Chapter 6

The Foreign
Exchange Market

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; and
is where foreign exchange transactions are
physically completed.

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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 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.
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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.

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Exhibit 6.1 Measuring Foreign Exchange Market

Activity: Average Electronic Conversions Per Hour

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Exhibit 6.2 Global Currency

Trading: The Trading Day

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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.

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Market Participants
The foreign exchange market consists of 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 operate

within these two tiers; 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.
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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.

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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.

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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.

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.

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Market Participants: Central Banks

and Treasuries
Central banks and treasuries use the market to acquire or
spend their countrys 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.

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Market Participants: Foreign

Exchange Brokers
Foreign exchange brokers are 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.

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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.
Exhibit 6.3 provides a structured map of
when settlement occurs within the
European market.

The date of settlement is referred to as the

value date.
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Exhibit 6.3
Foreign
Exchange
Settlement
in Europe

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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.)

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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).

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Market Size, Geographic Distribution,

and Currency Composition
In April 2010, a survey conducted by the Bank for
International Settlements (BIS) estimated the daily global net
turnover in the foreign exchange market to be $3.2 trillion.
Exhibit 6.4 shows that the most recent survey of foreign
exchange activity revealed modest growth in foreign
exchange trading over that seen in April 2007.
Exhibit 6.5 illustrates that the largest foreign exchange
markets are in London and New York followed distantly by
several others.
The dollar, euro, pound, and yen continue to dominate
foreign exchange.

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Exhibit 6.4 Global Foreign Exchange Market

Turnover, 1989-2010 (average daily turnover in
April, billions of U.S. dollars)

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Exhibit 6.5 Top 10 Geographic Trading Centers

in the Foreign Exchange Market, 1991-2010
(average daily turnover in April)

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Exhibit 6.6 Foreign Exchange Market Turnover by

Currency Pair (daily average in April)

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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.

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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, or
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.
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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) Base: USD Price: SF

However, this rate can also be stated as:

$0.6250/SF (American terms) Base: SF Price: USD

Exhibit 6.7 is an example of a foreign exchange

quote
Excluding two important exceptions, most
interbank quotations around the world are stated
in European terms.

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Exhibit 6.7 Foreign Currency

Quotations

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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.
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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. In the US, US$X/1.0 EUR
An indirect quote is a foreign currency price of a unit of
home currency. In Eurozone, EUR$Y/1.0 USD
The form of the quote depends on what the speaker
regards as home.

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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.

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Exhibit 6.8 Bid, Ask, and Mid-Point

Quotation

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Foreign Exchange Rates and

Quotes
Forward rates are typically
quoted in terms of points.

Pips: Last digits of spot

quotes
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.
Below 2 years (maturity): Cash
Rates Above 2 years: Swap
Rates

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Exhibit 6.9 shows how foreign exchange

rates are quoted in the WSJ

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Outright Spot: JPY/USD

Bid 118.27 Ask 118.37

Forward Quote (Pips):

Bid: -143

Ask: -140

Forward Rate:
Bid 118.27-1.43=116.84
Ask 118.37-1.40=116.97
Essentially the points reflect
interest rate differential

Exhibit 6.9 Exchange Rates: New

York Closing Snapshot

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Exhibit 6.9 Exchange Rates: New

York Closing Snapshot (cont.)

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Foreign Exchange Rates and

Quotes
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.

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Forward Exchange Rates and

Quotes

Quotations expressed in home currency terms

(Direct quotations in US: USD/JPY)

Quotations expressed in foreign currency terms

(Indirect quotations in US: JPY/USD)

Spot: JPY 118.27

Spot: USD 0.0084552

3-Month Forward: JPY 116.84

3-Month Forward: USD 0.0085587

The formula for % Forward Premium of

JPY becomes:

The formula for % Forward Premium of

JPY becomes:

100 x [(Forward-Spot)/Spot] x 360/90

100 x [(Spot-Forward)/Forward] x
360/90

=100 x [(118.27-116.84)/116.84] x 4 =
+4.90%
JPY is selling at a 4.90% Premium (+)
The formula for % Forward Premium of
USD becomes:
100 x [(Forward-Spot)/Spot] x 360/90
=100 x [(116.84-118.27)/118.27] x 4 =
-4.84%

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USD is selling at a 4.84% Discount

(-)

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=100 x [(0.0085587-0.0084552)/0.0084552]
x 4 = +4.90% [Text Error]

JPY is selling at a 4.90% Premium (+)

The formula for % Forward Premium of
USD becomes:
100 x [(Spot-Forward)/Forward] x
360/90
=100 x [(0.0084552-0.0085587)/0.0085587]
x 4 = -4.84%

USD is selling at a 4.84% Discount ()

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 (Exhibit 6.10) can be used to
check on opportunities for intermarket
arbitrage.
This situation arose because one banks
(Dresdner) quotation on / is not the
same a calculated cross rate between $/
(Barclays) and $/ (Citibank).
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Exhibit 6.10 Key Currency Rate

Calculations for January 3, 2012

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Intermarket Arbitrage
Citibank quote - $/
$1.3297/
Barclays quote - $/
$1.5585/
Dresdner quote - / 1.1722/
Cross rate calculation:
=
$1.3297/
$1.5585/ = 1.1721/
Because the rates are unequal, a triangular
arbitrage opportunity exists.
For another example, see Exhibit 6.11

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Exhibit 6.11 Triangular Arbitrage by

a Market Trader

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Foreign Exchange Rates

and Quotes in Percentage Terms
Measuring a change in the spot rate for quotations
expressed in home currency terms (direct
quotations):
% = Ending rate Beginning Rate

Beginning Rate

x 100

Quotations expressed in foreign currency terms

(indirect quotations):
% = Beginning Rate Ending Rate

Ending Rate

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x 100

Exhibit 6.12 Spot and Forward

Quotations for the Euro and Japanese Yen

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Triangular Arbitrage Example

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