Exchange Rates and Currency Swaps
Discussion Question 1 (50 points)
Describe spot exchange rates, forward exchange rates, and currency swaps. Compare and contrast the characteristics and uses of each. (A 2-page response required.)
Spot Exchange Rates
The spot exchange which is determined by the foreign market exchange policy is the working market value for the exchanging of currency from one form to another (Hassan & Mano, 2018). The world wide foreign exchange markets occurs through digital electroniuc configurations between the largest, multinational banks, cooportaions and mutual funds, hedge funds and international insurance companies in conjunction with the governmnet entities (Liao et al., 2019). In general definition, spot exchange rates are determined by the foreign exchange market whereby a large number of international currency trades, organizations and trade regions (nations) perform their trading activities.
Using digital computations and electronic revisions, the spot exchange transaction has been divided into simpler execution methods. Among the techniques utilized to carry out these transactions are:
- Digital Brokerage Systems – Is a model that provides the execution of trades between two parties using an automated order matching mechanism.
- Inter-Dealer Voice Broker – An inter-dealer voice broker is a foreign exchange broker with whom a spot exchange transaction is carried out over the phone. The broker in this instance serves as a financial intermediary and is responsible for facilitating seamless investment transactions between two parties.
- Direct execution – A spot exchange involving only two parties without including a third party by phone, email, or any other form of communication is referred to as direct execution.
- An electronic trading system employs software to streamline exchange activity. Making better financial decisions regarding a multibank system or single-bank trading platform is made simpler thanks to the process being exhibited.
Forward Exchange Rates
A forward agreement that details which currencies will be swapped, when the transaction will occur, the amount of each currency that will be exchanged, and which side of the agreement each participant will be on is reached between the businesses in the forward market. The arrangement may ultimately end up costing more than it is ultimately worth because any potential advantages from changes in currency rates are also anticipated. The interest rate serves as the basis for the prices in the forward market (Kohlscheen et al., 2016). The interest rates in the foreign exchange market are the differences between the two currencies involved and are further applied over the time from the date of the transaction to the date of settlement.
In comparison, the exchange rate used for on-the-spot currency exchanges is known as the spot rate. The exchange rate for a transaction on the foreign currency market that is scheduled to take place at a later time is known as the forward exchange rate.
Currency swaps
This is an arrangement reached between two or more foreign participants in trading to give and take the interesets involved in the debt of one curency for the interesst payment on the loan made on a concurent currency (Ranaldo, 2022). The aim of swaping the currencies in the foreign exchange market is to enable loans at a favourable interest rates which may be available in the direct borrrowing in the foreign market (Morina et al., 2020). Each participant to the arrangement pays a dividend on the loan principle amounts of the other throughout the term of the forex exchange. If principal amounts were exchanged throughout the swap, they are exchanged once more at the predetermined rate or the spot rate when the swap is complete.
In order to exchange interests that are fixed at a specific amount in one currency for fixed interest payments in another currency, currency swapping can also be further separated into fixed for fixed rate currency. A different kind of currency exchange is known as a fixed-for-floating rating, in which fixed interest payments in one currency are traded for floating interest payments in another (Liao & Zhang, 2020) Additionally, currency swaps are utilized to maintain low levels of exchange risks and lower the borrowing costs associated with the acquisition of an overseas debt. Due to the exchange of principal process, which requires the identical amount to be swapped after the predetermined period has passed, it is efficient.
