Importance of

Foreign Exchange Market Trading

l  Origins of the Market

l  International trade - No single currency is particularly
efficient as a medium of exchange.
l  International investment - Foreign assets are an
alternative store of value. They may also serve to offset
certain financial risks. Some of their features may not be
available domestically too.
l  Speculation - The aim is purely to earn higher returns.
FX Market Participants

l  FOREX market can be viewed as a two-tier market:

n  Wholesale or interbank market (87% of trading volume)
n  Retail or client market (13% of trading volume)
l  89% of currency trading in the world involved the US
dollar on one side of the transaction in 2004.
Spot Rate Market

l  The spot market involves almost the immediate purchase or sale of

foreign exchange.
l  Typically, cash settlement is made two business days after the
transaction for trades between the US dollar and non-North
American currency.
l  For regular spot trades between the US and the Canadian dollar,
settlements takes only 1 business day.
l  A spot contract is a binding commitment for an exchange of funds,
with normal settlement and delivery of bank balances following in
two business days (one day in the case of North American
currencies).
Spot Rate Quotations

l  Direct quotation
n  Price of foreign currency in terms of domestic currency.
l  Indirect Quotation
n  Price of domestic currency in terms of foreign currency.
n  e.g. the price of a Canadian dollar in the foreign currency.
Spot Rate Quotations

l  Most currencies in the interbank market are quoted in

European terms, that is, the US dollar is priced in terms
of foreign currency (indirect quote from US perspective).
l  By convention, however, it is standard practice to price
certain currencies in terms of the US dollar (in American
terms) i.e., the Euro and the Australian dollar.
Spot Rate Quotations (from US perspective)

USD
equiv USD equiv Currency per USD Currency per
Country Friday Thursday Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
Brazil (Real) 0.2939 0.2879 3.4025 3.4734 The direct
Britain (Pound) 1.5627 1.566 0.6399 0.6386 quote for
1 Month Forward 1.5596 1.5629 0.6412 0.6398 British
3 Months Forward 1.5535 1.5568 0.6437 0.6423 pound is:
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
£1=$1.5627
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975
Spot Rate Quotations (from US perspective)

USD equiv USD equiv Currency per USD Currency per

Country Friday Thursday Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 The indirect

Brazil (Real) 0.2939 0.2879 3.4025 3.4734
quote for
Britain (Pound) 1.5627 1.566 0.6399 0.6386 British
1 Month Forward 1.5596 1.5629 0.6412 0.6398
pound is:
3 Months Forward 1.5535 1.5568 0.6437 0.6423
£.6399 = $1
6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

Spot Rate Quotations (from US perspective)

USD equiv USD equiv Currency per USD Currency per

Country Friday Thursday Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 Note that the

Brazil (Real) 0.2939 0.2879 3.4025 3.4734 direct quote is
Britain (Pound) 1.5627 1.566 0.6399 0.6386 the reciprocal
1 Month Forward 1.5596 1.5629 0.6412 0.6398 of the indirect
3 Months Forward 1.5535 1.5568 0.6437 0.6423 quote:
6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1

1.5627 =
1 Month Forward 0.6681 0.6741 1.4968 1.4835 .6399
3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

The Bid-Ask Spread

l  The bid price is the price a dealer is willing to pay you

for something.
l  The ask price is the amount the dealer wants you to pay
for the thing.
l  The bid-ask spread is the difference between the bid and
ask prices.
Spot FX trading

l  Interbank bid-ask spreads are very small.

l  Retail bid-ask spread is wider than interbank spread. This
is to cover transaction costs.
l  In the interbank market, the standard size trade is about
U.S. $10 million or “ten dollar” in trader jargon.
l  Spot quotations are good for only few seconds.
Depreciation and Appreciation

l  Depreciation is a decrease in the value of a currency relative to

another currency.
n  A depreciated currency is less valuable (less expensive) and therefore
can be exchanged for (can buy) a smaller amount of foreign currency.
n  $1/€1 ! $1.20/€1 means that the dollar has depreciated relative to the
euro. It now takes $1.20 to buy one euro, so that the dollar is less
valuable.
n  The euro has appreciated relative to the dollar:
it is now more valuable.
Depreciation and Appreciation (cont.)

l  Appreciation is an increase in the value of a currency relative to

another currency.
n  An appreciated currency is more valuable (more expensive) and
therefore can be exchanged for (can buy) a larger amount of foreign
currency.
n  $1/€1 ! $0.90/€1 means that the dollar has appreciated relative to the
euro. It now takes
only $0.90 to buy one euro, so that the dollar is more valuable.
n  The euro has depreciated relative to the dollar:
it is now less valuable.
Depreciation and Appreciation (cont.)

l  A depreciated currency is less valuable, and therefore it can buy fewer

foreign produced goods that are denominated in foreign currency.
n  How much does a Honda cost? ¥3,000,000
n  ¥3,000,000 x $0.0098/¥1 = $29,400
n  ¥3,000,000 x $0.0100/¥1 = $30,000
l  A depreciated currency means that imports are more expensive and
domestically produced goods and exports are less expensive.
l  A depreciated currency lowers the price of exports relative to the price of
imports.
Depreciation and Appreciation (cont.)

l  An appreciated currency is more valuable, and therefore it can buy more

foreign produced goods that are denominated in foreign currency.
n  How much does a Honda cost? ¥3,000,000
n  ¥3,000,000 x $0.0098/¥1 = $29,400
n  ¥3,000,000 x $0.0090/¥1 = $27,000
l  An appreciated currency means that imports are less expensive and
domestically produced goods and exports are more expensive.
l  An appreciated currency raises the price of exports relative to the price of
imports.
Cross Rates

l  A cross-exchange rate is an exchange rate between a

currency pair where neither currency is the US dollar.
l  The cross-exchange rate can be calculated from the US
dollar exchange rates for the two currencies.
Cross Rates
Cross Rates

l  Suppose that S = .50 $/€

n  i.e. $1 = 2 €
l  And that S = .01$/¥
n  i.e. $1 = ¥ 100
l  What must the € /¥ cross
rate be?
€ $ $
since = / ,
¥ ¥ €
$1 $1 €1
/ = ⇒ S = .02€ / ¥ or €1 = ¥50
¥100 €2 ¥50
Cross Rates

l  If a customer wants to trade out a British pound into

Swiss francs, the bank will handle this trade by selling
British pounds for dollars and buying Swiss francs for
dollars
l  A vehicle currency is one that is widely used to
denominate international contracts made by parties who
do not reside in the country that issues the vehicle
currency.
l  Since in 2004, nearly ninety percent of foreign exchange
transactions involve exchanges of foreign currencies for
U.S. dollars; therefore, it is considered a vehicle currency.
Types of Trading Activities

l  Speculation entails more than the assumption of a risky

position. It implies financial transactions undertaken
when an individual’s expectations differ from the
market’s expectation.
l  Arbitrage is the simultaneous, or nearly simultaneous,
purchase of securities in one market for sale in another
market with the expectation of a risk-free profit.
Triangular Arbitrage

l  Ignoring transaction costs, the prices for any three

currencies A, B, & C must be consistent:
A = A × B
C B C
l  If the above relation does not hold, then profit
opportunities will be available based on triangular
arbitrage.
Triangular Arbitrage

l  If the direct quotes are not consistent with cross-

exchange rates, a triangular arbitrage profit is
possible.
l  Triangular arbitrage is the process of trading out
US dollar into a second currency, then trading it
for a third currency, which is in turn, traded for
US dollars.
Triangular Arbitrage

Suppose we
$
observe these
banks posting Barclays
Credit Lyonnais
these exchange S(¥/$ )=120
S(£/$)=1.50
rates.

¥ Credit Agricole
First calculate £
the implied cross S(¥/£)=85
rates to see if an
arbitrage exists.
Triangular Arbitrage

The implied S(¥/£) cross $

rate is S(¥/£) = 80 Barclays
Credit Lyonnais
S(¥/$)=120
S(£/$)=1.50
Credit Agricole has
posted a quote of S(¥/ Credit Agricole
£)=85 so there is an ¥ £
arbitrage opportunity. S(¥/£)=85
£1.50 $1 £1
So, how can we make money? × =
$1 ¥120 ¥80
Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.
Triangular Arbitrage

As easy as 1 – 2 – 3: $
1. Sell our $ for £, Barclays
Credit Lyonnais
2. Sell our £ for ¥, S(¥/$)=120
3 1 S(£/$)=1.50
3. Sell those ¥ for $.
2
¥ Credit Agricole
£
S(¥/£)=85
Triangular Arbitrage

Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
The Forward Market

l  Forward Rate Quotations

l  Long and Short Forward Positions
l  Forward Cross Exchange Rates
l  Swap Transactions
l  Forward Premium
The Forward Market

l  A forward contract is an agreement to buy or sell an asset in the

future at prices agreed upon today.
l  A forward contract, or outright forward, is an agreement made today
for an obligatory exchange of funds at some specified time in the
future (typically 1,2,3,6,12 months).
l  If you have ever had to order an out-of-stock textbook, then you have
entered into a forward contract.
l  The forward price may be the same as the spot price, but usually it is
higher (at a premium) or lower (at a discount) than the spot price.
Forward Rate Quotations

l  The forward market for FOREX involves agreements to

buy and sell foreign currencies in the future at prices
agreed upon today.
l  Bank quotes for 1, 3, 6, 9, and 12 month maturities are
readily available for forward contracts.
l  Forward contracts typically involve a bank and a
corporate counterparty and are used by corporations to
manage their exposures to foreign exchange risk.
Forward Rate Quotations

l  Consider the example from above:

l  for the British pound, the spot rate is
l  $1.5627 = £1.00
l  While the 180-day forward rate is
l  $1.5445 = £1.00
l  What’s up with that?
Spot Rate Quotations

USD equiv USD equiv Currency per USD Currency per

Country Friday Thursday Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Clearly the
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
market
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
participants
Britain (Pound) 1.5627 1.566 0.6399 0.6386
expect that
1 Month Forward 1.5596 1.5629 0.6412 0.6398
the pound
3 Months Forward 1.5535 1.5568 0.6437 0.6423
will be worth
6 Months Forward 1.5445 1.5477 0.6475 0.6461
less in dollars
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
in six months.
1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

Forward Rate Quotations

l  From Bristish perspective, the US dollar is trading at a

forward premium to the British pound and that the
premium increases out to six months.
l  The forward premium is greater the higher the further the
forward contract settlement date.
l  The forward market is pricing in a weakening of the
British pound vis-à-vis the US dollar.
l  In indirect terms, the British pound is trading at a forward
discount to the US dollar and that the discount increases
out to six months.
Long and Short Forward Positions

l  If you have agreed to sell anything (spot or forward) you

are “short”.
l  If you have agreed to buy anything (forward or spot) you
are “long”.
l  If you have agreed to sell forex forward, you are short.
l  If you have agreed to buy forex forward, you are long.
Foreign Exchange Market
Products and Activities
The Relationship between Spot and Forward Contracts
time dimension
Jan 1 Jul 1
US$
 borrow US$ at i$
B A
lend US$ at i$
currency dimension

Option 2 Option 1
‚ buy € sell €
buy € sell € forward forward
spot at spot at
at F at F
S S
A manager
wishes to
€ borrow € at i€ D own € on
C July 1.
ƒ lend € at i€
Summary

l  Foreign exchange markets:

n  Allow the conversion of purchasing power from one currency to
another;
n  Enables banking and credit across currencies, foreign trade
financing and trading in foreign currency futures and options;
l  Trading in the spot market involves immediate purchase
and sale of currencies;
l  In the forward market, buyers and sellers can enter into
agreements to buy or sell currencies at a future date and a
forward price.