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Chapter 15The Foreign Exchange Market: Participants and Mechanics

SummaryThe foreign exchange markets operate through a highly sophisticated network of telecommunications systems that link the numerous FX dealers and brokers located in all of the major cities of the world. Participants in the FX market also include those who have underlying commercial and financial transactions denominated in foreign currencies. This includes importers and exporters, and those investing or borrowing from overseas in a currency other than their home currency. In addition, there are speculators who buy and sell foreign currencies in the expectation of making profits from favourable exchange rate movements, and there are those who arbitrage exchange rate and/or international interest rate differentials across the different international markets. Central banks also enter the FX markets as buyers and sellers of foreign currency. A central bank may enter the FX market in order to meet its government’s foreign currency requirements or, from time to time, in an attempt to influence the value of a currency in the market.

The FX markets operate somewhere around the globe twenty-four hours a day. The markets are dynamic, with exchange rates changing in response to the continuous flow of economic, political, financial and social news and information into the markets. It is estimated that over USD1.5 trillion passes through the FX markets each day, facilitated by FX dealing rooms that use sophisticated, technology-based computer and communication systems.

The contracts that are traded in the FX markets are distinguished by their maturity or delivery dates. Spot and forward contracts are the most common contracts traded. Spot transactions have a value date that is two business days from today; that is, they require delivery of the foreign currency and financial settlement two business days from the contract date. Forward contracts specify a value date more than two business days from today.

Because of the technology-based nature of the trade in foreign currencies, universal conventions are adopted in the markets. The first-named currency in an FX quote is called the unit of the quotation, or the base currency. The base currency represents one unit of the currency. The second-named currency is known as the terms currency. FX dealers, or price-makers, quote two-way rates: the first and lower rate is the one at which the dealer buys the unit of the quotation; the second and higher rate is the one at which the dealer sells the unit. FX dealers will typically only quote the final two points, as it is presumed that market participants are aware of the big numbers that precede them. A point is the final decimal place in a quote. The spread is the difference between the bid and offer rates.

It is possible to derive a range of additional exchange rates on the basis of the few published rates; for example, transposed and cross-rates can be calculated. To transpose a quote from, say, a direct (USD/AUD) to an indirect quote (AUD/USD), the rule is to reverse the quote and then inverse by dividing into 1. As all currencies are quoted against the USD, it is often necessary to calculate a cross-rate that does not incorporate the USD. For example, to cross two direct quotes, place the new unit currency quote first, followed by the second quote. Simply divide opposite bid and offer rates.

The convention adopted in the quotation of forward rates is that the dealer quotes the forward points rather than the outright forward rates. To obtain the outright rate, the forward points are added to, or subtracted from, the spot rate. In calculating

Solutions Manual t/a Financial Institutions, Instruments and Markets, 4e by Christopher Viney 15-1

the forward points, the dealer uses the spot rate and the differential rates of interest in the money markets of the two countries whose currencies are quoted. The currency of the relatively high interest-rate country will be priced at a forward discount; the relatively low interest-rate currency will be quoted at a forward premium. Real-world complications were touched on, such as different ‘interest-rate days’ conventions (for example, the USA uses a 360-day year), interest-withholding tax, two-way quotations, and the effects of compounding periods, all of which affect the calculation of forward points and a forward exchange rate.

Finally, the European Monetary Union was discussed, and the significant impact it has had on the structure and operation of the FX markets. Twelve foreign currencies have been replaced by a single currency, the euro. The euro has become a major currency traded in the FX markets.

Review questions – suggested answersThe following suggested answers incorporate the main points that should be recognised by a student. An instructor should advise students of the depth of analysis and discussion that is required for a particular question. For example, an undergraduate student may only be required to briefly introduce points, explain in their own words and provide an example. On the other hand, a post-graduate student may be required to provide much greater depth of analysis and discussion.

1. Describe the functions, structure and operation of the international FX markets. Include in your answer the main locations of the markets, and explain the roles of FX dealers and FX brokers.

the FX market is a global market that facilitates transactions in international currencies 24-hours a day

the FX markets exist whenever and wherever financial transactions are conducted which are denominated in a foreign currency

major FX markets include London, New York, Tokyo, Singapore, Hong Kong, Sydney, Bahrain, Frankfurt, Paris and Zurich

the FX market facilitates the exchange of value from one currency to another the FX market allows market participants to buy and sell foreign currencies important reasons that there is an enormous demand to buy and sell foreign

currencies include: - financial flows arising from international trade in goods and services - cross-border capital transactions - investment and borrowing - speculative transactions - profiting from exchange rate movements - central bank transactions with the markets

the FX markets operate through the use of sophisticated electronic communication and information systems

trading in FX is conducted using telephone, telex and SWIFT (society for worldwide interbank financial telecommunications)

SWIFT is an electronic system that facilitates financial transactions for member institutions in the global market

when carrying out transactions, internationally adopted FX market conventions have developed

transactions are normally conducted through an FX dealer or an FX broker FX dealers – financial institutions that quote buy and sell prices, and act as

principals in the FX market


FX brokers – obtain the best prices in the FX market, and match FX dealers’ buy and sell orders, for a fee

2. Importers, exporters, investors and borrowers may all be participants in the FX markets. Explain why each of these parties would be involved in FX market transactions.

Firms conducting international trade transactions (importers and exporters): businesses that export goods or services in the international markets generally

receive payments in a foreign currency also businesses that import goods and services need to pay for those goods and

services, usually in a foreign currency the dominant currency of international trade is the USD, but other currencies, such

as the GBP, JPY and the EUR, are also quite prominent typically, an exporter is likely to sell foreign currency received and buy the local

currency through an FX market importers have to buy foreign currency in order to pay for their imports

Investors and borrowers in the international financial markets: deregulation of the international financial markets has resulted in an enormous

increase in the volume of capital flows around the world large corporations, financial institutions and governments raise funds in the

international capital markets borrowers with good credit ratings are able to diversify their funding sources in

the international capital markets, such as the euromarkets a large proportion of funds borrowed in the international markets is converted

from the currency borrowed back into the home currency, using the FX market other corporations and financial institutions invest overseas for example, funds managers for pension or superannuation funds will invest a

proportion of their investment portfolios in international stocks and debt securities the funds managers need to purchase FX in order to make the investments dividend or interest payments received by the funds managers will be

denominated in a foreign currency. The managers may sell on the FX markets to convert the receipts back into the home currency, for distribution to fund members

3. Distinguish between speculative and arbitrage transactions in the FX market. Describe arbitrage transactions using an example of a locational arbitrage and a triangular arbitrage.

Speculative transactions: speculative FX transactions are motivated by the pursuit of a profit the sheer volume of speculative transactions implies that, at times, speculators are

able to move the market price of a currency such transactions are always accompanied by an element of risk for example, with an expectation that the AUD will depreciate against the USD, a

speculator might buy the USD (sell the AUD) now. If correct, a profit will be made by converting the USD back into AUD after the AUD has depreciated. However, if the AUD appreciates instead, the speculator will lose

a speculator may take a long position or a short position long position – holding FX in expectation of a future sale


short position – entering into a forward contact to sell FX that is currently not held

Arbitrage transactions: arbitrage transactions are possible when price differences appear between markets the arbitrageur is able to carry out simultaneous buy and sell transactions in two

markets, to effect a risk-free profit locational arbitrage: an arbitrage opportunity whereby the exchange rate quoted by

two or more dealers, between two currencies, is different. The arbitrageur will buy the currency from the dealer quoting the lowest price and simultaneously sell the currency through the dealer quoting the highest price on that currency

triangular arbitrage: occurs when exchange rates between three or more currencies are out of perfect alignment. Again, the arbitrageur will simultaneously buy and sell a combination of currencies to take advantage of the price differences

arbitrage profit opportunities generally do not exist for long. The buy/sell actions of the arbitrageurs bring the prices back into equilibrium

4. Many developed economies operate within a floating-exchange-rate regime. Where a country has a floating exchange rate, consider the circumstance in which the central bank of that country might conduct transactions in the FX market.

The central banks of nation-states enter the FX markets periodically, for one or other of the following reasons: to acquire foreign currency to pay for their government's purchases of imports,

such as defence equipment, and to pay interest on, or to redeem, the government’s overseas borrowings

to change the composition of the central bank’s holdings of foreign currencies, as part of its management of official reserve assets. Official reserve assets are central bank’s holdings of foreign currencies, gold and international drawing rights

to influence the exchange rate. Central bank intervention in the FX market would not exist if the value of a currency was determined purely by market forces, that is, a so-called clean float. However, central banks may, at times, be significant buyers or sellers of a currency, when it considers the exchange rate is moving too rapidly, and is trading well outside rates that can be supported by economic fundamentals. If the goal is to slow down an appreciation of the exchange rate, the central bank will sell its local currency. In another example, if the Reserve Bank wished to support the AUD to stop it depreciating and perhaps assist it to appreciate, it would buy AUD and sell foreign currency

5. Outline the features of the main types of contracts that are created in the FX markets, distinguishing between short-dated, spot and forward transactions.

an FX transaction is described by its value date, that is, the day that the currency is delivered and settlement is made

spot transactions – the FX contract value date is two business days from the date of the initial order. The exchange rate is determined today, but delivery occurs in two business days. For example, if a company places an order with an FX dealer to buy USD1 million at a rate of AUD/USD0.6032 on a Tuesday, then the dealer will deliver USD1 million on the Thursday and the company will pay AUD1 657 824.93 also on the Thursday


forward transactions – the FX contract value date occurs at a specified date beyond the spot date, for example an order to sell EUR in three months. Again, the exchange rate is set today that will apply at spot plus three months. If today is 24 March, then the three-month forward value date will be 26 June, providing that is a business day (if not, the date will be moved forward to the next business day)

tod transactions – an FX contract with settlement and delivery today tom transactions – an FX contract with settlement and delivery tomorrow

6. The FX dealing room of a major bank notes that it is long in the USD, but is short in the EUR. Explain what is meant by these positions?

if the dealer is long in USD, it means that it is holding surplus USD on its account; that is, the USD are in excess of its currency requirements to meet existing FX contracts

if the dealer is short the EURO, it means that the dealer has entered into a forward contract to sell the EUR, when in fact it currently does not hold any EUR in its FX portfolio. The dealer may be holding the short position in an expectation that the EUR will depreciate before the forward value date. The dealer will then buy the actual EUR at the lower price on the value date, and sell at the higher price specified in the forward contract

7. ‘The FX market has a well-established set of language conventions. These conventions have been developed to allow the efficient communication of market data.’ Explain and illustrate this statement with reference to the language conventions used in the spot FX markets.

assume the following quote AUD/USD0.6052 – 56 the first-named currency in the quote is the base currency, or the unit of the quote;

that is one AUD equals USD0.6052 –56 the second-named currency is the terms currency, the USD. The terms currency is

valued relative to the base currency the quote is a two-way price, that is, a bid price (buy) and an offer price (sell) the first number is the bid price – AUD/USD0.6052 the second number is the offer price – AUD/USD0.6056 the market convention is to drop common numbers between the bid/offer price the bid/offer is from the perspective of the dealer, that is, the dealer will buy

1AUD for USD0.6052, or sell 1AUD for USD0.6056 the difference between the dealer’s bid/offer prices is the spread the spread in the example is 4 points (a point is the last decimal place in a quote)

8. Using the context of the currency pair USD/JPY, explain the terms ‘base currency’, ‘unit of the quotation’, ‘terms currency’, ‘direct quotation’, and ‘indirect quotation’.

base currency – the first-named currency in an FX quote, expressed as one unit in terms of the second currency. In the USD/JPY example, the base currency is the USD and is expressed as 1USD will be bought/sold for the amount of JPY that will be given in the quote

unit of the quotation is the base currency, that is, 1USD … terms currency – the second-named currency in the quote, that is, the JPY


direct quotation – when the USD is the base currency of the unit of the quotation as in the USD/JPY example

indirect quotation – when the USD is the terms currency and the other currency is the base currency in the quotation. In that case, the above quote would be transposed to JPY/USD

9. An FX dealer is quoting spot USD/SGD1.7850–56. (a) Explain from the perspective of the dealer what the FX quote indicates.

the price maker FX dealer will buy USD1 for SGD1.7850. The party that has entered into the FX contract with the dealer will sell USD1 and receive SGD1.7850

also, the dealer will sell USD1 for SGD1.7856, whereas the customer will receive USD1 and pay the dealer SGD1.7856

the dealer will make 4 points between its bid and offer transactions

(b) Transpose the quotation.

the USD/SGD1.7850 – 56 is a direct quote; the USD is the base currency it is possible to transpose the direct quote to an indirect quote (SGD/USD) rule: reverse, then invert

USD/SGD1.7850 – 1.7856Reverse the bid/offer prices1.7856 – 1.7850take the inverse, that is, divide both numbers into 1SGD/USD0.5600 – 0.5602

10. A toy manufacturer in Thailand is exporting goods to New Zealand. In order to ascertain the firm’s exposure to foreign exchange risk the company needs to calculate the THB/NZD cross-rate. An FX dealer quotes the following rates:USD/NZD 1.8540–70USD/THB 41.60–42.80Calculate the THB/NZD cross-rate.

most currencies are quoted against the USD, therefore it is necessary to calculate the cross rate to obtain the THB/NZD quote

crossing two direct FX quotations- place the currency that is to become the unit of the quotation first- divide opposite bid and offer rates, that is:- to obtain the bid rate: divide the base currency offer into the terms currency bid- to obtain the offer rate: divide the base currency bid into the terms currency offer

therefore, place the USD/THB quote first:USD/THB 41.60 – 42.80USD/NZD 1.8540 - 70

To determine the THB/NZD cross rate:1.8540 / 42.80 = 0.04331.8570 / 41.60 = 0.0446


THB/NZD 0.0433 - 46

11. An Australian manufacturer generates receipts in JPY from exports to Japan. At the same time, the company imports component parts from the USA, incurring commitments in USD. The company needs to determine its net open position to the JPY. Rates are quoted at:USD/JPY 107.23 – 107.46AUD/USD 0.5546 – 0.5556.Calculate the AUD/JPY cross-rate.

it is possible to use two methods to calculate this cross-rate: i) transpose the AUD/USD rate to a direct USD/AUD rate, and then use the two direct quote method (see question 10), or ii) use the direct and indirect quote method

crossing a direct and an indirect FX quotation:- to obtain the bid rate – multiply the two bid rates- to obtain the offer rate – multiply the two offer rates

to determine the AUD/JPY cross-rate:107.23 x 0.5546 = 59.47107.46 x 0.5556 = 59.70

AUD/JPY 59.47 – 59.70

12. An importer has entered into a contract under which it will require payment in GBP in one month. The company is concerned at its exposure to foreign exchange risk, and decides to enter into a forward exchange contract with its bank. Given the following (simplified) data, calculate the forward rate offered by the bank.AUD/GBP (spot): 0.5156–76One-month Australian interest rate: 6.75%One-month United Kingdom interest rate: 4.25%

the quote is from the perspective of the dealer, relative to the base currency the importer needs to buy GBP, therefore it will sell AUD to the dealer. The dealer

is therefore buying AUD, so need to use the bid rate Note: both countries use a 365 day year; assume 30 day contract

S [1 + ( It x contract days/days in year) ] [1 + (Ib x contract days/days in year)]

where: S = spot rateIb = interest rate of base currencyIt = interest rate of terms currency

Therefore, based on the above data:0.5156 [1 + (0.0425 x 30/365)] [1 + (0.0675 x 30/365)]

= 0.5156 (1.003493 / 1.005548)= AUD/GBP0.5145


13. When considering interest rate differentials and forward foreign exchange rate calculations between the USD and the GBP, what important adjustments need to be taken into account?

the USA uses a 360-day year convention, while the UK uses a 365-day convention need to recognise this variation in the forward exchange contract formula

14. Internationalisation of financial markets and the development of sophisticated technology information and support systems mean that foreign exchange dealers must have access to up-to-date information systems. Identify two global information providers typically used by FX dealers, and briefly describe the type of information that may be available.

in a physical sense, the FX market consists of a vast and highly sophisticated global network of telecommunications systems

to facilitate FX transactions, it is essential that the various dealing rooms around the globe have access to the same information at each moment in time

the information sought by the FX dealing rooms will be the current buy and sell rates for the various currencies, plus economic, political and social news that may affect the values of any particular currency

there are a number of global networks that provide such information, including Reuters, Bloomberg and the Dow Jones Telerate networks

these organisations facilitate the efficient flow of information into the FX markets FX dealing rooms typically access more than one information provider

15. ‘The European Monetary Union has had a significant impact on the structure and operation of the FX markets.’ Discuss the process of monetary union in Europe, and the issues relevant to the FX markets that are implied in the above statement.

the Maastricht treaty seeks to create economic and monetary union within Europe 15 countries are members of the EU; 12 countries participate in EMU EU and EMU are set to expand as new members are progressively allowed to join EMU has seen the removal of 12 foreign currencies from the FX market the euro was introduced for financial transactions in January 1999 euro notes and coins were introduced in January 2002 the euro has become a hard currency, used for international trade and financial

transactions central banks around the world support the euro by holding the euro as part of

their foreign reserves the removal of 12 currencies and the introduction of one major currency has

increased the liquidity in the FX market the introduction of the euro has removed foreign exchange risk for trade and

financial transactions, denominated in euro, that are carried out between member states


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