The foreign exchange market
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The Foreign Exchange Market. International Finance. Dr. A. DeMaskey. Learning Objectives. What is the foreign exchange market, its function, participants, size, geographic and currency composition?

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The Foreign Exchange Market

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The foreign exchange market

The Foreign Exchange Market

International Finance

Dr. A. DeMaskey


Learning objectives

Learning Objectives

  • What is the foreign exchange market, its function, participants, size, geographic and currency composition?

  • What is the difference between spot, forward, and swap transactions in the foreign exchange market?

  • What currency quotations are used by currency dealers and financial institutions when conducting foreign exchange transactions?

  • What currency arbitrage opportunities do exist in the foreign exchange market, and how profitable are they?


The foreign exchange market1

The Foreign Exchange Market

  • The FOREX market provides the physical and institutional structure through which the money of one country is exchanged for that of another country.

  • 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 rate.


Functions of the foreign exchange market

Functions of the Foreign Exchange Market

  • Transfer of purchasing power

  • Provision of credit

  • Minimizing foreign exchange risk


Structure of the foreign exchange market

Structure of the Foreign Exchange Market

  • An over-the-counter market

    • No centralized marketplace

    • A network of telephones, telex machines, computer terminals, and automated dealing systems.

  • Not confined to any one country

  • No fixed opening and closing times


The world of foreign exchange dealing

The World of Foreign Exchange Dealing


Size of the market

Size of the Market

  • Worldwide daily trading volume

  • Daily trading volume in the U.K.

  • U.S. daily turnover

  • Daily turnover in Tokyo


Market participants

Market Participants

Two Tier Market

FX

Broker

International Banks

Bank Customers

Central

Banks

Non-Bank

Dealers


Transactions in the interbank market

Transactions in the Interbank Market

  • Spot Transactions

  • Outright Forward Transactions

  • Swap Transactions


Global foreign exchange market turnover

Global Foreign Exchange Market Turnover

  • Two of the three categories fell between 1998 and 2001 with spot market daily turnover falling the most, from $568 billion in 1998 to $387 billion in 2001.

  • Forward transactions increased slightly from $128 billion in 1998 to $131 billion in 2001.

  • Swaps fell to $656 billion in 2001 from $734 billion in 1998.

    • The BIS attributes the introduction of the Euro, the growing share of electronic broking in the spot market and consolidation in banking as explanations for the reduction


Foreign exchange rate quotations

American Terms

U.S. dollar price of one unit of foreign currency

A direct quote in the U.S.

An indirect quote in Europe

European Terms

Foreign currency price of one U.S. dollar

A direct quote in Europe

An indirect quote in the U.S.

Foreign Exchange Rate Quotations


Bid and ask quotations

Bid and Ask Quotations

  • Bid Rate and Offer/Ask Rate

    • Outright quotations

    • Abbreviation

  • Reversing Bid and Offer Rate

  • Bid-Ask Spread


Cross rates

Cross Rates

  • Exchange rate determined through the relationship to a widely traded third currency.

  • Example:

    • A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and Japanese yen (¥) are quoted in US dollars

    • Assume the following quotes:

Japanese yen¥121.13/$

Mexican pesoPs9.190/$


Currency arbitrage

Currency Arbitrage

  • Capitalizing on the discrepancy in quoted prices.

    • No investment

    • No risk

  • Locational Arbitrage

  • Triangular Arbitrage


Locational arbitrage

Locational Arbitrage

  • When quoted exchange rates vary among locations, participants in the foreign exchange market can capitalize on the discrepancy.

  • Suppose the euro is quoted in London at 0.6064-80 and the pound sterling is quoted in Frankfurt at 1.6244-59.


Triangular arbitrage

Triangular Arbitrage

  • Cross rates can be used to check on opportunities for intermarket arbitrage.

  • Example: Assume the following exchange rates are quoted in New York, Frankfurt, and London, respectively:

    • $1.4443/£

    • $0.9045/€

    • €1.6200/£


Forward transactions

Forward Transactions

  • This transaction requires delivery at a future value date of a specified amount of one currency for another

  • The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed

  • Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months


Forward market participants

Forward Market Participants

T r a d e r

A r b i t r a g e r

S p e c u l a t o r

H e d g e r


Forward quotations

Forward Quotations

  • Outright Rate

  • Swap Rate

    • Discount or Premium

    • Annualized Percentage Discount or Premium

    • Swap Rate Expressed in Points


Swap rate

Swap Rate

  • Outright forward rate = Spot rate ±Swap rate/point

  • A point is the last digit of a quotation.

  • Add points to spot rate if currency is trading at a forward premium.

  • Subtract points from spot rate if currency is trading at a forward discount.


Bid and ask forward quotations

Bid and Ask Forward Quotations

  • If forward ask in points > forward bid in points forward premium

  • If forward ask in points < forward bid in points forward discount


Bid and ask forward quotations in points

Bid-and-Ask Forward Quotations in Points

  • Suppose you receive the following quotes for pound sterling relative to the U.S. dollar for spot, 1-, 3-, and 6-month forward:

  • “1.6075-85 10-15 14-22 20-30”


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