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The Basics of the Foreign Exchange Market

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The Basics of the Foreign Exchange Market

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  1. The Basics of the Foreign Exchange Market

  2. Defining The Foreign Exchange Market • The Foreign Exchange Market can be defined in terms of specific functions, or the institutional structure that: • (1) Facilitates the conversion of one country’s currency into another. • Through the buying and selling of currencies. • Allows global firms to move in and out of foreign currency as needed. (2) Sets and quotes exchange rates. • This is the ratio of one currency to another. • These rates determine costs and returns to global businesses. • (3) Offers contracts to manage foreign exchange exposure. • These hedging contracts allow global firms to offset their foreign currency exposures and manage foreign exchange risk. • Thus, they can concentrate on their core business.

  3. Quick Review of Market Characteristics • World’s largest financial market. • Estimated at $3.2 trillion dollars per day in trades. • NYSE-Euronext currently running about $40 billion per day. • Market is a 24/7 over-the-counter market. • There is no central trading location. • Trades take place through a network of computer and telephone connections all over the world. • Major trading center is London, England. • 34% of all trades take place through London (New York second at 17%). • Most popular traded currency is the U.S. dollar. • Accounts for 86% of all trades (euro second at 27%). • Most popular traded currency pair is the U.S. dollar/Euro. • Represents 27% of all trades (dollar yen second at 13%) • Currencies are either traded for immediate delivery (spot) or some specified future delivery (forward).

  4. How does the FX Market Quote Currencies? • (1) American Terms: • Expresses the exchange rate as the number of U.S. dollars per one unit of some foreign currency. • For example, $2.00 per (1) British pound. • (2) European Terms: • Expresses the exchange rate as the number of foreign currency units per one U.S. dollar. • For example, 120 yen per (1) U.S. dollar. • Most of the world’s currencies are quoted for trade purposes on the basis of European terms. • Exceptions include: British pound, Euro, Australian dollar. • Newspapers, like the Wall Street Journal, however, usually quote both.

  5. Quotes are Given by Time of Settlement • Spot Exchange Rate: • Quotes for immediate transactions (actually within 1 or 2 business days) • Forward Exchange Rate: • Quotes for future transactions in a currency (3 business days and out). • Forward markets are used by businesses to protect against unexpected future changes in exchange rates. • Forward rate allows businesses to “lock” in an exchange rate for some future period of time.

  6. Observing Changes in Spot Exchange Rates: What do they Mean? • Appreciation (or strengthening) of a currency: • When the currency’s spot rate has increased in value in terms of some other currency. • Depreciation (or weakening) of a currency: • When the currency’s spot rate has decreased in value in terms of some other currency.

  7. Forward Rate Quotes • As a rule, forward exchange rates are set at either a premium or discount of their spot rates. • If a currency’s forward rate is higher in value than its spot rate, the currency being quoted at a forward premium. • For example: the Japanese 1 month forward is greater than its spot (0.009034 versus 0.008999) • If a currency’s forward rate is lower in value than its spot rate, the currency is being quoted at a forward discount. • For example, the British pound 6 month forward is less than its spot (2.0417 versus 2.056).

  8. What Institutions are Involved in the Foreign Exchange Market? • Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) acting on behalf of: • (1) Their “external” clients” (primarily global firms: exporters, importers, multinational firms) • Acting in a broker capacity at the request of these clients and meeting the foreign currency needs of these clients. • (2) Their own banks (trading to generate profits). • Acting in a “dealer” (i.e., trading) capacity • Taking positions in currencies to make a profit. • In meeting the needs of their clients and their own trading activities, these global banks “establish” the “tone” of the market. • This is through a “market maker” function.

  9. Making the Market in FX • The market maker function of any global bank involves two primary foreign exchange activities: • (1) A willingness of the market maker to provide the market with “on-going” (i.e., continuous) two way quotes upon request: • (1) Provide a price at which they will buy a currency • (2) Provide a price at which they will sell a currency • This function provides the market with transparency • (2) A willingness of the market maker to actually buy and/or sell at the prices they quote: • Thus the market maker offers “firm” prices into the market! • This function provides the market with liquidity.

  10. ISO Currency Designations • All foreign currencies are assigned an International Standards Organization (ISO) abbreviation. • E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; MXN; SGD; ARS; THB; INR; RUB; ZAR; NZD; CHF; KRW • For individual countries see: http://www.oanda.com/site/help/iso_code.shtml • Since the exchange rate is simply the ratio (i.e., value) of one currency against another, market makers express this relationship using the two currencies’ ISO designations. • For Example: • USD/JPY • USD/MXN • EUR/USD • GBP/USD • EUR/JPY (this is a cross rate; since USD in not one of them)

  11. Base and Quote Currency • Given that a foreign exchange quote is simply the ratio of one currency to another, a “complete” market maker quote must have two ISO designations (e.g., EUR/USD or USD/JPY): • The first ISO currency quoted is called the base currency. • The second ISO currency quoted is called the quote currency. • For examples above: • EUR/USD: EUR is the base currency and USD is the quote currency. • USD/JPY: USD is the base currency and JPY is the quote currency.

  12. Bid and Ask Quotes • Recall that a market maker always provides the market with two prices, both a buy and sell quote (or price) for a currency. • For Example: EUR/USD: 1.2102/1.2106 • The first number quoted by the market maker is the market maker’s buy price ($1.2102). • It is called the market maker’s bidquote (or buy price) • The second quoted number is the market marker’s sell price ($1.2106). • It is called the market maker’s ask quote (or sell price) • Note: The bid quote is alwayslower than the ask quote.

  13. What Currency is The Market Maker Buying and Selling? • Given the example: EUR/USD: 1.2102/1.2106, which currency is the market maker selling and which currency is the market maker buying? • Answer: Market makers are always quoting prices at which they will buy or sell ONE UNIT of the base currency (against the quote currency). • So in the above example: • The market maker will buy euros for $1.2102 • This is the bid price for euros. • The market maker will sell euros for $1.2106 • This is the ask price for euros.

  14. Reading and Understanding Quotes • When viewing a foreign exchange quote, assign a value of 1 to the base currency (the base currency is the first in the ISO pair). The quotes you see refer to one unit of this base currency. • For example, if you see a market maker’s ask price for the EUR/USD of 1.2811, that means that if you were to buy one Euro (the base currency) you are going pay $1.2811. • If you see a market maker’s bid price for the USD/JPY of 120.10 that means if you were to sell one dollar (the base currency) you are going to get 120.10 for it. • Also, whenever the bid and ask prices are moving up, that means that the base currency is getting stronger and the quote currency is getting weaker.