Summary of Concepts Learned

This week, we covered the following concepts in foreign exchange (FX) markets:

• Spot market: The spot market is the market for immediate delivery of foreign currencies. The spot exchange rate is the price of one currency in terms of another currency at a particular point in time.

• Forward market: The forward market is the market for forward contracts, which are agreements to buy or sell a foreign currency at a predetermined price on a future date.

• Net long position: A net long position in a currency is when an investor has more of that currency than they need to offset their obligations.

• Net short position: A net short position in a currency is when an investor has less of that currency than they need to offset their obligations.

• Currency appreciation: Currency appreciation is when the value of a currency increases relative to other currencies.

• Currency depreciation: Currency depreciation is when the value of a currency decreases relative to other currencies.

• Interest rate parity: Interest rate parity is a theorem in international finance that states that the expected return on an investment in one country should be equal to the expected return on an investment in another country, taking into account the exchange rate and interest rates in both countries.

• Purchasing power parity: Purchasing power parity is a theory in international economics that states that the exchange rate between two currencies should reflect the relative prices of goods and services in the two countries.

• Foreign exchange risk: Foreign exchange risk is the risk that the value of a foreign currency will change, resulting in a loss or gain for a company or investor.

We also discussed the two-step decision-making process for making a lending decision to a party residing in a foreign country:

1. Credit risk assessment: The first step is to assess the credit risk of the borrower. This involves evaluating the borrower’s financial strength, credit history, and ability to repay the loan.

2. Country risk assessment: The second step is to assess the country risk of the borrower’s country. This involves evaluating the country’s political stability, economic stability, and legal environment.

Finally, we reviewed the four main types of FX risks faced by financial institutions:

1. Transaction risk: Transaction risk is the risk of an unexpected change in the exchange rate between two currencies between the time a transaction is initiated and the time it is settled.

2. Translation risk: Translation risk is the risk that the value of a company’s foreign assets and liabilities will change due to changes in exchange rates, resulting in a loss or gain on the company’s financial statements.

3. Economic risk: Economic risk is the risk that changes in a country’s economic conditions, such as a recession or high inflation, will adversely affect a company’s operations or investments in that country.

4. Operating risk: Operating risk is the risk of losses arising from a company’s internal operations, such as fraud or systems failures.

I hope this summary is helpful. Please let me know if you have any questions.