BWBB3033 Topic 8 Student Version

BWB3033 International Banking
TOPIC 9
BANKING ON THE
FOREIGN EXCHANGE MARKET
© Abmalek F. Abubakar, 2005

TOPIC OUTLINE
1. Definition and evolution

2. Spot and forward exchange rate
3. Emerging trend in FX Trading – Interest Rate
Parity, Forward and Swap, Covered Interest
Arbitrage, Currency Swap
4. Managing Risk – Hedging with FX Option

2
Introduction to Foreign Exchange Market
WHAT IS FOREIGN EXCHANGE ?

The exchange of a currency of one
country for the currency of another.
FOREIGN EXCHANGE MARKET
An arena through which one is able to transfer

purchasing power from one country to another.

FOREIGN EXCHANGE RATE
The price of one currency to another.
E.g. The price of 1 USD is 4.0545 MYR

The price of 1 EUR is 4.6156 MYR

THE FOREIGN EXCHANGE MARKET
“The foreign exchange market is the arena

through which one is able to transfer
purchasing power, provide credit for
international trade transactions and provide
means of minimizing exposure to the risk of
exchange rate fluctuations.”
D.K. Eiteman and A.I. Stonehill

Japan
Australia
HongKong
Singapore
Malaysia
9 am Msia Time
Middle East THE FX MARKETS New York

3 pm Msia Time NEVER SLEEP 9 pm Msia Time
London
3 pm Msia Time
BANKS AND THE FOREIGN EXCHANGE MARKET
The banks are the natural intermediary between

foreign exchange supply and demand. The main
task of a foreign exchange department is to
enable its commercial and financial customers
to convert assets held in one currency into
funds of another currency. This conversion can
take the form of a ‘spot’ transaction or a
‘forward’ operation .

BANKS AND THE FOREIGN EXCHANGE MARKET
Roles of banks in foreign exchange market:
1. Buying and selling currencies from

participants who use different currencies on
their business or travels.
2. Coordinating foreign exchange hedges for
bank customers.
3. Entering arbitrage transactions
4. Speculate on currency price movements for
their own account.
WHY THE NEED FOR FOREIGN EXCHANGE

MARKET ?
The foreign exchange market is

inevitable because :
1. each and every country in the world has its own
national currency
2. international trade and investments and related
transactions

THE NEED FOR FOREIGN EXCHANGE IN
SETTLEMENT OF IMPORT / EXPORT TRADE
IMPORTER Normally have his country’s

(Finland) currency, the FIM, to pay for
his purchase
EXPORTER Normally wants to be paid in

(Malaysia) his country’s currency, i.e.,
the MYR

TRADE SETTLEMENT OPTIONS
1. Using the importer’s national currency

i.e. the FIM
2. Using the exporter’s national currency

i.e. the MYR
3. Using a neutral currency

e.g. the US$

OVERVIEW OF THE FOREIGN EXCHANGE MARKET IN MALAYSIA
INTERBANK RETAIL
FEATURES
MARKET MARKET
Commercial Banks
Commercial Banks Corporations
Merchant Banks (Some) Importers/Exporters
Participants
FX Brokers Investors
Central Bank Travellers
Central Bank
Buying / Selling of
Buying / Selling for
Foreign Exchange for
Spot Dealing, Main Activities
value same day or
Forwards
forwards
Normally US Dollars Normally foreign
against various Commodity Traded currencies against local
currencies currency
USD3.0 million Standard Amount Any Amount
Interbank Rates Pricing Commercial Rates
Spot Date Settlement Dates Any Time

Foreign Exchange
EXCHANGE RATES
FX Rates can be expressed either as
 Direct Quotation (Price Quotation)
or
 Indirect Quotation (Volume Quotation)

Foreign Exchange
EXCHANGE RATES
Direct Quotation (Price Quotation)
A rate expressed such that the foreign currency is the

commodity currency and the local currency is the
reference currency.
direct quotation: 1 foreign currency unit = x home currency units
Commodity Reference
Currency Currency
In Malaysia US$ 1.00 = MYR 3.8000
In Japan US$ 1.00 = JPY 121.75

Foreign Exchange
EXCHANGE RATES
Indirect Quotation (Volume Quotation)

A rate expressed such that the foreign currency is the
reference currency and the local currency is the
commodity currency.
indirect quotation: 1 home currency unit = x foreign
currency units
Commodity Reference
Currency Currency
In Australia AUD 1.00 = USD 0.5670
In UK GBP 1.00 = USD 1.5855

Foreign Exchange
EXCHANGE RATES
How are FX rates quoted?

● Most countries use Direct Quotation
● When banks deal among each other, dealers
normally quote USD rates
● The values of the various local currencies are
expressed by indicating the price of one USD in
local currency
● E.g. USD 1.00 = MYR 3.8000
USD 1.00 = JPY 121.75
● Exception to the norm are currencies of some
former commonwealth countries which use Indirect
Quotation © Abmalek F. Abubakar, 2005
Foreign Exchange
EXCHANGE RATES
USD as the Commodity Currency
Because USD is widely accepted,

for various reasons, as the vehicle
currency for world trade and
financial settlements, it has
assumed the role of the
Commodity Currency for almost all
international foreign exchange
dealings
Foreign Exchange
EXCHANGE RATES
Reciprocal Rates
A rate quotation such that the Reference Currency in a

Volume Quotation is expressed as a unit in terms of the
Commodity Currency
If AUD 1.0 = USD 0.5670

Reciprocally this can be expressed as
US$ 1.0 = AUD ??
Algebraically, US$ 1.0 1
=
0.5670
= AUD 1.7636

Foreign Exchange
CROSS RATES
Cross Rates
A foreign exchange rate derived from two other
exchange rates.
Example : Given the following exchange rates, it is

possible to derive JPY 1.00 in terms of MYR
US$ 1.00 = MYR 3.8000
US$ 1.00 = JPY 121.75
Algebraically,
US$ 1.0000 = JPY 121.75 = MYR 3.8000
or JPY 121.75 = MYR 3.8000
Therefore JPY 1.0000 = MYR 3.8000
JPY 121.75
= MYR 0.031211
Foreign Exchange
CROSS RATES
Cross Rates
Example : Given the following exchange rates, it is
possible to derive JPY 1.00 in terms of MYR
US$ 1.00 = MYR 3.8000

US$ 1.00 = JPY 121.75
Algebraically,
US$ 1.0000 = JPY 121.75 = MYR 3.8000
or JPY 121.75 = MYR 3.8000
Therefore JPY 1.0000 = MYR 3.8000
JPY 121.75
= MYR 0.031211

Foreign Exchange
BID AND OFFER RATES
A foreign exchange rate is normally quoted in a 2-way

price with the Buying Price (BID RATE) followed by the
Selling Price (OFFER RATE).
Example : when Bank ABC quotes
Spot US$ / MYR 3.7990 / 10
It means : Bank ABC is willing to

 buy (BID) the commodity currency, i.e. US$ 1.0, at
a price of MYR 3.7990
 sell (OFFER) the commodity currency at a price of
MYR 3.8010
Foreign Exchange
BID AND OFFER RATES
In the quotation
US$ / MYR 3.8 0 90 / 10

Foreign Exchange
BID AND OFFER RATES
In the quotation reference bid

currency rate
US$ / MYR 3.8 0 90 / 10
commodity big offer

currency figure rate

Foreign Exchange
BID AND OFFER RATES The difference
between
In the quotation bid & offer
reference bid is called
currency rate “spread”
the
difference
between
bid & offer
is called US$ / MYR 3.8 0 90 / 10
“spread”
commodity big offer pips

currency figure rate

Foreign Exchange
PIPS & POINTS
PIPs are the numerical units behind the decimal

place of an exchange rate.
In the Quote, USD 1.0 = MYR 3.7995

5 Pips is MYR 0.0005
In the Quote, USD 1.0 = JPY 121.77

7 Pips is JPY 0.07
77 Pips is JPY 0.77
177 Pips is JPY 1.77

Foreign Exchange
FX EXPOSURE
What is the impact of a movement of 1 pip in exchange

rates to your company ?
1 pip = RM0.0001
Suppose your company has a payable of USD1,000,000 to

be made to a foreign supplier. Your breakeven rate is USD1
= RM3.8000.
A drop or an increase of RM0.0001 in the USD/RM
exchange rate would save or would cost your company
additional RM100.
Equivalent to RM10,000 for every 1 sen !!!

Foreign Exchange
BID AND OFFER RATES
There are always TWO parties to a quote

● The Quoting Party : The party that gives the price
● The Calling Party : The party that asks for the price
The Calling Party performs the opposite of the transaction
to the Quoting Party and only at the Quoting Party’s price.

Foreign Exchange
BID AND OFFER RATES
In the quotation : Spot US$ / MYR 3.7990 / 10
Quoting Party at Calling Party
BUYS US$ at MYR 3.7990 SELLS US$ at MYR 3.7990

3.7990 (Implicitly BUYS MYR)
(Implicitly SELLS MYR)
SELLS US$ at MYR 3.8010 BUYS US$ at MYR 3.8010

3.8010
(Implicitly BUYS MYR) (Implicitly SELLS MYR)

Foreign Exchange
BID AND OFFER RATES
In the quotation : Spot US$ / MYR 3.7990 / 10
BID RATE Rate at which the Quoting Party is willing to BUY

the Commodity Currency (or rate at which the
Calling Party can SELL the Commodity Currency)
OFFER RATE Rate at which the Quoting Party is willing to SELL

the Commodity Currency (or the rate at which the
Calling can BUY the Commodity Currency)
SPREAD The difference between the BID and the OFFER

rates.

Foreign Exchange
BID AND OFFER RATES
1 Confusion arises but one must be able to identify
PARTIES TO THE QUOTATION

Quoting Bank - the party that quotes the price
Calling Bank - the party that calls to ask the quoting
bank for a price

Foreign Exchange
BID AND OFFER RATES
THE PRICE
Bid Price - the rate at which the quoting bank is

willing to buy the commodity currency
Offer Price - the rate at which the quoting bank is
willing to sell the commodity currency

Foreign Exchange
BID AND OFFER RATES
THE CURRENCIES
Commodity Currency - the currency being priced

Reference Currency - the currency that gives value to the
commodity currency

Foreign Exchange
BID AND OFFER RATES
Confusion arises but one must be able to identify :
● Parties to the quotation

Quoting Bank – the party that quotes the price;
Calling Bank – the party that calls to ask the quoting
bank for a price
● The Price
Bid Price – the rate at which the quoting bank is willing
to buy the commodity currency;
Offer Price – the rate at which the quoting bank is
willing to sell the commodity currency
● The Currencies
Commodity currency – the currency being priced;
Reference currency – the currency that gives value to
the commodity currency
Foreign Exchange
BID AND OFFER RATES
Interpretation of the BID and OFFER rates
Spot US$ / MYR

Bid Rate Offer Rate
Quote US$1 = MYR 3.7990 3.8010
Quoting Bank Buys US$ Sells US$
Calling Bank Sells US$ Buys US$

Foreign Exchange
BID AND OFFER RATES
Interpretation of the BID and OFFER rates
Spot AUD / US$

Bid Rate Offer Rate
Quote AUD1 = US$ 0.5670 0.5680
Quoting Bank Buys AUD Sells AUD
Calling Bank Sells AUD Buys AUD

Foreign Exchange
CROSS RATES WITH BID AND OFFER
Bid Rate Offer Rate

US$ 1.0 = MYR 3.7990 3.8010
US$ 1.0 = THB 43.30 43.50
1. What is your quote if you are a bank and a

Malaysian importer asks for an exchange rate to
pay for his purchase from Thailand ?
2. How do you quote to a Malaysian exporter who

wishes to convert his export proceeds in THB into
MYR ?

Foreign Exchange
Bid Rate Offer Rate
US$ 1.0 = MYR 3.7990 3.8010
US$ 1.0 = THB 43.30 43.50
The bank is to quote its selling rate for THB against MYR
Points to note:
1. Assume importer will pay for the THB using MYR
2. Assume bank do not keep stocks of THB. It will have to buy THB from
the FX Market. This involves 2 steps :-
(a) Use the MYR received from importer to buy US$
(Bank can buy US$ from market at market selling rate of 3.8010)
[By doing that bank has a Long US$ & Short MYR position]
(b) Sell the US$ so acquired to obtain THB
(In the US$/THB quotation, bank can sell US$ at 43.30)
[This transaction creates Long THB & Short US$]
3. Netting the positions in (a) and (b) gives the bank Long THB & Short
MYR. This will be normalized by selling the THB to importer and get
paid by the importer in MYR.
Foreign Exchange
Bid Rate Offer Rate
US$ 1.0 = MYR 3.7990 3.8010
US$ 1.0 = THB 43.30 43.50
How does the bank quote its buying rate for THB against MYR ?
Points to note:
1. Assume exporter needs MYR by selling to the bank its THB proceeds
2. Assume bank do not have MYR and do not wish to keep stocks of
THB. It will have to buy MYR from the FX Market by selling THB. This
involves 2 steps :-
(a) Use the THB received from exporter to buy US$
(Bank can buy US$ from market at market selling rate of 43.50)
[By doing that bank has a Long US$ & Short THB position]
(b) Sell the US$ so acquired to obtain MYR
(In the US$/MYR quotation, bank can sell US$ at 3.7990)
[This transaction creates Long MYR & Short US$]
3. Netting the positions in (a) and (b) gives the bank Short THB & Long
MYR. This will be normalized by buying the THB and paid out MYR to
exporter.
Foreign Exchange
Before attempting to compute the cross rate for the

purchase of THB from the Malaysian exporter, you must
understand the following processes involved to determine
which rate to use:
Exporter Bank Market
Sells THB to Bank & Buys THB from
expects to receive exporter and pays -
MYR MYR
Covers itself by (i) Can sell THB (buy

- selling THB to the USD) at market offer
market to obtain USD rate 43.50
Next, (ii) use the USD Can sell USD (buy

- obtained to raise MYR) at market bid
MYR rate 3.7990

Foreign Exchange
Market Rates for US$/MYR

Bid Rate Offer Rate
US$ 1.0 = MYR 3.7990 3.8010
US$ 1.0 = THB 43.30 43.50
Having determined which market rate to use for the computation of

cross rates, then apply the chain methodology,
MYR ??? = THB 1.0

THB 43.50 = USD 1.0
USD 1.0 = MYR 3.7990
1 x 1 x 3.7990
THB 1.0 = = MYR 0.08733
43.50 x 1 x 1
At breakeven, you can buy the THB 100 at MYR 8.7333 from exporter
Foreign Exchange
For the computation of cross rate for the sale of THB to the
Malaysian importer, the following processes involved in
determining which rate to use:
Importer Bank Market
Buys THB from Bank Sells THB to importer

-
& pays MYR and obtained MYR
Covers itself by (i) Can sell MYR (buy

- selling MYR to the USD) at market offer
market to obtain USD rate 3.8010
Can sell USD (buy

Next, (ii) use the USD
- THB) at market bid
obtained to raise THB
rate 43.30

Foreign Exchange
Market Rates for US$/MYR

Bid Rate Offer Rate
US$ 1.0 = MYR 3.7990 3.8010
US$ 1.0 = THB 43.30 43.50
Having determined which market rate to use for the computation of

cross rates, then apply the chain methodology,
MYR ??? = THB 1.0

THB 43.30 = USD 1.0
USD 1.0 = MYR 3.8010
1 x 1 x 3.8010
THB 1.0 = = MYR 0.087783
43.30 x 1 x 1
At breakeven, you can sell the THB 100 at MYR 8.7783 from exporter
Banks and Foreign Exchange
SELLING BUYING BUYING

TT/OD TT OD
Units of Malaysian ringgit per unit of foreign currency:
1 US DOLLAR 3.8250 3.7750 3.7650
1 AUSTRALIAN DOLLAR 2.7350 2.6810 2.6650
1 BRUNEI DOLLAR 2.2350 2.1910 2.1830
1 CANADIAN DOLLAR 2.8990 2.8420 2.8300
1 EURO 4.7200 4.6260 4.6060
1 NEW ZEALAND DOLLAR 2.4880 2.4390 2.4230
1 PAPUA N GUINEA KINA 1.2240 1.1760 1.1600
1 SINGAPORE DOLLAR 2.2345 2.1910 2.1830
1 STERLING POUND 7.0250 6.8860 6.8660
1 SWISS FRANC 3.1080 3.0460 3.0310
100 BANGLADESH TAKA 6.6600 6.3100 6.1100
100 CHINESE RENMINBI N/A N/A N/A
100 DANISH KRONE 64.1000 61.5800 61.3800
100 HONGKONG DOLLAR 49.2100 48.2300 48.0300
100 INDIAN RUPEE 8.4600 8.1300 7.9300
100 INDONESIAN RUPIAH 0.0440 0.0400 0.0350
100 JAPANESE YEN 3.5110 3.4420 3.4320
100 NEW TAIWAN DOLLAR N/A N/A N/A
100 NORWEGIAN KRONE 56.1900 53.9900 53.7900
100 PAKISTAN RUPEE 6.7200 6.3900 6.1900
100 PHILIPPINE PESO 6.9200 6.7200 6.5200
100 SAUDI RIYAL 103.3500 99.3000 99.1000
100 SOUTH AFRICAN RAND 62.7700 60.3100 60.1100
100 SRI LANKA RUPEE 3.8200 3.6000 3.4000
100 SWEDISH KRONA 51.8600 49.8300 49.6300
100 THAI BAHT 9.5000 9.1300 8.9300

INTERPRETATION OF BANK EXCHANGE RATES
Selling Buying Buying

TT/OD TT OD
1 US Dollar 3.8250 3.7750 3.7650

1 British Pound 7.0250 6.8860 6.8660
Question :
Why are there two buying rates ?? … and
Why is the Buying OD rate lower than Buying TT rate ??


TT/OD TT OD
1 US Dollar 3.8250 3.7750 3.7650

1 British Pound 7.0250 6.8860 6.8660
 Bank sells foreign exchange;

Customer pays Ringgit
 Flow of currencies is immediate on same day


TT/OD TT OD
1 US Dollar 3.8250 3.7750 3.7650

1 British Pound 7.0250 6.8860 6.8660
 Bank buys foreign exchange;

Customer gets Ringgit
 Flow of currencies is immediate on same day


TT/OD TT OD
1 US Dollar 3.8250 3.7750 3.7650

1 British Pound 7.0250 6.8860 6.8660
 Bank buys foreign exchange;

Customer gets Ringgit
 Flow of Ringgit is immediate on same day;
Flow of foreign currency at later date

Selling TT/OD Buying TT Buying OD
US
3.8250 3.7750 3.7650
Dollar
Bank sells for Bank buys from Bank buys from
customers to remit by customers who have clients who receives
telegraphic transfers received TTs from checks or drafts from
overseas, or for overseas or exporters
exporters who who receive
receive documentary documentary credits
credits allowing calling for
reimbursement by reimbursements at
TTs sight or travelers
presenting travelers’
checks.
(applicable for (or people receiving (applicable for
importers or people money from overseas exporters, people
sending money applicable for receiving money from
outside Malaysia) exporters ) overseas, or
travelers)

TT/OD TT OD
1 US Dollar 3.8250 3.7750 3.7650
1 British Pound 7.0250 6.8860 6.8660
The rate in this column is used when a bank buys foreign currency
travelers’ checks or drafts from its customers. When presented, the
bank would normally buy the checks and pay the presenter in local
currency equivalent. Meanwhile, the bank would have to send the
checks to the issuer in the country of domicile for claim. Obviously
this will cost the bank some money in the form of interest loss from
the time the local currency is paid out to the check presenter until the
time the bank is reimbursed by the issuer of the checks.
The BUYING OD rate is computed using the formula,
Buying OD Buying TT Spot Rate x FCR x Reimbursement Period
= -
Rate Rate 360
The BUYING OD rate is computed using the formula,
Buying OD Buying TT Spot Rate x FCR x Reimbursement Period

= -
Rate Rate 360
Example : Spot US$/MYR is 3.8000

: US$ interest rate is 3.5% p.a.
: Reimbursement period is 14 days
The BUYING OD rate is therefore,

3.8000 x 3.5 x 14
Buying OD Rate = 3.7800 -
360 x 100
= 3.7748

How Banks Trade in Foreign Exchange
A bank dealer trades in the foreign exchange market

subject to strict compliance to the guidelines set by
his management. These include,
• The size of OPEN FX POSITION he can hold

• The cut-off point he has to unwind his “sour” FX
position and accept a loss.
• The size of his exposure with a counter party.
• The size of his exposure in a particular currency
for a particular settlement date.
Position Taking
In the foreign exchange market, it is perfectly

acceptable to start a position from either a LONG
or a SHORT side.
In foreign exchange trading, a bank dealer may

BUY or SELL a particular base (commodity)
currency, depending on his outlook and his
requirement.

Taking a LONG FX Position

If a dealer is long in a particular currency, he must be short in
another currency.
Suppose the prevailing rate for USD/DEM is 1.3900 and the dealer
believes that the USD/DEM rate may go up. Obviously the he would
go long on USD/DEM by buying, say USD1.0 million against the DEM.
This position will be recorded in his BLOTTER as follows:-
FX Blotter # 1 Currency : USD
Deal No. Counterparty Purchase Sale Rate Position Value Date

1 ABC Bank Spore 1,000,000 - 1.3900 +1,000,000 15/11
FX Blotter # 2 Currency : DEM

1 ABC Bank Spore - 1,390,000 1.3900 -1,390,000 15/11

Unwinding a LONG FX Position

When the USD/DEM exchange rate really goes up, say to 1.3950
level, the dealer would take profit and square his position by selling
USD1.0 million against DEM. This will be recorded as Deal No. 2 in
his blotter below. The residual DEM 5,000 in the DEM Blotter is the
profit he makes from this deal.

1 ABC Bank Spore 1,000,000 - 1.3900 +1,000,000 15/11
2 XYZ Bank F’furt - 1,000,000 1.3950 Square 15/11
FX Blotter # 2 Currency : DEM

1 ABC Bank Spore - 1,390,000 1.3900 -1,390,000 15/11
2 XYZ Bank F’furt 1,395,000 - 1.3950 + 5,000 15/11

Taking a SHORT FX Position

When a dealer is short in a particular currency, he must be long
in another currency.
Suppose the prevailing rate for USD/MYR is 3.8000 and the dealer
believes that the MYR is appreciating. Reacting to this situation,
certainly the dealer would go short on USD/MYR by selling, say
USD2.0 million against the MYR.

1 Crazy Bank Spore - 2,000,000 3.8000 -2,000,000 15/11
FX Blotter # 2 Currency : MYR

1 Crazy Bank Spore 7,600,000 - 3.8000 +7,600,000 15/11

Squaring a SHORT FX Position

Eventually when MYR really appreciates, say first to 3.7900 level, the dealer
may want to take profit by buying USD1.0 million first against MYR. If he feels
that the MYR can appreciate further, he may hold on to his remaining USD/MYR
position of USD1.0 million. Suppose the rate moves in his way to, say at 3.7750,
he would sell the remaining position at that level and square his USD/MYR
position.
These transactions will be recorded in his BLOTTER as follows:-

1 Crazy Bank Spore - 2,000,000 3.8000 -2,000,000 15/11
2 Cozy Bank Ldn 1,000,000 - 3.7900 -1,000,000 15/11
3 Mana Bank KL 1,000,000 - 3.7750 Square 15/11
FX Blotter # 2 Currency : MYR

1 Crazy Bank Spore 7,600,000 - 3.8000 +7,600,000 15/11
2 Cozy Bank Ldn - 3,790,000 3.7900 +3,810,000 15/11
3 Mana Bank KL - 3,775,000 3.7750 + 35,000 15/11

Elements of a Foreign Exchange Transaction
In any foreign exchange transaction, there must

exist the following 6 elements:
● the commodity currency

● the reference currency
● the rate of exchange
● the value date
● the amount of money to be exchanged
● the parties to the exchange

FX Trading
Broadly there are 5 types of FX trading activities:
1. Spot Foreign Exchange Dealing
2. Forward Foreign Exchange
3. FX Futures
4. FX Options
5. FX Swaps

Value Dates in FX Transactions
Overnight
Value Value Value Value

Today Tom Spot Spot/Next
Day 0 Day 1 Day 2 Day 3

Tom/Next


Today/Odd


Spot/Next


Determining the SPOT Value Date
Calendar
1 2 3 4 5 6 7 8 9
Date
Day M T W T F S S M T
Holiday in KL NY
Deal Date 1 2 3 5
Spot Date 3 5 9 9

Foreign Exchange
ELEMENTS OF A FOREIGN EXCHANGE TRANSACTION
In any foreign exchange transaction, there must

exist the following 6 elements:
● the commodity currency
i.e. the currency that is to be sold or purchased
● the reference currency

i.e. the currency that gives value to the commodity currency
● the rate of exchange

● the value date
● the amount of money to be exchanged
● the parties to the exchange
i.e. buyer buys what currency and seller sells what currency
DATES IN FOREIGN EXCHANGE DEALINGS
1. Contract (or transaction) Date
This refers to the date the foreign exchange transaction takes place.
2. Value Dates
This refers to the date on which the cash flows occur.
a) Spot Value Date
Settlement of an FX deal which takes place two business days
from the contract date.
b) Short Dates
Settlement of an FX deal that occur before spot date, either
same day (i.e. today) or one day after contract date (tomorrow).
c) Forward Value Dates
These are payment dates in settlement of FX contracts that are
to occur some round number of months in the future.
d) Cock Dates
Settlement of FX deal whose maturity date is some number of
days after spot date, other than the standard forward dates.
TRADING METHODOLOGY
Foreign exchange trading can be done through

either of the following methods:
1. direct with a counterparty over the telephone,

telex, or any computerized dealing system, or
2. through an intermediary such as the foreign

exchange brokers.

VALUE DATES
In a foreign exchange transaction, the value date

can be any specific date (FIXED DATE) or period
of dates (OPTIONAL DATES)
● value today (FIXED DATE)

● value tomorrow (FIXED DATE)
● value spot (FIXED DATE)
● value 1 mth from spot (FIXED DATE)
● value spot to 1 month (OPTIONAL DATE)
● value 2 to 3 months (OPTIONAL DATE)

FX TRADING
Broadly there are 3 main trading activities :-
1. Spot Foreign Exchange Dealing
2. Forward Foreign Exchange Transactions
3. FX Swap Transactions

Spot FX Dealing
Definition
The buying and selling of foreign currency
(usually US Dollar) against another currency
with actual settlement of the transaction taking
place 2 business days after date of deal.

Spot FX Dealing forms the bulk of the

transactions that takes place in the Interbank
Foreign Exchange Market.

Spot FX Trading
SPOT FX DEALING
Major Participants
1. Banks
They form the major buyers and sellers.

In Malaysia, only commercial banks are
authorized to trade in foreign exchange.
2. Brokers
They act as middlemen and bring buyers

and sellers together.

Spot FX Trading
SPOT FX DEALING
Commonly Traded Currencies
1. EUR/USD
2. USD/JPY
3. USD/CHF
4. GBP/USD
In Malaysia
1. USD/MYR
2. USD/SGD

Spot FX Trading
Spot FX Dealing
Pricing
The exchange rates in the spot forex market

fluctuate according to supply and demand of
the currencies concerned.

It may fluctuate quite widely sometimes in

response to political and economic news,
rumours, etc.

Spot Rates
SPOT FX RATES
Spot quotations consist of Bid (buy) and Ask or

Offer (sell) rates at which a Quoting Party will buy
and sell the base currency (or Commodity Currency)
against another currency (the Reference Currency).
From the Quoted Party’s point of view the bid is where

he can sell the commodity currency and the offer is
where he can buy the commodity currency.

Spot Rates
SPOT FX RATES
The Quoting Party spot quotations are normally 2-way

rates quoted, for example:
USD/DEM 1.71 23/33
verbally this would be quoted as ‘23/33’

Spot Rates
SPOT FX RATES

USD/DEM 1.71 23/33
The currencies in this quotations are:

USD - The Commodity Currency
DEM - The Reference Currency

Spot Rates
SPOT FX RATES

USD/DEM 1.71 23/33
1.71 - The big figure

23 - The BID rate
33 - The OFFER rate

Spot Rates
SPOT FX RATES
Avoid confusion concerning 2-way quotations by using the

following ‘rules’.
Rule 1 Establish which is the Commodity Currency

Rule 2 The Quoting Party buys the commodity
currency at the rate shown on the left side of
the quotation – the bid
Rule 3 The Quoting Party sells the commodity
currency at the rate shown on the right side of
the quotation – the offer

Spot Rates
SPOT FX RATES
Example
Consider a USD/DEM quote of 1.7108/18. The
commodity currency is USD. This means the quoting
party will buy 1 USD and pay you 1.7108 DEM for it
and the quoting party will sell you 1 USD and charge
you 1.7118 DEM for it.
Quote: Quoting Party Quoted Party

USD / DEM intends to can
BUY USD SELL USD
BID
SELL DEM BUY DEM
SELL USD BUY USD
OFFER
BUY DEM SELL DEM
Spot FX Trading
DETERMINING AVERAGE RATES, POSITION AND P&L
Suppose you trade in USD/DEM and after a hectic day you

want to find out your position – whether you are short or long in
the commodity currency. You also need to know the average
rate the position was created. How do calculate the average
rate?
To calculate the average rate:
1. Determine the total net DEM balance; and
2. Divide amount in (1) by net USD balance.
Suppose DEM balance = 12,737,000

USD balance = 9,000,000
Then your average rate = 1.4152
Effectively you are ‘long USD9.0 million at 1.4152’
Spot FX Trading
DETERMINING AVERAGE RATES, POSITION AND P&L
Suppose the market is now 1.41 60/70. To square your position

you would need to sell 9,000,000 USD at 1.4160. So your profit
since the start of the day would be:
Profit = - (9,000,000 x 1.4152) DEM + (9,000,000 x 1.4160) DEM

= - 12,736,800 + 12,744,000
= DEM 7,200
Alternatively, the P&L can be calculated as follows:

Profit = 9,000,000 x (1.4160 – 1.4152)
= 9,000,000 x 0.0008
= DEM 7,200

Spot FX Trading
TRADING LIMITS
A dealer’s position is controlled by the limits set on

how much he can be long or short in his currency.
The limit is set according to how much capital a bank

is prepared to risk on FX deals. Once a total exposure
limit has been established for a bank as a whole, its
value is allocated among the different desks and
dealers according to strategic currency importance,
dealer’s experience etc.

Spot FX Trading
SPOT TRADING STRATEGIES
1. Using the spreads
2. Shading the rates

Spot FX Trading
SPOT FX RISKS
There are several types of risk which must be considered and

managed for successful FX trading. The main risks include:
1. Settlement and replacement risk
2. Market risk

Spot FX Trading
SPOT FX RISKS
Pre-settlement Risk (or replacement cost risk) is the

risk that the non-defaulting counterparty will incur a cost (a
loss) in replacing a treasury contract.
Settlement Risk (or principal risk) is the risk that one
party in a foreign exchange trade pays out the currency it
sold but does not receive the currency it bought.
Market Risk is the risk of loss resulting from an

adverse movement in market rates on an open position. A
profit can rapidly become a loss and a loss can get even
bigger. A party who has a square position is not subject to
market risk.

Spot FX Trading
SPOT FX DEALING
Factors Affecting Exchange Rates
The exchange rates in the spot forex market

fluctuate according to supply and demand of
the currencies concerned.
It may fluctuate quite widely sometimes in

response to political and economic news,
rumours, etc.

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BWB3033 International Banking

© Abmalek F. Abubakar, 2005

1. Definition and evolution

© Abmalek F. Abubakar, 2005

WHAT IS FOREIGN EXCHANGE ?

FOREIGN EXCHANGE MARKET

An arena through which one is able to transfer

© Abmalek F. Abubakar, 2005

FOREIGN EXCHANGE RATE

The price of one currency to another.

E.g. The price of 1 USD is 4.0545 MYR

© Abmalek F. Abubakar, 2005

“The foreign exchange market is the arena

D.K. Eiteman and A.I. Stonehill

© Abmalek F. Abubakar, 2005

Middle East THE FX MARKETS New York

The banks are the natural intermediary between

© Abmalek F. Abubakar, 2005

Roles of banks in foreign exchange market:

1. Buying and selling currencies from

WHY THE NEED FOR FOREIGN EXCHANGE

The foreign exchange market is

© Abmalek F. Abubakar, 2005

IMPORTER Normally have his country’s

EXPORTER Normally wants to be paid in

© Abmalek F. Abubakar, 2005

1. Using the importer’s national currency

2. Using the exporter’s national currency

3. Using a neutral currency

© Abmalek F. Abubakar, 2005

Spot Date Settlement Dates Any Time

© Abmalek F. Abubakar, 2005

FX Rates can be expressed either as

 Direct Quotation (Price Quotation)

 Indirect Quotation (Volume Quotation)

© Abmalek F. Abubakar, 2005

Direct Quotation (Price Quotation)

A rate expressed such that the foreign currency is the

© Abmalek F. Abubakar, 2005

Indirect Quotation (Volume Quotation)

© Abmalek F. Abubakar, 2005

How are FX rates quoted?

USD as the Commodity Currency

Because USD is widely accepted,

A rate quotation such that the Reference Currency in a

If AUD 1.0 = USD 0.5670

© Abmalek F. Abubakar, 2005

Example : Given the following exchange rates, it is

US$ 1.00 = MYR 3.8000

© Abmalek F. Abubakar, 2005

A foreign exchange rate is normally quoted in a 2-way

Spot US$ / MYR 3.7990 / 10

It means : Bank ABC is willing to

US$ / MYR 3.8 0 90 / 10

© Abmalek F. Abubakar, 2005

In the quotation reference bid

US$ / MYR 3.8 0 90 / 10

commodity big offer

© Abmalek F. Abubakar, 2005

commodity big offer pips

© Abmalek F. Abubakar, 2005

PIPs are the numerical units behind the decimal

In the Quote, USD 1.0 = MYR 3.7995

In the Quote, USD 1.0 = JPY 121.77