THE FOREIGN

EXCHANGE
MARKET

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

LEARNING OBJECTIVES
•Explore the multitude of functions of the foreign exchange market
•Detail how the structure of the global currency market has been changing
•Describe the financial and operational transactions conducted in the
foreign exchange market
•Examine how the size of the global currency market has changed with
global economics
•Learn the forms of currency quotations used by currency dealers, financial
institutions, and agents of all kinds when conducting foreign exchange
transactions

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 Provides the physical and
institutional structure through which
Is the place where foreign exchange
the money of one country is
transactions are physically completed
exchanged for that of another
country

/
Facilitates the determination rate of
exchange between currencies

THE FOREIGN EXCHANGE MARKET

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET
 Foreign exchange transaction: an
agreement between a buyer and
Foreign exchange: the money of
a seller that a fixed amount of
a foreign country; i.e., foreign
one currency will be delivered
currency bank balances,
for a given amount of some
banknotes, checks, and drafts.
other currency at a specified
date.

THE FOREIGN EXCHANGE MARKET

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET
 Transfer Obtain or provide Minimize

purchasing power credit for international exposure to the risks

between countries; trade transactions; of exchange rate
changes

FUNCTIONS OF THE FOREIGN EXCHANGE MARKET

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET
MARKET PARTICIPANTS

1 2
The interbank or wholesale The client or retail market
market (multiples of US$1m (specific, smaller amounts).
or equivalent in transaction
size)

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

MARKET PARTICIPANTS
Bank and Speculators
Individuals
Nonbank and
and Firms
Dealers Arbitragers

Central banks
Brokers
and Treasuries

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

BANK AND NONBANK DEALERS
o Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
o The profit from buying foreign exchange at a “bid”
price and reselling it at a slightly higher “offer” or
“ask” price.
o Dealers in the foreign exchange department of
large international banks often function as “market
makers.”
o 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.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 INDIVIDUALS AND FIRMS
o Individuals (such as tourists) and firms (such as
importers, exporters, and MNEs) conduct
commercial and investment transactions in the
foreign exchange market.
o Their use of the foreign exchange market is
necessary but nevertheless incidental to their
underlying commercial or investment purpose.
o Some of the participants use the market to
“hedge” foreign exchange risk.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 SPECULATORS AND
ARBITRAGERS
o Speculators and arbitragers seek to profit from
trading in the market itself.
o They operate in their own interest, without a
need or obligation to serve clients or ensure a
continuous market.
o 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.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 CENTRAL BANKS AND
TREASURIES
o 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.
o 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.
o 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 their citizens.
o As willing loss takers, central banks and treasuries differ in motive
from all other market participants.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE BROKERS
oForeign exchange brokers are agents who
facilitate trading between dealers without
themselves becoming principals in the
transaction.
oDealers use brokers to expedite the transaction
and to remain anonymous, since the identity of
participants may influence short-term quotes.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 TRANSACTIONS IN
THE INTERBANK
MARKET

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

TRANSACTIONS IN THE INTERBANK MARKET
oA spot transaction in the interbank market is the
purchase of foreign exchange with delivery and
payment normally taking place on the second
following business day.
oThe date of settlement is referred to as the value
date.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 TRANSACTIONS IN THE INTERBANK MARKET
oAn 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.
oThe exchange rate is established at the time of
the agreement, but payment and delivery are
not required until maturity.
oForward exchange rates are usually quoted for
value dates of one, two, three, six and twelve
months.
oBuying forward and selling forward describe the
same transaction (the only difference is the
order in which currencies are referenced.)

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

TRANSACTIONS IN THE INTERBANK MARKET
oA swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates.
oBoth purchase and sale are conducted with the
same counterparty.
oSome different types of swaps are:
▪ Spot against Forward,
▪ Forward-Forward,
▪ Non-deliverable forwards (NDF).

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTATIONS

oA foreign exchange rate: the price of one

currency expressed in terms of another
currency.
oA foreign exchange quotation (or quote) is
a statement of willingness to buy or sell at
an announced rate.
CUR1/CUR2
Where: CUR1: base currency
CUR2: price currency

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTATIONS
Most foreign exchange transactions involve the U.S. dollar.
Professional dealers and brokers may state foreign exchange quotes
in one of two ways
◦ the foreign currency price of one dollar (European terms)
◦ the dollar price of one unit of foreign currency (American terms)

Most foreign currencies in the world are stated in terms of the

number of units of foreign currency needed to buy one dollar.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTATIONS
For example, the exchange rate between U.S. 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.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN CURRENCY QUOTATIONS

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTATIONS
oExceptions exist to the use of European terms quotes.
oThe two most important are quotes for the euro and U.K. pound sterling
which are both normally quoted in American terms.
oAmerican terms are also utilized in quoting rates for most foreign
currency options and futures, as well as in retail markets that deal with
tourists.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTATIONS
oForeign exchange quotes are at times described as either direct or
indirect.
oIn this pair of definitions, the home or base country of the currencies
being discussed is critical.
oDirect quote: home currency price of a unit of foreign currency.
oIndirect quote: a foreign currency price of a unit of home currency.
oThe form of the quote depends on what the speaker regards as
“home.”

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTATIONS
oInterbank quotations are given as a bid and ask (also referred to as offer).
oA bid is the price (i.e. exchange rate) in one currency at which a dealer will buy
another currency.
oAn ask is the price (i.e. exchange rate) at which a dealer will sell the other currency.
oDealers 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.
oA bid for one currency is also the offer for the other currency in the quote.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 BID, ASK and
MID-POINT
QUOTATION

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTES
oForward rates are typically quoted in terms of points.
oA forward quotation expressed in points is not a foreign exchange rate
as such.
oRather, it is the difference between the forward rate and the spot rate.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 Spot and Forward
Quotations for the
Euro and Japanese
Yen

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

SUMMARY
❑CUR1/CUR2
Where CUR1: unit/base currency
CUR2: price currency
❑European terms : the foreign currency price of one dollar
• Example: USD/EUR 0.8571 → 1USD = 0.8571EUR
❑American terms: the dollar price of one unit of foreign currency
• Example: EUR/USD 1.1666 → 1EUR = 1.1666USD

❑Direct quote: home currency price of a unit of foreign currency

• Example: EUR/USD 1.1666 if USD is home currency

❑Indirect quote: a foreign currency price of a unit of home currency.

• Example: EUR/USD 1.1666 if EUR is home currency

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTES
oForward quotations may also be expressed as the percent-per-annum
deviation from the spot rate.
oThis method of quotation facilitates comparing premiums or discounts
in the forward market with interest rate differentials.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTES
For quotations expressed in foreign currency terms (Indirect quotations) the formula is :
f ¥ = Spot – Forward x 360
Forward n x 100

Where n: the number of day

For quotations expressed in home currency terms (Direct quotations) the formula is:
f ¥ = Forward – Spot 360
Spot
x n x 100

Where n: the number of day

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTES

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTES
Percentage change in spot rate
For quotations expressed in foreign currency terms (Indirect quotations) the formula is :
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 −𝐸𝑛𝑑𝑖𝑛𝑔 𝑟𝑎𝑡𝑒
%∆= × 100
𝐸𝑛𝑑𝑖𝑛𝑔 𝑟𝑎𝑡𝑒

For quotations expressed in home currency terms (Direct quotations) the formula is:
𝐸𝑛𝑑𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 −𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑒
%∆= × 100
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑟𝑎𝑡𝑒

Example: The Mexican peso has changed recently in value from USD/MXN 22.4061 to 23.0000.
What is the percentage change in value of the Mexican peso? Given that the MXN is foreign
currency and USD is home currency.

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 FOREIGN EXCHANGE RATES AND QUOTES
oMany currency pairs are only inactively traded, so their exchange rate is
determined through their relationship to a widely traded third currency (cross
rate).
oExample: Given USD/JPY 118.79 and USD/MXN 14.8638

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

Key Currency Rate Calculations for January 3, 2012

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE RATES AND QUOTES
oCross rates can be used to check on opportunities for intermarket
arbitrage.
oFor instance, one bank’s (Dresdner) quotation on €/£ is not the
same as a calculated cross rate between $/£ (Barclay’s) and $/€
(Citibank), below.
◦ Citibank quote - $/€ - $1.3297/€
◦ Barclays quote - $/£ - $1.5585/£
◦ Dresdner quote - €/£ - €1.1722/£

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

INTERMARKET ARBITRAGE
Citibank quote - $/€ - $1.3297/€
Barclays quote - $/£ - $1.5585/£
Dresdner quote - €/£ - €1.1722/£
Cross rate calculation:
=
1.1721/
Because the rates are unequal, a triangular arbitrage opportunity exists
One approach– use $ to buy £; use £ to buy €; use € to buy $

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET

 Triangular
Arbitrage by a
Market Trader

INTERNATIONAL FINANCE – CHAPTER 5 – THE FOREIGN EXCHANGE MARKET