Lecture 5: The Foreign Exchange
Market
Understanding Foreign
Exchange Quotes
Where is this Financial Center?
View from La Defense to Arc de
Triomphe (Paris)
What Else About Paris and the
Champs-Elysées?
The Role of Global Banks in the FX Market

Large global banks (e.g., Deutsche Bank) are involved
in the interbank (i.e., wholesale) FX markets through:
 (1) Their “external” clients” (Other large banks,
exporters, importers, multinational firms, central
banks, large non-bank financial institutions)


(2) Their own banks (trading to generate profits).


Acting in a broker capacity at the request of these
clients.
Acting in a “dealer” (i.e., trading) capacity (Taking
positions (long and short) in currencies to make a profit).
In dealing with external clients, these large banks are
performing a “market maker” function:


Quoting prices upon demand to other parties in the
interbank market, and
Buying and selling currencies at their quoted prices.
“Making the Market” in FX


The market maker function 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.
Base and Quote Currency


Recall that a foreign exchange quote is simply
the ratio of one currency to another.
Thus, a “complete” market maker quote consist
of two ISO designations (e.g., EUR/USD or
USD/JPY):



The first ISO currency quoted in the sequence is
referred to as the base currency.
The second ISO currency quoted is referred to as 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.
Bid and Ask Quotes


A market maker always provides the market with
two prices, specifically a price at which they will
buy a currency and a price at which they will sell
a currency.
Example: EUR/USD: 1.2102/1.2106

The first number quoted by the market maker is the
market maker’s buy price for 1 unit of the base
currency ($1.2102).


This is the market maker’s bid quote (or buy price)
The second quoted number is the market marker’s sell
price for 1 unit of the base currency ($1.2106).

This the market maker’s ask quote (or sell price)
Bid Ask Quote Example

Example: GBP/USD: 1.5535/1.5537.

Assume you’re dealing with the market maker;
Questions:






(1) How much will you pay for 1 pound;
(2) how much will get when you sell 1 pound;
(3) how much will you pay for 1 U.S dollar;
(4) how much will you get when you sell 1 U.S. dollar?
Answers:
Bid Ask Quote Example Answers

Example: GBP/USD: 1.5535/1.5537.

Assume you’re dealing with the market maker;
Questions:


(1) How much will you pay for 1 pound;


(2) how much will get when you sell 1 pound;


$1.5535
(3) how much will you pay for 1 U.S dollar;


$1.5537
1/1.5535 = .6437 (64.37 British cents)
(4) how much will you get when you sell 1 U.S. dollar?

1/1.5537 = .6430 (64.36 British cents)
Bid Ask European Terms Example


Assume the following USD/JPY: 76.35/76.45
(Note: now the base currency is the dollar and
the quote currency is the yen)
Assume you’re dealing with the market maker;





Question: (1) How much will you pay for 1 dollar;
(2) how much will get when you sell 1 dollar;
(3) how much will you pay for 1 yen;
(4) how much will you get when you sell 1 yen?
Answers:
Bid Ask European Terms Answers


Assume the following USD/JPY: 76.35/76.45
(Note: now the base currency is the dollar and
the quote currency is the yen)
Assume you’re dealing with the market maker;

Question: (1) How much will you pay for 1 dollar;


(2) how much will get when you sell 1 dollar;


76.35 yen
(3) how much will you pay for 1 yen;


76.45 yen
1/76.35 = 0.0130975 (U.S. cents)
(4) how much will you get when you sell 1 yen?

1/76.45 = 0.0130804 (U.S. cents)
Bid Ask Spreads


The Bid Ask spread is the “profit” that a market maker
bank will make on a “round” transaction (i.e., buying
and selling an equal amount at the stated price).
Regardless of the type of quote (American terms or
European terms), the ask price is always higher than
the bid.


That is, what they will sell the base currency for is always
higher than what they will buy the base currency at.
Assume the following GBP/USD quote: 1.7921/1.7929

What is the dollar spread to the market maker on a “round”
transaction (assume 10 million pound transactions)?



Ask $1.7929 x £10,000,000 = $17,929,000 (price to sell pounds)
Bid $1.7921 x £10,000,000 = $17,921,000 (price to buy pounds)
Spread (Commission)
=
$ 8,000 (on round transaction)
Bid Ask Spread: European Terms

Assume the following USD/CAD quote:

1.0200/1.0210


Note the ask price is higher
What is the spread on a round transaction
assuming a $1,000,000 USD transaction.



Ask price 1.0210 x $1,000,000 = 1,021,000 CAD
Bid price = 1.020 x $1,000,000 = 1,020,000 CAD
Spread = 1,000 CAD
Foreign Exchange Pips (or Points)

Pips (sometimes called points) refer to the
smallest unit by which the prices for the currency
pair may vary.


Pip stands for percentage in point.
In the example: GBP/USD: 1.5535/1.5537, the
difference in the bid quote and ask quote lies in
the fourth decimal place, or 2 pips.

A Pip for a 4 decimal place quoted currency is actually
0.0001 of an exchange rate


Most currencies are quoted out to 4 decimal
places.
Today, some currencies are being quoted out to
5 decimal places because of competition among
electronic trading platforms (e.g., FXStreet).
Observations About Bid/Ask Spreads

Bid and ask spreads widen or narrow in response to a
number of factors. For example:
 Spreads increase with exchange rate volatility and
uncertainty.
 Spreads decrease with increases in market maker
competition.
 Spreads are smaller in wholesale (interbank) market than
in retail market (and tourist market).



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
Example: GPB/USD for September 26, 2011
Wholesale: 1.55145/1.55158; pip spread = 1.3
Retail: 1.5512/1.5516; pip spread = 4
Tourist retail (Wells Fargo quote): 1.4489/1.6152; spread =
0.1663 cents
Spreads can differ slightly among market markets.

As market makers attempt to adjust their positions and thus
make dealing with them more or less attractive.
Which Way is the Currency Moving?



Remember 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.
Thus, whenever the bid and ask prices are moving up,
that means that the base currency is getting stronger
(relative to the quote currency) and the quote currency is
getting weaker (relative to the base currency).
Conversely, whenever the bid and ask prices are moving
down, that means that the base currency is getting
weaker (relative to the quote currency) and the quote
currency is getting stronger.
Example: Which way is the
Currency Moving? Weakening or
Strengthening?
Currency
October 4,
2012
October 5,
2012
EUR/USD
1.3018
1.3036
GBP/USD
1.6193
1.6133
USD/JPY
78.50
78.67
USD/CHF
0.9306
0.9298
Move of
Foreign
Currency
Move of USD
Example: Which way is the
Currency Moving? Weakening or
Strengthening?
Currency
October 4,
2012
October 5,
2012
Move of
Foreign
Currency
Move of USD
EUR/USD
1.3018
1.3036
EUR
strengthening
USD
weakening
GBP/USD
1.6193
1.6133
GBP
weakening
USD
strengthening
USD/JPY
78.50
78.67
JPY
weakening
USD
strengthening
USD/CHF
0.9306
0.9298
CHF
strengthening
USD
weakening
Let’s Look at Real Time Currency Quotes


Go to the following web-site: http://www.fxstreet.com/
At this site, link to:


Go to Retail Rates Live

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
Rates and Charts
Select currency as USD
Observe ISO quotes
Observe bid and ask quotes.
Understand what currency and at what price the market maker is
buying or selling (base currency).
Understand what price you (a non-market maker) would buy or sell
the base currency to the market maker.
Observe changes in bid and ask quotes.
 If these are going up, the base currency is strengthening and the
quote currency is weakening. Reverse is true if these are going
down.
Next, link to: Interbank FX Rates Live and observe
majors and G7 (note quotes to 5 decimal places)
Let’s Look at Real Time Currency Charts


Again, go to the following web-site:
http://www.fxstreet.com/
At this site, link to:
 Rates and Charts
 Go to Streaming Forex Charts
 Observe different currency pairs: Make sure
you know which currency in the pair is
strengthening and which is weakening.
 Observe different time scales from ticks out
to monthly.
Candle Stick Charting of FX
Patterns
 Patterns
Examples
 Go to FXStreet.com
 At this site, link to:
 Rates and Charts
 Go to Streaming Forex
Charts
 Under chart type go to
Candle Stick