FOREIGN EXCHANGE MARKET

Week 2
The Foreign Exchange Market
• The foreign exchange market is the biggest financial market in
the world. Every day, transactions worth about 5.6 trillion
dollars are carried out within the market. The major aim of
introducing the foreign exchange market is to facilitate
international trade by enabling businesses to perform
transactions outside their local currency. The market operates
round the clock from Monday through Friday.
• Foreign exchange means the money of a foreign country; that
is, foreign currency bank balances, banknotes, checks and
drafts.
• A foreign exchange transaction is an agreement between a
buyer and a seller that a fixed amount of one currency will be
delivered for some other currency at a specified date.
The Foreign Exchange Market
• The Foreign Exchange Market provides:
– The physical and institutional structure through
which the money of one country is exchanged for
that of another country
– The determination rate of exchange between
currencies
– Is where foreign exchange transactions are physically
completed
Exhibit 4.1 Measuring Foreign Exchange Market Activity:
Average Electronic Conversations Per Hour.
volume of currency transactions across the globe
25,000

20,000

15,000

10,000

5,000 Greenwich Mean

Time

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyo opening closing open closing in America In NY opens
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
Functions of the Foreign Exchange Market
• The foreign exchange Market is the mechanism by
which participants:
– Transfer purchasing power between countries
– Obtain or provide credit for international trade transactions
– Minimize exposure to the risks of exchange rate changes
Market Participants
• The foreign exchange market consists of two tiers:
– The interbank or wholesale market (multiples of $1MM US or
equivalent in transaction size)
– The client or retail market (specific, smaller amounts)
• Five broad categories of participants operate within
these two tiers; bank and nonbank foreign exchange
dealers, individuals and firms, speculators and
arbitragers, central banks and treasuries, and foreign
exchange brokers.
Bank and Nonbank Foreign Exchange Dealers

• Banks and a few nonbank foreign exchange dealers operate

in both the interbank and client markets.
• The profit from buying foreign exchange at a “bid” price
and reselling it at a slightly higher “offer” or “ask” price.
• Dealers in the foreign exchange department of large
international banks often function as “market makers.”
• These dealers stand willing at all times to buy and sell those
currencies in which they specialize and thus maintain an
“inventory” position in those currencies.
Individuals and Firms
• Individuals (such as tourists) and firms (such as
importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
market.
• Their use of the foreign exchange market is necessary
but nevertheless incidental to their underlying
commercial or investment purpose.
• Some of the participants use the market to “hedge”
foreign exchange risk.
Speculators and Arbitragers
• Speculators and arbitragers seek to profit from trading
in the market itself.
• They operate in their own interest, without a need or
obligation to serve clients or ensure a continuous
market.
• While dealers seek the bid/ask spread, speculators seek
all the profit from exchange rate changes and
arbitragers try to profit from simultaneous exchange
rate differences in different markets.
Central Banks and Treasuries
• Central banks and treasuries use the market to acquire or
spend their country’s foreign exchange reserves as well as
to influence the price at which their own currency is
traded.
• They may act to support the value of their own currency
because of policies adopted at the national level or
because of commitments entered into through
membership in joint agreements such as the European
Monetary System.
• The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
• As willing loss takers, central banks and treasuries differ in
motive from all other market participants.
Foreign Exchange Brokers

• Foreign exchange brokers are agents who facilitate

trading between dealers without themselves becoming
principals in the transaction.
• For this service, they charge a commission.
• It is a brokers business to know at any moment exactly
which dealers want to buy or sell any currency.
• Dealers use brokers for their speed, and because they
want to remain anonymous since the identity of the
participants may influence short term quotes.
Transactions in the Interbank Market

• A Spot transaction in the interbank market is the

purchase of foreign exchange, with delivery and
payment between banks to take place, normally,
on the second following business day.
• The date of settlement is referred to as the
value date.
Transactions in the Interbank Market

• An outright forward transaction (usually called just

“forward”) requires delivery at a future value date of a
specified amount of one currency for a specified amount of
another currency.
• The exchange rate is established at the time of the
agreement, but payment and delivery are not required
until maturity.
• Forward exchange rates are usually quoted for value dates
of one, two, three, six and twelve months.
• Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which
currencies are referenced.)
Transactions in the Interbank Market
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
• Both purchase and sale are conducted with the same
counterparty.
• Some different types of swaps are:
– Spot against forward
– Forward-Forward
– Non deliverable Forwards (NDF)
Market Size

• In April 2001, a survey conducted by the Bank for

International Settlements (BIS) estimated the daily
global net turnover in traditional foreign exchange
market activity to be $1,210 billion.
• This was the first decline observed by the BIS since
it began surveying banks on foreign currency
trading in the 1980s.
Exhibit 4.2 Global Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)

800

700 Spot
Forwards
600 Swaps

500

400

300

200

100

0
1989 1992 1995 1998 2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001,” October 2001, www.bis.org.
Exhibit 4.3 Geographic Distribution of Foreign
Exchange Market Turnover (daily averages in April,
billions of US dollars)
700 United States
United Kingdom
600
Japan
500 Singapore
Germany
400

300

200

100

0
1989 1992 1995 1998 2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001,” October 2001, www.bis.org.
Exhibit 4.4 Currency Distribution of Global Foreign
Exchange Market Turnover (percentage shares
of average daily turnover in April)
Because all exchange transactions involve two currencies, percentage shares total to 200%
90 US dollar
80 euro
Deutshemark
70 French franc
EMS currencies
60
Japanese yen
50 Pound sterling
Swiss franc
40

30

20

10

0
1989 1992 1995 1998 2001
Source: Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001,” October 2001, www.bis.org.
Foreign Exchange Rates and Quotations

• A foreign exchange rate is the price of one

currency expressed in terms of another
currency.
• A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
Foreign Exchange Rates and Quotations
• Most foreign exchange transactions involve the US
dollar.
• Professional dealers and brokers may state foreign
exchange quotations in one of two ways:
– The foreign currency price of one dollar
– The dollar price of a unit of foreign currency
• Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar.
Foreign Exchange Rates and Quotations
• For example, the exchange rate between US dollars and
the Swiss franc is normally stated:
– SF 1.6000/$ (European terms)
• However, this rate can also be stated as:
– $0.6250/SF (American terms)
• Excluding two important exceptions, most interbank
quotations around the world are stated in European
terms.
Foreign Exchange Rates and Quotations
• As mentioned, several exceptions exist to the use of
European terms quotes.
• The two most important are quotes for the euro and
U.K. pound sterling which are both normally quoted in
American terms.
• American terms are also utilized in quoting rates for
most foreign currency options and futures, as well as in
retail markets that deal with tourists
Foreign Exchange Rates and Quotations
• Foreign exchange quotes are at times described as either
direct or indirect.
• In this pair of definitions, the home or base country of the
currencies being discussed is critical.
• A direct quote is a home currency price of a unit of foreign
currency.
• An indirect quote is a foreign currency price of a unit of
home currency.
• The form of the quote depends on what the speaker regard
as “home.”
Foreign Exchange Rates and Quotations
• Interbank quotations are given as a bid and ask (also
referred to as offer).
• A bid is the price (i.e. exchange rate) in one currency at
which a dealer will buy another currency.
• An ask is the price (i.e. exchange rate) at which a dealer will
sell the other currency.
• Dealers bid (buy) at one price and ask (sell) at a slightly
higher price, making their profit from the spread between
the buying and selling prices.
• A bid for one currency is also the offer for the opposite
currency.
Foreign Exchange Rates and Quotes
• Forward rates are typically quoted in terms of points.
• A forward quotation is expressed in points is not a
foreign exchange rate as such.
• Rather, it is the difference between the forward rate
and the spot rate.
• Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate.
• This method of quotation facilitates comparing
premiums or discounts in the forward market with
interest rate differentials.
Foreign Exchange Rates and Quotes
• For quotations expressed in foreign currency terms
(Indirect quotations) the formula becomes:
f ¥ = Spot – Forward 360
Forward x n x 100

• For quotations expressed in home currency terms

(Direct quotations) the formula becomes:
f ¥ = Forward – Spot 360
Spot x n x 100
Foreign Exchange Rates and Quotes

• Many currency pairs are only inactively traded, so their

exchange rate is determined through their relationship
to a widely traded third currency (cross rate).
• Cross rates can be used to check on opportunities for
inter market arbitrage.
• This situation arose because one bank’s (Dresdner)
quotation on €/£ is not the same a calculated cross rate
between $/£ (Barclay’s) and $/€ (Citibank).
Foreign Exchange Rates and Quotes

• Citibank quote - $/€ $0.9045/€

• Barclays quote - $/£ $1.4443/£
• Dresdner quote - €/£ €1.6200/£
• Cross rate calculation: =
$1.4443/£
= € 1.5968/£
$0.9045/€
 Exhibit 4.9A Triangular Arbitrage

Citibank
End with $1,014,533 Start with $1,000,000

Receive
(6) $1,014,533 (1) Sell $1,000,000 to
Barclays Bank at $1.4443/£

Dresdner Bank Barclays Bank

Sell
(5) €1,121,651 to (2) Receive £692,377
Citibank at $0.9045/€
(4)
Receive €1,121,651 (3) Sell £692,377 to Dresnder Bank
at €1.6200/£
Foreign Exchange Rates and Quotes
• Measuring a change in the spot rate for quotations
expressed in home currency terms (direct quotations):
%∆ = Ending rate – Beginning Rate
x 100
Beginning Rate
• Quotations expressed in foreign currency terms
(indirect quotations):
%∆ = Beginning Rate – Ending Rate
x 100
Ending Rate