Session 2

The Foreign
Exchange Market and
Derivatives

Lectured by Prof. Dr. Ferdinand D. Saragih, MA

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 The Foreign Exchange Market

• The Foreign Exchange Market provides:

– the physical and institutional structure
through which the money of one country is
exchanged for that of another country;
– the determination rate of exchange between
currencies, and
– is where foreign exchange transactions are
physically completed.

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 The Foreign Exchange Market

• Foreign exchange means the money of a

foreign country; that is, foreign currency
bank balances, banknotes, checks and
drafts.
• 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 date.
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 Geography

• The foreign exchange market spans the

globe, with prices moving and currencies
trading somewhere every hour of every
business day.
• As the next exhibit will illustrate, the
volume of currency transactions ebbs and
flows across the globe as the major currency
trading centers open and close throughout
the day.
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 Exhibit 6.1 Measuring Foreign Exchange Market:
Average Electronic Conversations Per Hour
25,000

20,000

15,000

10,000

5,000
Greenwich Mean
Time
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe Asia Americas London Afternoon 6 pm Tokyo

In Tokyo In Tokyo opening closing open closing in America In NY opens
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
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 Functions of the Foreign Exchange
Market
• The foreign exchange Market is the mechanism
by which participants:
– transfer purchasing power between countries;
– obtain or provide credit for international trade
transactions, and
– minimize exposure to the risks of exchange rate
changes.

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 Market Participants
• The foreign exchange market consists of two
tiers:
– the interbank or wholesale market (multiples of
$1MM US or equivalent in transaction size), and
– the client or retail market (specific, smaller
amounts).
• Five broad categories of participants operate
within these two tiers; bank and nonbank
foreign exchange dealers, individuals and
firms, speculators and arbitragers, central
banks and treasuries, and foreign exchange
brokers.
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 Market Participants: Bank and
Nonbank Foreign Exchange Dealers
• Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
• The profit from buying foreign exchange at a “bid”
price and reselling it at a slightly higher “offer” or
“ask” price.
• Dealers in the foreign exchange department of large
international banks often function as “market makers.”
• 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.

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 Market Participants: Individuals and
Firms

• Individuals (such as tourists) and firms (such

as importers, exporters and MNEs) conduct
commercial and investment transactions in the
foreign exchange market.
• Their use of the foreign exchange market is
necessary but nevertheless incidental to their
underlying commercial or investment purpose.
• Some of the participants use the market to
“hedge” foreign exchange risk.

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 Market Participants: Speculators and
Arbitragers
• Speculators and arbitragers seek to profit from
trading in the market itself.
• They operate in their own interest, without a
need or obligation to serve clients or ensure a
continuous market.
• 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.

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 Market Participants: Central Banks and
Treasuries
• 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.
• 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.
• 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 the interests of their
citizens.
• As willing loss takers, central banks and treasuries
differ in motive from all other market participants.
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 Transactions in the Interbank
Market
• 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 date of settlement is referred to as
the value date.

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 Transactions in the Interbank
Market
• An 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.
• The exchange rate is established at the time of the
agreement, but payment and delivery are not required
until maturity.
• Forward exchange rates are usually quoted for value
dates of one, two, three, six and twelve months.
• Buying Forward and Selling Forward describe the
same transaction (the only difference is the order in
which currencies are referenced.)

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 Transactions in the Interbank
Market
• 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 counterparty.
• Some different types of swaps are:
– spot against forward,
– forward-forward,
– nondeliverable forwards (NDF).

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 Market Size

• In April 2004, a survey conducted by the

Bank for International Settlements (BIS)
estimated the daily global net turnover in
traditional foreign exchange market
activity to be $1.9 trillion.
• This most recent period showed dramatic
growth in foreign exchange trading over
that seen in April 2001.

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 Exhibit 6.3
1000

900
Spot
800
Forwards
700 Swaps

600

500

400

300

200

100

0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 9.
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 Exhibit 6.4
800

700 United States

United Kingdom
600 Japan
Singapore
500
Germany
400

300

200

100

0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 13.

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 Exhibit 6.5
Because all exchange transactions involve two currencies, percentage
shares total 200%
90
US Dollar
80 Euro
Deutschemark
70
French Franc
60 EMS Currencies
JapaneseYen
50 Pound Sterling
Swiss Franc
40

30

20

10

0
1989 1992 1995 1998 2001 2004
Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 11.

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 Foreign Exchange Rates and
Quotations
• A foreign exchange rate is the price of
one currency expressed in terms of
another currency.
• A foreign exchange quotation (or quote)
is a statement of willingness to buy or
sell at an announced rate.

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 Foreign Exchange Rates and
Quotations
• Most foreign exchange transactions involve the
US dollar.
• Professional dealers and brokers may state
foreign exchange quotations in one of two
ways:
– the foreign currency price of one dollar, or
– the dollar price of a unit of foreign currency.
• Most foreign currencies in the world are stated
in terms of the number of units of foreign
currency needed to buy one dollar.
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 Foreign Exchange Rates and
Quotations
• For example, the exchange rate between US
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.

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 Foreign Exchange Rates and
Quotations
• As mentioned, several exceptions exist to the
use of European terms quotes.
• The two most important are quotes for the euro
and U.K. pound sterling which are both
normally quoted in American terms.
• American terms are also utilized in quoting
rates for most foreign currency options and
futures, as well as in retail markets that deal
with tourists.

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 Foreign Exchange Rates and
Quotations
• Foreign exchange quotes are at times described as
either direct or indirect.
• In this pair of definitions, the home or base
country of the currencies being discussed is
critical.
• A direct quote is a home currency price of a unit of
foreign currency.
• An indirect quote is a foreign currency price of a
unit of home currency.
• The form of the quote depends on what the speaker
regard as “home.”
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 Foreign Exchange Rates and
Quotations
• Interbank quotations are given as a bid and ask (also
referred to as offer).
• A bid is the price (i.e. exchange rate) in one currency at
which a dealer will buy another currency.
• An ask is the price (i.e. exchange rate) at which a
dealer will sell the other currency.
• Dealers 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.
• A bid for one currency is also the offer for the opposite
currency.

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 Foreign Exchange Rates and
Quotes
• Forward rates are typically quoted in
terms of points.
• A forward quotation is expressed in
points is not a foreign exchange rate as
such.
• Rather, it is the difference between the
forward rate and the spot rate.

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 Foreign Exchange Rates and
Quotes
• Forward quotations may also be
expressed as the percent-per-annum
deviation from the spot rate.
• This method of quotation facilitates
comparing premiums or discounts in the
forward market with interest rate
differentials.

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 Foreign Exchange Rates and
Quotes
• For quotations expressed in foreign currency
terms (Indirect quotations) the formula
becomes:
f ¥ = Spot – Forward 360
Forward x n x 100
• For quotations expressed in home currency
terms (Direct quotations) the formula becomes:
f ¥ = Forward – Spot 360
Spot x n x 100

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 Foreign Exchange Rates and
Quotes
• Many currency pairs are only inactively traded,
so their exchange rate is determined through
their relationship to a widely traded third
currency (cross rate).
• Cross rates can be used to check on
opportunities for intermarket arbitrage.
• This situation arose because one bank’s
(Dresdner) quotation on €/£ is not the same a
calculated cross rate between $/£ (Barclay’s)
and $/€ (Citibank).

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 Foreign Exchange Rates and
Quotes

• Citibank quote - $/€ $1.2223/€

• Barclays quote - $/£ $1.8410/£
• Dresdner quote - €/£ €1.5100/£
• Cross rate calculation: =
• $1.8410/£
= € 1.5062/£
$1.2223/€

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 Exhibit 6.9A Triangular Arbitrage
Citibank, New York
End with $1,002,538 Start with $1,000,000

€820,206
(6) x $1.2223/€ = (1) Exchange $1,000,000 with
$1,002,538 Barclays Bank for pounds at $1.8410/£

Dresdner Bank, Frankfurt Barclays Bank, London

Sell
(5) €820,206 to (2) $1,000,000 x $1.8410/£ = £543,183
Citibank at $1.2223/€
(4)
£543,183 x €1.5100/£ = (3) Exchange £543,183 with Dresdner
€820,206 for euros at €1.5100/£
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 Foreign Exchange Rates
and Quotes
• Measuring a change in the spot rate for
quotations expressed in home currency terms
(direct quotations):
%∆ = Ending rate – Beginning Rate
Beginning Rate x 100
• Quotations expressed in foreign currency terms
(indirect quotations):
%∆ = Beginning Rate – Ending Rate
Ending Rate x 100

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 Mini-Case Questions: The Venezuelan
Bolivar

• Why does a country like Venezuela

impose capital controls?
• In the case of Venezuela, what is the
difference between the gray market and
the black market?
• Create a financial analysis of Santiago’s
choices and use it to recommend a
solution to his problem.

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