Chapter 6

The Foreign
Exchange Market
 LECTURE OUTLINE

• Introduction to foreign exchange market

• Chapter 6:
– Definition and functions
– Forex market participants
– Forex transactions
– Forex rates and quotations
– Triangular arbitrage activity
• Chapter 9 (recommended reading)
– Forex rate determination
– Forex rate forecasting

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 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: 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

• 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.

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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.
• Speculators: seek all the profit from exchange
rate changes
• Arbitragers: try to profit from simultaneous
exchange rate differences in different markets.

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 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.

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 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.

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 Transactions in the Interbank
Market

• Spot transaction
– Value date (date of settlement)
• Outright forward transaction (forward)
– Buying forward
– Selling forward
• Swap

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 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.

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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 (A contract to deliver dollars for
euros in six months is both “buying euros forward
for dollars” and “selling dollars forward for euros.”)

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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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 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 &
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

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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
(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.
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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)
• 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.

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 Exhibit 6.7 Foreign Currency
Quotations

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 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.

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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. (base = foreign; term = home)
• An indirect quote is a foreign currency price of a unit of
home currency. (base = home; term = foreign)
• The form of the quote depends on what the speaker
regards as “home.”

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 Class Quiz

• From the viewpoint of an 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/$

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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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 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 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

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 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?

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 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

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 Exhibit 6.12 Spot and Forward
Quotations for the Euro and Japanese Yen

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 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 0.7360

exchange 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$?

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 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.

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 Foreign Exchange Rates and
Quotes: Forward quotations
• For quotations expressed in foreign currency
terms (Indirect quotations) the formula
becomes: base currency = home (fp on term)
f ¥ = Spot – Forward x 360 x 100
Forward n
• For quotations expressed in home currency
terms (Direct quotations) the formula
becomes: base currency = foreign (fp on base
f ¥ = Forward – Spot x 360 x 100
Spot n

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 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:

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 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%.

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 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).
• 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).

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 Exhibit 6.10 Key Currency Rate
Calculations for January 3, 2012

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 Calculate cross rate

Currency USD EUR JPY

JPY 83.735 ?

EUR 0.7549 ?

USD 1.3247 0.0119

Calculate cross rate:

JPY/EUR = JPY/USD : EUR/USD = 83.735/0.7549 = 110.9219
EUR/JPY = EUR/USD : JPY/USD = 0.00901

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 Intermarket Arbitrage

• Citibank quote - $/€ $1.1.3297/€

• Barclays quote - $/£ $1.5585/£
• Dresdner quote - €/£ €1.1722/£

=
• Cross rate calculation:
$1.5585/£ = € 1.1721/£
$1.3297/€
Because the rates are unequal, a triangular
arbitrage opportunity exists.
(The £ value Dresdner quote is higher than
calculated cross rate → should sell £ and buy €)
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 • 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.

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 Exhibit 6.11 Triangular Arbitrage by
a Market Trader

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 CROSS RATE CALCULATION WITH
BID - ASK EXCHANGE RATES

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