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The Basics of the Foreign

Exchange Market

Defining The Foreign Exchange


The Foreign Exchange
Market
Market can be defined in terms
of specific functions, or the institutional structure that:
(1) Facilitates the conversion of one countrys currency
into another.
Through the buying and selling of currencies.
Allows global firms to move in and out of foreign currency as
needed.

(2) Sets and quotes exchange rates.


This is the ratio of one currency to another.
These rates determine costs and returns to global businesses.

(3) Offers contracts to manage foreign exchange


exposure.
These hedging contracts allow global firms to offset their foreign
currency exposures and manage foreign exchange risk.
Thus, they can concentrate on their core business.

Quick Review of Market


Characteristics
Worlds largest financial market.
Estimated at $3.2 trillion dollars per day in trades.

NYSE-Euronext currently running about $40 billion per day.

Market is a 24/7 over-the-counter market.

There is no central trading location.


Trades take place through a network of computer and
telephone connections all over the world.

Major trading center is London, England.

34% of all trades take place through London (New York


second at 17%).
Most popular traded currency is the U.S. dollar .
Accounts for 86% of all trades (euro second at 27%).

Most popular traded currency pair is the U.S.


dollar/Euro.

Represents 27% of all trades (dollar yen second at 13%)

Currencies are either traded for immediate delivery


(spot) or some specified future delivery (forward).

How does the FX Market Quote


Currencies?

(1) American Terms:

Expresses the exchange rate as the number of U.S.


dollars per one unit of some foreign currency.
For example, $2.00 per (1) British pound.

(2) European Terms:


Expresses the exchange rate as the number of
foreign currency units per one U.S. dollar.
For example, 120 yen per (1) U.S. dollar.

Most of the worlds currencies are quoted for


trade purposes on the basis of European terms.
Exceptions include: British pound, Euro, Australian
dollar.

Newspapers, like the Wall Street Journal,


however, usually quote both.

Quotes are Given by Time of


Settlement
Spot Exchange Rate:
Quotes for immediate transactions
(actually within 1 or 2 business days)

Forward Exchange Rate:


Quotes for future transactions in a
currency (3 business days and out).
Forward markets are used by businesses to
protect against unexpected future changes in
exchange rates.
Forward rate allows businesses to lock in an
exchange rate for some future period of time.

Observing Changes in Spot


Exchange Rates: What do
they Mean?
Appreciation (or strengthening) of a
currency:
When the currencys spot rate has increased in
value in terms of some other currency.

Depreciation (or weakening) of a currency:


When the currencys spot rate has decreased in
value in terms of some other currency.

Forward Rate Quotes


As a rule, forward exchange rates are set
at either a premium or discount of their
spot rates.
If a currencys forward rate is higher in value
than its spot rate, the currency being quoted
at a forward premium.
For example: the Japanese 1 month forward is
greater than its spot (0.009034 versus 0.008999)

If a currencys forward rate is lower in value


than its spot rate, the currency is being
quoted at a forward discount.
For example, the British pound 6 month forward is
less than its spot (2.0417 versus 2.056).

What Institutions are Involved in


the Foreign Exchange Market?
Large global banks (e.g., Deutsche Bank, HSBC,
UBS, Citibank) acting on behalf of:
(1) Their external clients (primarily global
firms: exporters, importers, multinational firms)
Acting in a broker capacity at the request of these clients
and meeting the foreign currency needs of these clients.

(2) Their own banks (trading to generate


profits).
Acting in a dealer (i.e., trading) capacity
Taking positions in currencies to make a profit.

In meeting the needs of their clients and their


own trading activities, these global banks
establish the tone of the market.
This is through a market maker function.

Making the Market in FX


The market maker function of any global bank
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.

ISO Currency Designations


All foreign currencies are assigned an International
Standards Organization (ISO) abbreviation.
E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; MXN; SGD; ARS;
THB; INR; RUB; ZAR; NZD; CHF; KRW
For individual countries see:
http://www.oanda.com/site/help/iso_code.shtml

Since the exchange rate is simply the ratio (i.e., value) of


one currency against another, market makers express this
relationship using the two currencies ISO designations.
For Example:
USD/JPY
USD/MXN
EUR/USD
GBP/USD
EUR/JPY (this is a cross rate; since USD in not one of them)

Base and Quote Currency


Given that a foreign exchange quote is
simply the ratio of one currency to another,
a complete market maker quote must
have two ISO designations (e.g., EUR/USD
or USD/JPY):
The first ISO currency quoted is called the base
currency.
The second ISO currency quoted is called 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

Recall that a market maker always


provides the market with two prices, both a
buy and sell quote (or price) for a currency.
For Example: EUR/USD: 1.2102/1.2106
The first number quoted by the market maker is
the market makers buy price ($1.2102).
It is called the market makers bid quote (or buy price)

The second quoted number is the market


markers sell price ($1.2106).
It is called the market makers ask quote (or sell price)

Note: The bid quote is always lower than the


ask quote.

What Currency is The Market


Maker Buying and Selling?
Given the example: EUR/USD: 1.2102/1.2106,

which currency is the market maker selling and


which currency is the market maker buying?
Answer: Market makers are always quoting
prices at which they will buy or sell ONE
UNIT of the base currency (against the quote
currency).
So in the above example:
The market maker will buy euros for $1.2102
This is the bid price for euros.

The market maker will sell euros for $1.2106


This is the ask price for euros.

Reading and Understanding


Quotes
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.
For example, if you see a market makers ask price for the
EUR/USD of 1.2811, that means that if you were to buy
one Euro (the base currency) you are going pay $1.2811.
If you see a market makers bid price for the USD/JPY of
120.10 that means if you were to sell one dollar (the base
currency) you are going to get 120.10 for it.

Also, whenever the bid and ask prices are moving


up, that means that the base currency is getting
stronger and the quote currency is getting weaker.