Foreign Exchange Market

9/15/2022 @G S Hiremath, IIT Kharagpur

 An Introduction
• 164 different types of currencies

• Bretton Woods to floating exchange rate system

• Participants: Individuals, corporations, commercial banks and central banks;

• Interbank market – role of intermediaries

• Role of central bank

• Monitoring
• Intervention
• Profiting on currency reserves
• Discreet and conspicuous acts of Central Banks

• Hard currencies

• Trading centres

• Introduction of Euro
9/15/2022 @G S Hiremath, IIT Kharagpur
Price quotation

• Price Quotation: Price of foreign currencies in terms of domestic

currencies – Price of domestic currencies in terms of foreign
currencies
• Volume quotation – Wholesale and Retail

9/15/2022 @G S Hiremath, IIT Kharagpur

Exchange Rate

20 USD
Customer Store

1 Book

Customer
1 Book / 20 USD = 1/20 Book/USD = 0.05 book/USD
Store
20 USD/1 = 20/1 USD/Book
Inverse Ratio
Exchange Rate

1.07 USD
Customer Store

1 Euro

1 euro/1.07 USD = 1/1.07 = Euros/USD

1.07 USD/1 Euro = 1.07 USD/Euro
Understanding Exchange rates
• Direct and Indirect Quote

• Cross Exchange Rate

X USD / Currency A

Y USD / Currency B

𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐴 𝑌 𝑈𝑆𝐷 𝑌
𝑥 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐴 /𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦𝐵
𝑋 𝑈𝑆𝐷 𝐶𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐵 𝑋

• Bid-Ask Spread
𝐴𝑠𝑘 𝑟𝑎𝑡𝑒 −𝐵𝑖𝑑 𝑟𝑎𝑡𝑒
• = %𝐵𝑖𝑑 − 𝐴𝑠𝑘 𝑠𝑝𝑟𝑒𝑎𝑑
𝐴𝑠𝑘 𝑟𝑎𝑡𝑒

• Triangular Arbitrage

9/15/2022 @G S Hiremath, IIT Kharagpur

Currency appreciation and depreciation

• Store and Customer perspective

Previous exchange rate: X currency A / Currency B

Current exchange rate: Y currency A / Currency B

𝑋 > 𝑌 𝑋 − 𝑌 > 0 , Currency A has appreciated and Currency B has depreciated, relative to one another

𝑋 < 𝑌 𝑋 − 𝑌 > 0 , Currency A has appreciated and Currency B has depreciated, relative to one another

9/15/2022 @G S Hiremath, IIT Kharagpur

 Understanding Exchange rates
• Spot

• Forwards

• Outright forward rate: ratio at which two currencies will be exchange on future date

• Forward premium/discount

European terms American terms

𝑆𝑝𝑜𝑡 𝑅𝑎𝑡𝑒 − 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑅𝑎𝑡𝑒 12 𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑅𝑎𝑡𝑒 − 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 12

𝑥 𝑥100 𝑥 𝑥100
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 𝑛 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒 𝑛

9/15/2022 @G S Hiremath, IIT Kharagpur

Interest Parity

𝐹 (1+𝑟𝑑 ) (1+𝑟𝑑 )
• Covered interest parity (CIP): = 𝑜𝑟 𝐹 = 𝑆
𝑆 (1+𝑟𝑓 ) (1+𝑟𝑓 )

9/15/2022 @G S Hiremath, IIT Kharagpur

In class exercise

Bid Ask
Euros $ 1.194 $ 1.245

Yen $ 0.009245 $ 0.00967

What are the bank’s bid/ask spreads? How much would you lose if you converted
$500 into euros and $500 into yen, and the back into dollars.

9/15/2022 @G S Hiremath, IIT Kharagpur

Useful resources

• For data on foreign exchange market and learn about trading in FX market:
https://www.oanda.com
• For data on foreign exchange market and learn about trading in FX market: (the latest
one is also on course website in reading material)
http://www.bis.org/publ/rpfx02t.pdf

• Article on Warren Buffet’s FX activities

http://www.theage.com.au/articles/2004/05/11/1084041400648.html?from=storyrhs

• Foreign exchange survey by New York Fed

https://www.newyorkfed.org/fxc/volumesurvey/index.html

9/15/2022 @G S Hiremath, IIT Kharagpur