The Market for Foreign Exchange

Outline
 Function and Structure of the FX Market
 FX Market Participants
 Correspondent Banking Relationships
 The Spot Market
 Spot Rate Quotations
 The Bid-Ask Spread
 Spot FX Trading
 Cross Exchange Rate Quotations
 Triangular Arbitrage
 Spot Foreign Exchange Market Microstructure

5-2
Outline
 The Forward Market
 Forward Rate Quotations
 Long and Short Forward Positions
 Non-Deliverable Forward Contracts
 Forward Cross-Exchange Rates
 Swap Transactions
 Forward Premium
 Exchange-Traded Currency Funds

5-3
FX Market Participants
 The FX market is a two-tiered market:
 Interbank market (wholesale)
 About 100-200 banks worldwide stand ready to make a market in

foreign exchange.
 Nonbank dealers account for about 40% of the market.

 There are FX brokers who match buy and sell orders but do not

carry inventory and FX specialists.

 Client market (retail)
 Market participants include international banks, their
customers, nonbank dealers, FX brokers, and central banks.

5-4
Circadian Rhythms of the FX Market
Electronic Conversations per Hour
average peak
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
1:00 3:00 5:00 7:00 9:00 11:00 1:00 15:00 5:00 19:00 9:00 11:00
10 am in Lunch Europe Asia Lunch Americas London New 6 pm in
Tokyo hour in coming in going out hour in coming in going out Zealand NY
Tokyo London coming in

Source: Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York,
www.newyorkfed.org.

5-5
Forex Market Timing
Forex Market
 Foreign Exchange Market
The foreign exchange market is the market in which
currencies are bought and sold against each other

 Exchange Rate
The price of one currency relative to another
The exchange rate is the number of units of one
currency (Price currency/Quoted Currency) that one
unit of another currency (base currency) will buy

The price represents how much of the quote currency is

needed for you to get one unit of the base currency
Methods of Quote
 Direct Quote: The direct quoting is the amount of local currency needed
to buy one unit of the foreign currency and the amount of home
currency respectively due to be received when one unit of foreign
currency is being sold i.e. 1 foreign currency unit = x home currency
units ( INR 82/ US $)
 
 Indirect Quote: The indirect quote is the amount of foreign currency

needed to buy one unit of the home currency i.e. 1 home currency unit =
x foreign currency units ( US $ 0.0122/ INR)
 
 Cross Currency Quote: When a currency quote is given without the

Indian Rupee as one of its components, this is called a cross currency,

i.e. when home currency is not involved in the currency pair. The most
common cross currency pairs are the USD/EUR, EUR/GBP, GBP/JPY
Correspondent Banking Relationships

 Large commercial banks maintain demand deposit

accounts with one another, which facilitates the
efficient functioning of the FX market.

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Correspondent Banking Relationships
 Bank A is in London. Bank B is in New York.
 The current exchange rate is £1.00 = $2.00.
 A currency trader employed at Bank A buys £100m
from a currency trader at Bank B for $200m settled
using its correspondent relationship.

Bank A $200 Bank B

London £100 NYC
5-10
Correspondent Banking Relationships
Bank A buys £100m from Bank B for $200m

Bank A $200 Bank B

London £100 NYC

Assets Liabilities Assets Liabilities

£ deposit at B £300m B’s Deposit $1,000m $ deposit at A $1000m A’s Deposit £300m
£400m $1,200m $1200m £400m
$ deposit at B $800m B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m
$600m £100m £100m $600m
Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m
Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E $2,200m

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Practice Problem
 Bank X is in Milan. Bank Y is in London.
 The current exchange rate is €1.10 = £1.00.
 Show the correct balances in each account if a
currency trader employed at Bank X buys
£100,000,000 from a currency trader at Bank Y for
€110,000,000.

5-12
Practice Problem
Bank X buys £100m from Y for €110m

Bank X €110m Bank Y €1.10 =

Milano £100m London £1.00
Bank X Bank Y
Assets Liabilities Assets Liabilities

£ deposit £300 Y’s €1,21 € deposit €1,210 X’s £300

at Y £400
m deposit €1,320
0m at X €1,320
m deposit m £400
€ deposit m€880 Y’s m £200 £ deposit £200m
m X’s €880
m
at Y €770
m deposit £100 m at X £100 deposit €770m
Other £600
m Other £400
m Other €590
m Other m€810
Assets m L&E m Assets
Total m
€2,02 L&E
Total L&E m
€2,02
Total £1,70 Assets 0m 0m
Total L&E
Assets 0m 5-13

Check: £1,700m = €1,320m x £1.00 +£100 + £400

€1.10
Check: €2,020m = £400m x € 1.10 + € 770 + €810
£1.00
Correspondent Banking Relationships
 International commercial banks communicate with
one another using:
 SWIFT: The Society for Worldwide Interbank Financial
Telecommunications.
 CHIPS: Clearing House Interbank Payments System.
 ECHO: Exchange Clearing House Limited, the first global
clearinghouse for settling interbank FX transactions.

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The Bid-Ask Spread
 The bid price is the price a dealer is willing to pay
you for something.
 The ask price is the amount a dealer wants you to
pay for something.
 It doesn’t matter if we’re talking used cars or used
currencies: the bid-ask spread is the difference
between the bid and ask prices.

5-15
 The Bid-Ask Spread
 A dealer could offer:
 A bid price of $1.3090 per €.
 An ask price of $1.3092per €.

 While there are a variety of ways to quote the above, the bid-
ask spread represents the dealer’s expected profit.

Ask Price – Bid Price

Percent Spread = × 100
Ask Price

$1.3092– $1.3090
0.0153% = x 100
$1.3092

5-17
 The Bid-Ask Spread
A dealer pricing pounds in terms of dollars would likely
quote these prices as 00–05.

Anyone trading $10m knows the “big figure.”

USD Bank American Terms European Terms

Quotations Bid Ask Bid Ask

Pounds 1.5400 1.5405 .6491 .6494

5-18
The Bid-Ask Spread

USD Bank American Terms European Terms

Quotations Bid Ask Bid Ask

Pounds 1.5400 1.5405 .6491 .6494

Notice that the reciprocal of the S($/£) bid $1,540
Dealer Customer
is the S(£/$) ask.
£1,000
Customer sells pounds to dealer at direct bid

£.6494 £1.00 $1,000

Dealer Customer
=
£649.40
$1.00 $1.5400

Buy USD from dealer at indirect ask

Currency Conversion with Bid-Ask Spreads
 A speculator in New York wants to take a $10,000
position in the pound.
 After his trade, what will be his position?

Bid Ask Dealer will pay $1.5400 for 1 GBP;

he is asking $1.5405.
S($/£) 1.5400 – 05
He will pay £.6491 for $1 and will
S(£/$) .6491– 94 charge £.6494 for $1

£0.6491 £1
$10,000 × = £6,491 $10,000 × = £6,494
$1.00 $1.5400

5-20
 Sample Problem
• A businessman has just completed transactions in Italy and
England. He is now holding €250,000 and £500,000 and wants
to convert to U.S. dollars.
• His currency dealer provides this quotation:
GBP/USD 0.6488 – 93
USD/EUR 1.4739 – 44
• What are his proceeds from conversion?

He sells €250,000 at the dealer’s bid price:

€250,000 x $1.4739 =$368,475

€1.00
He sells £500,000 at the dealer’s ask price:
£500,000 x $1.00 =$770,060.06
£.6493 $1,138,535.06
5-21
 Another Sample Problem
 An Italian has just completed transactions in America and England.
 He is now holding $100,000 and £500,000, and wants to convert both

amounts to the euro.

 His currency dealer provides this quotation:
GBP/USD 0.6488 – 93
USD/EUR 1.3095 – 98
 What are his proceeds from conversion?

$770,060.06 = £500,000 x $1.00

£.6493

($770,060.06 + $100,000) x €1.00 = €664,269.40

$1.3098

5-22
Spot FX Trading
 In the interbank market, the standard size trade is
about U.S. $10 million.
 A bank trading room is a noisy, active place.
 The stakes are high.
 The “long term” is about 10 minutes.

5-23
Cross Rates
 Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and
that S($/£) = 2.00 (i.e., £1.00 = $2.00).
 What must the €/£ cross rate be?

$1.50 £1.00 £0.75

× =
€1.00 $2.00 €1.00
€1.00 = £0.75

Pay attention to your “currency algebra”!

5-24
 Cross Rates with Bid-Ask Spreads
£10,000 sell £ at bid $15,400 buy € at ask €11,763
USD Bank American Terms European Terms
Quotations
Bid Ask Bid Ask

Pounds 1.5400 1.5405 .6491 .5073

Euros 1.3087 1.3092 .7638 .7641
€/£ €1.1763 £0.8501
To find the €/£ cross bid rate, consider a retail customer who:
Starts with £10,000, sells £ for $, and buys €:
$1.5400 €1.00 1
£10,000 × × = €11,763 €1.1763/£
£1.00 $1.3092
He has effectively sold £ at a €/£ bid price of €1.1763/£.
5-25
 Cross Rates with Bid-Ask Spreads
€10,000 sell € at bid $13,087 buy £ at ask £8,495
USD Bank American Terms European Terms
Quotations
Bid Ask Bid Ask

Pounds 1.5400 1.5405 .6491 .5073

Euros 1.3087 1.3092 .7638 .7641
€/£ €1.1763 €1.1771 £0.8495 £0.8501
To find the €/£ cross ask rate, consider a retail customer who
starts with €10,000, sells € for $, and buys £:
$1.3087 £1.00 1
€10,000 × × = £8,495 = €1.1771/£
€1.00 $1.5405 €1/£0.8495
He has effectively bought £ at a €/£ ask price of €1.1771/£.
5-26
 Cross Rates with Bid-Ask Spreads

direct indirect
Bank American Terms European Terms
Quotations Bid Ask Bid Ask

£:$ $1.5400 $1.5405 £.6491 £.6494

€:$ $1.3087 $1.3092 €.7638 €.7641
€/£ €1.1763 €1.1771 £0.8495 £0.8501
Recall that the reciprocal of €1.1763 €1.00
the S(£/€) bid is the S(€/£) ask. =
£1.00 £0.8501
He has bought £ at a €/£ ask price of €1.1771/£
Bid-ask quote would be €/£: 1.1763-71
5-27
 Triangular Arbitrage

Bank Quotations Bid Ask

Deutsche Bank ₹:$ ₹74.20 $74.50
Credit Lyonnais ₹:£ ₹100.00 ₹100.40
Credit Agricole $/£ $1.33 $1.35

Suppose we observe these banks posting these exchange rates. As we

have calculated the “no arbitrage” $/£ cross bid and ask rates, we can see
that there is an arbitrage opportunity:

5-28
Spot Foreign Exchange Microstructure
 Market microstructure refers to the mechanics of
how a marketplace operates.
 The bid-ask spreads in the spot FX market:
 Increase with FX exchange rate volatility.
 Decrease with dealer competition.
 Private information is an important determinant of
spot exchange rates.

5-29
The Forward Market
 Forward Rate Quotations
 Long and Short Forward Positions
 Non-Deliverable Forward Contracts
 Forward Cross Exchange Rates
 Forward Premium
 Swap Transactions

5-30
Forward Rate Quotations
 The forward market for FX involves agreements to
buy and sell foreign currencies in the future at prices
agreed upon today.
 Bank quotes for 1, 3, 6, 9, and 12 month maturities
are readily available for forward contracts.
 Longer-term swaps are available.

5-31
 Forward Rate Quotations

Consider the exchange rates Country/currency in US$ per US$

shown to the right. For UK pound 1.5405 .6491
British pounds, the spot
1-mos forward 1.5402 .6493
exchange rate is
3-most forward 1.5396 .6495
$1.5405 = £1.00 while the
180-day forward rate is 6-mos forward 1.5389 .6498
$1.5389 = £1.00
What’s up with that? Clearly market participants expect
that the pound will be worth less in
dollars in six months.

5-32
Forward Rate Quotations
 Consider the (dollar) holding period return of a
dollar-based investor who buys £1 million at the spot
exchange rate and sells them forward:

gain $1,538,900 – $1,540,000 –$1,100

$HPR = = =
pain $1,540,000 $1,540,000

$HPR = –0.0007
Annualized dollar HPR = –0.14% = –0.07% × 2

5-33
Forward Premium
 The interest rate differential implied by forward
premium or discount.
 For example, suppose the € is appreciating from
S($/€) = 1.55 to F180($/€) = 1.60.
 The 180-day forward premium is given by:

F180($/€) – S($/€) 360 = 1.60 – 1.55 × 2

f180,€v$ = × 1.55
S($/€) 180

= 0.0645, or 6.45%

5-34
Long and Short Forward Positions
 If you have agreed to sell anything (spot or forward),
you are “short.”
 If you have agreed to buy anything (forward or
spot), you are “long.”
 So, if you have agreed to sell an FX forward, you are
short, and if you have agreed to buy an FX forward,
you are long.

5-35
 Payoff Profiles
profit

f
y of ng
Pa l o n i n
m o
fro siti ,000
Consider the payoffs at maturity
po 10
£ to a long position in a six month
$611 forward contract on £10,000.

Spot exchange in 6 months $/£

$1.50/£
−$389 $1.60/£ Country/currency in US$ per
$1.5389/£ US$
UK pound 1.5405 .6491
1-mos forward 1.5402 .6493
loss

3-most forward 1.5396 .6495

6-mos forward 1.5389 .6498 5-36
Non-Deliverable Forward Contracts
 Due to government-initiated capital controls, the currencies
of some emerging market countries not freely traded.
 For many of these currencies, trading in non-deliverable
forward contracts exists.
 A non-deliverable forward contract is settled in cash, usually
U.S. dollars.
 Settlement is calculated by the difference between the forward price
agreed to in the contract and the spot price at maturity of the contract
multiplied by the contract size.

5-37
 Forward Cross Rates
Currencies
U.S.-dollar foreign-exchange rates in late New York trading.
--------Friday-------
Country/currency in US$ per US$
Euro area euro 1.3092 .7638
The 3-month forward €/£ 1-mos forward 1.3093 .7638
cross rate is: 3-mos forward 1.3098 .7635
6-mos forward 1.3107 .7630
$1.3098 £1.00 £0.8507 UK pound 1.5405 .6491
× =
€1.00 $1.5396 €1.00 1-mos forward 1.5402 .6493
3-mos forward 1.5396 .6495
6-mos forward 1.5389 .6498

5-38
Swaps
 A swap is an agreement to provide a counterparty
with something he or she wants in exchange for
something that you want.
 Often on a recurring basis, e.g., every six months for five
years.
 Swap transactions account for approximately 56
percent of interbank FX trading, whereas outright
trades are 11 percent.

5-39
Exchange-Traded Currency Funds
 Individual shares are denominated in the U.S. dollar and
trade on the New York Stock Exchange.

 Consider an ETF where each share represents 100 euros.

The price of one share at any point in time will reflect the
spot dollar value of 100 euros plus accumulated interest
minus expenses.

 Six additional currency trusts exist on the Australian

dollar, British pound sterling, Canadian dollar, Mexican
peso, Swedish krona, and the Swiss franc.

 Currency is now recognized as a distinct asset class, like

stocks and bonds. Currency ETFs facilitate investing in
these currencies.
5-40