Lecture 3
The Foreign Exchange
Market
Lecturer: Dao Mai Huong
The Foreign Exchange Market
The foreign exchange market is perhaps the largest, most
globally integrated, and
most active financial market in the world. The transactions that
take place there are
the lifeblood of a global economy that comprises many different
national currencies.
By enabling the transfer of funds and purchasing power from
one currency to another, the foreign exchange market offers an
important means for price discovery that facilitates
international trade and investment activity
—Simon Potter, Executive Vice President of the Markets Group of the Federal Reserve Bank
of New York, at the 2015 FX Week Conference, New York City, 14 July 2015.
LECTURE OUTLINE
Introduction to foreign exchange market
Definition and functions
Forex market participants
Forex transactions
Forex rates and quotations
Triangular arbitrage activity
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 of exchange rate between currencies; and
is where foreign exchange transactions are physically completed.
The Foreign Exchange Market
Foreign exchange means the money of a
foreign country; that is, foreign currency bank
balances, banknotes, checks and drafts.
A foreign exchange transaction: 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.
Geography
The foreign exchange market spans the globe, with
prices moving and currencies trading somewhere every
hour of every business day.
As Exhibit 6.1 illustrates, the volume of currency
transactions ebbs and flows across the globe as the
major currency trading centers open and close
throughout the day.
Exhibit 6.2 highlights the major trading centers that
keep currency trading a 24-hour activity.
Measuring Foreign Exchange Market Activity: Average
Electronic Conversions Per Hour
Global Currency Trading: The Trading
Day
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; and
minimize exposure to the risks of exchange rate changes.
Market Participants
Two tiers:
the interbank or wholesale market (multiples of $1MM US or
equivalent in transaction size), and
the client or retail market (specific, smaller amounts).
Five broad categories of participants:
Bank and nonbank foreign exchange dealers,
individuals and firms conducting commercial or investment
transactions,
speculators and arbitragers,
central banks and treasuries,
and foreign exchange brokers.
Market Participants: 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.
Market Participants: 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.
Market Participants: 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.
Speculators: seek all the profit from exchange rate
changes
Arbitragers: try to profit from simultaneous exchange
rate differences in different markets.
Market Participants: Central Banks and Treasuries
Use the market to acquire or spend their country’s foreign
exchange reserves and to influence the price at which
their own currency is traded.
Because of policies adopted at the national level or
because of commitments in joint agreements
The motive is not to earn a profit, but to influence the
foreign exchange value of their currency in a manner that
will benefit the interests of their citizens.
Market Participants: Foreign Exchange
Brokers
Foreign exchange brokers: Agents who facilitate trading between dealers
without themselves becoming principals in the transaction.
Dealers use brokers to expedite the transaction and to remain anonymous,
since the identity of participants may influence short-term quotes.
FX trading
The foreign exchange trading involves 3 components:
(1) the foreign exchange trade transaction agreement—
the interaction of dealers, brokers, and
aggregators
(2) electronic communication and notification for
payment and settlement through SWIFT
(3) final settlement of the currency trade.
Transactions in the Interbank Market
Spot transaction
Value date (date of settlement)
Outright forward transaction (forward)
Buying forward
Selling forward
Swap
Transactions in the Interbank Market
A spot transaction: 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.
Foreign
Exchange
Settlement
in Europe
Foreign exchange transaction and
settlement
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 (A contract to deliver dollars for euros in six
months is both “buying euros forward for dollars” and
“selling dollars forward for euros.”)
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,
nondeliverable forwards (NDF).
Global Foreign Exchange Market Turnover, 1989-2016
Top 6 Geographic Trading Centers in the Foreign
Exchange Market, 1995-2016
Foreign Exchange Market Turnover by Currency Pair
Foreign Exchange Rates & Quotations
Key Terms:
Foreign exchange rate
Foreign exchange quotation (or Quote)
American terms vs. European terms
Direct quote vs. Indirect quote
Bid vs. Ask quotes
Spot vs. forward quotes
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.
Currency symbols:
Exchange Rate Quotes
Every currency exchange involves two currencies, currency
1 (CUR1) and currency 2 (CUR2):
CUR1 / CUR2
In practice: base/unit quote/price
E.g. EUR/USD 1.2174 →EUR: base currency, USD: price currency,
and the exchange rate is USD 1.2174 = EUR 1.00.
FOR THE REST OF THE COURSE: EUR/ USD, USD/JPY, or
GBP/USD will be quoted as $1.2170/€, ¥83.16/$, and $1.5552/£.
Foreign Exchange Rates and Quotations
Most foreign exchange transactions involve the U.S.
dollar.
Professional dealers and brokers may state foreign
exchange quotations in one of two ways:
the foreign currency price of one dollar (European term), or
the dollar price of a unit of foreign currency (American term).
Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar.
Foreign Exchange Rates and Quotations
For example, the exchange rate between U.S. dollars and the Swiss franc is
normally stated:
SF 1.6000/$ (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
The two important exceptions are quotes for the euro and U.K. pound
sterling which are 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
Exhibit 6.7 Foreign Currency Quotations
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. (base = foreign; quote = home)
An indirect quote is a foreign currency price of a unit of home
currency. (base = home; quote = foreign)
The form of the quote depends on what the speaker regards as
“home.”
Class Quiz
From the viewpoint of a US investor, which of the following would be a direct
quote in the foreign exchange market?
A. SF 2.40/£
B. $ 1.50/£
C. £ 0.55/€
D. € 0.90/$
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.
Exhibit 6.8 shows a bid, ask, and mid-point quotation.
Bid, Ask, and Mid-Point Quotation
Exchange Rates: New York Closing
Snapshot
Exchange Rates: New York Closing
Snapshot (cont.)
Foreign Exchange Rates
and Quotes in Percentage Terms
Measuring a change in the spot rate (percent change in the
value of foreign currency)
For quotations expressed in home currency terms (direct
quotations):% change in value of base currency
%∆ = Ending rate – Beginning Rate x 100
Beginning Rate
For quotations expressed in foreign currency terms (indirect
quotations):% change in value of term currency
%∆ = Beginning Rate – Ending Rate x 100
Ending Rate
Foreign Exchange Rates
and Quotes in Percentage Terms
Example: Japanese yen has recently changed in value from JPY76.73/USD to
JPY77.02/USD. Your home currency is the U.S. dollar. What is the percent
change in the value of the Japanese yen?
Foreign Exchange Rates and Quotes:
Forward quotations
Forward rates are typically quoted in terms of points.
A forward quotation expressed in points is not a foreign exchange rate as
such.
Rather, it is the difference between the forward rate and the spot rate.
Exhibit 6.9 shows how foreign exchange rates are quoted in the WSJ
Spot and Forward Quotations for the Euro and
Japanese Yen
Lecture Example
You need to make a payment of $ 100k to an offshore beneficiary in 93
days. You need to sell A$ to buy $ to make this payment.
You wish to enter into a forward transaction with the Bank today to fix a
forward exchange rate at which you will buy $ 100k and sell A$ in 93 days.
Assume the following:
Current A$/$ spot exchange 0.7360
rate
Forward point -140
Forward exchange rate ?
If you enter into the Forward transaction with the Bank, on the forward
settlement date you must buy $100k from the bank in exchange for A$?
Foreign Exchange Rates and Quotes:
Forward quotations
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:
Forward quotations
For quotations expressed in foreign currency terms (Indirect quotations) the
formula becomes: base currency = home (fp on price)
f f = Spot – Forward 360 x x 100
Forward n
For quotations expressed in home currency terms (Direct quotations) the formula
becomes: base currency = foreign (fp on base)
f f = Forward – Spot 360
x x 100
Spot n
Foreign Exchange Rates and Quotes:
Forward quotations
Example: Calculate the forward premium on the yen given the table below”
Using direct quote:
Using indirect quote:
Foreign Exchange Rates and Quotes:
Forward quotations
Forward Quotes—Percentage Basis
Spot 1.6135 $/£
90-day forward discount on £ is 0.29%
Forward = 1.6135*(1 – 0.0029) = $1.6088/£
We say the U.S. dollar is trading at a forward premium relative to the British
pound.
If the forward quote is –47 points, percentage forward quote is –0.0047 / 1.6135
= –0.0029 = –0.29%.
Foreign Exchange Rates and Quotes: Cross
rates
Many currency pairs are only inactively traded, so their
exchange rate is determined through their relationship
to a widely traded third currency (cross rate).
E.g. a Mexican importer needs Japanese yen to pay for purchases in
Tokyo. Both the Mexican peso (MXN or Ps) and the Japanese yen
(JPY or ¥) are commonly quoted against the U.S. dollar (USD or $).
Calculate the exchange rate JPY/MXN and MXN/JPY:
Calculate cross rate
Currency USD EUR JPY
JPY 83.735 ?
EUR 0.7549 ?
USD 1.3247 0.0119
Calculate the missing rate:
Key Currency Rate Calculations for
January 3, 2012
Intermarket Arbitrage
Cross rates (Exhibit 6.10) can be used to check on opportunities for
intermarket arbitrage.
This situation arose because one bank’s (Dresdner) quotation on €/£ is not the
same a calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank).
Intermarket Arbitrage
Citibank quote - $/€ $1.3297/€
Barclays quote - $/£ $1.5585/£
Dresdner quote - €/£ €1.1722/£
=
Cross rate calculation:
$1.5585/£
$1.3297/€
= € 1.1721/£
Because the rates are unequal, a triangular arbitrage opportunity exists.
(The £ value Dresdner quote is higher than calculated cross rate → should sell £ and
buy €)
Triangular Arbitrage by a Market Trader
Step 1: Infer the cross rate for 2 currencies from the exchange rate
of each currency with a third currency.
Step 2: Compare the cross rate and the quoted rate to determine if
there is an opportunity to make profit by buying low (ask price)
in one place and selling high (bid price) elsewhere (Buy
undervalued & sell overvalued currency).
Step 3: List all the transactions involved to utilize the arbitrage
opportunity.
Step 4: Whatever currency you start with, you should end up with
that same currency.
CROSS RATE CALCULATION WITH BID - ASK
EXCHANGE RATES
Summary
Foreign exchange market: functions, structures and participants
Foreign exchange transactions
Foreign exchange rates and quotations
Cross rate and triangular arbitrage
