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Foreign Exchange Market

Reading: Chapter 6

Lecture Outline
Describe the FX market Identify participants and currencies Understand spot and forward rates Calculate & use cross and forward rates Triangular arbitrage Changes in exchange rates

Functions of FX Market
The foreign exchange market is the mechanism by which participants:
transfer purchasing power between countries; obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.

Types of Transactions
A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day.
The date of settlement is referred to as the value date.

Types of Transactions
An outright forward transaction (usually called just forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months. Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)

Types of Transactions
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 counterparty.

Some different types of swaps are:

spot against forward, forward-forward, nondeliverable forwards (NDF).

Market Participants
The foreign exchange market consists of two tiers:
the interbank or wholesale market (multiples of $1M US or equivalent in transaction size), and the client or retail market (specific, smaller amounts).

Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

Market Participants
Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.
They profit from buying foreign exchange at a bid price and reselling it at a slightly higher offer or ask price. Dealers in the foreign exchange department of large international banks often function as market makers. These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an inventory position in those currencies.

Market Participants
Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose. Some of the participants use the market to hedge their foreign exchange risk.

Market Participants
Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

Market Participants
Central banks and treasuries use the market to acquire or spend their countrys foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System. The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.

As willing loss takers, central banks and treasuries differ in motive from all other market participants.


Types of Activities
An activity that leaves one open to exchange rate fluctuations where one aims to make a profit.

Allows the firm to transfer exchange rate risk inherent in foreign currency transactions or positions.

Arbitrage take advantage of inconsistent prices to make risk-free profits. These profits are unlikely to last long.
Spatial (or Locational) Arbitrage Triangular Arbitrage Covered Interest Arbitrage Lecture 3

Foreign Exchange Rates & Quotations

A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.


Bid & Ask Quotes

Foreign currency dealers provide two quotes:
Bid Price: Price at which the dealer is willing to buy foreign currency from you. Ask Price: Price at which the dealer is willing to sell foreign currency to you. It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread.

The less traded and more volatile a currency, the greater is the spread.

Direct & Indirect Quotes

Direct Quote: Home currency per unit of Foreign currency (FC) - e.g. AUD/ quote is 1.6003 1.6499

Indirect Quote: Foreign currency per unit of Home currency - e.g. /AUD quote of 0.6061 0.6249
Note that in all cases, the reciprocal of a direct quote is an indirect quote:

Also, you might encounter an exchange rate quotation in American terms (US$/FC) or European terms (FC/US$).

Forward Quotes Points

A forward quotation expressed in points is not a foreign exchange rate as such. It is the difference between the forward rate and the spot rate. When the Bid Points > Ask Points, you subtract the points from the spot rate to get the outright forward quote. If the Bid Points < Ask Points, you add the points to the spot rate to get the outright forward quote