ICF

Anshul Jain

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.

Geography
The foreign exchange market spans the globe,
with prices moving and currencies trading
somewhere every hour of every business day.
The volume of currency transactions ebbs and
flows across the globe as the major currency
trading centers open and close throughout the
day.

Global Currency Trading: The

Trading Day

Foreign Exchange Market Activity: Average

Electronic Conversions Per Hour

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 countrys 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.
The date of settlement is referred to
as the value date.

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).

BIS Triennial Central Bank

Survey
April 2016
52 Central Banks, 1300 Banks
Trading in foreign exchange markets averaged $5.1
trillion per day in April 2016. This is down from $5.4
trillion in April 2013, a month which had seen
heightened activity in Japanese yen against the
background of monetary policy developments at that
time.
Compare with worldwide stock trading volume of $44
Trillion in the 6 months up to June 2016.

 For first time since 2001, spot turnover declined. Spot transactions
fell to $1.7 trillion per day in April 2016 from $2.0 trillion in 2013.
In contrast, the turnover of FX swaps rose further, reaching $2.4
trillion per day in April 2016. This rise was driven in large part by
increased trading of FX swaps involving yen.
The US dollar remained the dominant vehicle currency, being on
one side of 88% of all trades in April 2016. The euro, yen and
Australian dollar all lost market share. In contrast, many emerging
market currencies increased their share. The renminbi doubled its
share, to 4%, to become the worlds eighth most actively traded
currency and the most actively traded emerging market currency,
overtaking the Mexican peso. The rise in the share of renminbi was
primarily due to the increase in trading against the US dollar. In
April 2016, as much as 95% of renminbi trading volume was
against the US dollar.
The share of trading between reporting dealers grew over the
three-year period, accounting for 42% of turnover in April 2016,
compared with 39% in April 2013. Banks other than reporting
dealers accounted for a further 22% of turnover. Institutional
investors were the third largest group of counterparties in FX
markets, at 16%.
In April 2016, sales desks in five countries the United Kingdom,

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 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.

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.

Bid, Ask, and Mid-Point Quotation

Foreign Exchange Rates

and Quotes in Percentage Terms
Measuring a change in the spot rate for
quotations expressed in home currency terms
(direct quotations):

x 100
% = Ending
rate

Beginning
Rate
Beginning Rate

Quotations expressed in foreign currency terms

(indirect quotations):
% = Beginning Rate Ending x
Rate
100
Ending Rate

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 can be used to check on
opportunities for intermarket
arbitrage.

Exhibit 6.9

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/
= 1.1721/
$1.3297/
Because the
rates are unequal, a
triangular arbitrage opportunity
exists.

Triangular Arbitrage by a Market

Trader

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.

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

360
n

X 100

For quotations expressed in home

currency terms (Direct quotations)
the formula becomes:
f = Forward
Spot
Spot

360
n

X 100