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
 Foreign Exchange Markets
• There are six main characteristics of the
FOREX markets which will be discussed
– The geographic extent
– The three main functions
– The market’s participants
– Its daily transaction volume
– Types of transactions including spot,
forward and swaps
– Methods of stating exchange rates,
quotations, and changes in exchange rates
 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
 The Spot Market for Foreign
Exchange
• Spot Market
– A market for the immediate purchase
and delivery of currencies.
• Spot Exchange Rates
– Market prices of foreign exchanges in
the spot market that are the rates
pertaining to the trading of foreign-
currency-denominated deposits among
major banks in amounts of $1 million
and more.
 Central Bank

Order placed order placed

Order Proceed Open Bid Order Proceed

Double auction

Industry Commercial bank Commercial bank Industry

Order placed inside spread shown Order placed inside spread shown

Exchange
Broker
Inter-bank Spot Market

Inter-bank foreign exchange is the largest

financial market with a turnover of almost
one trillion dollars.
The foreign exchange market is an informal
arrangement of the larger commercial
banks and a number of foreign exchange
brokers. They are linked together by
telephone, telex, and a satellite
communications network called Society
for Worldwide International Financial
Telecommunication (SWIFT). Computer
based communications system based in
Settlement between banks
Bank that purchased foreign currency have to pay the bank
that sold the foreign currency. The payment generally takes
place via a clearing house; an institution at which banks
keep funds that can be moved from one bank’s account to
another’s to settle interbank transactions. When foreign
exchange is trading against dollar, the clearing house is
called CHIPS: Clearing House Interbank Payments
System, located in New York.
Bank settlement via CHIPS
CHIPS is a computerized mechanism through which
banks hold US $ to pay each other when buying or selling
foreign exchange. System is owned by large New York
clearing banks, over 150 members and handled over
150,000 transactions a day, worth hundreds of billion of $.
Retail versus Interbank Spot rates
Exchange rates between interbanks determined in the
market. Exchange rates faced by the banks’ clients are
based on these interbank rates. Clients are charged slightly
more than the going interbank selling rate: ask rate, pay
slightly less than the interbank buying rate: bid rate.
Foreign exchange rates can be given two ways.
§ Number of US$ per foreign currency unit: U.S. $
equivalent
§ Number of units of foreign currency per U.S. $: European
terms
 Quote Conventions
• It is important to remember that in
countries other than in the United
States, all exchange rates with the
dollar are usually given as direct rates.
• There are two exceptions that give the
indirect rates in countries other than the
United States:
– British pound (has always been quoted as
dollar price of one pound).
– Euro (convention adopted quotes the
foreign currency value of one euro).
 The Spot Market -
Conventions
• Denote the spot rate as S
• For most currencies, use 4 decimal places in
calculations
– With exceptions: i.e. S(¥/$)=109.0750, but
S($/¥)=0.009168
• If we are talking about the US, always quote spot rates as
the dollar price of the foreign currency
– i.e. as direct quotes, S($/€), S($/C$), S($/£), etc
• Increase in the exchange rate  the US dollar is
depreciating
– Costs more to buy 1 unit of foreign currency
• Decrease in the exchange rate  the US dollar is
appreciating
Quotation Conventions
 Bid-Ask Quotes
• Bid price: the exchange rate at
which the dealer is willing to buy a
currency.
• Ask (offer) price: the exchange
rate at which the dealer is willing to
sell a currency.
• Midpoint price = (ask + bid)/2
 Bid-Ask Quotes
• Consider the following direct quote in
the United States:
($/Euro) 0.9838 – 0.9841
• The bid price is 0.9838 $/Euro
• The ask price is 0.9841 $/Euro
• The midpoint price is 0.98395 $/Euro
 Direct Exchange Quotes
• A direct exchange rate is the domestic
price of foreign currency.
• A direct quote is a home currency price of a
unit of a foreign currency

• Let “DC” be the domestic currency, and

“FC” be the foreign currency.
• A direct quote could be represented as:
0.5 DC : 1 FC, for example.
 More on Direct Quotes
• For example, the Japanese quote the
U.S. dollar exchange rate as 150
Yen/$ (150 yen per dollar) — a direct
rate in Japan.
• Quotations are usually given with five
digits. For example,
• 150.51 Yen/$
• 0.6079 pounds sterling/$
 Indirect Foreign Exchange Quotes

• An indirect exchange rate is the amount

of foreign currency equivalent to one
unit of domestic currency.
• An indirect quote is a foreign currency price in
a unit of the home currency
• For example, 2 FC: 1 DC
– Note this conveys the same information as
our previous example.
– Another example: 0.0067$/Yen would be an
indirect quote in Japan.
 Cross Rates
• A cross rate is the exchange rate between two
countries inferred from each country’s exchange
rate with a third country.
• Many currencies pairs are inactively traded,
so their exchange rate is determined through
their relationship to a widely traded third
currency
– Example: A Mexican importer needs
Japanese yen to pay for purchases in
Tokyo. Both the Mexican peso (MXP)
and Japanese yen (¥) are quoted in US
dollars
• Assume Japanese
the
yen ¥110.73/$
following quotes:
Mexican peso MXP 11.4456/$
 Foreign Exchange Rates &
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
Japane yen/U doll ¥ 110.73
  ¥9.6745/MXP
se
Mexica S
pesos/ ardoll /$
MXP11.4456/$
n US ar
 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
 Summary of Learning
Objectives
• 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
 Summary of Learning
Objectives
• 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