CHAPTER 5 another via a network of telephones,

computer terminals, and automated

THE MARKET FOR FOREIGN EXCHANGE
dealing systems.

"MONEY REPRESENTS PURCHASING

"The Mouse Takes Over the Floor."
POWER"
THE FX MARKET PARTICIPANTS

The market for foreign exchange can be

The market for foreign exchange is the
viewed as a two-tier market. One tier is
largest financial market in the world by
the wholesale or interbank market and
virtually any standard. It is open
the other tier is the retail or client market.
somewhere in the world 365 days a year,
24 hours a day.

THE FX MARKET PARTICIPANTS

FUNCTION AND STRUCTURE OF THE FX FX market participants can be

MARKET categorized into five groups:

The structure of the foreign exchange • international banks

market is an outgrowth of one of the
• bank customers
primary functions of a commercial
banker: to assist clients in the conduct of • nonbank dealers
international commerce.
• FX brokers
• central banks.
FUNCTION AND STRUCTURE OF THE FX
MARKET
INTERNATIONAL BANKS
The spot and forward foreign exchange
markets are over-the-counter (OTC) International banks provide the core of
markets. The foreign exchange market is the FX market. Approximately 100 to 200
a worldwide linkage of bank currency banks worldwide "make a
actively
traders, nonbank dealers, and FX brokers, market" in foreign exchange, that is, they
who assist in trades, connected to one stand willing to buy or sell foreign
currency for their own account influence the price of its currency against
that of a major trading partner, or a
country that it "fixes" or "pegs" its
BANK CUSTOMERS currency against.

These international banks serve their

retail clients, the bank customers, in
CORRESPONDENT BANKING
conducting foreign commerce or making
RELATIONSHIPS
international investment in financial
assets that require foreign exchange. The interbank market is a network of
correspondent banking relationships,
with large commercial banks maintaining
NONBANK DEALER demand deposit accounts with one
another, called correspondent banking
Nonbank dealers are large nonbank
accounts. The correspondent bank
financial institutions whose size and
account network allows for the efficient
frequency of trades make it cost-
functioning of the foreign exchange
effective to establish their own dealing
market
rooms to trade directly in the interbank
market for their foreign exchange needs.

SPOT MARKET

FX BROKERS The spot market involves almost the

immediate purchase or sale of foreign
FX brokers match dealer orders to buy
exchange. Typically, cash settlement is
and sell currencies for a fee, but do not
made two business days (excluding
take a position themselves. Brokers have
holidays of either the buyer or the seller)
knowledge of the quotes offered by
after the transaction for trades between
many dealers in the market.
the U.S. dollar and a non-North American
currency. For regular spot trades

CENTRAL BANKS between the U.S. dollar and the Mexican

peso or the Canadian dollar, settlement
The central bank (national monetary takes only one business day.
authority) has intervened in the foreign
exchange market in an attempt to
SPOT RATE QUOTATION
Spot rate currency quotations can be
stated in direct or indirect terms. To
understand the difference, let's refer to
Exhibit 5.4. The exhibit shows currency
quotations by bank dealers from ICAP
and other sources as of 4:00 p.m.
eastern time for Wednesday, June 5,
2013..
1. Direct Quotation
The first column provides direct
quotations from the U.S. perspective,
that is, the price of one unit of the foreign
currency in U.S. dollars. For example, the
spot quote for one U.K. pound was
$1.5405. (Forward quotations for one-,
three-, and six-month contracts, which
will be discussed in a following section,
appear directly under the spot quotations
for five currencies.)
2. Indirect Quotation
The second column provides indirect
quotations from the U.S. perspective,
that is, the price of one U.S. dollar in the
foreign currency.
For example, we see that the spot quote
for one dollar in U.K. pound sterling was
£0.6491. Obviously, the direct quotation
from the U.S. perspective is an indirect
quote from the British viewpoint, and the
indirect quote from the U.S. perspective
is a direct quote from the British
viewpoint.
Most currencies in the interbank market
are quoted in European terms, that is, the
U.S. dollar is priced in terms of the
foreign currency (an indirect quote
fromthe U.S. perspective). By convention,
however, it is standard practice to price
certain currencies in terms of the U.S.
dollar, or in what is referred to as
American terms (a direct quote from the
U.S. perspective). Prior to 1971, the
British pound was a nondecimal currency;
that is, a pound was not naturally
divisible into 10 subcurrency units. Thus,
it was cumbersome to price decimal
currencies in terms of the pound.
CROSS-EXCHANGE RATE
is an exchange rate between a currency
pair where neither currency is the US
Dollar the cross-exchange rate can be
calculated from the U.S. Dollar exchange
rates for the two currencies, using either
European or Americanterm quotations.
EXAMPLE: Suppose the exchange rate
between the euro and the United States
dollar is €0.8477 per $1. Further suppose
that the exchange rate between the
Japanese yen and the United States
dollar is ¥112.2145 per $1. What is the
exchange rate between the Japanese yen
and the euro in terms of Japanese yen
per euro?
ALTERNATIVE EXPRESSION FOR THE
CROSS EXCHANGE RATE
It is easier to think of cross-exchange
rates calculated as the PRODUCT of an
American term and European term
exchange rate rather than as
QUOTIENT of two American term or two
Europeanbterm exchange rates.
THE BID-ASK SPREAD
• bid price - price to buy
• ask price - price to sell
SPOT FX TRADING
WHAT IS SPOT FX?
it is the purchase or sale of forex 'on the
spot', which means the exchange takes
place at the exact point that the trade is
settled.
KEEP THIS THREE THINGS IN MIND
WHEN IT COMES TO SPOT FOREX
TRADING..
1. you're always trading a currency pair
with spot FX
2. you can buy or sell spot FX markets
3. you can speculate on currency
markets with lower spreads
THE CROSS-RATE TRADING DESK
• When the exchange rate between 2
currencies where neither currency is the
US Dollar.
the
• Cross rate must be internally consistent;
otherwise arbitrage profit exist.
TRIANGULAR ARBITRAGE
• Triangular Arbitrage is the process of
trading out of the U.S dollar into a
second currency, then trading it for a
third currency, which is in turn traded for
U.S dollar.
• The purpose is to earn an arbitrage
profit via trading from the second to the
third currency when the direct exchange
rate between the two is not in alignment
with the cross-exchange rate
SPOT FOREIGN EXCHANGE – Dominguez
MICROSTRUCTURE
• Confirmed their findings.
Market microstructure refers to the basic
mechanics of how a marketplace
operates. THE FORWARD MARKET

The forward market involves contracting

today for the future purchase or sale of
FIVE EMPIRICAL STUDIES ON FX
foreign exchange.
MARKET

THE FORWARD PRICE

– Huang and Masulis (1999)
The forward price may be the same as
• They concluded that dealer competition
the spot price, but usually it is higher (at
is a fundamental determinant of the spot
a premium) or lower (at a discount) than
FX bid- ask spread.
the spot price
– Lyons (1998)
• He determined that the dealer's profits
THE FORWARD MATURITY
came primarily from the dealer's role as
an intermediary. • Bank quotes for maturities of 1, 3, 6, 9,
and 12 months are readily available.
– Lyons & Melvin (1998)
• Quotations on nonstandard, or broken-
• Their study provides evidence against
term, maturities are also available.
the common view that private
information is irrelevant, since all market • Maturities extending beyond one year
participants are assumed to possess the are becoming more frequent, for good
same set of public information. bank customers, a maturity extending
out to 5, and even as long as 10 years, is
– Cheung & Chinn (2001)
possible.
• The purpose of their survey was to elicit
information about several aspects of
exchange rate dynamics not typically THE FORWARD RATE QUOTATIONS
observ- ab trading data.
Forward Rate quotations appear directly S(S/SF) 1.0614
under the spot rate quotations for five
F(S/SF) 1.0617
major currencies for one-, three-, and six-
month maturities. F(S/SF) 1.0624

EXAMPLE: The settlement date of a F($/SF) = 1.0636

three- month forward transaction is three
calendar months from the spot
settlement date for the currency. THE FORWARD RATE QUOTATIONS

________ European term forward quotations are

the reciprocal of the American term
Today is Wednesday, June 5, 2013
quotes. In European terms, the
Spot settlement is June 7 corresponding Swiss franc forward
quotes to those stated above are:
Forward settlement date would be
September 9, 2013 (since September 7 S(SF/S)=9421
falls on a Saturday)
F(SF/S)=.9418
________
F(SF/S)=.9412

F(SF/S)=9402
THE FORWARD RATE QUOTATIONS

Forward quotes are either direct or

LONG AND SHORT FORWARD
indirect, one being the reciprocal of the
POSITIONS
other. From the U.S. perspective, a direct
forward quote is in American terms. As • One can buy (take a long position) or
an example, let's consider the American sell (take a short position) foreign
term Swiss franc forward quotations in exchange forward.
relationship to the spot rate quotation for • Bank customers can contract with their
Wednesday, June 5, 2013. We see that: international bank to buy or sell a
specific sum of freely traded FX for
delivery on a certain date.

• Likewise, interbank traders can

establish a long or short position by
dealing with a trader from a competing
bank
If one uses the forward contract, he has
"locked in" the forward price for forward
purchase or sale of foreign exchange
Non- Deliverable Forward Contracts
• The NDF contract is cash-settled,
mostly in US Dollars, on the due date
(maturity)
• The settlement happens to depend
upon the spot rate on maturity and the
agreed forward rate
• And the settlement will result in either a
net receipt or a net paymen between the
parties to the contract
Forward Cross- Exchange Rates
A forward cross- exchange rate is a
prediction of what the exchange rate
between the two currencies will be at a
future date.
Forward Premium
• Forward premium refers to the
difference between the spot exchange
rate and the forward exchange rate of
two currencies.
• It represents the cost or benefit of
buying or selling a currency forward,
compared to buying or selling it in the
spot market.
• If the forward exchange rate is higher
than the spot exchange rate, the currency
is said to be trading at a forward
premium.
• if the forward exchange rate is lower
than the spot exchange rate, the currency
is said to be trading at a forward
discount.
OUTRIGHT FORWARD TRANSACTION
a type of transaction where two parties
agree to buy or sell a given amount of
currency at a predetermined rate at some
point in the future.
SWAP TRANSACTION
is the simultaneous sale (or purchase) of
A DAY spot foreign exchange against a
forward purchase (or sale) of
approximately an A B equal amount of
the foreign currency.
UNDERLYING ASSETS:

• STOCKS
• OIL FUTURES
• FOREIGN CURRENCIES
• BONDS

EXCHANGE TRADED FUND (ETF)

An exchange-traded fund (ETF) is a

portfolio of financial assets in which
shares representing fractional ownership
of the fund trade on an organized
exchange.