THE FOREIGN EXCHANGE
MARKET
SUBJECT: INTERNATIONAL FINANCE
SOURCE: EITMAN ET AL. (2016)
MODIFIED BY: DWI NASTITI DANARSARI
THE FOREIGN EXCHANGE MARKET
 The Foreign Exchange Market provides:
 the physical and institutional structure through which the money of one country is
exchanged for that of another country;
 the determination rate of exchange between currencies; and
 is where foreign exchange transactions are physically completed.
THE FOREIGN EXCHANGE MARKET
 Foreign 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.
GEOGRAPHY
 The foreign exchange market spans the globe, with prices moving and currencies
trading somewhere every hour of every business day.
 As Exhibit 6.1 illustrates, the volume of currency transactions ebbs and flows across
the globe as the major currency trading centers open and close throughout the day.
 Exhibit 6.2 highlights the major trading centers that keep currency trading a 24-hour
activity.
EXHIBIT 6.1 MEASURING FOREIGN EXCHANGE MARKET ACTIVITY: AVERAGE
ELECTRONIC CONVERSIONS PER HOUR
EXHIBIT 6.2 GLOBAL CURRENCY TRADING: THE TRADING DAY
FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
 The foreign exchange market is the mechanism by which participants:
 transfer purchasing power between countries;
 obtain or provide credit for international trade transactions; and
 minimize exposure to the risks of exchange rate changes.
MARKET PARTICIPANTS
 The foreign exchange market consists of two tiers:
 the interbank or wholesale market (multiples of $1MM US or equivalent in
transaction size), and
 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 conducting commercial or investment
transactions, speculators and arbitragers, central banks and treasuries, and foreign
exchange brokers.
MARKET PARTICIPANTS: BANK AND NONBANK
FOREIGN EXCHANGE DEALERS
 Banks 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.
MARKET PARTICIPANTS: INDIVIDUALS AND FIRMS
 Individuals (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.
MARKET PARTICIPANTS: SPECULATORS AND
ARBITRAGERS
 Speculators 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.
MARKET PARTICIPANTS: CENTRAL BANKS AND
TREASURIES
 Central banks and treasuries use the market to acquire or spend their country’s
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 citizens.
 As willing loss takers, central banks and treasuries differ in motive from all other
market participants.
MARKET PARTICIPANTS: FOREIGN EXCHANGE
BROKERS
 Foreign exchange brokers are agents who facilitate trading between dealers without
themselves becoming principals in the transaction.
 Dealers use brokers to expedite the transaction and to remain anonymous, since the
identity of participants may influence short-term quotes.
TRANSACTIONS IN THE INTERBANK MARKET
 A 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.
 Exhibit 6.3 provides a structured map of when settlement occurs within the European
market.
 The date of settlement is referred to as the value date.
EXHIBIT 6.3
FOREIGN
EXCHANGE
SETTLEMENT
IN EUROPE
TRANSACTIONS IN THE INTERBANK MARKET
 An 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 MARKET
 A 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 forward,
 forward-forward,
 nondeliverable forwards (NDF).
MARKET SIZE, GEOGRAPHIC DISTRIBUTION, AND
CURRENCY COMPOSITION
 In April 2010, a survey conducted by the Bank for International Settlements (BIS)
estimated the daily global net turnover in the foreign exchange market to be $3.2
trillion.
 Exhibit 6.4 shows that the most recent survey of foreign exchange activity revealed
modest growth in foreign exchange trading over that seen in April 2007.
 Exhibit 6.5 illustrates that the largest foreign exchange markets are in London and
New York followed distantly by several others.
 The dollar, euro, pound, and yen continue to dominate foreign exchange.
EXHIBIT 6.4
GLOBAL FOREIGN
EXCHANGE
MARKET
TURNOVER, 19892010 (AVERAGE
DAILY TURNOVER
IN APRIL, BILLIONS
OF U.S. DOLLARS)
EXHIBIT 6.5 TOP 10
GEOGRAPHIC TRADING
CENTERS IN THE
FOREIGN EXCHANGE
MARKET, 1991-2010
(AVERAGE DAILY
TURNOVER IN APRIL)
EXHIBIT 6.6
FOREIGN
EXCHANGE MARKET
TURNOVER BY
CURRENCY PAIR
(DAILY AVERAGE IN
APRIL)
FOREIGN EXCHANGE RATES AND QUOTATIONS
 A foreign exchange rate is the price of one currency expressed in terms of another
currency.
 A foreign exchange quotation (or quote) is a statement of willingness to buy or sell
at an announced rate.
FOREIGN EXCHANGE RATES AND QUOTATIONS
 Most foreign exchange transactions involve the U.S. dollar.
 Professional dealers and brokers may state foreign exchange quotations in one of
two ways:
 the foreign currency price of one dollar, or
 the dollar price of a unit of foreign currency.
 Most foreign currencies in the world are stated in terms of the number of units of
foreign currency needed to buy one dollar.
FOREIGN EXCHANGE RATES AND QUOTATIONS
 For example, the exchange rate between U.S. dollars and the Swiss franc is normally
stated:
 SF 1.6000/$ (European terms)
 However, this rate can also be stated as:
 $0.6250/SF (American terms)
 Exhibit 6.7 is an example of a foreign exchange quote
 Excluding two important exceptions, most interbank quotations around the world are
stated in European terms.
EXHIBIT 6.7 FOREIGN CURRENCY QUOTATIONS
FOREIGN EXCHANGE RATES AND QUOTATIONS
 As 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 tourists.
FOREIGN EXCHANGE RATES AND QUOTATIONS
 Foreign 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 regards as “home.”
EXAMPLE OF DIRECT/INDIRECT QUOTE
 A woman in Paris might see this quote:
EUR 0.8214 = USD 1.00
Since in France the home currency is the euro (the price) and the foreign currency is the
dollar (the unit), in Paris this quotation is a direct quote on the dollar or a price quote on the
dollar; and an indirect quote on the euro (the foreign currency price of one unit of home
currency)
She might say to herself, “0.8214 euros per dollar,” or “it will cost me 0.8214 euros to get
one dollar.”
 The two quotes are obviously equivalent (at least to four decimal places), one being
the reciprocal of the other.
FOREIGN EXCHANGE RATES AND QUOTATIONS
 Interbank 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.
 Exhibit 6.8 shows a bid, ask, and mid-point quotation.
EXHIBIT 6.8 BID, ASK,
AND MID-POINT
QUOTATION
EXHIBIT 6.9
EXCHANGE RATES:
NEW YORK CLOSING
SNAPSHOT
EXHIBIT 6.9
EXCHANGE RATES:
NEW YORK
CLOSING
SNAPSHOT
(CONT.)
FOREIGN EXCHANGE RATES AND QUOTES
 Many 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 (Exhibit 6.10) can be used to check on opportunities for intermarket
arbitrage.
 This situation arose because one bank’s (Dresdner) quotation on €/£ is not the same a
calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank).
EXHIBIT 6.10 KEY CURRENCY RATE CALCULATIONS FOR JANUARY
3, 2012
INTERMARKET ARBITRAGE
 Citibank quote - $/€ $1.3297/€
 Barclays quote - $/£
$1.5585/£
 Dresdner quote - €/£ €1.1722/£
=
 Cross rate calculation:
$1.5585/£
$1.3297/€
= € 1.1721/£
Because the rates are unequal, a triangular arbitrage opportunity exists.
For another example, see Exhibit 6.11
EXHIBIT 6.11 TRIANGULAR ARBITRAGE BY A MARKET TRADER
FOREIGN EXCHANGE RATES
AND QUOTES IN PERCENTAGE TERMS
 Measuring a change in the spot rate for quotations expressed in home currency
terms (direct quotations):
%∆ = Ending rate – Beginning Rate
Beginning Rate
x 100
 Quotations expressed in foreign currency terms (indirect quotations):
%∆ = Beginning Rate – Ending Rate
Ending Rate
x 100
EXHIBIT 6.12 SPOT AND FORWARD QUOTATIONS FOR THE EURO
AND JAPANESE YEN
FOREIGN EXCHANGE RATES AND QUOTES
 Forward rates are typically quoted in terms of points.
 A forward quotation expressed in points is not a foreign exchange rate as such.
 Rather, it is the difference between the forward rate and the spot rate.
 Exhibit 6.9 shows how foreign exchange rates are quoted in the WSJ
FOREIGN EXCHANGE RATES AND QUOTES
 Forward 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 QUOTES
 For quotations expressed in foreign currency terms (Indirect quotations) the formula becomes:
f ¥ = Spot – Forward
Forward
x
360
n
x 100
 For quotations expressed in home currency terms (Direct quotations) the formula becomes:
f ¥ = Forward – Spot x 360
Spot
n
x
100
EXAMPLE
 Foreign currency terms
 Home currency terms
EXERCISE PROBLEM
Answer a.
We know:
GBP/USD
JPY/USD
We aim to compute:
JPY/GBP
JPY/GBP = JPY/USD : GBP/USD = JPY/USD x USD/GBP
= 109.31 x 1/0.6178 = JPY176.3942/GBP
Answer b.
Yen we obtain = GBP 2,000 x JPY176.3942/GBP =
JPY353,868..57