Chapter 4The Foreign Exchange Market

The Foreign Exchange MarketThe Foreign Exchange Market provides: The physical and institutional structure through which the money of one country is exchanged for that of another countryThe determination rate of exchange between currenciesIs where foreign exchange transactions are physically completed

The Foreign Exchange MarketForeign exchange means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks and drafts.A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date.

GeographyThe foreign exchange market spans the globe, with prices moving and currencies trading somewhere every hour of every business day.As the next exhibit will illustrate, the volume of currency transactions ebbs and flows across the globe as the major currency trading centers open and close throughout the day.

Exhibit 4.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversations Per HourSource: Federal Reserve Bank of New York, The Foreign Exchange Market in the United States, 2001, www.ny.frb.org.

Functions of the Foreign Exchange MarketThe foreign exchange Market is the mechanism by which participants:Transfer purchasing power between countriesObtain or provide credit for international trade transactionsMinimize exposure to the risks of exchange rate changes

Market ParticipantsThe foreign exchange market consists of two tiers:The interbank or wholesale market (multiples of $1MM US or equivalent in transaction size) 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.

Bank and Nonbank Foreign Exchange DealersBanks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.The 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.

Individuals and FirmsIndividuals (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 foreign exchange risk.

Speculators and ArbitragersSpeculators 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.

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

Foreign Exchange BrokersForeign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction.For this service, they charge a commission.It is a brokers business to know at any moment exactly which dealers want to buy or sell any currency.Dealers use brokers for their speed, and because they want to remain anonymous since the identity of the participants may influence short term quotes.

Transactions in the Interbank MarketA 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.

Transactions in the Interbank MarketAn 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.)

Transactions in the Interbank MarketA 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 forwardForward-ForwardNondeliverable Forwards (NDF)

Market SizeIn April 2001, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1,210 billion.This was the first decline observed by the BIS since it began surveying banks on foreign currency trading in the 1980s.

Exhibit 4.2 Global Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, October 2001, www.bis.org.

Exhibit 4.3 Geographic Distribution of Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, October 2001, www.bis.org.

Exhibit 4.4 Currency Distribution of Global Foreign Exchange Market Turnover (percentage shares of average daily turnover in April)Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, October 2001, www.bis.org.Because all exchange transactions involve two currencies, percentage shares total to 200%

Foreign Exchange Rates and QuotationsA 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.

Foreign Exchange Rates and QuotationsMost foreign exchange transactions involve the US dollar.Professional dealers and brokers may state foreign exchange quotations in one of two ways:The foreign currency price of one dollarThe dollar price of a unit of foreign currencyMost foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.

Foreign Exchange Rates and QuotationsFor example, the exchange rate between US dollars and the Swiss franc is normally stated:SF 1.6000/$ (European terms)However, this rate can also be stated as:$0.6250/SF (American terms)Excluding two important exceptions, most interbank quotations around the world are stated in European terms.

Foreign Exchange Rates and QuotationsAs mentioned, several exceptions exist to the use of European terms quotes.The two most important are quotes for the euro and U.K. pound sterling which are both normally quoted in American terms.American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with toursists.

Foreign Exchange Rates and QuotationsForeign exchange quotes are at times described as either direct or indirect.In this pair of definitions, the home or base country of the currencies being discussed is critical.A direct quote is a home currency price of a unit of foreign currency.An indirect quote is a foreign currency price of a unit of home currency.The form of the quote depends on what the speaker regard as home.

Foreign Exchange Rates and QuotationsInterbank quotations are given as a bid and ask (also referred to as 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 currency.

Foreign Exchange Rates and QuotesForward rates are typically quoted in terms of points.A forward quotation is expressed in points is not a foreign exchange rate as such.Rather, it is the difference between the forward rate and the spot rate.

Foreign Exchange Rates and QuotesForward quotations may also be expressed as the percent-per-annum deviation from the spot rate.This method of quotation facilitates comparing premiums or discounts in the forward market with interest rate differentials.

Foreign Exchange Rates and QuotesFor quotations expressed in foreign currency terms (Indirect quotations) the formula becomes:f = Spot Forward 360

For quotations expressed in home currency terms (Direct quotations) the formula becomes:f = Forward Spot 360

Foreign Exchange Rates and QuotesMany currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate).Cross rates can be used to check on opportunities for intermarket arbitrage.This situation arose because one banks (Dresdner) quotation on / is not the same a calculated cross rate between $/ (Barclays) and $/ (Citibank).

Foreign Exchange Rates and QuotesCitibank quote - $/$0.9045/Barclays quote - $/ $1.4443/Dresdner quote - /1.6200/Cross rate calculation:$1.4443/

$0.9045/

= 1.5968/

Exhibit 4.9A Triangular ArbitrageCitibankDresdner BankBarclays BankReceive 1,121,651Receive $1,014,533End with $1,014,533Start with $1,000,000Sell $1,000,000 to Barclays Bank at $1.4443/Receive 692,377Sell 692,377 to Dresnder Bankat 1.6200/Sell 1,121,651 toCitibank at $0.9045/(1)(2)(3)(4)(5)(6)

Foreign Exchange Rates and QuotesMeasuring a change in the spot rate for quotations expressed in home currency terms (direct quotations):% = Ending rate Beginning Rate

Quotations expressed in foreign currency terms (indirect quotations): % = Beginning Rate Ending Rate