the market for foreign exchange - ut arlington – · pdf filethe market for foreign...

EunResnick: International Financial Management, Third Edition
I. Foundations of International Financial Management
4. The Market for Foreign Exchange
158 The McGrawHill Companies, 2004
74
CHAPTER 4
The Market for Foreign Exchange
MONEY REPRESENTS PURCHASING power. Possessingmoney from your country gives you the power to purchasegoods and services produced (or assets held) by other resi-dents of your country. But to purchase goods and servicesproduced by the residents of another country generally firstrequires purchasing the other countrys currency. This is doneby selling ones own currency for the currency of the countrywith whose residents you desire to transact. More formally,ones own currency has been used to buy foreign exchange,and in so doing the buyer has converted his purchasing powerinto the purchasing power of the sellers country.
The market for foreign exchange is the largest financialmarket in the world by virtually any standard. It is open some-where in the world 365 days a year, 24 hours a day. The 2001triennial central bank survey compiled by the Bank for Inter-national Settlements (BIS) places worldwide daily trading ofspot and forward foreign exchange at $1.2 trillion dollars perday. This is equivalent to nearly $200 in transactions for everyperson on earth. This, however, represents a 19 percent de-crease over 1998. The decline is due to the introduction of thecommon euro currency, which eliminates the need to trade oneeuro zone currency for another to conduct business transac-tions, and to consolidation within the banking industry. Londonremains the worlds largest foreign exchange trading center.According to the 2001 triennial survey, daily trading volume inthe U.K. is estimated at $504 billion, a 21 percent decreasefrom 1998. U.S. daily turnover was $254 billion, which repre-sents a 28 percent decline from 1998. Exhibit 4.1 presents a piechart showing the shares of global foreign exchange turnover.
Broadly defined, the foreign exchange (FX or FOREX)market encompasses the conversion of purchasing powerfrom one currency into another, bank deposits of foreign cur-
rency, the extension of credit denominated in a foreign currency, foreign trade financ-ing, trading in foreign currency options and futures contracts, and currency swaps.Obviously, one chapter cannot adequately cover all these topics. Consequently, weconfine the discussion in this chapter to the spot and forward market for foreign ex-change. In Chapter 9, we examine currency futures and options contracts, and in Chap-ter 10, currency swaps are discussed.
This chapter begins with an overview of the function and structure of the foreign ex-change market and the major market participants that trade currencies in this market.Following is a discussion of the spot market for foreign exchange. This section covershow to read spot market quotations, derives cross-rate quotations, and develops theconcept of triangular arbitrage as a means of ensuring market efficiency. The chapterconcludes with a discussion of the forward market for foreign exchange. Forward mar-ket quotations are presented, the purpose of the market is discussed, and the purpose ofswap rate quotations is explained.
Function and Structure of the FOREX MarketFX Market ParticipantsCorrespondent Banking Relationships
The Spot MarketSpot Rate QuotationsThe Bid-Ask SpreadSpot FX TradingCross-Exchange Rate QuotationsAlternative Expressions for the Cross-Exchange RateThe Cross-Rate Trading DeskTriangular ArbitrageSpot Foreign Exchange Market Microstructure
The Forward MarketForward Rate QuotationsLong and Short Forward PositionsForward Cross-Exchange RatesSwap TransactionsForward PremiumSummaryKey WordsQuestionsProblemsInternet ExercisesMINI CASE: Shrewsbury Herbal Products, Ltd.References and Suggested Readings
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www.bis.org.
This is the website of the Bankfor International Settlements.Many interesting reports andstatistics can be obtained here.The report titled TriennialCentral Bank Survey can bedownloaded for study.

This chapter lays the foundation for much of the discussion throughout the remain-der of the text. Without a solid understanding of how the foreign exchange marketworks, international finance cannot be studied in an intelligent manner. As authors, weurge you to read this chapter carefully and thoughtfully.
The structure of the foreign exchange market is an outgrowth of one of the primaryfunctions of a commercial banker: to assist clients in the conduct of international com-merce. For example, a corporate client desiring to import merchandise from abroadwould need a source for foreign exchange if the import was invoiced in the exportershome currency. Alternatively, the exporter might need a way to dispose of foreign ex-change if payment for the export was invoiced and received in the importers homecurrency. Assisting in foreign exchange transactions of this type is one of the servicesthat commercial banks provide for their clients, and one of the services that bank cus-tomers expect from their bank.
The spot and forward foreign exchange market is an over-the-counter (OTC)market; that is, trading does not take place in a central marketplace where buyers andsellers congregate. Rather, the foreign exchange market is a worldwide linkage of bankcurrency traders, nonbank dealers, and FX brokers who assist in trades connected toone another via a network of telephones, telex machines, computer terminals, and au-tomated dealing systems. Reuters and EBS are the largest vendors of quote screenmonitors used in trading currencies. The communications system of the foreign ex-change market is second to none, including industry, governments, the military, andnational security and intelligence operations.
Twenty-four-hour-a-day currency trading follows the sun around the globe. Threemajor market segments can be identified: Australasia, Europe, and North America.Australasia includes the trading centers of Sydney, Tokyo, Hong Kong, Singapore, andBahrain; Europe includes Zurich, Frankfurt, Paris, Brussels, Amsterdam, and London;and North America includes New York, Montreal, Toronto, Chicago, San Francisco,and Los Angeles. Most trading rooms operate over a 9- to 12-hour working day,
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www.ny.frb.org.
This is the website of theFederal Reserve Bank of NewYork. The on-line article titledThe Basics of Foreign Tradeand Exchange can bedownloaded for study. Thereport titled The ForeignExchange and Interest RateDerivatives Markets Survey:Turnover in the United Statescan also be downloaded.
EXHIBIT 4.1
Shares of ReportedGlobal ForeignExchange Turnover,2001
Note: Percent of total reporting foreign exchange turnover, adjusted for intracountry double-counting.Source: Foreign Currency Exchange, Federal Reserve Bank of New York, www.ny.frb.org.
Japan 10%
Singapore 7%
Germany 6%
Switzerland 5%
Hong Kong SAR 5%
Australia 4%
France 3%
Canada 3%
Netherlands 2%
Italy 1%
Sweden 2%Denmark 2%
United States17%
United Kingdom33%
Countries withshares less than1% not included.
Function and Structure of the FOREX Market
www.about.reuters.com/transactions
This website explains thevarious Reuters spot andforward FX electronic tradingsystems.
www.ebsp.com
This website explains the EBSSpot electronic dealing system.

although some banks have experimented with operating three eight-hour shifts in or-der to trade around the clock. Especially active trading takes place when the tradinghours of the Australasia centers and the European centers overlap and when the Euro-pean and North American centers overlap. More than half of the trading in the UnitedStates occurs between 8:00 A.M. and noon eastern standard time (1:00 P.M. and 5:00P.M. Greenwich Mean Time [London]), when the European markets were still open.Certain trading centers have a more dominant effect on the market than others. For ex-ample, trading diminishes dramatically in the Australasian market segment when theTokyo traders are taking their lunch break! Exhibit 4.2 provides a general indication ofthe participation level in the global FX market by showing electronic trades per hour.
The market for foreign exchange can be viewed as a two-tier market. One tier is thewholesale or interbank market and the other tier is the retail or client market. FXmarket participants can be categorized into five groups: international banks, bank cus-tomers, nonbank dealers, FX brokers, and central banks.
International banks provide the core of the FX market. Approximately 100 to 200banks worldwide actively make a market in foreign exchange, that is, they standwilling to buy or sell foreign currency for their own account. These international banksserve their retail clients, the bank customers, in conducting foreign commerce or mak-ing international investment in financial assets that require foreign exchange. Bankcustomers broadly include MNCs, money managers, and private speculators. Accord-ing to 2001 BIS statistics, retail or bank client transactions account for approximately13 percent of FX trading volume. The other 87 percent of trading volume is from in-terbank trades between international banks or nonbank dealers. Nonbank dealers arelarge nonbank financial institutions such as investment banks, who

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