International Foreign

Exchange Market
Definition: Foreign Exchange Market
• Foreign exchange market is the market composed
primarily of banks, serving firms and consumers who
wish to buy and sell various currencies
• Foreign exchange market business facilitate
international trade and transactions
• The term should not be thought of as a special
building or location where traders exchange
currencies
• Usually foreign exchange completed without the
transacting parties meeting physically
• Arrangements can be made by phone, or via the
internet
Geographical Extent of the Forex Market
• Foreign exchange market is the largest financial
market in the world
• It is open somewhere in the world 365 days a year,
24 hours a day
• Daily trading of spot and forward foreign exchange
exceeds $1 trillion per day
• This amount is much lower compared to 1998, when
the Euro was not yet in circulation and all the
member countries of the Euro had to exchange
currencies with one another
• London is the largest foreign exchange trading centre
with daily volume of $500 billion in 2001
Geographical Extent of the Forex Market
• There are three major segments
1. Austrasia: with Sydney, Tokyo, Hong Kong, Singapore
and Bahrain as the major trading centres
2. Europe: with Zurich, Frankfurt, Paris, Brussels,
Amsterdam and London - major trading centres
3. North America: with New York, Montreal, Toronto,
Chicago, San Francisco and Los Angeles as the main
trading centres
• The 24 hour a day trading follows the sun around the
globe
• Most trading rooms operate over 9-12 hour working
day, some use three 8-hour shifts to trade around the
clock
Organisation and Functions of Forex Market
• Trading does not take place in a central marketplace
where buyers and sellers meet
• It is done over-the-counter (OTC)
• This is a worldwide linkage of bank currency traders,
non-bank dealers and foreign exchange brokers
• These assist in trades connected to one another via
network of telephones, computer terminals, internet
and automated dealing systems
• The communication system of the forex market is the
most advanced, even more advanced than those of
industry, government, military and intelligence
operations
Functions of the Forex Market
1. Transfer of purchasing power:
• International trade involve trading parties from
countries with different currencies
• Each would have liked to deal in its own currency
• But the trade must be invoiced in one currency
• So whichever currency is used, one of the parties
must transfer the purchasing power to or from its
own national currency
• The forex market provides the mechanism for
carrying out these purchasing power transfers
2. Credit Provision
• Movements of goods from one country to another takes time
• Somehow some traders want the stock in transit to be financed
• The exporter may agree to carry the accounts receivables until
the time of payment, with or without interest
• The importer may pay cash on shipment and finance the goods
with his/her local bank
• Foreign exchange market provides a means of financing
through Letters of Credit, banker’s acceptance etc.
3. Minimizing Foreign Exchange Risk
• The forex market provides “hedging” facilities for transferring
foreign exchange risk to someone else
Foreign Exchange Market Participants
Forex Market is a two-tier market
1. Wholesale (interbank) market
2. Retail (client) market
The Forex market can be categorized in five groups
1. International banks
2. Bank customers
3. Non-bank dealers
4. Foreign exchange brokers
5. Central Banks
Foreign Exchange Market Participants
1. International Banks:
• Provide the core of the foreign exchange market
• Between 100 and 200 banks worldwide actively
“make a market” in foreign exchange
• By buying or selling foreign currency for their own
account
2. Bank Customers
• These are customers of the international banks
• The international banks serve their retail clients in
conducting foreign commerce or making
international investment in financial assets that
require foreign exchange
Foreign Exchange Market Participants
• Among bank customers are the multinational
companies, portfolio investors, tourists, importers,
exporters, money managers and private speculators
• Bank customers account for approx. 13% of forex
trading volume
3. Non Bank Dealers
• Large non-bank financial institutions such as
investment banks
• Their size and frequency of trading make it cost
effective to establish their own dealing rooms
• With their own dealing rooms they can trade
directly in the interbank market for their foreign
exchange needs
• They profit from buying foreign exchange at a bid price
and reselling it at a slightly higher offer price (also
known as the ask price)
Foreign Exchange Market Participants
There is high competition among dealers worldwide, which
narrows the spread between bid and offer prices, and that
makes the market efficient
4. Foreign Exchange Brokers
• These are the market participants who match dealer orders to
buy and sell currencies for a fee
• They normally do not take a position themselves
• They normally collect quotes offered by many dealers in the
market
• So interbank traders use a broker primarily to disseminate a
currency quote to many other dealers
• Nowadays the role of brokers has become less important because of increase
in computerized electronic dealing system
• The computerized systems provide the same services at lower fees
• 50-70% of trade is conducted through electronic dealing systems
Foreign Exchange Market Participants
5. Speculators and Arbitragers
• These participate in the market to seek profit from the
market
• They operate for their own interest
• They do not have a need or obligation to serve
clients
• Recall: Dealers get their profit from the spread
between the bid and offer prices in addition to the gain
from foreign exchange rate changes
• Speculators seek all their profits from exchange rate
changes
• Arbitragers try to profit from simultaneous exchange
rate differences in the market
Foreign Exchange Market Participants
6. Central Banks
• Often central banks intervene in the foreign exchange market
to influence the price (exchange rate) of its currency against
that of a major trading partner, or a country that it “fixes” or
“pegs” its currency against
Intervention
• The process of using foreign currency reserve to buy one’s
currency
• To decrease its supply in the forex market
• Or to sell one’s currency for foreign currency to increase its
supply and lower its price
• Sometimes intervention may target one trading partner to
boost imports and correct trade deficits with that partner
 International Money Market
• The international money market is a market where
international currency transactions between
numerous central banks of countries are carried on.
• The transactions are mainly carried out using gold
or in US dollar as a base.
• The basic operations of the international money
market include the money borrowed or lent by the
governments or the large financial institutions.
• The international money market is governed by the
transnational monetary transaction policies of
various nations’ currencies.
 Eurocurrency Market
• All the world currencies banked outside their
countries of origin are called Eurocurrency and
trade on the Eurocurrency market
• e.g. US dollars in Tokyo are called Eurodollars,
British pounds in New York are called Europounds,
Euros in New York are Euroeuros etc
• The Eurocurrency market is characterized by large
transactions, involving only the largest companies,
banks and governments
 Eurocurrency Market
Sources of Eurocurrency Deposits
• Governments with excess funds from prolonged
trade surplus
• Commercial banks with excess currency
• International companies with excess cash
• Extremely rich individuals
Value
• Eurocurrency market is valued at around $6 trillion,
and London accounts for 20% of all deposits
 Eurocurrency Market
Why is Eurocurrency market found to be attractive
1. Complete absence of regulation lowers the costs
• Banks charge borrowers less and pays investors more
and still obtain profit
2. Low transaction costs because transactions are large
3. Interbank interest rates are interest rates that the
world’s largest banks charge one another for loans
• London Interbank Offer Rate (LIBOR) is the interest rate charged
by London banks to other large banks borrowing Eurocurrency
• London Interbank Bid Rate (LIBID) is the interest rate offered by
London banks to large investors for Eurocurrency deposits
 Eurocurrency Market
Disadvantage of Eurocurrency Market
• There is greater risk because of the lack of
government regulation

However, Eurocurrency transactions are fairly safe

because of the size of banks involved
 Correspondent Banking Relationship
• The interbank market is a network of correspondent banking
relationships
• Large commercial banks maintain demand deposit accounts
with one another called correspondent bank
• The network of correspondent banks allow for efficient functioning
of the forex market
SWIFT: Society for Worldwide Interbank Financial
Telecommunications: is a private non profit money transfer
system with HQ in Brussels
• Has intercontinental switching centres in the Netherlands
and Virginia
• Allows international commercial banks to communicate
instructions for transfers
 Correspondent Banking Relationship
CHIPS: The Clearing House Interbank Payment System
• Is a clearing house for interbank settlement in US$
payments between international banks
ECHO: Exchange Clearing House Ltd
• Was a multilateral netting system
• On each settlement date it netted each client’s
payment and receipt in each currency
• It was the first global clearing house for settling
interbank foreign exchange transactions
• Began operations in August 1995
• Currently it is no longer operating
Spot Market
 Spot Market
Meaning and Functions of the Spot Market
• The spot market involves the immediate purchase or
sale of foreign exchange
• It is the most common type of foreign exchange
transactions
• The foreign exchange transaction are agreed upon
and executed immediately at the rate that is known
as the spot rate
• Due to the geography of the forex market, normally
settlements are done within two business days
• This accounts for about 1/3 of the forex trades
Spot Market
• At any given point in time, the spot exchange rate
between two currencies should be similar across
various banks
• If there is a large discrepancy, customers or other
banks would purchase large amounts of currency
from a lower quoting bank and sell immediately to a
higher quoting bank
• Such actions are known as arbitrage
• They would eliminate those discrepancy
Direct and Indirect Spot Quotation
Direct Quote
• Is the amount of domestic currency which is equal to
one foreign currency unit
• e.g. TZS 2100=$ 1 is a direct quotation for Tanzania
Indirect Quote
• Is the amount of foreign currency that is equal to one
domestic currency unit
• In Tanzania and most other countries direct quotes
are more common
• In UK indirect quotes are commonly used
Direct and Indirect Quotation
• Currencies may be quoted in either direction
• US $ and Euro might be quoted €/$ or $/€
• i.e €1.1414/$ or $0.8763/€
• Direct quote is simply the reciprocal of the indirect
quote
• If a currency is quoted €1.1414/$, the € is the term
currency (reference currency) and the $ is the base
currency
European Terms: When the $ is priced in terms of a
foreign currency (an indirect quote from US perspective)
American Terms: other currencies are priced in terms of
$ (direct quote from the US perspective)
Direct and Indirect quotations
• It is a standard practice to use American terms
• However, most currencies in the interbank market
are quoted in European terms
Bid – Ask Spread
• Banks do not charge a commission on their currency
transactions
• They profit from the spread between the buying and
selling rates of the foreign exchange transactions
• Quotes are always in pairs
• The first rate is the buying or bid price
• The second is the selling or ask or offer price
• The bid price is the price the dealer is willing to pay for a
currency
• The ask price is the amount the dealer wants you to pay
for the currency
• The bid-ask spread is the difference between the bid and
ask prices
Bid – Ask Spread
• When considering the prices banks use, remember
that the bank will buy the base currency low and sell
the base currency high
• Example

• A dealer would likely quote these prices as 72-77

• It is presumed that anyone trading $10m already
knows the “big figure”
Example of Spot Quotation
Given a quotation $1.9072-77/£
• Base currency is £
• Bid price is $1.9072/£: the dealer buys and the
customer sells the £
• Ask price $1.9077/£: the dealer sells and the
customer buys the £
• The customer receives less when selling and pays
more when buying the base currency
• Dealer’s Profit = Ask Price – Bid Price
• Dealer’s profit =1.9077-1.9072 =$0.0005/£
Spot Foreign Exchange Trading
• For most currencies quotations are carried out to
four decimal places in both the American and
European terms
• However, for some currencies (e.g. Japanese Yen)
quotation in European terms are carried out only to
two or three decimal places, but in American terms
the quotations of the Yen may be carried out to as
many as eight decimal places
Spot Foreign Exchange Trading

• In the interbank market, the standard size trade

among large banks in the major currencies is for the
equivalent of $10 million
• Dealers quote both the bid and the ask, willing to
either buy or sell up to $10 million at the quoted
prices
Spot Foreign Exchange Trading
• The interbank foreign exchange traders use a
shorthand abbreviation in expressing spot currency
quotation
• Consider the $/£ bid-ask quote given above: i.e.
$1.9072-1.9077/£
• Here 1.90 is known as the big figure
• It is assumed to be known by all traders
• The last two digits to the right are referred to as the
small figure
• It is unambiguous for a trader to respond to a 72-77
when asked what his quote for the £ is
• Retail bid-ask spread is wider than the interbank
spread
Cross Exchange Rate Quotations
• Cross-exchange rate is the exchange rate
between a currency pair where neither currency
is the domestic currency
• The cross exchange rate can be calculated from
the US $ exchange rates for the two currencies
using either the American or European term
quotations
Cross Exchange Rate
A tourist from UK who is now in Las Vegas USA wants
to visit Ruaha National Park. He wishes to change his
Pound Sterlings into Tanzanian Shillings ad goes into a
Vegas bureau de change and observes the following
exchange rate quotations
TZS/USD 2080-95
USD/GBP 1.8300-10
At what rate will the bureau sell TZS spot vs the £?
At what rate will the bank buy TZS spot vs the £?
What will be the two-way quotation of spot TZS vs £?
Cross Exchange Rate
Step 1
Define TZS and £ in terms of available and desired
currencies. The bank sells TZS so the customer buys
TZS so:
AC = GBP and DC = TZS
Step 2:
How should the exchange rate between TZS and £ be
quoted?
Since TZS is a low value currency it should be TZS/GBP
Spot Rate Movements
• Exchange rate movement is caused by the market
interaction (supply and demand forces)
• It is called appreciation or depreciation
• In other cases the currency value change may be
initiated by the government when it up-value or
devalue its currency
Triangular Arbitrage
• If direct quotes are not consistent with the cross-
exchange rates, a triangular arbitrage profit is
possible
• Triangular arbitrage is the process of trading out the
domestic currency into a second currency and then
trading it for a third currency which is in turn traded
for the domestic currency