THE FOREIGN

EXCHANGE
MARKET
CHAPTER OVERVIEW

I. INTRODUCTION
II. ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
III. THE SPOT MARKET
IV. THE FORWARD MARKET
V. INTEREST RATE PARITY
THEORY
PART I. INTRODUCTION

I. INTRODUCTION
A. The Currency Market:
where money denominated in one
currency is bought and sold
with money denominated in
another currency.
INTRODUCTION

B. International Trade and

Capital Transactions:
- facilitated with the ability
to transfer purchasing power
between countries
INTRODUCTION

C. Location
1. OTC-type: no specific
location
2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide
Interbank Financial
Telecommunications
PART II.
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET

I . PARTICIPANTS IN THE
FOREIGN EXCHANGE MARKET
A. Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level
- business customers.
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. Two Types of Currency

Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd
business day
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

2. Forward Market:
- transactions take place at a
specified future date
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial
and central banks
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

II. CLEARING SYSTEMS

A. Clearing House Interbank
Payments System
(CHIPS)
- used in U.S. for electronic
fund transfers.
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. FedWire

- operated by the Fed

- used for domestic transfers

ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

III. ELECTRONIC TRADING

A. Automated Trading
- genuine screen-based
market
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. Results:
1. Reduces cost of trading
2. Threatens traders’
oligopoly of information
3. Provides liquidity
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET

A. Largest in the world
1995: $1.2 trillion daily
2019: $710 . 2 trillion
daily
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. Market Centers (1995):

London = $464 billion
daily
New York= $244 billion
daily
Tokyo = $161 billion
daily
PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have four
different quotes:
a. spot price
b. 30-day
c. 90-day
d. 180-day
THE SPOT MARKET

B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $.5838/dm
b. European terms
example: dm1.713/$
THE SPOT MARKET

2. For nonbank customers:

Direct quote
gives the home currency
price of one unit of foreign
currency.
EXAMPLE: dm0.25/FF
THE SPOT MARKET

C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee
charged by the bank
 Bid = the price at which
the bank is willing to buy
 Ask = the price it will sell
the currency
THE SPOT MARKET

4. Percent Spread Formula (PS):

Ask  Bid
PS  x100
Ask
THE SPOT MARKET

D. Cross Rates
1. The exchange rate
between 2 non - US$
currencies.
THE SPOT MARKET

2. Calculating Cross Rates

When you want to know
what the dm/ cross rate
is, and you know
dm2/US$ and .55/US$

then dm/ = dm2/US$  .55/US$

= dm3.636/ 
THE SPOT MARKET

E. Currency Arbitrage
1. If cross rates differ from
one financial center to
another, and profit
opportunities exist.
THE SPOT MARKET

2. Buy cheap in one int’l market,

sell at a higher price in
another

3. Role of Available Information

THE SPOT MARKET

F. Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of

original transaction.
THE SPOT MARKET

G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty
about future exchange
rate requires
THE SPOT MARKET

1.) Demand for higher risk

premium

2.) Bankers widen bid-ask

spread
MECHANICS OF SPOT
TRANSACTIONS
SPOT TRANSACTIONS: An
Example
Step 1. Currency transaction:
verbal agreement, U.S. importer
specifies:
a. Account to debit (his acct)
b. Account to credit (exporter)
MECHANICS OF SPOT
TRANSACTIONS
Step 2. Bank sends importer
contract note including:
- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.
MECHANICS OF SPOT
TRANSACTIONS
Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporter’s.
Value Date.
U.S. bank debits importer’s
account.