1

The Market for Foreign Exchange

Chapter Objective: This chapter serves to introduce the student to the institutional

framework within which exchange rates are determined. This chapter lays the foundation for much of the discussion

throughout the remainder of the text, thus it deserves your careful attention.

Chapter Outline Function and Structure of the FOREX Market The Spot Market The Forward Market

4Chapter four

2

FUNCTION AND STRUCTURE OF FX MARKET

Dispersed broker-dealer or Over the Counter (OTC) market

Size: $3.2 trillion per day (2007, BIS)

US$ - most trade currency, considered the vehicle currency that expedites transactions between currencies of limited circulation

UK – largest market for foreign exchange (FX) activity

3

FOREIGN EXCHANGE ACTIVITY

4

FOREX Market Participants

The FOREX market is a two-tiered market: Wholesale (Interbank, 87% of trading volume) and Retail (Client

market, 13% of market).  Why so much wholesale?  Much wholesale trading is speculative trading (trying to correctly

judge the direction of currency values) or arbitrage trading (exploiting ex-rate discrepancies between dealers). 

Currency trading is a profit center for large banks.

Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

5

FOREX Market Participants

1. INTL BANKS and BANK CUSTOMERS.  100-200 large commercial banks worldwide provide the core of the FX

market and actively participate, "make a market" in FX, trading FX on behalf of bank customers (MNCs,

money managers, exporters, importers, private traders). Most interbank trades are speculative or arbitrage transactions.

2. NONBANK DEALERS.  Wholesale currency traders who are NOT commercial banks, e.g. Investment

banks (Solomon Smith Barney, M-L, JP Morgan, Goldman Sachs, etc.) establish their own trading centers to trade directly in the FX market, and

account for 28% of the interbank (wholesale) volume.

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FOREX Market Participants

3. FX BROKERS.  Brokers/intermediaries who track quotes offered by many dealers in the

global market, and then match buyers and sellers for a fee (bid/ask spread), and "make a market," without taking a position themselves (no currency inventory). 

More and more trading (50-70%) now takes place through automated electronic trading systems, making the role of FX brokers unnecessary. 

This trend will continue as electronic trading becomes more advanced.

4. CENTRAL BANKS.  If a country has a fixed ex-rate (Argentina until recently, Hong Kong), or a

pegged rate (China), the central bank (or currency board) has to make regular interventions to support the fixed/pegged ex-rate.

7

Spot Rate Quotations

Cash (or spot) market for currency, involves immediate delivery (within one or two days), represents 33% of total FX market. 

Spot rates (S) can be quoted two ways.  Ex-rate is just a ratio of two currencies, can be expressed two ways: S = $/£, or S = £/$. 

1.When the domestic currency ($) is on the top, S($/£)=$1.5272/£ it is called: Direct quote; American terms; U.S. $ Equivalent

2. When the foreign currency (£) is on the top S(£/$) =£0.6548/$, it is called: Indirect Quote or European terms, or Currency PER $

Spot rates are reported both ways.  Most currencies are priced and traded against the US$ (90% world

currency market involves the dollar on one side of transaction),

8

Spot Rate Quotations

Note that the direct quote is the reciprocal of the indirect quote:

6399.

15627.1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)

Currency per USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv FridayCountry

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The Bid-Ask Spread

Bid/Ask Spread provides a commission/brokerage fee for currency traders/brokers. 

The Bid price is the price a dealer is willing to pay for a currency = Sb

(j/k)

The Ask price is the amount the dealer offers to sell you a currency. It’s the price the dealer wants for the sale of currency = Sa (j/k)

Bid-Ask Spread = [Ask price - Bid price] > 0

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Spot FX trading

In the interbank market, the standard size trade is about US$10 mil. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes. Trading Jargon

Trading Size: $10 million = 10 dollars Quotation: A$/US$ = A$1.9264 - A$1.9273 Quote: 64 to 73 (9 point spread)

One dealer’s spread = 66 to 75, what are his/her expectations? Will have more clients selling US$ to dealer for A$ Expects US$ to appreciate, therefore building up inventory in US$

Currency Nicknames: Cable, Loonie, Aussie, Swissie, Greenback, Sing dollar, Kiwi

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CROSS FX-RATE QUOTATIONS

Cross Ex-Rate is an ex-rate that does NOT involve $, e.g. €/£.  See cross currency rates on page 86.

Example:  S(€/£) = S($/£) / S($/€) = S($/£) x  S(€/$), so S =  €/£ (The $s cancel, leaving €/£).

Assume: S($/£) = 1.6944 and S($/€) = 1.1584 

So S($/£) = 1.6944 / 1.1584 =  €1.4627/£.        S($/€)

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Triangular Arbitrage

$

£€

Credit Lyonnais

S(£/$)=0.60

Credit Agricole

S(€/£)=1.65

Barclays

S(€/$)=0.95

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.

13

Triangular Arbitrage

$Credit

Lyonnais

S(£/$)=0.60

Credit Agricole

S(€/£)=1.65

Barclays

S(€/$)=0.95

As easy as 1 – 2 – 3:1. Sell our $ for £, 2. Sell our £ for €, 3. Sell those € for $.

€ £

1

2

3

$The implied S(€/£) cross rate is S(€/£) =1.5833

Credit Agricole has posted a quote of S(€/£)=1.65

so there is an arbitrage opportunity.

So,how can we make money?

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Triangular Arbitrage

Sell $100,000 for £ at S(£/$) = 0.60

receive £60,000

Sell our £ 60,000 for € at S(€/£)= 1.65

receive €99,000

Sell € 99,000 for $ at S(€/$) = 0.95receive $104,210

profit per round trip = $ 104,210- $100,000 = $4,210

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Spot Foreign Exchange Microstructure

Market Microstructure are the mechanics of how a marketplace operates.

Spot mkt Bid-Ask spreads increase with FX exchange rate volatility and decrease

with dealer competition. Private information is an important determinant of

spot exchange rates. - Mkt adjusts to econ info in 1min. - 1/3 of traders claim adjustment < 10 sec - Central bank intervention does not work; it increase

volatility.

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Forward market

Contract settled today for future delivery/receipt of FX.  Agree today on P (fx-rate) and Q, future settlement in 1, 3, 6, 9,

12 months, 2, 5, 10 years, etc..  Forward rates are available for most major currencies at most

maturities. Compared to the spot rate, FX is usually trading at either a

Forward Discount (currency is expected to depreciate) or Forward Premium (currency is expected to appreciate).

If you have agreed to sell FX forward, you are short. If you have agreed to buy FX forward, you are long.

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Quotations

Clearly the market participants expect that the pound will be worth less in dollars in six months.

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)

Currency per USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv FridayCountry

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Payoff Profiles ($/SF)

loss

0 S3($/SF)

F3($/SF) =.6670

Short position-F3($/SF)

F3($/SF) Long positionprofit

Since this is a zero-sum game, the long position payoff is the opposite of the short.

.6700

-.0030

S3 > F3 results in a loss of the Short position

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Forward Cross Exchange Rates

It’s just a “delayed” example of the spot cross rate discussed above.

In generic terms

)/($

)/($)/(

and

)/($

)/($)/(

kF

jFjkF

jF

kFkjF

N

NN

N

NN

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Forward Premium

It’s just the interest rate differential implied by forward premium or discount.

For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307

The forward premium is given by:

0275.5235.

5235.5307.

180

360

€)/($

€)/($€)/($180$,€180

S

SFf v

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SWAP TRANSACTIONS

A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency.

Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade.

Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

Forward bid-ask prices are usually quoted in terms of forward points. See example 4.5