The Foreign

Exchange Market

Saurabh
Kumar
 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
– Is where foreign exchange transactions are
physically completed
 The Foreign Exchange Market
• Foreign exchange means the money of a
foreign country; that is, foreign currency bank
balances, banknotes, checks and drafts.
• 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 date.
 Geography
• The foreign exchange market spans the
globe, with prices moving and currencies
trading somewhere every hour of every
business day.
• As the next exhibit will illustrate, the volume
of currency transactions ebbs and flows
across the globe as the major currency
trading centers open and close throughout
the day.
 Measuring Foreign Exchange Market Activity:
Average Electronic Conversations Per Hour
25,000

20,000

15,000

10,000

5,000
Greenwich Mean
Time
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyo opening closing open closing in America In NY opens

Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
 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
– 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)
– 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,
speculators and arbitragers, central banks and
treasuries, and foreign exchange brokers.
 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.
 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.
 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.
 Central Banks and Treasuries
• Central banks and treasuries use the market to acquire
or spend their country’s 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 citicizens.
• As willing loss takers, central banks and treasuries differ
in motive from all other market participants.
 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 commission.
• It is a brokers business to know at any moment exactly
which dealers want to buy or sell any currency.
• Dealers use brokers for their speed, and because they
want to remain anonymous since the identity of the
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)
 Market Size
• In April 2001, a survey conducted by the
Bank for International Settlements (BIS)
estimated the daily global net turnover in
traditional foreign exchange market
activity to be $1,210 billion.
• This was the first decline observed by the
BIS since it began surveying banks on
foreign currency trading in the 1980s.
 Global Foreign Exchange Market Turnover (daily
averages in April, billions of US dollars)

800

700 Spot
Forwards
600 Swaps

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.
Geographic Distribution of Foreign
Exchange Market Turnover (daily averages in April,
billions of US dollars)
700 United States
United Kingdom
600
Japan
500 Singapore
Germany
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)
Because all exchange transactions involve two currencies, percentage shares total to 200%
90 US dollar
80 euro
Deutshemark
70 French franc
EMS currencies
60
Japanese yen
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.
 Market for the Indian Rupee
• Indian Forex market has also grown in size with an
average monthly turnover of US$ 23 bn in the merchant
segment and US$ 90 bn in inter-bank foreign exchange
market during 2000-01.
• The US dollar was on one side of 89 per cent of all
transactions, followed by the euro (37 per cent), the yen
(20 per cent) and the Pound sterling (17 per cent). In
terms of currency pairs, US dollar/euro continued to be
by far the most traded currency pair in April 2004,
accounting for 28 per cent of global turnover, followed by
US dollar/yen with 17 per cent and US dollar/Pound
sterling with 14 per cent.
 Market for the Indian Rupee
• With the implementation of the
recommendations of the Sodhani Committee,
money and the foreign exchange markets have
been fully integrated.
• Against this context, the role of RBI has been to
stabilize rupee price and the monetary policy
has been singularly devoted to exchange rate
stability rather than economic growth on a long-
range perspective.
 Market for the Indian Rupee
• With the financial markets in India acquiring
greater depth and maturity in the recent years,
the issue of greater integration of various market
segments among themselves, on the one hand,
and with the global markets, on the other, has
come to the forefront.
• During the post-reform period, the structure of
financial market has witnessed a remarkable
change in terms of the types, the number and
the spectrum of maturity of financial instruments
traded in various segments of money, gilts and
foreign exchange markets.
 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
US dollar.
• Professional dealers and brokers may state
foreign exchange quotations in one of two ways:
– The foreign currency price of one dollar
– 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 Exchange Rates
and Quotations
• For example, the exchange rate between US
dollars and the Swiss franc is normally stated:
– SF 1.6000/$ (European terms)

• However, this rate can also be stated as:

– $0.6250/SF (American terms)

• Excluding two important exceptions, most

interbank quotations around the world are stated
in European terms.
 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 toursists.
 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
regard 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.
 Foreign Exchange Rates
and Quotes
• Forward rates are typically quoted in terms
of points.
• A forward quotation is 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
• 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.
• This situation arose because one bank’s
(Dresdner) quotation on €/£ is not the same a
calculated cross rate between $/£ (Barclay’s)
and $/€ (Citibank).
 Foreign Exchange Rates
and Quotes
• Citibank quote - $/€ $0.9045/€
• Barclays quote - $/£ $1.4443/£
• Dresdner quote - €/£ €1.6200/£
• Cross rate calculation: =
$1.4443/£ = € 1.5968/£
$0.9045/€
 Triangular Arbitrage

Citibank
End with $1,014,533 Start with $1,000,000

(6) Receive $1,014,533 (1) Sell $1,000,000 to

Barclays Bank at $1.4443/£

Dresdner Bank Barclays Bank

(5) Sell €1,121,651 to (2) Receive £692,377
Citibank at $0.9045/€
(4) Receive €1,121,651 (3) Sell £692,377 to Dresnder Bank
at €1.6200/£
 Problem??
• Citibank quotes US Dollar per pound at
$ 1.5400 / £
• National Westminster quotes Euro per
Pound at € 1.6000 / £
• Deutschebank quotes dollars per euro
$ 0.9700 / €
• Calculate how can a market trade at
Citibank with $ 1,000,000 can make an
inter-market arbitrage profit?