The Foreign Exchange Market

Understanding Foreign
Exchange Quotes
Where is this Financial Center?
La Defense in Paris: The View the
Other Way
How FX market operates 24/7?
The Role of Big Banks in the FX Market
◼ Large global banks (e.g., Deutsche Bank and UBS) are
involved in the interbank (i.e., wholesale) FX markets
through:
❑ (1) Their “external” clients” (Other large banks,
exporters, importers, multinational firms, central
banks, large non-bank financial institutions)
◼ Acting in a broker capacity at the request of these clients.
❑ (2) Their own banks (trading to generate profits).
◼ Acting in a “dealer” (i.e., trading) capacity
◼ Taking positions (long and short) in currencies to make a profit.
❑ In dealing with external clients, these large banks are
performing a “market maker” function:
◼ Quoting prices upon demand to other parties in the
interbank market, and
◼ Buying and selling currencies at their quoted prices.
“Making the Market” in FX
◼ The market maker function involves two primary
foreign exchange activities:
◼ (1) A willingness of the market maker to provide the
market with “on-going” (i.e., continuous) two way
quotes upon request:
❑ (1) Provide a price at which they will buy a currency
❑ (2) Provide a price at which they will sell a currency
◼ This function provides the market with transparency

◼ (2) A willingness of the market maker to actually buy

and/or sell at the prices they quote:
❑ Thus the market maker offers “firm” prices into the market!
◼ This function provides the market with liquidity.
Base and Quote Currency
◼ Recall that a foreign exchange quote is simply
the ratio of one currency to another.
◼ Thus, a “complete” market maker quote consist
of two ISO designations (e.g., EUR/USD or
USD/JPY):
❑ The first ISO currency quoted in the sequence is
referred to as the base currency.
❑ The second ISO currency quoted is referred to as the
quote currency.
◼ For examples above:
❑ EUR/USD: EUR is the base currency and USD is the quote
currency.
❑ USD/JPY: USD is the base currency and JPY is the quote
currency.
Bid and Ask Quotes
◼ A market maker always provides the market with
two prices, specifically a price at which the
market maker will buy a currency and a price at
which they will sell a currency.
◼ Example: EUR/USD: 1.2102/1.2106
❑ The first number quoted by the market maker is the
market maker’s buy price for 1 unit of the base
currency ($1.2102).
◼ This is the market maker’s bid quote (or buy price)
❑ The second quoted number is the market marker’s sell
price for 1 unit of the base currency ($1.2106).
◼ This the market maker’s ask quote (or sell price)
Bid Ask Example
◼ Example: GBP/USD: 1.5535/1.5537.
◼ Assume you’re dealing with the market maker:
❑ Questions:
❑ (1) How much will you pay for 1 pound;
❑ (2) how much will you get when you sell 1 pound;
❑ (3) how much will you pay for 1 U.S dollar;
❑ (4) how much will you get when you sell 1 U.S. dollar?
◼ Answers:
Bid Ask Example
◼ Example: GBP/USD: 1.5535/1.5537.
◼ Assume you’re dealing with the market maker:
❑ Questions: (1) How much will you pay for 1 pound; (2) how
much will get when you sell 1 pound; (3) how much will you
pay for 1 U.S dollar; (4) how much will you get when you
sell 1 U.S. dollar?
◼ Answers:
❑ (1) You can buy pounds for $1.5537 (ask price).
❑ (2) You will get $1.5535 for each pound you sell (bid
price).
❑ (3) You can buy 1 USD for 1/1.5535 = 64.37 pence.
❑ (4) When you sell 1 USD you will receive 1/1.5537 =
64.36 pence.
Bid Ask European Terms Example
◼ Assume the following USD/JPY: 76.35/76.45 (Note:
now the base currency is the dollar and the quote
currency is the yen)
◼ Assume you’re dealing with the market maker:
❑ Questions:
❑ (1) How much will you pay for 1 dollar;
❑ (2) how much will you get when you sell 1 dollar;
❑ (3) how much will you pay for 1 yen;
❑ (4) how much will you get when you sell 1 yen?
◼ Answers:
Bid Ask European Terms Example
◼ Assume the following USD/JPY: 76.35/76.45 (Note: now the
base currency is the dollar and the quote currency is the yen)
◼ Assume you’re dealing with the market maker:
❑ Question: (1) How much will you pay for 1 dollar; (2) how
much will get when you sell 1 dollar; (3) how much will you
pay for 1 yen; (4) how much will you get when you sell 1
yen?
◼ Answers:
❑ (1) You can buy dollars for 76.45 (ask price).
❑ (2) You will get 76.35 for each dollar you sell (bid
price).
❑ (3) You can buy 1 yen for 1/76.35 = 0.0130975 cents.
❑ (4) When you sell 1 yen you will receive 1/76.45 =
0.0130804
Bid Ask Spreads
◼ The Bid Ask spread is the “profit” that a market maker
bank will make on a “round” transaction (i.e., buying
and selling an equal amount at the stated price).
◼ Regardless of the type of quote (American terms or
European terms), the ask price is always higher than
the bid.
❑ That is, what they will sell the base currency for is always
higher than what they will buy the base currency at.
◼ Assume the following GBP/USD quote: 1.7921/1.7929
❑ What is the dollar spread to the market maker on a “round”
transaction (assume 10 million pound transactions)?
◼ Ask $1.7929 x £10,000,000 = $17,929,000 (price to sell pounds)
◼ Bid $1.7921 x £10,000,000 = $17,921,000 (price to buy pounds)
◼ Spread (Commission) = $ 8,000 (on round transaction)
Pips (or Points)
◼ Pips (sometimes called points) refer to the smallest unit by which the
prices for the currency pair may vary.
❑ Pip stands for percentage in point.
◼ In the example: GBP/USD: 1.5535/1.5537, the difference in the bid
quote and ask quote lies in the fourth decimal place, or 2 pips.
❑ A Pip for a 4 decimal place quoted currency is actually 0.0001 of an exchange
rate
◼ Traditionally most currencies were quoted out to 4 decimal places, with
the Japanese Yen being the major an exception, being quoted only to
the second decimal point (and thus a pip is 0.01 of an exchange rate).
◼ Today, however, many currency pairs which were traditionally quoted to
4 decimal places are now sometimes being quoted out to 5 decimal
places and the pairs which have former been quoted to 2 decimal
places are quoted out to 3 and 4 decimal places. The reason is that
new electronic platforms (e.g., ForexStreet) have entered the forex
market and price competition has become greater. In response to this
competition, many trading platforms have added an additional decimal
place to their quotes.
Observations About Bid/Ask Spreads
◼ Bid and ask spreads (pip spreads) widen or narrow in
response to a number of factors, including:
❑ Bid/ask spreads increase with exchange rate volatility and
uncertainty.
❑ Bid/ask spreads decrease with increases in market maker
competition.
❑ Bid/ask spreads smaller in wholesale (interbank) market than in
retail market (and tourist market).
◼ Example: GPB/USD for September 26, 2011
◼ Wholesale: 1.55145/1.55158; pip spread = 1.03
◼ Retail: 1.5512/1.5516; pip spread = 4
◼ Tourist retail (Wells Fargo quote): 1.4489/1.6152; pip spread = 1663 pips
❑ Bid/ask spreads can differ slightly among markets.
◼ As market makers attempt to adjust their positions and thus make dealing
with them more or less attractive.
Which Way is the Currency Moving?
◼ Remember when viewing a foreign exchange quote,
assign a value of 1 to the base currency (the base
currency is the first in the ISO pair). The quotes you see
refer to one unit of this base currency.
◼ Thus, whenever bid or ask prices are moving up, that
means that the base currency is getting stronger (relative
to the quote currency) and the quote currency is getting
weaker.
◼ Conversely, whenever bid or ask prices are moving
down, that means that the base currency is getting
weaker (relative to the quote currency) and the quote
currency is getting stronger.
Example: Which way is the
Currency Moving?
Currency Sept 23 Sept 24 Foreign USD
Currency
EUR/USD 1.3475 1.3455

GBP/USD 1.5511 1.5518

USD/JPY 76.56 76.45

USD/CHF 0.9051 0.9059

Example: Which way is the
Currency Moving?
Currency Sept 23 Sept 24 Foreign USD
Currency
EUR/USD 1.3475 1.3455 EUR USD
weakened strengthened
GBP/USD 1.5511 1.5518 GBP USD
strengthened weakened
USD/JPY 76.56 76.45 JPY USD
strengthened weakened
USD/CHF 0.9051 0.9059 CHF USD
weakened strengthened
Let’s Look at Real Time Currency Quotes
◼ Go to the following web-site: http://www.fxstreet.com/
◼ At this site, go to:
❑ Rates and Charts
❑ Go to Retail Rates Live
◼ Select currency as USD
◼ Observe ISO quotes
◼ Observe bid and ask quotes.
◼ Understand what currency and at what price the market maker is
buying or selling (base currency).
◼ Understand what price you (a non-market maker) would buy or sell
the base currency to the market maker.
◼ Observe changes in bid and ask quotes.
❑ If these are going up, the base currency is strengthening and the
quote currency is weakening. Reverse is true if these are going
down.
◼ Next, link to: Interbank FX Rates Live and observe
majors and G7 (note quotes to 5 decimal places)
THANK YOU