Finance of International Trade

Đinh Trần Thanh Mỹ

Department of International Business
Chaper 3

THE FOREIGN EXCHANGE

MARKET
 Chapter 3

International
business

Currency
Foreign
systems
exchange
across
rate
countries

International
payment
 Part I

FOREIGN EXCHANGE RATES &

QUOTATIONS
Exchange rate Currency symbols

- The quotations are designated by traditional currency symbols –

ISO code (ISO 4217:2008)
- The ISO code were developed for use in electronic communications
- Three-letter ISO codes
 Exchange rate

- Exchange: is the ‘’converted” from one national currency into

another national currency. This conversion must be based on a
certain rate relation – exchange rate.
- Exchange rate:
The rate comparative relationship between the value of the
national currency with the other national currency
As the price of a currency is expressed by other currencies
Eg: USD/VND = 22,870 Exchange rate between USD & VND is 22,870
1 USD = 22,870 VND
Exchange rate Exchange rate

- The exchange rate is the price of one country’s money in terms of

another country’s money.
- The “spot” exchange rate is the price for immediate exchange.
(Immediate usually means within two working days.) This amounts
to about 33% of all trading.
- The “forward” exchange rate is the price for exchange to take
place at some specific time in the future, often 30, 90, 180 days.
This amounts to about 11% of all trading.
- A “swap” is a “package trade” that includes both a spot exchange
of two currencies and a contract to the reverse forward exchange a
short time later. This is useful when the parties to the swap have
only a short-term need for the currency. This amounts to about 56%
of all trading.
 Exchange rate quotes

CUR1/CUR2

Base currency/ Unit currency Price currency/ Quote currency

(single unit)

 The number of units of the price currency (CUR2) required in

exchange for receiving one unit of the base currency (CUR1)
 Ex: EUR/USD = 1.2174 -> 1EUR = 1.2174 USD
 Exchange rate quotes

Base/ Unit currency

GBP/USD = 1.21035 – 1.21061

Quote/ Price currency

Bid rate
Ask rate

Bid –Ask Spread

 Exchange rate quotes
Tỷ giá các ngoại tệ Ngân hàng TMCP Ngoại thương Việt
Nam ngày 28/09/2021

Mã NT Tên ngoại tệ Mua tiền mặt Mua chuyển khoản Bán

AUD AUSTRALIAN DOLLAR 16,133.12 16,296.08 16,807.16
CAD CANADIAN DOLLAR 17,568.38 17,745.84 18,302.39
CNY YUAN RENMINBI 3,455.59 3,490.50 3,600.51
EUR EURO 25,936.39 26,198.38 27,286.23
GBP POUND STERLING 30,388.59 30,695.55 31,658.23
HKD HONGKONG DOLLAR 2,852.26 2,881.07 2,971.43
JPY YEN 200.05 202.07 211.63
KRW KOREAN WON 16.66 18.51 20.29
MYR MALAYSIAN RINGGIT - 5,388.49 5,502.18
SGD SINGAPORE DOLLAR 16,383.33 16,548.82 17,067.83
THB THAILAND BAHT 597.8 664.22 689.17
USD US DOLLAR 22,640.00 22,670.00 22,870.00
 Market conventions

European terms & American terms

Exchange rate Market conventions

Direct & Indirect quotations

- Direct quote is expressed as one unit of foreign currency in home

currency terms (European terms)
1 foreign currency = X home currency
- Ex: 1 USD = 0.8214 EUR
1 USD = 22,870 VND
- Indirect quote is expressed as one unit of home currency in foreign
currency terms (American terms)
1 home currency = X foreign currency
- Ex: 1 EUR = 1.2174 USD
1 AUD = 0.7075 USD
Exchange rate Market conventions

Direct & Indirect quotations

- Example:
1 USD = 1.6000 CFH
1 CFH = 0.625 USD (1/1.6)
 Sfr1.6/US$ can be interpreted as:
+ direct quote of the US$ in terms of Sfr
+ indirect quote of the Sfr in terms of US$
Exchange rate Market conventions

Bid & Ask rates

- A Bid is the price in one currency at which a dealer will buy another
currency
- An Ask is the price at which a dealer will sell the other currency
- Dealers bid (buy) at one price and ask (sell) at a slightly higher price,
making their profit from the spread between the prices.
- The bid-ask spread may be quite large for currencies that are traded
infrequently, in small volumes, or both.
- Bid/Ask Spread (Percentage) = [(ask rate - bid rate)/ask rate] x 100
Exchange rate Market conventions

Bid & Ask rates

Exchange rate Market conventions

Bid & Ask rates

- Example: ¥118.27/$ - ¥118.37/$ is the bid/ask rates for Japanese

yen and $
- Note: These bid and ask quotes are given here as indirect quotes for
the ¥ in terms of the US$ (i.e. direct quotes for the US$ in terms of
¥).
- Hence, bank will buy $ but sell yen at ¥118.27/$ and sell $ but buy
yen at ¥118.37/$
Exchange rate Market conventions

Bid & Ask rates

Spread:
* Bank will buy $ at ¥118.27/$ and sell $ at ¥118.37/$
 So bid/ask spread for $ = [(118.37 – 118.27)/118.37] x 100= 0.08%

* Bank will sell ¥ at ¥118.27/$ and buy ¥ at ¥118.37/$

 So bid/ask spread for ¥ = [(1/118.27)-(1/118.37)]/(1/118.27) x 100
= 0.08%
* The percentage bid/ask spread is always the same for both currencies.
 Cross rates

- Many currencies pairs are inactively traded, so their exchange rate

is determined through their relationship to a widely traded third
currency
- Ex: A Vietnamese importer needs Japanese yen to pay for
purchases in Tokyo. The US dollar is quoted in both VND and
Japanese yen (¥), i.e. we have direct quotes for the US dollar in
terms of VND and ¥ (or indirect quotes for both the VN dong and
the Japanese yen in terms of the US dollar)
Japanese Yen ¥118.79/$
Vietnam Dong VND22,870/$
 Cross rates

- The Vietnamese importer can buy one US dollar for 22,870 Vietnam
Dong and with that dollar buy ¥118.79.
- The cross rate calculation (direct quote for the Yen in terms of VND)
would be:
(VND/US$)/(¥/US$) = (VND22,870/$)/(¥ 118.79/$)
= VND192.52/¥
 1 Yen = 192.52 VND
+ indirect quote for VND in terms of Yen
1 VND = 0.0051 Yen (1/192.52)
Exchange rate Exercises

1. Determine Bid rate, Ask rate and Spread (Bid/Ask)

GBP/USD = 1,6805 – 07
EUR/USD = 1,3389 – 91
USD/CHF = 0,9059 – 60
AUD/USD = 0,9264 – 66
USD/CAD = 1,0921 – 22
USD/HKD = 7,7512 – 14
USD/JPY = 101,77 – 78
Exchange rate Exercises

1. Determine Bid rate, Ask rate and Spread (Bid/Ask)

BID ASK SPREAD (%)

GBP/USD

EUR/USD

USD/CHF

AUD/USD

USD/CAD

USD/HKD

USD/JPY
Exchange rate Exercises

1. If the direct quote of the US dollar is: USD1 = AUD0.9340, what is

its indirect quote?

2. If the indirect quote of the Japanese yen is: AUD1 = JPY81.542,

what is its direct quote?
Exchange rate Exercises

3. Convert the following indirect quotes to direct quotes, and direct

quotes to indirect quotes:
a. Euro: €1.22/$ (indirect quote)
b. Russia: RUB30/$ (indirect quote)
c. Canada: US$0.72/C$ (direct quote)
d. Denmark: $0.1644/DKr (direct quote)
 Part II

THE FOREIGN EXCHANGE MARKET

 The Foreign exchange market

- The FOREX market provides the physical and institutional structure

through which:
• The money of one country is exchanged for that of another country
• The rate of exchange between currencies is determined
• Foreign exchange transactions are physically completed
- Foreign exchange: money of a foreign country – foreign currency bank
balances, banknotes, checks, drafts
- 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 exchange rate on a specified date.
 The Foreign exchange market

There are six main characteristics of the FOREX markets which 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
 Functions of the Foreign exchange market

Transfer of Purchasing Power

-> transfer purchasing power between countries, which is necessary as
international trade and capital transactions involve parties living in countries
with different national currencies

Provision of credit
-> obtain or provide credit for international trade transaction, related to
negotiable instruments such as bank’s acceptance, letter of credit

Minimizing Foreign exchange risks

-> Minimize exposure to exchange rate risk; the FOREX market provides
“hedging” facilities for transferring foreign exchange risk to someone else
who is more willing to carry risk
 Structure of the FOREX market

Time of Day and Currency Trading

- The foreign exchange market is not a single place like the NY Stock
Exchange (NYSE).
- Geographically, the FOREX market spans the globe with prices
moving and currencies trading every hour of every business day
- It is a widely decentralized 24-hour-a-day market, made up of banks
and traders communicating electronically.
Structure of FOREX market

Source: Eiteman et al. (2016)

Structure of FOREX market
Structure of FOREX market
 Structure of the FOREX market

Market participants

- Foreign exchange dealers: banks & a non bank foreign exchange

dealers; profit from buying foreign exchange at a bid price
and reselling it at a slightly higher ask price
- Participants in commercial and investment transactions: importers
& exporters, international portfolio investors, multinational firms,
tourists & others use the FX
- Speculators & Arbitrageurs seek to profit from trading within the
market itself. Speculators seek all their profit from exchange rate
changes; Arbitragers try to profit from simultaneous differences in
exchange rates in different markets.
 Structure of FOREX market

Market participants

- Central banks & treasuries use the market to acquire or spend their
country’s foreign exchange reserves as well as to influence the price
at which their own currency is traded, a practice known as foreign
exchange intervention
- Foreign exchange brokers are agents who facilitate trading between
dealers without themselves becoming principals in the transaction
and charge a small commission for this service.
 Structure of FOREX market

Market participants

Source: vnfbs.com
 Transactions in the Interbank market

FOREX

Derivati
Primary
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Market
Market
Spot Forward Swap Future Option
transacti transacti transacti transacti transacti
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 Transactions in the Interbank market

Spot transaction

- A spot transaction in the interbank market is the purchase or sale of

foreign exchange at a specified rate, with immediate delivery and
payment between banks to take place (in practice, often not until the
second business day following).
- The settlement date is often referred to as the value date.
 Example – Spot market transaction

 Vietnamese importing firm buys a U.S. product from a U.S. firm,

which requires payment in U.S. dollars ($).
 The Vietnamese importing firm contacts its bank, gets a quote on
the dollar-VN dong exchange rate, and approves it.
 The Vietnamese importing firm instructs its bank to take VN dong
from its checking account, convert these to dollars, and transfer the
amount to the U.S. producer.
 The Vietnamese bank instructs its “correspondent” bank in New
York to take U.S. dollars from its account and pay the U.S. producer
by transferring them to the producer’s bank.
 Transactions in the Interbank market

Forward transaction

- A forward transaction occurs where 2 parties agree to exchange

currencies at a future date at an agreed exchange rate.
• The exchange rate is specified and agreed upon at the time of the
transaction, but payment and delivery occur in the future.
• Forward rates are contracts quoted for settlement (value) dates of
one, two, three, six, nine and twelve months.
• Terminology typically used is buying (selling) forward.
• For example, a contract to deliver dollars for euros in six months is
both buying euros forward for dollars and selling dollars forward for
euros.
 Transactions in the Interbank market

Swap transaction
- 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, the dealer incurs no exchange rate exposure.
- Another type of swap is a forward-forward swap
 Transactions in the Interbank market

Swap transaction

- Example: A dealer sells £20,000 forward for dollars for delivery in

two months at $1.8420/£ and simultaneously buys £20,000 forward
for delivery in three months at $1.8400/£
- 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
Transactions in the Interbank market
 Factors affecting FOREX rates

- Changes in the supply and demand for particular currencies.

- Confidence in a currency:
+ Economic indicators: interest rates, GDP, inflation and
employment rates.
+ Political stability of the country and global events (wars,
pandemics..).
- Balance of payment: in surplus or in deficit
- Capital transactions: in terms of short term or long term
investment