The Market for Foreign Exchange

By Vijay Tita

Outline of the chapter

Objective of the chapter The meaning and background of the Foreign Exchange Market Function and structure of the FX market The spot Market The Forward Market

Objective of the Chapter

To provide an introduction to the organization and operation of the spot and forward foreign exchange market. This chapter provides institutional arguments of the foreign exchange market and details of how foreign exchange is quoted and traded worldwide.

Meaning of FX Market

The FX market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, trading in foreign currency options & futures contracts and currency swaps.

Background of the FX market

Largest financial market Remains open 24*7 and 365 days The BIS places worldwide daily trading of foreign exchange at $1.88 tn in 2004 London remains largest FX trading centre Trading volume in UK is estimated at $753 bn in 2004, 49% increase from 2001

Shares of reported global FX turnover by country in 2004

Country United kingdom United states Japan Share in % 31 19 8

Singapore Germany
Switzerland Hong kong Australia France Canada Netherlands Denmark Sweden Russia

5 5
3 4 3 3 2 2 2 1 1

Function of FX market
primary function is to assist clients in conduct of international commerce This function is an extension of one of the functions of a commercial banker

Structure of the FX market

The FX market can be viewed as two tier market : i) wholesale or interbank market ii) retail or client market Timings for three major market segments Foreign Exchange Market participants Corresponding Banking relationship

FX Market Participants
International banks Bank customers Nonbank dealers FX brokers Central banks

Corresponding Banking Relationship

The interbank market is a network of Correspondent Banking Relationship with large commercial banks maintaining demand deposit accounts with one another, called corresponding banking accounts. It allows for the efficient functioning of the FX market

The Spot Market

Spot rate quotations The Bid-Ask spread Spot FX trading Cross Exchange Rate quotations Alternative Expression for Cross Exchange Rate The cross rate Trading Desk Triangular Arbitrage Spot FX market Microstructure

The Spot Market (Cont)

Spot Rate quotations a) Direct Quotations (American terms) b) Indirect Quotations (European terms)

The Spot Market (Cont)

Example of Direct quotations from US perspective (dollars): Thursday spot quote for British pound is $1.9077 Example of Indirect quotations from US perspective (pounds): Thursday spot quote for British pound is 0.5242

The Spot Market (Cont)

The Bid-Ask spread Interbank FX traders buy currency for inventory at the bid price and sell from inventory at the higher offer or ask price. There is a reciprocal relationship between American and European bid and ask quotations

The Spot Market (Cont)

Spot Foreign Exchange Trading Spot quotations are good for only a few seconds. If a trader cannot immediately make up his mind whether to buy or sell at given prices, the quotes are likely to be withdrawn Interbank FX traders use abbreviations in expressing spot quotations big figure and small figure

The Spot Market (Cont)

Cross-Exchange Rate Quotations A cross exchange rate is an exchange rate between a pair where neither currency is the U.S. dollar It can be calculated from the U.S. $ exchange rates for the two currencies, using either European or American term quotations

The Spot Market (Cont)

For example, the / cross rate can be calculated from American term quotes

s(/) = s($/) / s($/) = 1.9077 / 1.3112 = 1.4549

The Spot Market (Cont)

For example, the / cross rate can be calculated from European term quotes

s(/) = s(/$) / s(/$) = 0.7627 / 0.5242 = 1.4550

The Spot Market (Cont)

The cross rate trading desk Banks frequently handle this trade for its customers by selling British pounds for U.S. dollars and then selling U.S. dollars for Swiss Francs. suppose a bank operates in more than one foreign currencies, its trading room would be organized with different currency trade desk Refer Example 5.2

The Spot Market (Cont)

Triangular Arbitrage opportunity it is the process of trading out of U.S. $ into a second currency, then trading it for a third currency, which in turn traded for U.S. $ The purpose is to earn arbitrage profit Refer Example 5.3

The Forward Market

Forward Rate Quotations Long and Short Forward positions (refer example 5.4) Forward Cross-Exchange Rates Swap Transactions Forward Premium

The Forward Market (cont)

Forward Rate Quotations it can be direct or indirect, one being the reciprocal of another from U.S. perspective direct quote is in American terms s($/SF)= 0.8470 f1($/SF)= 0.8485 f3($/SF)= 0.8517 f4($/SF)= 0.8573

The Forward Market (cont)

Swap Transactions it can be classified as outright or swap transactions an outright forward transaction is an uncovered speculative position in a currency, even though it might be a part of currency hedge to the bank customer to the other side of the transaction

The Forward Market (cont)

Swap Transactions Swap transaction is the simultaneous sale (purchase) of spot FX against forward purchase (sale) of approximately an equal amount of the foreign currency Refer Example 5.5

Thank You