06

Chapter 6
The Foreign
Exchange
Market
Foreign Exchange Markets:

Learning Objectives
Examine the functions performed by the foreign
exchange (FOREX) market, its participants, size,
geographic and currency composition
Distinguish among spot, forward, swap, and other
types of foreign exchange financial instruments
Identify the forms of currency quotations used by
currency dealers, financial institutions, and agents
Analyze the interaction among changing currency
values, cross exchange rates and opportunities arising
from inter-market arbitrage
Copyright 2006 Pearson Addison-Wesley. All rights reserved.
6-2
Foreign Exchange Markets

The FOREX market provides the physical and
institutional structure through which
The money of one country is exchanged for that of
another country
The rate of exchange between currencies is determined
Foreign exchange transactions are physically completed
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
6-3
Foreign Exchange Markets

There are six main characteristics of the
FOREX markets which will be discussed
The geographic extent
The three main functions
The markets participants
Its daily transaction volume
Types of transactions including spot, forward
and swaps
Methods of stating exchange rates, quotations,
and changes in exchange rates
6-4
Geographic Extent of the Market

Geographically, the FOREX market spans the
globe with prices moving and currencies
trading every hour of every business day
Major world trading starts each morning in
Sydney and Tokyo
Then moves west to Hong Kong and
Singapore
Continuing to Europe and finishing on the West
Coast of the U.S.
6-5
Geographic Extent of the Market

Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
25,000
20,000
15,000
10,000
5,000
Greenwich Mean
Time
0
1
10 AM
Lunch Europe
In Tokyo In Tokyoopening
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Asia
closing
Americas London
open
closing
Afternoon
in America
6 pm Tokyo
In NY opens
6-6
Functions of the FOREX Market

The FOREX market is the mechanism by which
participants
Transfer purchasing power between countries
This is necessary as international trade and capital
transactions normally involve parties living in countries with
different national currencies
Obtain or provides credit for international trade

transactions
Inventories in transit must be financed
Minimize exposure to exchange rate risk

FOREX markets provide instruments utilized in hedging
or transferring risk to more willing parties
6-7
Market Participants
The FOREX market consists of two tiers, the
interbank or wholesale market, and the client
or retail market
Five broad categories of participants operate
within these two tiers
Bank and non bank foreign exchange dealers
Individuals and firms conducting commercial or
investment transactions
Speculators and arbitragers
Central banks and treasuries
Foreign exchange brokers
6-8
Bank and Non-bank Dealers

These participants profit from buying
currencies at a bid price and then reselling
them at an offer or ask price
Competition among dealers narrows the
spread between the bid and offer rate
contributing to the markets efficiency
Dealers on behalf of large international banks
often act as market makers, often willing to
stand in and buy or sell these currencies
without having a counterpart with which to
unload the inventory
6-9
Bank and Non-bank Dealers

They trade amongst other banks and dealers in
order to keep their inventory levels at
manageable levels
Currency trading is profitable and often
contributes between 10% - 20% of a banks
average net income
Small- to medium-sized banks rarely act as
market makers yet still participate in the
interbank market
6-10
Individuals and Firms Conducting

Commercial/Investment Transactions
Importers, exporters, portfolio investors, MNEs,
tourists and others use the FOREX market to
facilitate execution of commercial or
investment transactions
Some of these participants use the market to
hedge foreign exchange rate risk
6-11
Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading
in the market itself
They operate for their own interest, without need or
obligation to serve clients or ensure a continuous
market
Speculators seek all their profit from exchange rate
changes
Arbitragers try to profit from simultaneous differences
in exchange rates in different markets
A large proportion of speculation and arbitrage is
conducted on behalf of major banks by traders
employed by those banks
6-12
Central Banks and Treasuries

Central banks and treasuries use the market to acquire
or spend their countrys currency reserves as well as to
influence the price at which their own currency trades
They may act to support the value of their currency
because of their governments policies or obligations or
because of commitments entered through joint float
agreements such as the European Monetary System
(EMS)
Consequently their motive is not to profit but rather
influence the foreign exchange value of their currency
in a manner that will benefit their interests
6-13
Foreign Exchange Brokers

Foreign exchange brokers are agents who
facilitate trading between dealers without
themselves becoming principals in the
transaction
For this service they charge a small
commission
They maintain instant access to hundreds of
dealers worldwide via open lines and at times
may maintain such lines with several banks,
with separate lines for differing currencies, spot
and forward rates
6-14
Transactions in the Interbank

Market
Transactions within this market can be
executed on a spot, forward, or swap basis
A spot transaction requires almost immediate
delivery of foreign exchange
A forward transaction requires delivery of
foreign exchange at some future date
A swap transaction is the simultaneous
exchange of one foreign currency for another
6-15
Spot Transactions
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
The settlement date is often referred to as the
value date
This is the date when most dollar transactions
are settled through the computerized Clearing
House Interbank Payment Systems (CHIPS) in
New York
6-16
Outright 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
Terminology typically used is buying or selling forward
A contract to deliver dollars for euros in six months is
both buying euros forward for dollars and selling dollars
forward for euros
6-17
Swap Transactions
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
counterpart
A common type of swap is a spot against forward
The dealer buys a currency in the spot market and
simultaneously sells the same amount back to the same
bank in the forward market
Since this transaction occurs at the same time and with
the same counterpart, the dealer incurs no exchange
rate exposure
6-18
Swap Transactions
Forward-forward swaps A dealer sells
20,000 forward for dollars for delivery in two
months at $1.8420/ and simultaneously buys
20,000 forward for delivery in three months at
$1.8400/
The difference between the buying and selling
price is equivalent to the interest rate differential
Thus a swap can be viewed as a technique for
borrowing another currency on a fully
collateralized basis
6-19
Swap Transactions
Non-deliverable forwards (NDFs) NDFs
possess the same characteristics as traditional
forward contracts except that they are settled
only in US dollars and the foreign currency
being sold or bought forward is not delivered
The dollar-settlement feature reflects the fact
that NDFs are contracted offshore and are
beyond the reach and regulatory frameworks of
the home country governments
Pricing of NDFs reflects basic interest rate
differentials
6-20
Size of the FOREX Market

The Bank for International Settlements (BIS)
estimates that daily global net turnover in
traditional FOREX market activity to be
US$1,210 billion in April 2001
This was the first decline observed by the BIS
since it began surveying banks on FOREX
trading in the 1980s
6-21

Global Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)
800
Spot
Forwards
Swaps
700
600
500
400
300
200
100
0
1989
1992
1995
1998
2001
Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and
Derivatives Market Activity in April 2001, October 2001, www.bis.org.

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
BIS attributes the introduction of the Euro, the growing
share of electronic brokering in the spot market and
consolidation in banking as explanations for the
reduction
6-23

Geographic Distribution of Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)
700
United States
United Kingdom
Japan
Singapore
Germany
600
500
400
300
200
100
0
1989
1992
1995
1998
2001
Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001, October 2001, www.bis.org.

Currency Distribution of Global Foreign Exchange Market Turnover
(percentage shares of average daily turnover in April)
90
US dollar
euro
80
Deutshemark
French franc
EMS currencies
Japanese yen
70
60
50
Pound sterling
Swiss franc
40
30
20
10
0
1989
1992
1995
1998
2001
Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives
Market Activity in April 2001, October 2001, www.bis.org.
Foreign Exchange Rates &

Quotations
A foreign exchange quote is a statement of willingness
to buy or sell at an announced rate
In the retail market (newspapers and exchange booths),
quotes are often given as the home currency price of the
foreign currency
Interbank quotes professional dealers or brokers may

state quotes in one of two ways
The foreign currency price of one dollar
Sfr1.6000/$, read as 1.600 Swiss francs per dollar
The dollar price of a unit of foreign currency

$0.6250/Sfr, read as 0.625 dollars per Swiss franc
6-26

Quotations
The former quote is considered to be in
European terms and the latter is considered
to be American terms
Almost all European currencies, except two,
are quoted the European way
The Pound Sterling and the Euro are the
exceptions
Additionally, Australian and New Zealand
dollars are also quoted in American terms
6-27

Quotations
Direct and Indirect Quotes
A direct quote is a home currency price of a unit
of a foreign currency
Sfr1.6000/$ is a direct quote in Switzerland
An indirect quote is a foreign currency price in a

unit of the home currency
Sfr1.600/$ is an indirect quote in the US,
$0.625/Sfr is a direct quote in the US and an
indirect quote in Switzerland
6-28

Quotations
Interbank quotes are given as a bid and ask
The bid is the price at which a dealer will buy
another currency
The ask or offer is the price at which a dealer
will sell another currency
Example: 118.27 - 118.37/$ is the bid/ask for
Japanese yen
The bank will buy yen at 118.27 per dollar and sell
yen at 118.37 per dollar making profit on the spread
6-29

Quotations
Expressing Forward Quotations on a Points
Basis
The previously mentioned rates for yen were
considered outright quotes
Forward quotes are different and typically
quoted in terms of points
A point is the last digit of a quotation, with
convention dictating the number of digits to the
right of the decimal
Hence a point is equal to 0.0001 of most
currencies
6-30

Quotations
Expressing Forward Quotations on a Points
Basis
The yen is quoted only to two decimal points
A forward quotation is not a foreign exchange
rate, rather the difference between the spot and
forward rates
Example:
Bid
Ask
Outright spot:
Plus points (3 months)
Outright forward:
118.27
118.37
-1.43
-1.40
116.84
116.97
6-31

Quotations
Forward Quotations in Percentage Terms
Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate
This is similar to the forward discount or premium
calculated earlier
The important thing to remember is which currency is

being used as the home or base currency
For indirect quotes (i.e. quote expressed in foreign
currency terms), the formula is
FC
Spot - Foward 360

=
x
x 100
Foward
days
6-32

Quotations
For direct quotes (i.e. quote expressed in home
currency terms), the formula is
Forward - Spot 360

f =
x
x 100
Spot
days
H
6-33

Quotations
Example: Indirect quote
105.65 - 105.04 360

f =
x
x 100 = + 2.32% p.a.
90
105.04
Example: Direct quote
0.009520183 - 0.009465215 360

f =
x
x 100 = + 2.32% p.a.
90
0.009465215
$
6-34

Quotations
Cross Rates
Many currencies pairs are inactively traded, so
their exchange rate is determined through their
relationship to a widely traded third currency
Example: A Mexican importer needs Japanese
yen to pay for purchases in Tokyo. Both the
Mexican peso (MXP) and Japanese yen () are
quoted in US dollars
Assume the following quotes:
Japanese yen
110.73/$
Mexican peso
MXP 11.4456/$
6-35

Quotations
Cross Rates
The Mexican importer can buy one US dollar for
11.4456 Mexican pesos and with that dollar buy
110.73; the cross rate would be
110.73/$
Japanese yen/US dollar
=
= 9.6745/MXP
MXP11.4456/$
Mexican pesos/US dollar
6-36

Quotations
Intermarket Arbitrage
Cross rates can be used to check on
opportunities for intermarket arbitrage
Example: Assume the following exchange rates
are quoted
Citibank
$1.2223/
Barclays Bank
$1.8410/
Dresdner Bank
1.5100/
6-37

Quotations
Intermarket Arbitrage
The cross rate between Citibank and Barclays
is
$1.8410/
= 1.5062/
$1.2223/
This cross rate is not the same as Dresdners
rate quote of 1.5100/
Therefore, an opportunity exists for risk-less
profit or arbitrage
6-38

Quotations Citibank New York
End with $1,002,538
(6)
Receive $1,002,538
Start with $1,000,000

(1)
Sell $1,000,000 to Barclays

Bank at $1.8410/
Deutsche Bank
Barclays Bank, London
(5)
(2)
Receive 543,183
(3)
Sell 543,183 to Dresdner Bank

at 1.5100/
(4)
Sell 820,206 to Citibank

at $1.2223/
Receive 820,206
6-39
Summary of Learning Objectives

The three functions of the foreign exchange market
(FOREX) are to transfer purchasing power, provide
credit, and minimize foreign exchange rate risk
The FOREX is composed of two tiers: the interbank
market and the client market. Participants within these
tiers include bank and nonbank foreign exchange
dealers, individuals and firms conducting commercial
and investment functions, speculators and arbitragers,
central banks and treasuries and foreign exchange
brokers
6-40

Geographically, the FOREX market spans the globe,
with prices moving and currencies traded every hour of
every business day
A foreign exchange rate is the price of one currency
expressed in terms of another currency
A foreign exchange quotation is a statement of
willingness to buy or sell currency at an announced
price
Transactions within the FOREX market are executed
either on a spot basis requiring delivery two days after
the transaction or on a forward basis requiring
settlement at some designated future date
6-41

European terms quotations are the foreign currency
price of one US dollar. American terms are the dollar
price of a foreign currency
Quotations can also be direct or indirect. A direct
quote is the home currency price of a unit of foreign
currency, while an indirect quote is the foreign currency
price of a unit of the home currency
Direct and indirect are not synonymous for American
and European terms, because the home currency will
change for calculation purposes
6-42

A cross rate is an exchange rate between two
currencies, calculated from their common
relationships with a third currency
When cross rates differ from the direct rates
between two currencies, intermarket arbitrage
is possible
6-43
Mini Case: The Venezuelan Bolivar

Black Market
On January 21st 2003, the bolivar closed at a record
low
The next day President Hugo Chavez suspends sale of
U.S. dollars
Immediately, and unofficial black market for currencies
(namely the exchange of bolivars for U.S. dollars)
develops
Capital flight escalates while controls are put into place
Discuss why capital controls would be used in this
situation; analyze Santiagos choices and recommend
solutions
What is the difference between a gray market and a
black market (with reference to this case)?
6-44
Venezuelan Official and Gray Market Exchange Rates,

Venezuelan bolivar/US $ (January 2002March 2004)
Bolivar/US$
3500
Gray Market Exchange Rate

3000
Capital controls are instituted

on January 22, 2003, to stop the
capital outflows from Venezuela
2500
The bolivar is devalued once

again on Feb 14, 2004, from
Bs1600/$ to Bs1920/$
2000
Official Exchange Rate

1500
Two weeks later, on February 5, 2003,

Venezuela announces the imposition of
strict capital controls, the formation of
the CADIVI to manage the currency,
and the fixing of the bolivar at Bs1600/$
1000
500
1
1/
2
1/
00
2
1
2/
2
1/
00
1
3/
2
1/
00
2
1
4/
2
1/
02
03
02
03
02
03
03
02
02
03
03
02
04
03
03
02
03
04
02
03
04
03
03
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20 / 20
20
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
/
1
1
1
1
1
1
11
11
11
11
11
11
11
11
11
11
11
11
11
11
11
11
11
/1
/1
/1
/1
/1
/1
9/
9/
8/
8/
7/
7/
6/
3/
5/
6/
4/
2/
5/
3/
1/
2/
1/
11
10
10
12
12
11
2
00
Exhibit 6.1 Measuring Foreign Exchange

Market Activity: Average Electronic
Conversions per Hour
6-46
Exhibit 6.2 Global Foreign Exchange

Market Turnover, 19892004 (daily
averages in April, billions of US$)
6-47
Exhibit 6.3 Geographic Distribution of Foreign

Exchange Market Turnover, 19892004 (daily
averages in April, US$ billions)
6-48
Exhibit 6.4
Currency Distribution of Global

Foreign Exchange Market Turnover (percentage
shares of average daily turnover in April)
6-49
Exhibit 6.5 Spot and Forward Quotations

for the Euro and Japanese Yen
6-50
Exhibit 6.6 Foreign Exchange Rate

Quotations on the U.S. Dollar/British
Pound in the Financial Press
6-51
Exhibit 6.7 Key Currency Cross Rates
6-52
Exhibit 6.8 Triangular Arbitrage
6-53
Exhibit 1 Venezuelan Official and Gray Market

Exchange Rates, Venezuelan Bolivar/U.S. Dollar
(January 2002March 2004)
6-54

06

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Chapter 6

Foreign Exchange Markets:

Foreign Exchange Markets

A foreign exchange transaction is an agreement

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Markets

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Geographic Extent of the Market

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Geographic Extent of the Market

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Functions of the FOREX Market

Obtain or provides credit for international trade

Minimize exposure to exchange rate risk

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Bank and Non-bank Dealers

Bank and Non-bank Dealers

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Individuals and Firms Conducting

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Speculators and Arbitragers

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Central Banks and Treasuries

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Brokers

Transactions in the Interbank

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Outright Forward Transactions

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Size of the FOREX Market

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Size of the FOREX Market

Size of the FOREX Market

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Size of the FOREX Market

Size of the FOREX Market

Foreign Exchange Rates &

Interbank quotes professional dealers or brokers may

The dollar price of a unit of foreign currency

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Rates &

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Rates &

An indirect quote is a foreign currency price in a

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Rates &

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Rates &

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Foreign Exchange Rates &

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Foreign Exchange Rates &

The important thing to remember is which currency is

Spot - Foward 360

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Foreign Exchange Rates &

Forward - Spot 360

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange Rates &

105.65 - 105.04 360

Example: Direct quote

0.009520183 - 0.009465215 360

Copyright 2006 Pearson Addison-Wesley. All rights reserved.