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The Basics of The Foreign Exchange Market
The Basics of The Foreign Exchange Market
Exchange Market
Defining The Foreign Exchange Market
• The Foreign Exchange Market can be defined in terms of
specific functions, or the institutional structure that:
• (1) Facilitates the conversion of one country’s 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
• World’s 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 world’s 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