Foreign Exchange

Market

1. Definition and Organization of

the Foreign Exchange Markets
foreign exchange markets are markets on
which individuals, firms and banks buy and sell
foreign currencies:
foreign exchange trading occurs with the help of
the telecommunication net between buyers and
sellers of foreign exchange that are located all over
the world
a single international foreign exchange market for
every single currency
foreign exchange trading takes place at least in
some of the world financial centers in every
moment

The Currency Market

Where money denominated in one
currency is bought and sold with money
denominated in another currency.
International Trade and Capital
Transactions:
facilitated with the ability to transfer
purchasing power between countries.

Location
1. OTC-type: no specific location
2. Most trades by phone, telex, or
SWIFT
SWIFT: Society for Worldwide
Interbank Financial
Telecommunications

Participants in the foreign

exchange market
Participants at 2 Levels
1. Wholesale Level (95%) - major banks
2. Retail Level (business customers)
Two Types of Currency Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business day
2. Forward Market:
- transactions take place at a specified future date

Participants by Market
Spot Market
a.commercial banks
b.Brokers
c.customers of commercial and central banks
. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators

CLEARING SYSTEMS
A. Clearing House Interbank Payments
System (CHIPS)
- used in U.S. for electronic fund
transfers.
B. FedWire
- operated by the Fed
- used for domestic transfers

ELECTRONIC TRADING
A. Automated Trading
- genuine screen-based market
B. Results:
1. Reduces cost of trading
2. Threatens traders oligopoly of
information
3. Provides liquidity

2. Foreign Exchange Market Functions

Clearing of Currencies and Provision of Credit

Clearing of currencies:
service of exchanging one currency for
another

Provision of Credit:
trader that bought a certain good from
the manufacturer, needs time to sell this
good to the final customer and to pay
the manufacturer with the money he
received from the customer

Foreign Exchange Market and

Insurance Against Foreign
Exchange Risk

activities with which the foreign

exchange market participants avoid
exchange rate risk or activities with
which they are closing their open foreign
exchange position
closed foreign exchange position:
size of the assets in a certain currency is
equal to the size of the liabilities in the
same currency
full insurance against exchange rate risk
with respect to this currency

Foreign Exchange Market and

Insurance Against Foreign
Exchange Risk
open foreign exchange position:

long: net assets in a certain currency

short: net liabilities in a certain currency

in the spot or forward foreign exchange

market
standardized forward contracts and options

Foreign Exchange Markets and Conscious

Foreign Exchange Risk Acceptance

activities in which economic

consciously
open
their
exchange positions long or
hoping to get profits in all
exchange market segments

agents
foreign
short
foreign

3. Foreign Exchange Market

Participants
Economic Agents and Types of Activities
on Foreign Exchange Markets

Economic Agents and Types of

Activities on Foreign Exchange
Markets

bank clients (individuals, firms, nonbanking financial institutions):

all those groups of legal and physical

persons that need foreign currency in doing
their commercial or investment business

commercial banks:
the most important group of foreign
exchange market participants
they buy and sell foreign currencies for their
clients and trade for themselves

Economic Agents and Types of

Activities on Foreign Exchange
Markets
brokers:
agents
that
connects
dealers
interested in buying and selling foreign
exchange, but does not become an
active client in the transaction
they provide their client, the bank, with
the information about the exchange
rates at which banks are willing to buy
or sell a particular currency

Economic Agents and Types of

Activities on Foreign Exchange
Markets

central banks:

foreign exchange market interventions

are meant to influence the exchange
rate of the domestic currency in a way
that is beneficial for the domestic
economy and, consequently, for the
country
it does not necessarily have a profit, it
can also have a loss

Economic Agents and Motivation for the

Foreign Exchange Market Participation

arbitragers:
they want to earn a profit without
taking any kind of risk (usually
commercial banks):
try to profit from simultaneous exchange
rate differences in different markets
making use of the interest rate differences
that exist in national financial markets of
two countries along with transactions on
spot and forward foreign exchange market
at the same time (covered interest parity)

Economic Agents and

Motivation for the Foreign
Exchange Market Participation
hedgers and speculators:
hedgers do not want to take risk while
participating in the market, they want to
insure themselves against the exchange
rate changes
speculators think they know what the
future exchange rate of a particular
currency will be, and they are willing to
accept exchange rate risk with the goal
of making profit
every foreign exchange market
participant can behave either as a

4. Size and Structure of Foreign

Exchange Market Transactions
the biggest share of all financial markets in the world

5. Types of Foreign Exchange

Market Transactions Spot Foreign
Exchange Transactions
almost immediate delivery of foreign
exchange
Outright Forward Transactions
buyer and seller establish the exchange rate at the time of
the agreement, payment and delivery are not required until
maturity
forward exchange rates:
1, 3, 6, 9 months, one year

Swap Transactions
simultaneous purchase and sale of a given
amount of foreign exchange for two different
value dates:
spot against forward swaps:

Hedging
the act of reducing exchange rate risk

Forward Rate Quotations

Two Methods:
a) Outright Rate: quoted to
commercial customers.

b) Swap Rate:

quoted in the
interbank
market
as
a
discount or premium.

Futures positions
Futures are similar to forwards
First, futures positions require a margin deposit to be
posted and maintained daily.
If a loss is taken on the contract, the amount is debited
from the margin account after the close of trading.
In other words, these futures are cash settled and no
underlying instruments or principals are exchanged.
Secondly, all contract specifications such as expiration
time, face amount, and margins are determined by the
exchange instead of by the individual trading parties.

Futures
basic characteristics of futures:
the amount of the currency that is being traded
type of currency quotation
contract expiration
last day of trading with the contract
settlement day
margin requirements

information about futures trading

futures usage:
arbitrage between outright forward contract
and futures
rarely used as an insurance instrument
(rigidity!)

 similarities and differences between outright

forward contract and futures:
both need to be executed unconditionally
they are usually established for at most one year

Options
Options are a way of buying or selling a
currency at a certain point in the future.
An option is a contract which specifies the
price at which an amount of currency can
be bought at a date in the future called the
expiration date.
Unlike forwards and futures, the owner of
an option does not have to go through with
the transaction if he or she does not wish
to do so.

Types of options
The buyer of a call has the right but not the obligation to buy the
underlying asset at the strike price on or before a specified date in
the future.
However, the seller has a potential obligation to sell the
underlying asset at the strike price on or before a specified date in
the future if the holder of the option exercises his or her right.
The buyer of a put has the right but not the obligation to sell the
underlying asset at the strike price on or before a specified date in
the future.
On the other hand, the seller of a put has a potential obligation to
buy the underlying asset at the strike price on or before a
specified date in the future if the holder of the option exercises
his/her right.

Options
basic characteristics of options:
financial instrument that gives the buyer
the right, but not the obligation, to buy or
sell a standardized amount of a foreign
currency, that is traded, at a fixed price at
a particular time, or until a particular time
in the future
call option and put option
American and European options
three different prices:
exercise/strike price
cost, price or value of the option
underlying or actual spot exchange rate

Options
types of options trading:
in organized markets:
standardized contracts with given strike
prices, standardized durations (1, 3, 6, 9,
12 months) and expirations
only certain currencies, contract amounts
are standardized

over-the-counter trading:
expiration date, strike price and contract
amount depend on the individual needs of
the client
counterparty risk!
retail and interbank market

Options
Usage of options:
when the economic agent expects that
the exchange rate trend of a particular
currency could change drastically
when the economic agent does not
know for sure that a certain foreign
exchange flow will occur in the future
advantages:
fixed option costs
options do not need to be executed

6. Quotations of Currencies on
Foreign
Exchange Markets
quotation of a currency tells us at what price is a
financial mediator willing to buy or sell a certain
currency

Currency Quotations in Spot Foreign

Exchange Markets
European and American quotation
direct and indirect quotation (which currency is
regarded as a domestic/basis currency)

Forward Contract
an agreement between a bank and a
customer to deliver a specified
amount of currency against another
currency at a specified future date
and at a fixed exchange rate.