Chapter 6

The Foreign
Exchange Market
 Foreign Exchange Markets

• The FOREX market provides the physical and

institutional structure through which
– The money of one country is exchanged for that of
another country
– The rate of exchange between currencies is determined
– Foreign exchange transactions are physically completed
• A foreign exchange transaction is an
agreement between a buyer and a seller that a
fixed amount of one currency will be delivered for
some other currency at a specified rate

6-2 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Markets
• There are six main characteristics of the
FOREX markets which will be discussed
– The geographic extent
– The three main functions
– The market’s participants
– Its daily transaction volume
– Types of transactions including spot, forward
and swaps
– Methods of stating exchange rates, quotations,
and changes in exchange rates

6-3 © 2012 Pearson Education, Inc. All rights reserved.

 Geographic Extent of the Market
• Geographically, the FOREX market spans the globe with
prices moving and currencies trading on 24-hour-a business
day basis
– from 5 p.m. EST on Sunday until 4 p.m. EST on Friday. 

Note: Our time zone

• Major world trading starts each morning in Sydney and
Tokyo
• Then moves west to Hong Kong and Singapore
• Continuing to Europe and finishing on the West Coast of the
U.S.

6-4 © 2012 Pearson Education, Inc. All rights reserved.

 Exhibit 6.2 Global Currency Trading:
The Trading Day

Asia time is 8 hrs ahead/faster

Asia time is GMT+8

6-5 © 2012 Pearson Education, Inc. All rights reserved.

 Market Hours and Trade Volume

Our time zone

6-6 © 2012 Pearson Education, Inc. All rights reserved.

 Functions of the FOREX Market
• The FOREX market is the mechanism
by which participants
– Transfer function
• This is necessary as international
trade and capital transactions normally
involve parties living in countries with
different national currencies
– Credit function
• Obtain or provides credit for international trade transactions
– Movement of goods take time, inventories in transit must be
financed
– Bankers’ acceptance, letter of credit, borrowing foreign currency
by swap
– Hedging function
• FOREX markets provide instruments utilized in “hedging” to
minimize exchange rate risk

6-7 © 2012 Pearson Education, Inc. All rights reserved.

 The Bank as the Import/Export Intermediary

• Letter of Credit (L/C) is a bank’s conditional promise to pay, issued by a

bank at the request of an importer ,in which the bank promises to pay an
exporter ,upon presentation of documents specified in the L/C
• A draft is a written order by an exporter instructing an importer or its agent
to pay a specified amount at a specified time. When a draft is accepted by a
bank, it becomes a banker’s acceptance. Exporter may discount the
acceptance note in order to receive the funds up-front

6-8 © 2012 Pearson Education, Inc. All rights reserved.

6-9 © 2012 Pearson Education, Inc. All rights reserved.
 Market Participants
• The FOREX market consists of two tiers:
– the interbank or wholesale market
– the client or retail market
• Five broad categories of participants operate
within these two tiers
– Bank and non bank foreign exchange dealers
– Individuals and firms conducting commercial or
investment transactions
– Speculators and arbitragers
– Central banks and treasuries
– Foreign exchange brokers

6-10 © 2012 Pearson Education, Inc. All rights reserved.

 Market Participants
 Bank and non bank foreign exchange dealers
 Operate in both interbank and client markets
 Profit from buying at a bid price, reselling at ask(offer) price
 Worldwide competition drive down the spread
 Dealers stand willing at all times to buy and sell currencies and
maintain ‘inventory’ position
 Mostly act as market makers-a series of calls between key market
players to sound out their intentions
 Quite profitable for commercial and investment banks.
 Many major currencies trading banks in US derive 10% to 20% of
their annual net income from currency trading
 Do not make market for every currency
 Small (<$10b, 20% in US) to medium-size ($10-50b, 10%) banks
 Do not act as market makers
 Buy from and sell to dealers to offset transactions with own
customers
 Filling customers needs for less important currencies

6-11 © 2012 Pearson Education, Inc. All rights reserved.

 The Largest Banks In The World

• The 10 Biggest Banks in the World

• BY KEVIN B. JOHNSTON
•   Updated May 15, 2019
•  We have listed the world’s banks from largest to smallest and indicated the dollar value
of their assets. 1. Industrial & Commercial Bank of China, $3.62 trillion in total assets.
• 2. China Construction Bank Corp, $2.94 trillion.
• 3. Agricultural Bank of China, $2.82 trillion.
• 4. Bank of China, $2.63 trillion.
• 5. HSBC Holdings (HSBC), England, $2.57 trillion
• 6. JPMorgan Chase & Co. (JPM), United States, $2.45 trillion.
• 7. BNP Paribas, French, $2.4 trillion
• 8. Mitsubishi UFJ Financial Group, Japan, $2.459 trillion.
• 9. Bank of America (BAC), $2.15 trillion.
• 10. Credit Agricole Group, French, $1.91 trillion.

• Source:
https://www.investopedia.com/articles/investing/122315/worlds-top-10-banks-jpm-wfc.asp

6-12 © 2012 Pearson Education, Inc. All rights reserved.

 Top 10 largest banks in Malaysia

• Maybank,Total assets: RM 765.3 billion

(2017)
• CIMB Bank, RM 308.45 billion (2017)
• Public Bank Berhad, RM 395.28 billion
(2017)
• RHB Bank,RM 236.7 billion (2016)
• Hong Leong Bank, RM 164.82 billion
(2017)
•  AmBank Group, RM 142.8 billion
(2017) 
• United Overseas Bank (Malaysia), RM
101.85 billion (2017)
•  Bank Rakyat, Rm 105.15 billion (2017)
•  OCBC Bank (Malaysia) Berhad, RM
79.47 billion (2017)
•  HSBC Bank Malaysia Berhad, RM 72.93
billion (2016)

RM1 = $0.2464, 31/12/2017 RM1 = $0.28534, 31/12/2014

6-13 © 2012 Pearson Education, Inc. All rights reserved.

 Market Participants
• Individuals and firms conducting commercial or
investment transactions
 Importers
 Exporters
 International portfolio investors
 MNEs,
 Tourists
 For commercial and investment purposes
 To hedge foreign exchange risk

6-14 © 2012 Pearson Education, Inc. All rights reserved.

 Market Participants
• Speculators and arbitragers
 Speculators: a person who invests in stocks, property, or other ventures
in the hope of making a profit.
 Arbitragers try to profit from simultaneous exchange rate differences in
different markets
 they seek profit from trading in the market itself
 From exchange rate changes
 Operate in their own interests
 No need to serve clients
 No need to ensure a continuous market
 Banks also act as speculators and arbitrageurs
 Banks seldom admit

6-15 © 2012 Pearson Education, Inc. All rights reserved.

 Market Participants
• Bank Negara's trading scandal
• Central banks and • The Malaysian central bank's controversial
treasuries strategy to speculate in foreign exchange
markets began in the late 1980s with the
 Use the market to acquire backing of former premier Mahathir
foreign currencies Mohamad.
 Influence the price of their own
currency
• That plan ended in disaster and, by the end of
 pay foreign obligations
1993, Bank Negara Malaysia's (BNM) capital
 adjust and balance its foreign-
base was wiped out with accumulated losses
exchange reserves estimated then at RM9 billion (S$2.9 billion at
current rates).
 Motive is not to earn a
profit • But a former assistant governor at the central
bank, Datuk Abdul Murad Khalid, claimed last
 Willingly take a loss on to
month that the losses were actually US$10
support the value of their billion, or RM44 billion (S$14.2 billion).
own money.
• The central bank's forex losses in 1991 made
 Case: RM44b Alleged amount
of forex losses suffered by international headlines, forcing the
Malaysia's central bank when resignation of BNM's governor, Tan Sri Jaffar
Dr Mahathir was PM Hussein.
• Stepping down too was Tan Sri Nor Mohamed
Yakcop, then a deputy governor and chief
architect of its international forex trading
campaign.
• Source: http://www.straitstimes.com/asia/se-asia/forex-
probe-puts-spotlight-on-mahathir-era-scandals
6-16 © 2012 Pearson Education, Inc. All rights reserved.
 Market Participants
• Foreign exchange brokers
 Are agents who facilitates trading between dealers
 Know at any moment exactly which dealers want to
buy or sell any currency
 Find opposite parties without revealing their identities
until reached a deal.
 Dealers use brokers to expedite transaction and
remain anonymous
 Charge a small commission
 Maintain instant access to hundreds of dealers world wide
via telephone lines

6-17 © 2012 Pearson Education, Inc. All rights reserved.

 Transactions in the Interbank Market

• Transactions within this market can be executed

on a spot, forward, or swap basis
– A spot transaction requires almost immediate delivery of
foreign exchange
– A forward transaction requires delivery of foreign
exchange at some future date
– A swap transaction is the simultaneous purchase and
sale, conducted with the same counterparty, of a given
amount of foreign exchange for 2 different value
(settlement) dates.

6-18 © 2012 Pearson Education, Inc. All rights reserved.

 Spot Transactions
• A spot transaction in the interbank market is the
purchase of foreign exchange, with delivery and
payment between banks to take place, normally,
on the second following business day
– The settlement date is often referred to as the value date
– A contract is reached on Monday between a US bank for
the transfer of ₤10,000,000 to the account of a London
bank.
• If the spot exchange rate $1.5470/₤, the US bank would transfer
₤10,000,000 to London bank on Wednesday,
• and the London bank would transfer $15,470,000 to the US bank at
the same time.

6-19 © 2012 Pearson Education, Inc. All rights reserved.

 US$1.5160/₤

Source: Bloomberg. As of 18 May 2013, 6.29pm

6-20 © 2012 Pearson Education, Inc. All rights reserved.

 Source: Bloomberg. As of 14 July 2015, 5.10 pm

6-21 © 2012 Pearson Education, Inc. All rights reserved.

 Source: Bloomberg. As of 27 July 2016, 11.02pm

6-22 © 2012 Pearson Education, Inc. All rights reserved.

 Source: Bloomberg. As of 24 Mar 2017, 5.52pm

6-23 © 2012 Pearson Education, Inc. All rights reserved.

 https://www.bloomberg.com/markets/currencies/cross-rates

11 July 2019, 2.39PM

6-24 © 2012 Pearson Education, Inc. All rights reserved.

 Dealer who buys ₤ willing Dealer who sells ₤ asks
to pay US$1.25240 per ₤ for US$1.25280/₤, he will
sell 1 ₤ for US$1.25280

https://www.fxstreet.com/rates-charts/rates 11 July 2019, 2.47PM

6-25 © 2012 Pearson Education, Inc. All rights reserved.

6-26 © 2012 Pearson Education, Inc. All rights reserved.
6-27 © 2012 Pearson Education, Inc. All rights reserved.
6-28 © 2012 Pearson Education, Inc. All rights reserved.
 Outright Forward Transactions
• Usually just called ‘forward’
• This transaction requires delivery at a future value date of a
specified amount of one currency for another
• The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed
– Forward rates are contracts quoted for value dates of one, two, three,
six, nine and twelve months
– We can speak of buying or selling forward to describe
the same transaction
• A contract to deliver dollars for euros in six months is
– buying euros forward for dollars
– selling dollars forward for euros

6-29 © 2012 Pearson Education, Inc. All rights reserved.

 Source: http://www.fxstreet.com/rates-charts/forward-rates/

6-30 © 2012 Pearson Education, Inc. All rights reserved.

 Swap Transactions
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates
• Both purchase and sale are conducted with the
same counterpart
• A common type of swap is a spot against forward
– The dealer buys a currency in the spot market and
simultaneously sells the same amount back to the same
bank in the forward market
– Swap transaction formed 57% of all FOREX activity in
April 2010.

6-31 © 2012 Pearson Education, Inc. All rights reserved.

 Swap Transactions

• Forward-forward swaps – A dealer sells £20,000

forward for dollars for delivery in two months at
$1.8420/£ and simultaneously buys £20,000
forward for delivery in three months at $1.8400/£
– The difference between the buying and selling price is
equivalent to the interest rate differential
• How much is the interest rate differential?
– Thus a swap can be viewed as a technique for borrowing
another currency on a fully collateralized basis
• receive $36840 in 2 months
• Pay $36800 in 3 months

6-32 © 2012 Pearson Education, Inc. All rights reserved.

6-33 © 2012 Pearson Education, Inc. All rights reserved.
6-34 © 2012 Pearson Education, Inc. All rights reserved.
6-35 © 2012 Pearson Education, Inc. All rights reserved.
 Size of the FOREX Market

• The Bank for International Settlements (BIS)

estimates that daily global net turnover in
traditional FOREX market activity to be USD 3.7
trillion in April 2010
Average 2013: $5.4 trillion
2016: $5.1 trillion
2018, 1st half: $1.84 trillion

6-36 © 2012 Pearson Education, Inc. All rights reserved.

 Exhibit 6.4 Global Foreign Exchange Market
Turnover, 1989-2010 (average daily
turnover in April, billions of US dollars)

6-37 © 2012 Pearson Education, Inc. All rights reserved.

6-38 © 2012 Pearson Education, Inc. All rights reserved.
 http://www.reuters.com/article/2013/09/05/bis-
survey-volumes-idUSL6N0GZ34R20130905

6-39 © 2012 Pearson Education, Inc. All rights reserved.

 Size of the FOREX Market

• The United Kingdom (London) and the

United States (New York) make up
roughly 55% of the foreign exchange
market, as of April 2010
• The London trade alone makes up
36.7% of daily transactions in the
foreign exchange market
• Followed by the US (17.9%), Japan
(6.2%), Singapore (5.3%), Switzerland
(5.2%) and Hong Kong (4.2%)
• Asian markets growing more rapidly
than European markets

6-40 © 2012 Pearson Education, Inc. All rights reserved.

 Exhibit 6.5 Top 10 Geographic Trading
Centers in the Foreign Exchange Market,
1992-2010 (average daily turnover in April)

6-41 © 2012 Pearson Education, Inc. All rights reserved.

 Exhibit 6.6 Foreign Exchange Market
Turnover by Currency Pair (Daily averages
in April)

6-42 © 2012 Pearson Education, Inc. All rights reserved.

 • Source: http://www.bis.org/publ/rpfx16fx.pdf

6-43 © 2012 Pearson Education, Inc. All rights reserved.

 Source: http://www.bis.org/publ/rpfx16fx.pdf

6-44 © 2012 Pearson Education, Inc. All rights reserved.

 Source: http://www.bis.org/publ/rpfx16fx.pdf

6-45 © 2012 Pearson Education, Inc. All rights reserved.

 Daily FX Turnover in Malaysia

Source: BNM

6-46 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations

• A foreign exchange quote is a statement of

willingness to buy or sell at an announced rate
– In the retail market (newspapers and exchange booths),
quotes are often given as the home currency price of the
foreign currency
• Currency Traditional Symbol ISO 4217 Code
– U.S. dollar $ USD
– European euro € EUR
– Great Britain pound £ GBP
– Japanese yen ¥ JPY
– Mexican peso Ps MXN

6-47 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations
• Interbank quotes – professional dealers or brokers may state
quotes in one of two ways
– European terms: The foreign currency price of one US dollar
• € 0.8214/$, read as 0.8214 Euro per US dollar
– American terms: The US dollar price of a unit of foreign currency
• $1.2174/€, read as 1.2174 US dollars per Euro

6-48 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations

• Direct and Indirect Quotes

– A direct quote is a home currency price of a unit
of a foreign currency
• MYR3.1091/$
– is a direct quote in Malaysia
– Indirect quote in the US
– An indirect quote is a foreign currency price in a
unit of the home currency
• $0.3213/MYR
– Is a direct quote in the US,
– is a indirect quote in Malaysia

6-49 © 2012 Pearson Education, Inc. All rights reserved.

 Source: Yahoo Finance. As of 11 July, 2019, 3.36PM

6-50 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations

• Interbank quotes are given as a bid and ask

– The bid is the price at which a dealer will buy another
currency
– The ask or offer is the price at which a dealer will sell
another currency
• For example the bid and ask for spot euros would
probably be shown “1.2170/78” on a video screen.
• In some cases between professional traders, they
may only quote the last two digits of both the bid
and ask, “70-78”, because they know what the
other figures are.

6-51 © 2012 Pearson Education, Inc. All rights reserved.

 Exhibit 6.8 Bid, Ask, and Mid-Point
Quotation
Beware of
different quotation
in different
source:

Bid, ask are from

dealer’s point of view

6-52 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations

• Expressing Forward Quotations on a Points Basis

– Forward quotes are different and typically quoted in
terms of points
– A point is the last digit of a quotation, with convention
dictating the number of digits to the right of the decimal
• Hence a point is equal to 0.0001 of most currencies

Source: http://www.fxcm.co.uk/web-based-forex-platform.jsp

6-53 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations

• Cross Rates
– Many currencies pairs are inactively traded, so their
exchange rate is determined through their relationship to
a widely traded third currency
– Example: A Mexican importer needs Japanese yen to pay
for purchases in Tokyo. Both the Mexican peso (MXP)
and Japanese yen (¥) are quoted in US dollars
• Assume the following quotes:

Japanese yen ¥82.04/$

Mexican peso MXP 12.2324/$

6-54 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations
Japanese yen ¥82.04/$
Mexican peso MXP 12.2324/$
• Cross Rates
– The Mexican importer can buy one US dollar for
12.2324 Mexican pesos and with that dollar buy
¥82.04; the cross rate would be

Japanese yen/US dollar ¥ 82.04/$

= = ¥6.7068 MXP
Mexican pesos/US dollar MXP12.2324/$

6-55 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations

• Intermarket Arbitrage
– Cross rates can be used to check on
opportunities for intermarket arbitrage
– Example: Assume the following exchange rates
are quoted

Citibank, US $1.3297/€
Barclays Bank, UK $1.5585/£
Dresdner Bank, Canada €1.1722/£

6-56 © 2012 Pearson Education, Inc. All rights reserved.

 Foreign Exchange Rates &
Quotations Citibank $1.3297/€
Barclays Bank $1.5585/£
Dresdner Bank €1.1722/£
• Intermarket Arbitrage
– The cross rate between Citibank and Barclays is

$1.5585/ £
= € 1.1721/£
$1.3297/ €

– This cross rate is not the same as Dresdner’s

rate quote of €1.1722/£
– Therefore, an opportunity exists for risk-less
profit or arbitrage

6-57 © 2012 Pearson Education, Inc. All rights reserved.

 Exhibit 6.11 Triangular Arbitrage by a
Market Trader Citibank $1.3297/€
Barclays Bank $1.5585/£
Dresdner Bank €1.1722/£

752,133x1.3297 100,000/1.5585

641,643x1.1722

6-58 © 2012 Pearson Education, Inc. All rights reserved.