange risks of importers who are expected to pay the proceeds of the goods in foreign currency on a future date with a rate firmly quoted today. They can also be used to lock in the value of an expected dividend payment coming in from abroad or an export receivable. Such a single forward purchase or a single forward sale of a foreign currency against domestic currency or other currency is known as an "outright forward" to distinguish itself from a swap transaction which is a combination of a spot purchase with a simultaneous forward sale or vice versa. Outright deal can be a hedge, however, it is a speculative transaction if it does not have a commercial or financial underlying transaction.
Option Forward Transactions (择期业务)
The introduction of floating rates of exchange has substantially increased the demand by international traders and investors for forward cover to protect themselves against extreme fluctuations. Since it is usually difficult for them to pinpoint the exact date on which the payment will be required or the earning will be received, banks are often called upon to provide option forward contracts. It should be made clear that the option granted by the bank to its customers is an option only to the date of delivery within the contracted period and that such contract must be satisfied by the last date of the option period. The foremost consideration for the bank in pricing an option forward contract must be that of protecting it against the possibility that the delivery will be called for at the most inopportune time during the option period. In the case of a "buyer's option", where forwards are dealt at a discount, the bank (the seller) must assume that the delivery will be taken on the first day of the option, so spot rate will be quoted and no discount will be allowed. Should the forward rate be at a premium, the bank should assume that the delivery will not be made until the last date allowable under the terms of the option forward contract, so the forward price will be the sum of the spot rate plus the corresponding premium. In the case of a "seller's option" contract, the bank will be the buyer, the opposite should be exactly assumed. In both cases, the bank must allow the smallest discount or charge the highest premium consistent with market rates for its protection.
Swap Transactions (掉期业务)
Swap transactions consist of a simultaneous sale or purchase of spot currency accompanied by a purchase or sale, respectively, of the same currency for forward delivery. They also known as "double deals" as the spot is "swapped" against the forward. If the spot part of the transaction represents a purchase of a foreign currency, the forward side will represent a sale of the foreign currency. Conversely, if the spot part is a sale, the forward part will be a purchase. Different exchange rates are used for the contracts, the spot rate and the forward rate, representing the return each party can earn on the currency held for the period.
Swap transactions are mostly used in investments of foreign securities, in intercompany loans between parent company and its foreign subsidiaries, in credit swaps, in covering the exchange risks associated with cash flow transactions and in hedging to protect the value of physical and financial assets denominated in foreign currencies. The difference between the forward price and the spot will generally equal the cost of covering the exchange risks.