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Chapter 6

The Foreign
Exchange Market

Copyright 2010 Pearson Prentice Hall. All rights reserved.

The Foreign Exchange (FX) Market

The FX Market: Different currencies are exchanged
and FX rates are determined.
Foreign exchange (FX) = money of a foreign
country (foreign currency bank balances,
banknotes, checks and drafts).
The FX market spans the globe, with prices
moving and currencies trading somewhere every
hour of every business day.
The volume of currency transactions ebbs and
flows across the globe* as the major currency
trading centers open and close throughout the

Exhibit 6.1 Measuring Foreign Exchange Market

Activity: Average Electronic Conversions Per Hour


Exhibit 6.2 Global Currency Trading:

The Trading Day


Functions of the Foreign Exchange

The FX Market, participants:
obtain or provide credit for international trade
transactions, and
risk-hedging: minimize exposure to the risks of
exchange rate changes.
purchase/invest currencies as assets, expecting
certain price movements.


Market Participants
The FX market consists of two tiers:
the interbank or wholesale market (multiples of $1MM
US or equivalent in transaction size banks, dealers,
financial institutions)
the client or retail market (specific, smaller amounts
general firms, individuals).

participants: banks, nonbank foreign exchange

dealers, other financial institutions, general
firms, individuals, and central banks and
treasuries; there are speculators and


Bank and Nonbank FX Dealers & others..

Banks and nonbank foreign exchange dealers operate in both
the interbank and client markets.
They carry inventory of currencies and post bid-ask prices:
buy at a bid price and sell at a slightly higher offer or
ask price FX market is a dealer market; these dealers market makers
(FX brokers: match buy/sell orders; not taking inventory
As in other areas of global marketplace, technology/internet
is rapidly changing the market microstructure/dynamics! (e.g.
eFX online currency trading)


Speculators and Arbitragers; Central

Banks and Treasuries
Speculators and arbitragers seek to profit from trading
- While dealers seek the bid/ask spread, speculators
seek all the profit from exchange rate changes;
arbitragers try to profit from simultaneous exchange
rate differences in different markets.

Central banks and treasuries buy or sell their

countrys FC reserves; influence FX rate.
- The motive is not to earn a profit per se, but to
influence FX rates in a manner that will benefit the
interests of their citizens willing loss takers.


Transactions in the Interbank Market

A spot transaction: settlement date (value date)
usually the second following business day in the
wholesale mkt; settlement sooner in the retail mkt.
An outright forward transaction (or 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 agreed/determined now; but
payment/ delivery are not required until maturity.
- Forward exchange rates - usually quoted for value
dates of one, two, three, six and twelve months.
- buying forward or selling forward can describe the
same transaction: e.g. euro vs dollar - buying euros
forward (w/ dollars) = selling dollars forward (for

Transactions in the Interbank Market

A foreign exchange (FX) swap transaction in the interbank
market - simultaneous purchase and sale of a given amount
of foreign exchange for often two different value dates.
Both purchase and sale are often conducted with the same
counterparty (why? buy foreign bonds and stocks need to
hedge future currency values; IRP CIA)
- Many different, at-times complicated transactions:
- spot against forward;
- forward-forward;
Also, nondeliverable forwards (NDF), .etc etc
((side note: many sorts of swaps. FX swap, interest rate
swap, currency swap,, central bank (liquidity) currency

Nondeliverable forward (NDF)

No actual delivery of currencies
Settle with dollars
Offshore contract to avoid regulations by the
currency country
Many emerging market currencies Latin American
nations, Asian countries - 90s Asian financial crisis
booming NDF markets
Korean Won; Taiwanese dollar; Chilean peso, Chinese
RMB Non-internationalized currencies; convertibility
restrictions (recently RMB going global/international)
(International, fully convertible currencies USD,
Euro, Japanese Yen, UK Pound, Swiss Franc, Canadian
dollar, Australian dollar etc.)

FX market size
A triennial survey by the Bank for International Settlements
(BIS) estimates global FX trading volume usually in April:
April 2007:$3.2 trillion per day;
April 2010:$4.0 trillion per day;
April 2013:$5.3 trillion per day (not in the book)*
dramatic growth in FX trading: currency derivative
(forwards, swaps, options) > 60% volume (spot < 40%)!
1) London mkt still #1, then US, Singapore (economy
small), Japan, H.K.
2) $ most traded, then euro, yen, pound, Australian $,
Mexican peso 8th (significant increase), Yuan (CNY) 9th ! (a


Exhibit 6.4 Global Foreign Exchange Market

Turnover, 1989-2010 (average daily turnover in
April, billions of U.S. dollars)


Exhibit 6.5 Top 10 Geographic Trading Centers in

the Foreign Exchange Market, 1991-2010 (average
daily turnover in April)


Exhibit 6.6 Foreign Exchange Market Turnover by

Currency Pair (daily average in April)


FX Rates - Quotations
(Most foreign exchange transactions involve USD.)
- European term: foreign currency price of one dollar
- American term: dollar price of a unit foreign currency*
Ex) SF 1.6000/$ (European term); $0.6250/SF (American
- direct quote: home currency price of a unit foreign currency
- indirect quote: foreign currency price of a unit home
Ex) SF 1.6000/$ (European term) direct quote for a Swiss
& indirect quote for an American
Confusingly enough, using ISO** 4271 codes (e.g. USD, EUR,
GBP, JPY, CHF, MXNlast page of the book):
- SF 1.6000/$ (European term) = USD/CHF 1.6
- $0.6250/SF (American term) = CHF/USD 0.6250
i.e. / is NOT a divisor ()
however, in practice conventions vary; in this class either SF
1.6000/$ or CHF 1.6/USD i.e. / is a divisor!

FX Rates and Quotations

Interbank quotations are given as a bid and ask (or offer).
A bid is the price (i.e. exchange rate) in one currency at
which a dealer will buy another currency.
An ask is the price (i.e. exchange rate) 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 buying and selling prices.
A bid for one currency is also the offer for the opposite


Foreign Exchange Rates and Quotes

- see my review; alternatively the following:
For quotations expressed in foreign
currency terms (Indirect quotations) the
formula becomes (f = forward premium):
f = Spot Forward 360

x 100

For quotations expressed in home currency

terms (Direct quotations) the formula
becomes (f = forward premium):
f = Forward Spot 360

x 100

Foreign Exchange Rates and Quotes

Many currency pairs - inactively traded
their exchange rate - determined through their
relationship to a widely traded third currency (cross
Ex) Mexican peso dollar; dollar yen cross rate:
peso vs Yen
- Cross rated can be calculated for major currencies too.
- Cross rates can be used to check on opportunities for
intermarket/triangular arbitrage.


Intermarket/Triangular arbitrage <--possible

because one banks (Dresdner) quotation on / cross

rate between $/ (Barclays) and $/ (Citibank).

Citibank quote - $/ $1.3297/

Barclays quote - $/
Dresdner quote - /
Cross rate calculation:
= 1.1721/

Exhibit 6.11 Triangular Arbitrage by a Market



(Risk-free) arbitrage opportunity

Short-lived, relatively rare opportunity, especially
considering transaction cost
Opportunity, if any, vanishes very quickly
Computer based algorithmic trading instantaneously
captures it and executes trades (HFT: high frequency
Often some risk may be assumed
Only large institutions/banks with huge capital access
can do it.