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Contents
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Definition and Organization of the Foreign Exchange Markets. Foreign Exchange Market Functions. Foreign Exchange Market Participants. Size and Structure of Foreign Exchange Market Transactions. Types of Foreign Exchange Market Transactions. Quotations of Currencies on Foreign Exchange Markets.

Definition and Organization of the Foreign Exchange Markets

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foreign exchange markets are markets on which individuals, firms and banks, buy and sell foreign currencies:
o 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. o can actually talk about a single international foreign exchange market for every single currency. o foreign exchange trading takes place at least in some of the world financial centers in every moment. interbank-markets client markets

Foreign Exchange Market Functions

Clearing of Currencies and Provision of Credit
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Clearing of currencies:
o service of exchanging one currency for

another
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Provision of Credit:
o 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

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Hedging: o activities with which the foreign exchange market participants avoid exchange rate risk or activities with which they are closing their open foreign exchange position o closed foreign exchange position: o size of the assets in a certain currency is equal to the size of the liabilities in the same currency o full insurance against exchange rate risk with respect to this currency o open foreign exchange position: o long: net assets in a certain currency o short: net liabilities in a certain currency o in the spot or forward foreign exchange market o standardized forward contracts and options

Foreign Exchange Markets and Conscious Foreign Exchange Risk Acceptance

activities in which economic agents consciously open their foreign exchange positions long or short hoping to get profits o in all foreign exchange market segments
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Foreign Exchange Market Participants Economic Agents and Types of Activities on Foreign Exchange Markets
Client buys $ with

Local bank

Bro kers

Main banks interbank market

Purchas es and s ales of big mu ltinational companies

Local bank

Client buys with $

Economic Agents and Types of Activities on Foreign Exchange Markets

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bank clients (individuals, firms, non-banking financial institutions):

o all those groups of legal and physical persons

that need foreign currency in doing their commercial or investment business

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commercial banks:
o the most important group of foreign exchange

market participants o they buy and sell foreign currencies for their clients and trade for themselves

Economic Agents and Types of Activities on Foreign Exchange Markets

brokers: o agents that connects dealers interested in buying and selling foreign exchange, but does not become an active client in the transaction o 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 o central banks: o 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 o it does not necessarily have a profit, it can also have a loss
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Economic Agents and Motivation for the Foreign Exchange Market Participation
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arbitragers:
o they want to earn a profit without taking any kind

of risk (usually commercial banks):

o try to profit from simultaneous exchange

rate differences in different markets o 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)

Continuing
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hedgers and speculators:

o hedgers do not want to take risk while

participating in the market, they want to insure themselves against the exchange rate changes o 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 o every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction

Size and Structure of Foreign Exchange Market Transactions

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The biggest share of all financial markets in the world

Siz an Structure of Transactions in the Foreign Exchange Markets e d ,
Currency
1989 Traditional foreign exchange 590 transactions 1992 1995 1998

Percentage 87 30 21 11 5 7 39 200,00

820 400
420 -

1190 520
670 45

1490 590
900 97

Spot market transactions

350

Forward market 240 transactions Untraditional foreign exchange transactions

$ DEM FRF CHF Other All currencies

Types of Foreign Exchange Market Transactions Spot Foreign Exchange Transactions

Almost immediate delivery of foreign exchange Outright forward transactions o buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity o forward exchange rates:
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1, 3, 6, 9 months, one year

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. o Currency quotations in spot foreign exchange market o European and American quotation o direct and indirect quotation (which currency is regarded as a domestic/basis currency)
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Currency Quotations in Spot Foreign Exchange Markets

American quotation European quotation
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Definition: number of units of $ needed to buy a unit of a foreign currency Definition: number of units of a foreign currency needed to buy $1 Direct quotation in the USA: number of units of a domestic currency ($) needed to buy a unit of foreign currency Direct quotation outside the USA: number of units of a domestic currency needed to buy a unit of a foreign currency ($) Indirect quotation outside the USA: number of units of a foreign currency ($) needed to buy a unit of a domestic currency Indirect quotation in the USA : number of units of a foreign currency needed to buy a unit of a domestic currency

Continuing
bid price and offer/sell price quotation: o bid price is the exchange rate at which a bank is willing to buy another currency o offer/sell price is the exchange rate at which the same bank is willing to sell the currency in question o transaction costs: o banks usually do not charge provision o difference between the bid and offer/sell price represents the banks profit and is called a margin or spread
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Continuing
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cross exchange rate:

o can be calculated with the help of the

relationship of two currencies with a third currency

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triangular currency arbitrage:

o it enables profit earning because of

inconsistency between currency quotations in different financial centers o buying a particular currency in one financial center and selling it in another financial

Currency Quotations in Forward Foreign Exchange Markets

outright quotation o tokovna quotation, forward premium/discount: o forward discount: o when a currency is worth less (is cheaper relative to another currency) in the forward foreign exchange market than in the spot foreign exchange market o forward premium: o when a currency is worth more (is more expensive relative to another currency) in the forward foreign exchange rate market than in the spot foreign exchange market o annual forward premium and discount
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