THE FOREIGN

EXCHANGE
MARKET
Chapter Overview
 Introduction
 Organization of the Foreign Exchange
Market
 The Spot Market
 The Forward Market
 Interest Rate Parity Theory
Introduction
 The FOREX market provides the physical
and institutional structure through which the
money of one country is exchanged for that
of another country
 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 rate
Introduction
 There are six main characteristics of the
FOREX markets
 The geographic extent
 The three main functions
 The Market’s participants
 Its daily transaction volume
 Types of transactions including spot, forward and
swaps
 Methods of stating exchange rates, quotations
and changes in exchanges rates
Geographic Extent of the Market

 Geographically the FOREX market spans the

globe with prices moving and currencies
trading on a 24 hour basis
 Three major segments can be identified as
Australia, Europe and North America
Functions of the FOREX Market
 The FOREX market is the mechanism by
which participants transfer purchasing power
between countries, obtains or provides credit
for international trade and minimizes
exposure to exchange rate risk
 Transferring of purchasing power is necessary
because international trade and capital
transactions normally involve parties in countries
with different currencies yet each party wishes to
transact in their own currency
Functions of the FOREX Market
 Because the movement of goods between
countries take time inventory in transit must
be financed. The FOREX market provides a
source of credit via specialized instruments
such as letter of credit
 The FOREX market provides hedging
facilities for transferring foreign exchange risk
to someone else more willing to carry that
risk
Participants in the Foreign Exchange
Market
Participants at 2 Levels
 Wholesale Level (95%)
 major banks
 Retail Level
 business customers
Correspondent Banking
Relationships
 Large commercial banks maintain demand

deposit accounts with one another which facilities

the efficient functioning of the FOREX Market
 International commercial banks communicate with
one another with:
 SWIFT: Society for Worldwide Interbank Financial
Telecommunications
 CHIPS: Clearing House Interbank Payments System
 ECHO: Exchange Clearing House Limited, the first
global clearing house for settling interbank FOREX
transactions
Types of Currency Market

Two Types of Currency Markets

Spot Market
 immediate transaction

 recorded by 2nd business day

Forward Market
 transactions take place at a specified future
date
Participants in the Market

Spot Market
 commercial banks

 brokers

 customers of commercial and central

banks
The Spot Market
 Inter-bank quotations are given as a bid and ask (also
referred to as offer/demand) – market makers
 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
 The bid-ask spread is the spread between stated bid
and ask rates for a currency
 Example: USD 1.4419-28 /Pound means that the banks
are willing to buy (bid) Pounds for 1.4419 USD and sell
(ask) Pound for 1.4428 USD
 For widely traded currencies: dollar, pound, euro, yen,
Swiss franc the spread is on the order of 0.05%-0.08%
 For less traded and more volatile currencies: larger
spreads
Foreign Exchange Rates and
Quotations
 A direct quote is a home currency price of a
unit of a foreign currency
 Rs 50/$ is a direct quote in India
 An indirect quote is a foreign currency price
in a unit of the home currency
 .02 / Rs is an indirect quote in the India
Transactions Costs
Bid-Ask Spread used to calculate the fee charged
by the bank

Bid = the price at which the bank is willing to buy

Ask = the price it will sell the currency

Percent Spread Formula (PS):

PS=Ask – Bid/ Ask* 100

Participants in the Market

Forward Market
 arbitrageurs
 traders
 hedgers
 speculators
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/brokers 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
Foreign Exchange rates and
Quotations
 A direct quote is a home currency price of a
unit of a foreign currency
 Rs 50/$ is a direct quote in India
 An indirect quote is a foreign currency price
in a unit of the home currency
 .02 / Rs is an indirect quote in the India
Bank and Non-Bank Dealers
 These participants profit from buying
currencies at a bid price and then reselling
them at an offer or ask price
 Competition among dealers narrows the
spread between the bid and offer rate
contributing to the market’s efficiency
 Currency trading is profitable and often
contributes between 10-20% of a banks
average net income
Central banks and Treasuries
 Central banks and treasuries use the market to
acquire or spend their country’s currency reserves
as well as to influence the price at which their own
currency trades
 They may act to support the value of their currency
because of their government’s policies or obligations
or because of commitments entered through joint
float agreements such as European Monetary
System
 Consequently their motive is not to profit but rather
influence the foreign exchange value of their
currency in a manner that will benefit their interests
Foreign Exchange Brokers
 Foreign exchange brokers are agents who
facilitate trading between dealers without
themselves become principals in the
transaction
 For this service they charge a small
commission
 They maintain instant access to hundreds of
dealers worldwide via open lines and at times
may maintain such lines with several banks,
with separate lines for differing currencies,
spot and forward rates
Transactions in the Interbank Market
Transactions within this market can be
executed on a spot, forward, or swap basis:
 A spot transaction requires almost immediate

delivery of foreign exchange

 A forward transaction requires delivery of

foreign exchange at some future date

 A swap transaction is the simultaneous

exchange of one foreign currency for another

The Forward Contract
 An agreement between a bank and a
customer to deliver a specified amount of
currency against another currency at a
specified future date and at a fixed exchange
rate
Purpose of a Forward

Hedging: The act of reducing exchange rate

risk
Forward Rate Quotations

Two Methods:
 Outright Rate: quoted to commercial

customers
 Swap Rate: quoted in the interbank market
as a discount or premium.
Calculating the forward premium or
discount
= F-S/S*12/n*100
Where,
F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the forward
contract
Forward Contract Maturities
 Contract Terms
 30-day
 90-day
 180-day
 360-day
 Longer-term Contracts
Triangular arbitrage
Arbitrage possibility due to differences in exchange rate
quotations

 Start with 1,000,000 USD → Sell at (USD1.4443/Pound)

→ receive 692,377 Pounds sell at (Euro1.6200/Pound)
→ receive 1,121,651 Euro →sell at (USD0.9045/Euro)
→receive 1,014,533 USD
 Profit: 1,014,533 – 1,000,000 = 14,533 USD
Triangular arbitrage

Citibank Start with $1000000

Receive
$1,014,533 Sell $1000000
to Barclays
Bank at 1.4443/
pound (Buy)

Dresdner Receive 692,377

Barclay Pounds
Sell to Citibank at
Sell to Dresdner bank
$0.9045/ € (buy USD)
at 1.6299/ Euro (buy
Receive €1,121,651
Euro)