Chapter 15

Foreign exchange: The structure and operation of the FX market

Foreign exchange market participants

Ø Foreign exchange dealers and brokers

• Foreign dealers: financial institutions that quote two way prices and
act as principals in the FX market
• Foreign brokers: obtain the best prices in the global FX market and
match FX dealers’ buy and sell orders for a fee
Ø Central banks
• Acquire foreign currency to pay for their government’s purchases of
imports such as defence equipment
• Change the composition of the central bank’s holdings of foreign
currencies as part of its management of official reserve assets
• Influence the exchange rate (when they consider the exchange rate
is moving too rapidly, and is trading well outside that can be
supported by economic fundamentals)
Ø Firms conducting international trade transactions
• Businesses that export goods or services in the international
markets may receive payment in a foreign currency (sell foreign
currency and buy local currency)
• Businesses that import goods or services will need to pay for those
goods and services in foreign currency (sell local currency and buy
foreign currency)
Ø Investors and borrowers in the international capital markets
• Commercial bank foreign borrowings are usually converted into the
home currency
• Payment of interest and principal need to be made in the
denominated currency of the loan
• Corporations and financial institutions investing overseas need to
purchase foreign currency to make investments
• Dividends or interest payments received from overseas investments
will be denominated in foreign currency
Ø Speculative transactions
• Businesses and financial institutions attempt to anticipate future
exchange rate movements to make a profit
 • There is a risk involved that the exchange rate will move in the
opposite direction to that anticipated, or in the anticipated
direction but by less than expected
• Long position occurs when the underlying asset has been bought
forward
• Short position is by entering into a forward contract to sell an asset
that is not held at that time
Ø Arbitrage transactions
• Taking advantage of buy and sell price differences between markets
• Involve no FX risk exposure
• Two types of arbitrage:
o Geographic – where two dealers in different locations quote
different rates on the same currency
o Triangular – occurs when exchange rate between 3 or more
currencies are out of perfect alignment
• They exist because markets are not perfectly efficient and because
prices or exchange rates may not adjust immediately to new
information in all markets

Operation of the FX market

Ø FX market is a global market, operating 24 hours a day according to

business hours across the time zones
Ø Typically, the price of each currency at any point in time will be identical,
regardless of the geographic location of the FX dealing rooms offering the
quotes, otherwise arbitrage profits could be made
Ø The FX market consists of a vast and highly sophisticated global network of
telecommunications systems, that provide the current buy and sell rates
for various currencies in dealing rooms located around the globe

Spot and forward transactions

Ø Of the various currency contracts that can be bought or sold on the FX

markets, the most common are those that have a maturity date:
• Spot transactions – maturity date two business days after the FX
contract is entered into
• Forward transactions – maturity date more than two days after the
FX contract is entered into
• Tod value transactions – transactions entered into today, with same
day value or settlement
 • Tom value transactions – transactions entered into today, for
settlement tomorrow

Spot market quotations

Ø Asking for a quotation

• The price of currency expressed in terms of another currency
• The first currency mentioned is the one whose price is being
sought – the base currency
• The second currency in an FX quote is referred to as the terms
currency
Ø Two way quotations
• Example: Australian dollar/euro may be expressed as EUR/AUD
1.6155-65
o The two numbers indicate the dealer’s buy and sell price
o The dealer will buy EUR1 for AUD1.6155
o The dealer will sell EUR1 for AUD1.6165
o Dealer buys low and sell high
• Buy price is also referred to as the bid price and sell price is also
referred to as the ask price
• Spread is the points difference between bid and offer prices in a
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quote 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑠𝑝𝑟𝑒𝑎𝑑 = × 100
*'+ &$'(#
• Point is the final decimal place in an FX quotation, and usually the
spread is only a few points
Ø Transposing spot quotations
• Consider a quote EUR/AUD 1.6155-65, where the EUR is the unit of
the quotation
• To fine the value of the AUD/EUR, the quotation would need to be
transposed
• Firstly reverse the bid and offer prices: 1.6165-55
• Then take the inverse: AUD/EUR 0.6186-90
Ø Calculating cross rates
• There are two ways in which currencies can be quoted against the
USD
o Direct quote: where the USD is the base currency
o Indirect quote: where the USD is the term currency
• To calculate the cross rate, follow the steps below
1. Place the currency that is to become the unit of the quotation
first
 2. Transpose the rate if the currency to be quoted first is the term
currency
3. Transpose the rate if the currency to be quoted second is the
base currency
4. Multiply the two bid rates (this gives the bid rate)
5. Multiply the two offer rates (this gives the offer rate)

Forward market quotations

Ø Forward exchange rate is the bid/offer rate applicable at a specified date

beyond the spot value date
Ø The forward exchange rate varies from the spot rate due to interest rate
parity (interest rate parity is the principle that exchange rates will adjust to
reflect interest rate differentials between countries)
Ø The points will be either at a premium or a discount to the spot price
Ø Forward exchange rates are quoted as forward points, either above or
below the spot rate
• If the forward points are rising, then add them to the spot rate
(base currency is at a forward premium; interest rate of the base
currency is lower)
• If the forward points are falling, then subtract them to the spot rate
(base currency is at a forward discount; interest rate of the base
currency is higher)
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• 𝑃𝑜𝑖𝑛𝑡𝑠 = 𝑆 4 !"#$%#& &%() − 16
,-./*× &%() *+ (,%# 2

Ø Modifications to the points are needed as:

• Different borrowing and lending rates apply in the Euromarkets
where interest rates are generally taken
• Also charge margins for cost and perhaps adjust the points to
reflect the dealer’s overall relationship with the company and
market competition
Ø Some real world complications
• Two way FX quotations: care in selecting appropriate bid and offer
rates in calculating forward rates
• Different interest rate year conventions: when interest rates are
based on different conventions, it is necessary to convert one or
other rate so that the two are comparable
• Variations in compound interest period: consider the effective rate
of interest on borrowed funds and the value of deposits
 • Borrowing and lending interest rates

European monetary union and the FX market

Ø The EMU and the birth of a new single currency, the euro, took effect on 1
January 1999
Ø The EMU involved the establishment of the European Central Bank, which
is responsible for the determination and implementation of EU monetary
policy
Ø It has removed twelve foreign currencies from the FX markets and
introduced a single euro, which has become a new global currency
Ø It led to an increase in the liquidity of the euro FX market and other FX
markets around the globe
Ø It reduced FX currency risk that previously was associated with financial
transactions between EU member states