PPTCH 04 R

Chapter 4
The Foreign
Exchange Market
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
Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-2

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.
Exhibit 4.1 Measuring Foreign Exchange Market
Activity: Average Electronic Transactions 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;
1) bank and nonbank foreign exchange dealers,
2) individuals and firms,
3) speculators and arbitragers,
4) central banks and treasuries, and
5) foreign exchange brokers.
4-7
1) 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.

2) 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.

3) 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.

Ex:
Citibank is quoting the USD/£ at 1.4445-55.
HSBC is quoting the USD/£ at 1.4425-35.
How much can you make?
Buy £10 million from HSBC an

simultaneously sell £10million to Citibank.
Buy £ from HSBC:
£10,000,000  1.4435 = USD14,435,000
Sell £ to Citibank:
£10,000,000  1.4445 = USD14,445,000
Profit = USD10,000
• Citibank quote - $/€ $0.9045/€

• Barclays quote - $/£ $1.4443/£
• Dresdner quote - €/£ €1.6200/£
• Cross rate calculation: =
$1.4443/£ = € 1.5968/£
$0.9045/€

Exhibit 4.9A 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 $0.9045/€
(4) Receive €1,121,651 (3) Sell £692,377 to Dresnder Bank
at €1.6200/£ 4-13
Speculating on Anticipated
Exchange Rates
Currency Lending Rate Borrowing Rate
US Dollars 6.72% 7.2%
NZ Dollars 6.48% 6.96%
•A Chicago bank expects the exchange rate of the NZ$ to

appreciate from its present level of US$0.50 to US$0.52 in 30
days.
•The bank is able to borrow US$20 million on a short-term basis

from other banks.

Exchange Rates
Present 30days time
Expected Exchange rate US$0.50 US$0.52
•Borrow US$20 million in US.

•Convert the US$20 million to NZ$ (US$20,000,000/0.50)
NZ$40,000,000.
•Lend the NZ$ for 30 days in NZ and earn interest of
(NZ$40,000,000  6.48%  30/360) NZ$216,000.
•Total money obtained is NZ$40,216,000
•Convert the NZ$40,216,000 back to US$ after 30 days
(NZ$40,216,000 0.52 = US$20,912,320)
Exchange Rates
Present 30days time
•Interest that has to be paid to US bank is (US$20,000,000

7.2%30/360) US$120,000. Total payment is US$20,120,000
•Total profit = US$20,912,320 - US$20,120,000
= US$792,320

Exchange Rates
Present 30days time
•What if the exchange rate is expected to be US$0.48 in 30

days? What should be done?
•Borrow in NZ$, convert them to US$, and lend the US$ in U.S.
•Ex: Borrow NZ$40 million (Profit = US$800,640).

4) 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
citizens.
• As willing loss takers, central banks and treasuries
differ in motive from all other market participants.
Typically, official foreign exchange reserves are held to:
a) support and maintain confidence in the policies for

monetary and exchange rate management including the
capacity to intervene in support of the national currency;
b) limit external vulnerability by maintaining foreign
currency liquidity to absorb shocks during times of crisis
or when access to borrowing is curtailed and in doing so;
c) provide a level of confidence to markets that a country
can meet its external obligations;

Typically, official foreign exchange reserves are held to:
d) demonstrate the backing of domestic currency by

external assets;
e) assist the government in meeting its foreign exchange
needs and external debt obligations; and
f) maintain a reserve for national disasters or
emergencies.

5) 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
• 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
• 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)
25
Currency Swaps
• A currency swap is a transaction in which two parties
agree to exchange a fixed amount of one currency for
another.
• The rationale for such a transaction is to hedge currency

risk and the interest rate risk that typically goes with it.
• In a currency swap, the notional principal in two different

currencies is exchanged.
– Typically, this first exchange is often based on prevailing spot exchange
rates at the time.
26
Currency Swaps
• Illustration
– Pacific Gloves Corporation (PGC), a Malaysian glove and rubber products
manufacturer has a large and burgeoning market in Taiwan.
– The company feels that it has to have its own warehouse and distribution centre in
Taiwan.
– The total cost for land, building and all shipping and handling equipment is
expected to be TWD 200 million.
– This will be an one-off investment with subsequent capital expenditure expected to
be minimal.
– Given its expected cash flows from Taiwan operations, PGC believes it can settle a
TWD 200 million financing in 3 years.
– Accordingly, the company has negotiated with its Taiwanese banker, The National
Bank of Taipei (NBOT), funding as follows:
Principle amount = TWD 200 million
Interest = Fixed 9% payable annually at year end
Loan tenor = 3 years; with lump sum principle payment at end of 3rd year
27
Currency Swaps
• Illustration
– Evergreen, the Taiwanese shipping and transportation giant has operations at
all of Malaysia’s ports.
– It now wants to build its own handling facility at Malaysia’s newest port,
The Port of Tanjung Pelepas.
– The total investment needed will be RM 20 million.
– Assume that the spot exchange rate between the TWD and the ringgit is 10
TWD per ringgit
– Evergreen’s Malaysian banker, Public Bank Berhad (PBB) is willing to
provide funding as follows:
Principle amount = RM 20 million
Interest = Fixed 6% payable annually at year end
Loan tenor = 3 years; with lump sum principle payment at end of 3rd year
• Since the two companies have opposite needs, a currency
swap can be a means by which both companies manage the
exchange rate risk.
28
Currency Swaps
• Illustration
– If each firm takes the loan being offered by its bank without doing
anything more, they face exchange rate risk on both the principal amount
and the annual interest payments.
– The swap can be structured to lock-in the prevailing exchange rate and
avoid any currency risk on both the principal and interest.
– The currency swap will work as following:

• PGC takes the loan principal of TWD 200 million from NBOT and forwards it
to Evergreen, which in turn, gives PGC the RM20 million it has received from
PBB.
• PGC now takes the RM20 million received from Evergreen, converts it at the
spot rate to 200 million TWD
• These principal amounts are then reversed at the end of 3rd year.
29
Currency Swaps
• Illustration
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.

Exhibit 4.2 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.

Exhibit 4.3 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
Market Activity in April 2001,” October 2001, www.bis.org. 4-32
Exhibit 4.4 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
4-33
Market Activity in April 2001,” October 2001, www.bis.org.
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.

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.
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.

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 tourists.

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. 1 foreign currency unit = x home
currency units
• An indirect quote is a foreign currency price of a unit
of home currency. 1 home currency unit = x foreign
currency units
• The form of the quote depends on what the speaker
regard as “home.”
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.

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.

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.

and Quotes
• For quotations expressed in foreign currency
terms (Indirect quotations) the formula
becomes:
f ¥ = Spot – Forward 360
Forward x n x 100
• For quotations expressed in home currency

terms (Direct quotations) the formula becomes:
f ¥ = Forward – Spot x 360 x 100
Spot n

and Quotes
Ex:
If the 90 day ¥ / $ forward exchange rate is 109.50 and
the spot rate is ¥ / $ = 109.38
Quotations expressed in foreign currency terms :

(109.38 – 109.50)/109.50 x (360/90) X 100% = -0.44% (discount)
Quotations expressed in home currency terms :

(109.50 – 109.38)/109.38 x (360/90) X 100% = 0.44% (premium)

and Quotes
• Measuring a change in the spot rate for
quotations expressed in home currency terms
(direct quotations):
%∆ = Ending rate – Beginning Rate
Beginning Rate x 100
• Quotations expressed in foreign currency terms

(indirect quotations):
%∆ = Beginning Rate – Ending Rate x 100
Ending Rate

Exchange Rate Determination
Definition:
• Depreciation –
A decline in a currency’s value
• Appreciation –
The increase in a currency value.
• %  in foreign currency value = S – St-1

St-1
RM Exchange rates
Date USD GBP EUR JPY100 CHF AUD CAD
4/1/2010 3.4195 5.4999 4.8844 3.6866 3.2951 3.0656 3.2663
5/1/2010 3.3885 5.4507 4.8869 3.6766 3.2936 3.0918 3.2601
6/1/2010 3.3875 5.4137 4.8629 3.6861 3.2736 3.0950 3.2644
7/1/2010 3.3705 5.3970 4.8554 3.6574 3.2800 3.1088 3.2608
8/1/2010 3.3785 5.3857 4.8362 3.6217 3.2668 3.0932 3.2649
11/1/2010 3.3335 5.3643 4.8407 3.6145 3.2833 3.1057 3.2490
12/1/2010 3.3475 5.3814 4.8450 3.6285 3.2856 3.1005 3.2341
13/1/2010 3.3495 5.4155 4.8501 3.6792 3.2870 3.0911 3.2244
14/1/2010 3.3330 5.4291 4.8453 3.6333 3.2776 3.0987 3.2347
15/1/2010 3.3400 5.4524 4.8195 3.6645 3.2654 3.0977 3.2569

Date USD % EUR % AUD %

4/1/2010 3.41950 4.88440 3.06560
5/1/2010 3.38850 0.90657 4.88690 -0.05118 3.09180 -0.85465
6/1/2010 3.38750 0.02951 4.86290 0.49111 3.09500 -0.10350
7/1/2010 3.37050 0.50185 4.85540 0.15423 3.10880 -0.44588
8/1/2010 3.37850 -0.23735 4.83620 0.39544 3.09320 0.50180
11/1/2010 3.33350 1.33195 4.84070 -0.09305 3.10570 -0.40411
12/1/2010 3.34750 -0.41998 4.84500 -0.08883 3.10050 0.16743
13/1/2010 3.34950 -0.05975 4.85010 -0.10526 3.09110 0.30318
14/1/2010 3.33300 0.49261 4.84530 0.09897 3.09870 -0.24587
15/1/2010 3.34000 -0.21002 4.81950 0.53247 3.09770 0.03227

Exchange Rate Equilibrium
• Like any other products sold in markets, the

price of a currency is determined by the demand
for that currency relative to supply.
•At any point in time, a currency should exhibit

the price at which the demand for that currency
is equal to supply, and this represents the
equilibrium exchange rate.

Demand for a Currency

• The demand schedule is downward sloping
because foreigners (firms, individuals etc.) will
be encouraged to purchase more £ when the £ is
worth less, as this will require less foreign
currency to obtain the desired £.

Value of £
$1.60
$1.55
$1.50
D
Quantity of £
Demand Schedule for British Pounds

Supply for a Currency

• When the £ is valued high, British consumers
are more likely to purchase foreign goods.
•Thus, they supply a greater number of pounds
to the market, to be exchanged for the foreign
currency.

Value of £
$1.60
$1.55
$1.50
Quantity of £
Supply Schedule for British Pounds

Value of £
$1.60
$1.55
$1.50
D
Quantity of £
Equilibrium Exchange Rate Determination

Value of £
$1.60
$1.55
$1.50
D
Shortage
Quantity of £
Equilibrium Exchange Rate Determination - Shortage

Value of £
Surplus S
$1.60
$1.55
$1.50
D
Quantity of £
Equilibrium Exchange Rate Determination - Surplus

Impact of Liquidity
•The liquidity of a currency affects the
sensitivity/volatility of the exchange rates to
large transactions.
•If the currency’s spot market is liquid, its
exchange rate will not be highly sensitive to a
single purchase/sale of the currency.

Factors That Influence Exchange
Rates
e  f INF , INT , INC , GC, EXP

where
e  percentage change in the spot rate
INF  change in the differenti al between home and foreign country' s inflation
INT  change in the differenti al between home and foreign country' s interest rate
INC  change in the differenti al between home and foreign country' s income level
GC  change government controls
EXP  change in expectatio ns of future exchange rates

Rates
e  f INF , INT , INC, GC, EXP
INF – Relative Inflation rates
• The sudden jump in a home country’s inflation should cause

an increase in the demand of foreign goods (assuming that
both home and foreign firms sell goods that can serve as
substitutes to each other). This will lead to increase in the
demand for foreign currency.
•The increase in home country’s inflation should reduce

foreign desire for local goods and therefore will reduce the
supply of foreign currency for sale.

Value of £
S2
S
$1.60
$1.55
$1.50
D2
D
Quantity of £

Rates
INT – Relative Interest rates
• Changes in relative interest rates affect investment in foreign

securities, which influences the demand for and supply of
currencies and therefore influences exchange rates.
•Assume the home country’s interest rates rise while the
foreign interest rates remain constant. Local investors would
reduce their demand for foreign currencies since local interest
rate is higher. Demand 
•Foreign investors, will want to invest more in the home
country. Supply of foreign currency will increase as foreigners
invest more in financial instrument in home country. Supply 
Value of £
S
S2
$1.60
$1.55
$1.50
D
D2
Quantity of £

Rates
Real Interest rates
• A relatively high interest rate may reflect expectations of

relatively high inflation.
•High inflation can put a downward pressure on the local

currency.
•Fisher Effect
Real interest rate  Nominal interest rate – Inflation rate

Rates
INC - Relative Income Level
•Because income can affect the amount of imports demanded,

it can affect exchange rates.

Value of £
S
$1.60
$1.55
$1.50
D2
D
Quantity of £

Rates
GC - Government Controls
Government can influence the equilibrium exchange rate in

many ways:
1. Imposing foreign exchange barriers (i.e. Tobin tax)
2. Imposing foreign trade barriers
3. Intervening (buying/selling currencies) in the forex market
4. Affecting macro variables such as inflation, interest rates
and income levels.

Rates
EXP - Expectations
•Like other financial markets, forex markets react to news that

may have a future effect.
•1994 economic crisis in Mexico

•1997 Asian Financial Crisis
•1998 Russian financial crisis
•Argentine economic crisis (1999–2002)
•Financial crisis of 2007–2010

Rates
Financial factors
Trade-related factors

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Chapter 4

• The Foreign Exchange Market provides:

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-2

• Foreign exchange means the money of a

• The foreign exchange market spans the

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

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Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-6

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-8

• Individuals (such as tourists) and firms (such as

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-9

• Speculators and arbitragers seek to profit from

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-10

Buy £10 million from HSBC an

• Citibank quote - $/€ $0.9045/€

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-12

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

Dresdner Bank Barclays Bank

•A Chicago bank expects the exchange rate of the NZ$ to

•The bank is able to borrow US$20 million on a short-term basis

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•Borrow US$20 million in US.

•Interest that has to be paid to US bank is (US$20,000,000

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•What if the exchange rate is expected to be US$0.48 in 30

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a) support and maintain confidence in the policies for

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d) demonstrate the backing of domestic currency by

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• Foreign exchange brokers are agents who facilitate

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Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-23

• The rationale for such a transaction is to hedge currency

• In a currency swap, the notional principal in two different

– The currency swap will work as following:

• In April 2001, a survey conducted by the

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• However, this rate can also be stated as:

• Excluding two important exceptions, most

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• For quotations expressed in home currency

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Quotations expressed in foreign currency terms :

Quotations expressed in home currency terms :

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• Quotations expressed in foreign currency terms

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• %  in foreign currency value = S – St-1

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Date USD % EUR % AUD %

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• Like any other products sold in markets, the

•At any point in time, a currency should exhibit

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4-48

Demand for a Currency