FOREX Markets

SESSION OUTLINE
 Foreign Exchange Market & Participants
 Structure of FOREX Market
 Exchange Rates
 Spot Quotes
• Direct Quotes & Indirect Quotes
• European Terms & American Terms
• Bid Ask Rate, Spread, Spread %
• Cross Rate, Cross Rate Calculation
 FOREIGN EXCHANGE
 Functions of Money:
• Unit of account
• Store value
• Medium of exchange
 When it comes to Foreign Exchange, it creates additional
issues to be addressed.
 Foreign Exchange: It is the money of a foreign country
represented in bank balances, bank notes, cheques, drafts.
• Home currency: Currency of country the person is residing
• Foreign currency: All other currencies
 Foreign Exchange transaction: Is an agreement between
a buyer and seller that a fixed amount of one currency will
be delivered for some other currency at a specified rate.
 FOREIGN EXCHANGE MARKET
 Knowledge & operation of and mechanics of foreign exchange
markets is important for fundamental understanding of
international financial management.
 Foreign Exchange market: Physical and institutional structure
through which the money of one country is exchanged for that of
another country.
• It is a mechanism by which participants transfer purchasing power
between countries, by exchanging money, obtain or provide credit for
international transactions and minimize exposure to the risks of
exchange rate fluctuations.
 Simply put:
• Foreign exchange market is the market in which participants are able to
buy, sell, exchange and speculate on currencies.
• Foreign exchange market is a global decentralized or over-the-
counter market for the trading of currencies.
 IMPORTANCE OF FOREX MARKET
 International trade & capital transactions normally involve parties with
difference national currencies. But the transactions can be undertaken
in only currency.
 Hence one party has to deal in a foreign currency and manage the
effects of such dealing.
 International goods movement takes time (i.e. in transit) and needs to
be financed. Forex market provides the sources of financing.
 Provide hedging facilities for transferring foreign exchange risks to
some one else who is willing to carry the risks, at a price.
 International travellers need to exchange their home currency to
obtain foreign (local) currency so that they can spend while in that
foreign country.
STRUCTURE OF FOREX MARKET
 PARTICIPANTS OF FOREX MARKET
 Central Banks
 Major commercial banks
 Investment banks
 Corporations for international business transactions
 Hedge funds
 Pension and mutual funds
 Insurance companies
 Forex brokers
 Speculators
 FOREX MARKET
 The structure of the Forex market is rather unique because
it is a massive Over-the-Counter (OTC) market and is
independent of any centralized exchange as in the case of
stock markets.
 This market determines the foreign exchange rate.
 It includes all aspects of buying, selling and
exchanging currencies at current or determined (forward)
prices.
 The foreign exchange market – also called forex, FOREX, or
currency market – trades currencies.
 It is considered to be the largest financial market in the
world. 
 Aside from providing a floor for the buying, selling,
 BENEFITS OF USING THE FOREX MARKET
 Fewer rules, which means investors aren't held to strict
standards or regulations as those in other markets. 
 No clearing houses and no central bodies that oversee the
forex market. 
 Market is open 24 hours a day, you can trade at any time of
day, which means there's no cut off time to be able to
participate in the market.
 You can get in and out whenever you want and you can buy
as much currency as you can afford. However, many
countries do have restrictions on foreign exchange
transactions by its residents as well as non-residents.
 THE BIGGEST IN THE WORLD OF
FINANCE
 The foreign exchange market is unique for several reasons,
mainly because of its size.
 Trading volume in the forex market is generally very large
because of the number of people who participate, the ease
of trading as well as accessibility to the market.
 As an example, trading in foreign exchange markets
averaged $ 6.60 trillion per day in 2019. This was up 66%
from almost a decade ago in 2010.
 The Bank for International Settlements, which is owned by
60 central banks, conducts a triennial survey of currency
trading, the latest one being in 2019.
• Look up www.bis.org
AVG. DAILY FOREX TRADE VOLUMES (US
$M)
7,000 7,000
6,595
298
108
6,000 6,000

5,357
337
5,000 54 5,066 5,000
254
82
3,203

4,000 4,000
2073,973 2,240
43
2,378
2123,324
3,000 31 3,000
1,759

679 999
1,714
2,000 1,934 700 2,000
119
21 475
954
362
1,000 2,047 1,987 1,000
209 1,489 1,652
1,005
631
... ...
2004 2007 2010 2013 2016 2019

Spot transactions Outright forwards Foreign exchange swaps

Currency swaps Options and other products² Foreign exchange instruments
% SHARE OF TOP 10 CURRENCIES

100.0

90.0

80.0

70.0

60.0

50.0

40.0

30.0

20.0

10.0

...
USD EUR JPY GBP AUD CAD CHF CNY³ HKD³ NZD³

2010 2019
 FOREX MARKET CHARACTERISTICS
 The forex market has unique characteristics and properties
that make it an attractive market for investors who want to
optimize their profits.
 Open 24 Hours a Day, 5 Days a Week.
 In the forex market, as one major forex market closes
(timing), another market in a different part of the world
opens for business.
 Unlike stocks, the forex market operates 24 hours daily
except on weekends.
TWO-TIERED WITH MULTIPLE PARTICIPANTS
RETAIL & WHOLESALE
 Although the market is two-tiered, retail and wholesale
markets connect through market makers who serve retail
clients and participate in wholesale market.
WHY DO MARKET PARTICIPANTS TRADE?
 OPERATION OF FOREX MARKET
 Time and Day of operation
 Currency of operation – mostly USD
 Trading platforms
• Personal – individual to individual. In India, not permitted to deal in this
manner.
• Official trading floors by open bidding – no longer being used
• Electronic platforms – most common
 Settlement of transactions:
• SWIFT: Society for Worldwide Interbank Financial Telecommunications. Used
by over 25,000 financial institutions in over 210 countries. SWIFT is the
platform for communication between banks.
• CHIPS: Clearing House Interbank Payment Settlement. Owned by 12 private
commercial banks in US to enable daily settlement of US $ transactions. Is
easy since over 60% of world wide forex transactions are in US$ and
maintained/ settled in NY.
 SWIFT – CHIPS EXAMPLE

1. BOI sells US $ 1 Mln to SBI

• BOI has maintained a US $ A/c with American Express NY.
• SBI has maintained a US $ A/c with Citibank NY.
2. BOI sends a SWFT message to Amex for the sale
• Amex Dr. BOI and CR. Citibank and send electronic cheque
through CHIPS to Citi
3. Citi receives electronic cheque through CHIPS
• Citi Dr. Amex and Cr. SBI
• Citi sends SWIFT message to SBI

 CHIPS calculates net balances at 6PM every day and pays

off/ settles.
 APPRECIATION & DEPRECIATION
 Changes in exchange rates is that they are relative prices.
 Consequently, there are always two ways to describe the same
situation.
 After the change in the exchange rate, it will always be true that it
takes relatively less of one currency to purchase the other currency
and relatively more of the latter currency to purchase the former.
 The terms appreciation and depreciation are typically used to
describe changes in exchange rates when exchange rates are
allowed to be flexible – that is, to fluctuate freely in response to
changes in demand and supply.
 The rate of appreciation or depreciation of one currency relative to
another can be calculated as the percentage rate of change of the
exchange rate
• = (New exchange rate - Old exchange rate)/ Old exchange rate
 APPRECIATION & DEPRECIATION
 Consider an example.
 Suppose the exchange rate between the dollar and the yen
changes from ¥120/$ to ¥100 /$.
• Yen has strengthened / appreciated (USD is weakened &
depreciated)
• How much did ¥ gain/ lose?
• How much did $ lose/ gain?
 INR 72 / USD to INR 72.50 / USD
• Rupee has appreciated or depreciated?
• How much did INR gain/ lose?
• How much did $ lose/ gain?
 FOREX SPOT MARKET
 The spot market involves the immediate purchase or sale of
foreign exchange.
• Cash settlement occurs mostly 2 days from the date of transaction.
• Hence Spot is T+2
• Same day = Today
 Some currency pairs may settle earlier even if they are on Spot.
• USD-CAD; USD-TRY are T+1
• RUB-RMB also settle in T+1 and may settle in T+0
 Contract made on
• Mon; settles on Wed
• Thurs; settles on Mon
• Fri; settles on Tue
 Legal holidays, Saturday and Sundays in either currencies are
excluded.
 FOREX SPOT MARKET
 Currencies are typically quoted against the US dollar.
 Interbank FOREX traders
• Buy currency for their inventory at the bid price.
• Sell currency from their inventory at the ask price.
 Bid Price = Price at which Bank is willing to BUY
 Ask Price = Price at which Bank is willing to SELL
 Quotes are 2 ways that is they quote Bod and Ask, as
follows:
• USD 1 = INR 70.5230/ 70.5650
• The first price is Bid and the second is Ask
 Bid price is always < Ask price
 BID – ASK
 Bid – Ask spread is a transaction cost for trader and profit for
the market maker.
 USD 1 = INR 70.5230/ 70.5650
 You can buy $ 1 from bank at Rs. 70.5650 (Bank sells to you,
hence Bank’s Ask)
 You can sell $ 1 to bank at Rs. 70.5230 (Bank buys from you,
hence Bank’s Bid)
 Spread = 70.5650-70.5230 = 0.0420
 Spread % = (Ask-Bid)/ Ask = 0.0420/ 70.5650 = 0.06%
 Bid for one currency is the Ask (of offer) for the opposite
currency.
 It is important to note that the quotes must be read from the
dealer/ bank’s perspective.
 EXCHANGE RATES, CODES
 An exchange rate is the relative price of two monies.
 Rather than write out the full name of these currencies, contractual
parties use abbreviations.
 In banking and commercial transactions, it is important that all parties
understand which currencies are being used.
 Hence, there is a need for standardization of the abbreviations.
 The International Organization for Standardization (called ISO from the
Greek word for equal)
 Currency code notations can be symbols or three digit codes for every
country. For ex:
• India INR Re (or ₹)
• USA USD $
• Europe EUR €
 The 3 digit codes are standardized using ISO codes.
 Applicable standard is ISO 4217:2008.
 QUOTATION NOTATION
 Quotes used by traders can be quite confusing. Please note
we don’t
 Quotes given by traders / Google : use this
• EUR / USD = 1.11713 or EURUSD =1.11713 notation

 Mathematically it is correct to express : USD1.11713/EUR

• Meaning USD 1.11713 per EUR (or 1 EUR = USD 1.11713)
 Currency quotes are given as:
CUR 1/ CUR 2
Cur 1: Base or Unit or Named currency
CUR 2: Price or Quote or Terms currency
 DIRECT & INDIRECT QUOTES
 Direct Quote:
• A direct quote gives the price of one unit of foreign currency
expressed in so many units of home currency. (That is 1 FC = X
units of HC)
 INR 71.2880 / USD => 1 USD = INR 71.2880 (In India)
 Observe that the quote is 1 USD (FC) costs INR 71.2880 (HC)
 A quote of USD 1= INR 71.2880 still remains a Direct Quote
because it is expressing the no. of units of HC for 1 unit of FC

 Indirect Quote:
• An Indirect quote gives the price of one unit of home currency
expressed in so many units of foreign currency units. (That is 1
HC = X units of FC)
 USD 0.01398/ INR => 1 INR = USD 0.01398 (In India)
 Observe that the quote is 1 INR (HCC) costs USD 0.01398 (FC)
 QUOTES
 It is important to understand the quote logic rather than
which currency is appearing first. But quote convention
must be followed depending on whom the bank is
quoting to.
 Quote conventions used when USD is involved, are of 2
types: American and European
 American Quote: FC (Base)/ USD (Price)
• No. of USD per 1 unit of FC ($ price of 1 FC unit)
• EUR/ USD 1.11713 or EUR 1 = USD 1.11713
 European Quote: USD (Base)/ FC (Price)
• No. of units of FC per 1 USD (FC price for 1 $)
• USD/ EUR 0.89438 or USD 1 = EUR 0.89438
 QUOTES – INVERSE QUOTES – IMPLIED QUOTES

 For every quote (A/B) between two currencies, there exists

an inverse quote (B/A), where currency A is bought and sold,
with its price expressed in terms of currency B.
 Implied inverse (B/A) quote
 = 1/ (A/B)Ask - (1/(A/B)Bid
 INR / USD = 71.2880 – 71.2928
 Implied USD /INR =(1/71.2880)-(1/71.2928)
 Implied USD / INR = 0.0140276/ 0.0140267
 INVERSE QUOTE – CONTD
(BANK’S PERSPECTIVE).

 Let us look at Euro / USD quote :

 EUR / USD : 1.6688 /1.6693
 EUR / USD : 1.6688-93
 The (EUR / USD) bid rate is the rate at which the bank is
ready to buy dollar (which also means the rate at which it is
ready to sell Euro, which will be the ask rate in the USD /
EUR quote).
 Hence the (EUR / USD) bid rate would correspond to the
inverse of (USD / EUR ask rate)
 In USD / EUR terms, it would be reciprocal ie ) 1/ 1.6688,
which is equal to $0.5992.

29
BID – ASK RATES INTERPRETATION
EXAMPLE
 Spot - Bid-Ask Rates
 CAD / USD AUD/USD
Bid Ask Bid Ask
1.1641 1.1646 1.2948 1.2956

 Bank buys 1 USD and pays (sells) 1.1641 CAD

 Bank sells 1 USD and receives (buys)1.1646 CAD
 Bank buys 1 USD and pays (sells) 1.2948 AUD
 Bank sells 1 USD and receives(buys) 1.2956 AUD
 QUOTES INTERPRETATION FROM THE BANK/ DEALER’S
PERSPECTIVE

 CAD 1.1641-46 / USD

 AUD 1.2948-56 /USD
_____________________________________
 CAD 1.1641-46 / USD
• Means banks Buys USD@1.1641 against CAD &
• Sells USD@ 1.1646 against CAD
_____________________________________
 AUD 1.2948-56 /USD
• Means banks Buys USD@1.2948 against AUD &
• Sells USD @ 1.2956
 INVERSE QUOTE – CONTD.
 Similarly EUR / USD ask rate would correspond to inverse of
USD / EUR bid rate.
 In EUR / USD terms – ask rate 1.6693 – would correspond to
USD / EUR Bid rate – 1/1.6693 = $0.0.5990.
 Hence to calculate the implied inverse quote, the bid and
ask terms of the given quote have to be reversed and their
reciprocals calculated.
 For the example :
 Implied (USD / EURO)bid = 1/ (EURO / USD)ask
 Implied (USD / EURO)ask = 1/ (EURO / USD)bid
 So the implied Inverse rate is : USD / EUR : 0.5990 / 0.5992
 EUR / USD : 1.6688 /1.6693 = USD / EUR : 0.5990 / 0.5992
32
 CROSS RATES
 Many currency pairs are inactively traded.
 So, their relationship is determined through their relationship
with a widely traded common third currency, mostly the USD.
 The third currency is the intermediate currency.
 Such determination is called Cross rate or Synthetic rate.
exchange rate between two currencies computed by
reference to a third currency, usually the US dollar.
 To calculate exchange rates between other currencies with
USD as the intermediate currency:
• For example Euro / GBP rate would be calculated through EUR
/USD quote and the USD / GBP quote.
• The EUR / GBP thus calculated is called as Cross rate or synthetic
rate.
33
 SYNTHETIC QUOTES
 In the foreign exchange markets, it is a practice to quote
most of the currencies against the dollar, and to calculate
the exchange rates between other currencies with the dollar
as the intermediate currency.
 The rate thus calculated is called cross rate or synthetic
cross rate.
• Synthetic (A/C)bid = (A/B)bid x (B/C)bid
• Synthetic (A/C)ask = (A/B)ask x (B/C)ask
 The synthetic cross rates can also be calculated if the
inverse quotes are available for any of the required rates.
• Synthetic (A/C) bid = (A/B) bid x 1/(C/B)ask
• Synthetic (A/C)ask = (A/B)ask x 1/(C/B) bid
 CURRENCY ARBITRAGE
 A currency arbitrage is a forex strategy in which
a currency trader takes advantage of different spreads
offered by brokers for a particular currency pair by making
trades.
 Different spreads for a currency pair imply disparities
between the bid and ask prices.
 “Arbitrage is the simultaneous purchase and sale of an asset
to profit from an imbalance in the price.”
 It is a trade that profits by exploiting the price differences of
identical or similar financial instruments on different
markets or in different forms.
 If the synthetic rate is less than the actual bid rate, then
arbitrageurs have a chance to make a profit by three-point
arbitrage. (Triangular Arbitrage)
 A TRIANGULAR ARBITRAGE - EXAMPLE
 Following quotes are available:
• Citibank USD 1.3297 = 1 Eur
• Barclays USD 1.5585 = 1 GBP
• Dresdner Eur 1.1722 = 1 GBP
• Is there an Arbitrage opportunity?
 First calculate the EUR-GBP cross rate based on Citi &
Barclays quote:
• Eur/ GBP = Eur/ 1 USD * 1 USD/ GBP
• (0.752049/1) * (1/ 0.641643) = Eur 1.1721/ GBP
• Since this cross rate is not the same as Eur/ GBP quoted by
Dresdner, an arbitrage opportunity exists
 Calculate for USD 1,000,000
 A TRIANGULAR ARBITRAGE - EXAMPLE

Step 6: Trader receives Citiban Step 1: Trader sells USD

USD 1,000,112 from k 1,000,000 to Barclays at
Dresdner USD1.5585/GBP

Dresdn Barclay
er s

Step 5: Trader sells Eur Step 2: Trader receives

752,153 to Citi at USD GBP 641,643.
1.3297/ EUR
Step 4: Trader receives Step 3: Trader sells GBP
Eur 752,153 from Braclays 641,643 to Dresdner at
Eur1.722/GBP
 BANKS ACCOUNTS WITH EACH OTHER
 Banks also maintain accounts with each other.
 These are called Nostro and Vostro Accounts
 Nostro A/c
• Meaning “ours” in Latin
• That is an a/c held by a bank in foreign currency in another
bank.
 Vostro A/c
• Meaning “yours” in Latin
• That is a/c of another bank held in our bank
 The two terms refer to the same a/c but named differently
from each entity’s perspective
 EXAMPLE
 SBI maintains a US $ A/c with Citibank, NY
 This is termed as Nostro A/c by SBI
 And termed Vostro A/c by Citibank
 $ sent to India will be credited by SBI to A/c holder and Dr.
to its Nostro A/c; Citibank will Cr. the Vostro A/c and Dr.
Cash. Hence for Citibank it’s a liability and for SBI, its an
asset.
 The purpose of these accounts is to simplify the settlements
without the foreign currency actually moving in and out.
 They are different from regular bank accounts in that these
are maintained by financial institutions.
Forward Quotations
 FORWARD QUOTATIONS
 Forward market involves contracting today for the future
purchase or sale of foreign exchange.
 Forward transaction (more formally called outright forward
transaction) requires delivery at a future date of a specified
amount of one currency for a specified amount of another
currency.
 Exchange rate is established at the time of agreement, but
payment and delivery are only at maturity.
 Forward rates are normally quoted for value dates of 1, 2, 3 6
and 12 months. Demand is high for maturities of 1 year or less.
 Payment of forward contracts is on 2nd business day after the
even month anniversary of the trade.
• 2-month forward entered on March 18 will be for value date of May
20, or the next business day.
 FORWARD QUOTATIONS
 Buying and selling Forward is for the same transaction. Example:
• Contract to deliver $ for € in 6 months is both “buying € forward for $”
and “selling $ forward to buy €”
 Spot rates are quoted on outright basis, i.e. all digits expressed.
 Even Forward rates are quoted on outright basis for commercial
customers.
 In the inter bank market, forward rates are quoted as a discount
from or premium on, the spot rate.
 Depending on the currency, forward rates are quoted in “Pips”.
 A Pip is the last digit of the currency quotation.
 Forward rates:
• For 1 year or less are called ‘Cash rates’
• For more than 1 year are called ‘Swap rates’
 EXAMPLE OF PIPS
 Spot rate $/ € 1.0897/ 1.0901
 2 months Cash rate $/ € 1.0932/ 1.0937
 Hence 2 months
• Cash Bid rate is at 35 pips; and
• Cash Ask rate is at 36 pips
 2 years Swap rate $/ € 1.1378/ 1.1423
 Hence 2 years swap rate
• Swap Bid rate is at 481 pips; and
• Swap Ask rate is at 522 pips
 Sometimes, the points may be quoted simply as swap rates even
though the question may have periods less than 2 years. Most
books follow this method. Hence consider cash and swap
interchangeably. Concentrate on the spot, pips which are more
important to calculate forward.
 FORWARD QUOTATIONS
 Foreign currency is:
• At Forward discount if Forward rate < Spot rate
• At Forward premium if Forward rate > Spot rate
• If Forward rate = Spot rate, it is at par
 A forward quotation expressed in points is in reality not a quotation.
Rather, it is the difference between the forward and spot rate.
 That is why, spot rate is never given in points, but on outright basis.
 Swap rates (points) do not carry +ve or -ve sign, but can be
converted to outright by adding or subtracting the points as follows:
• Bid points < Ask points; Forward is at Premium; Add to Spot rates
• Bid points > Ask points; Forward is at Discount; Subtract from Spot rates
 CALCULATING FORWARD PREMIUM/ DISCOUNT

 Forward Premium or Discount depends on the designated

HC.
 When calculating for HC
Spot – Forward 360 days (or) 12 months
----------------- * ---------------------------
Spot Forward days (or) months

 When calculating for FC

Spot – Forward 360 days (or) 12 months
----------------- * ---------------------------
Forward Forward days (or) months
FORWARD PREMIUM

FC/ HC HC/ FC
Spot rate ¥ 118.27/ $ $/ ¥ 0.0084552
3-month ¥ 116.84/ $ $/ ¥ 0.0085587
forward
Forward premium in FC terms
(Spot-Forward)/ (118.27- 4.90%
Forward * 360/90 116.84)/116.84 *
360/90
In 3 months, less ¥ required for $, hence ¥ is selling at a
3-month forward premium of 4.90% against the $
Forward premium HC terms
(Forward-Spot)/ (0.0084552- -4.90%
Spot * 360/90 0.0085587) /
0.0084552*360/90
In 3 months, more $ required for ¥, hence $ is selling at a 3-
month forward discount of 4.90% against the ¥