Foreign Exchange Markets

Foreign Exchange Markets
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

Foreign Exchange Markets
There are six main characteristics of the FOREX markets which will be discussed
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 exchange rates

FOREX Market Geography
Geographically, the FOREX market spans the globe with prices moving and currencies trading on a 24 hour basis Major exchanges are located in Singapore, Hong Kong and Tokyo in the East Then it moves to Bahrain, and London for the European area And on to New York, San Francisco and Sydney

with a daily average turnover of US$1.9 trillion — 30 times larger than the combined volume of all U. for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY). Currencies are traded in pairs. equity markets. also referred to as the "Forex" or "FX" market is the largest financial market in the world.S. "Foreign Exchange" is the simultaneous buying of one currency and selling of another.Introduction The Foreign Exchange market. .

" . it required as much as US$1 million to open an account.Some Interesting facts… Before Internet era. The forex market continues to grow at a phenomenal rate. daily forex trading volume surged from US$5 billion to US$1. From 1997 to the end of 2000.5 trillion. 85% of all daily transactions involve trading a group of currencies known as the "Majors.

How to Read a Currency Quote currency pair base currency quote currency Bid price Ask Price SIMPLE !! .

Few Jargons !! lot Long market Short market Margin Leverage Trading currencies on margin lets you increase your buying power. you could purchase up to $200. .000 worth of currency-because you only have to post 1% of the purchase price as collateral. Here's a simplified example: If you have $2.000 in buying power. Another way of saying this is that you have $200.000 cash in a margin account that allows 100:1 leverage.

) As you expected. your profit is US $1100.260 USD. you would buy Euros (simultaneously selling Dollars) and then wait for the exchange rate to rise.00 .0236/42. Since you originally sold (paid) 101. you must now sell Euros for Dollars to realize any profit. EUR/USD rises to 1. To execute this strategy. your initial margin deposit would be 1.0236. at 1% margin. Total profit = US $1100. So you make the trade: purchasing 100.Example of a FOREX trade Suppose you feel that the EUR is undervalued against the dollar.000 Euros.260 Dollars.360 USD. you will receive 102.000 EUR (1 lot) and selling 101.0236 Dollars. When you sell the 100.000 Euros at the current EUR/USD rate of 1. You can now sell 1 EUR for 1. (Remember. Since you bought Euros and sold Dollars in your previous trade.

Tools for determining future movements in Money Market Fundamental Analysis Thorough analysis of economic and political data with the goal of determining future movements in a financial market. . price trends. Technical Analysis An effort to forecast future market activity by analyzing market data such as charts. and volume.

Some reasons to trade in FOREX 24-hour forex trading Superior liquidity 100:1 Leverage in forex trading Lower transaction costs Equal profit potential in both rising and falling markets .

Some Cautions The market could move against you. Due to the leverage effect!! . You could lose your entire investment.

000 15.000 10.000 Greenwich Mean Time 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 10 AM Lunch Europe In Tokyo In Tokyoopening Asia closing Americas London open closing Afternoon in America 6 pm Tokyo In NY opens .000 5.FOREX Market Geography Measuring FOREX Market Activity: Average Electronic Conversations Per Hour 25.000 20.

FOREX Market Functions The FOREX market is the mechanism by which participants transfer purchasing power between countries. 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 . obtains or provides credit for international trade.

inventory in transit must be financed. The FOREX market provides a source of credit via specialized instruments such as letters of credit The FOREX market provides ―hedging‖ facilities for transferring foreign exchange risk to someone else more willing to carry that risk .FOREX Market Functions Because the movement of goods between countries takes time.

the interbank or wholesale market. and the client or retail market Five broad categories of participants operate within these two tiers Bank and non bank foreign exchange dealers Individuals and firms conducting commercial or investment transactions Speculators and arbitragers Central banks and treasuries Foreign exchange brokers .FOREX Market Participants The FOREX market consists of two tiers.

Market maker: A broker-dealer willing to accept the risk of holding a particular currency in order to facilitate trading in that currency.Bank/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 Dealers on behalf of large international banks often act as market makers. Offer (Ask price): the price a seller is willing to receive. Bid-Ask spread: The amount that the ask price exceeds the bid. . often willing to stand in and buy or sell these currencies without having a counterpart with which to unload the ―inventory‖ Bid price: The price a buyer is willing to pay.

20% of a banks’ average net income Small.to medium-sized banks rarely act as market makers yet still participate in the interbank market .Bank/Non-Bank Dealers They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels Currency trading is profitable and often contributes between 10% .

MNEs. exporters.Commercial Investment Importers. tourists and others use the FOREX market to facilitate execution of commercial or investment transactions Some of these participants use the market to hedge foreign exchange rate risk . portfolio investors.

without need or obligation to serve clients or ensure a continuous market Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks .Speculators & Arbitragers Speculators and arbitragers seek to profit from trading in the market itself They operate for their own interest.

Central Banks & 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 the European Monetary System (EMS) 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 .

with separate lines for differing currencies. spot and forward rates .Foreign Exchange Brokers Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming 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.

Types of transactions .

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 .Inter-Bank Market Transactions Transactions within this market can be executed on a spot.

normally. on the second following business day The settlement date is often referred to as the value date This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York . with delivery and payment between banks to take place.Spot Transactions A spot transaction in the interbank market is the purchase of foreign exchange.

nine and twelve months Terminology typically used is buying or selling forward A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros .Outright Forward Transactions This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction. two. six. three. but payment and delivery are delayed Forward rates are contracts quoted for value dates of one.

the dealer incurs no exchange rate exposure .Swap Transactions 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 counterpart A common type of swap is a spot against forward The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market Since this transaction occurs at the same time and with the same counterpart.

000 forward for dollars for delivery in two months at $1.Swap Transactions Forward-forward swaps – A dealer sells £20.6820/£ The difference between the buying and selling price is equivalent to the interest rate differential Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis .6870/£ and simultaneously buys £20.000 forward for delivery in three months at $1.

Swap Transactions Non-deliverable forwards (NDFs) – NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments Pricing of NDFs reflects basic interest rate differentials .

210 billion in April 2001 .FOREX Market Size The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$1.

org. www. billions of US dollars) 800 700 600 500 400 300 200 100 0 1989 1992 1995 1998 2001 Spot Forwards Swaps Source: Bank for International Settlements.FOREX Market Size Global Foreign Exchange Market Turnover (daily averages in April. Next survey planned for April 2004.” October 2001.bis. “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001. .

FOREX Market Size Two of the three categories fell between 1998 and 2001 with spot market daily turnover falling the most. from $568 billion in 1998 to $387 billion in 2001 Forward transactions increased slightly from $128 billion in 1998 to $131 billion in 2001 Swaps fell to $656 billion in 2001 from $734 billion in 1998 BIS attributes the introduction of the Euro. the growing share of electronic broking in the spot market and consolidation in banking as explanations for the reduction .

“Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001.” October 2001. Next survey planned for April 2004. .bis.org. www.FOREX Market Size Geographic Distribution of Foreign Exchange Market Turnover (daily averages in April. billions of US dollars) 700 600 500 400 300 200 100 0 1989 United States United Kingdom Japan Singapore Germany 1992 1995 1998 2001 Source: Bank for International Settlements.

www. “Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001.bis.” October 2001.org.FOREX Market Size Currency Distribution of Global Foreign Exchange Market Turnover (percentage shares of average daily turnover in April) 90 80 70 60 50 40 30 20 10 0 1989 1992 1995 1998 2001 Source: Bank for International Settlements. Next survey planned for April 2004. US dollar euro Deutshemark French franc EMS currencies Japanese yen Pound sterling Swiss franc .

600 Swiss francs per dollar • European quote The dollar price of a unit of foreign currency • $0. read as 0.625 dollars per Swiss franc • American quote . read as 1.6250/Sfr.FOREX Rates & Quotes A foreign exchange quote is a statement of willingness to buy or sell at an announced rate In the retail market (newspapers and exchange booths). quotes are often given as the home currency price of the foreign currency Interbank quotes – professionals state forex quotes in one of two ways The foreign currency price of one dollar • Sfr1.6000/$.

Australian and New Zealand dollars are also quoted in American terms . except two.FOREX Rates & Quotes The former quote is considered the ―European quote‖ and the latter is the ―American quote‖ Almost all European currencies. are quoted the European way The Pound Sterling and the Euro are the exceptions Additionally.

37 per dollar making profit on the spread .27 per dollar and sell yen at ¥118.¥118.FOREX Rates & Quotes Bid and Ask Quotations Interbank quotes are given as a bid and ask • The bid is the price at which a dealer will buy another currency • The ask or offer is the price at which a dealer will sell another currency – Example: ¥118.37/$ is the bid/ask for Japanese yen – The bank will buy yen at ¥118.27 .

with convention dictating the number of digits to the right of the decimal • Hence a point is equal to 0.FOREX Rates & Quotes Expressing Forward Quotations on a Points Basis The previously mentioned rates for yen were considered outright quotes Forward quotes are different and typically quoted in terms of points A point is the last digit of a quotation.0001 of most currencies .

43 ¥116.27 -1.37 -1.84 Ask ¥118.FOREX Rates & Quotes Expressing Forward Quotations on a Points Basis The yen is quoted only to two decimal points A forward quotation is not a foreign exchange rate.40 ¥116.97 . rather the difference between the spot and forward rates Example: Bid Outright spot: Plus points (3 months) Outright forward: ¥118.

FOREX Rates & Quotes Forward Quotations in Percentage Terms Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate • This is similar to the forward discount or premium calculated earlier The important thing to remember is which currency is being used as the home or base currency • For indirect quotes (i.Foward 360  x x 100 Foward days .e. the formula is f FC Spot . quote expressed in foreign currency terms).

FOREX Rates & Quotes Forward Quotations in Percentage Terms • For direct quotes (i.e. the formula is Forward . quote expressed in home currency terms).Spot 360 f  x x 100 Spot days H .

04 90 ¥ Example: Direct quote 0.a.a.009520183 .FOREX Rates & Quotes Forward Quotations in Percentage Terms Example: Indirect quote 105. 0. 105.009465215 90 $ .32% p.04 360 f  x x 100   2.009465215 360 f  x x 100   2.32% p.0.65 .105.

625/Sfr is a direct quote in the US An indirect quote is a foreign currency price in a unit of the home currency • Sfr1. • $0.625/Sfr is a direct quote in the US and an indirect quote in Switzerland .FOREX Rates & Quotes Direct and Indirect Quotes A direct quote is a home currency price of a unit of a foreign currency • Sfr1.6000/$ is a direct quote in Switzerland • $0.600/$ is an indirect quote in the US.

190/$ . Both the Mexican peso (Ps) and Japanese yen (¥) are quoted in US dollars • Assume the following quotes: Japanese yen ¥121.13/$ Mexican peso Ps9. so their exchange rate is determined through their relationship to a widely traded third currency Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo.FOREX Rates & Quotes Cross Rates Many currencies pairs are inactively traded.

13/$ Japanes yen/US dollar   ¥ 13 .13.190 and with that dollar buy ¥121.190 / $ .FOREX Rates & Quotes Cross Rates The Mexican importer can buy one US dollar for Ps9.1806 / PS Mexican pesos/US dollar PS 9. the cross rate would be ¥ 121.

4443/£ €1.FOREX Rates & Quotes Intermarket Arbitrage Cross rates can be used to check on opportunities for intermarket arbitrage Example: Assume the following exchange rates are quoted Citibank Barclays Bank Dresdner Bank $0.9045/€ $1.6200/£ .

FOREX Rates & Quotes Intermarket Arbitrage The cross rate between Citibank and Barclays is $1.5968/ £ $0. so an opportunity exists for risk-less profit .4443/£  € 1.9045/€ • This cross rate is not the same as Dresdner’s rate quote of €1.5800/£.

651 to Citibank at $0.533 (1) Start with $1.000.014.651 (2) (3) Barclays Bank Receive £692.533 (6) Receive $1.121.000.6200/£ (4) .000 to Barclays Bank at $1.121.014.FOREX Rates & Quotes Citibank End with $1.377 Sell £692.377 to Dresdner Bank at €1.4443/£ Dresdner Bank (5) Sell €1.000 Sell $1.9045/€ Receive €1.

Thank you .

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