5 the Market for Foreign Exchange

8/4/2019 5 the Market for Foreign Exchange

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The Market for

Foreign

ExchangeBy Vijay Tita


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Outline of the chapter

Objective of the chapter

The meaning and background of theForeign Exchange Market

Function and structure of the FXmarket

The spot Market

The Forward Market


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Objective of the Chapter

To provide an introduction to theorganization and operation of the spotand forward foreign exchange market.

This chapter provides institutionalarguments of the foreign exchangemarket and details of how foreign

exchange is quoted and tradedworldwide.


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Meaning of FX Market

The FX market encompasses theconversion of purchasing power fromone currency into another, bank

deposits of foreign currency, theextension of credit denominated in aforeign currency, foreign trade

financing, trading in foreign currencyoptions & futures contracts andcurrency swaps.


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Background of the FX market

Largest financial market

Remains open 24*7 and 365 days

The BIS places worldwide daily

trading of foreign exchange at $1.88tn in 2004

London remains largest FX trading

centre Trading volume in UK is estimated at

$753 bn in 2004, 49% increase from

2001


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Shares of reported global FX turnoverby country in 2004

Country Share in %

United kingdom 31

United states 19

Japan 8

Singapore 5

Germany 5Switzerland 3

Hong kong 4

Australia 3

France 3

Canada 2

Netherlands 2

Denmark 2

Sweden 1

Russia 1


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Function of FX market

primary function is to assist clients inconduct of international commerce

This function is an extension of one of

the functions of a commercial banker


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Structure of the FX market

The FX market can be viewed as twotier market :

i) wholesale or interbank market

ii) retail or client market

Timings for three major marketsegments

Foreign Exchange Market participants

Corresponding Banking relationship


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FX Market Participants

International banks

Bank customers

Nonbank dealers

FX brokers

Central banks


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Corresponding BankingRelationship The interbank market is a network of

Correspondent Banking Relationshipwith large commercial banks

maintaining demand deposit accountswith one another, called correspondingbanking accounts.

It allows for the efficient functioning ofthe FX market


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The Spot Market

Spot rate quotations The Bid-Ask spread

Spot FX trading

Cross Exchange Rate quotations Alternative Expression for Cross

Exchange Rate

The cross rate Trading Desk Triangular Arbitrage

Spot FX market Microstructure


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The Spot Market (Cont)

Spot Rate quotationsa) Direct Quotations

(American terms)

b) Indirect Quotations(European terms)


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Example of Direct quotations from USperspective (dollars):Thursday spot quote for British poundis $1.9077

Example of Indirect quotations fromUS perspective (pounds):

Thursday spot quote for British poundis 0.5242


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The Bid-Ask spread

Interbank FX traders buy currency forinventory at the bid price and sell

from inventory at the higher offer orask price.

There is a reciprocal relationship

between American and European bidand ask quotations


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Spot Foreign Exchange Trading

Spot quotations are good for only afew seconds. If a trader cannot

immediately make up his mindwhether to buy or sell at given prices,the quotes are likely to be withdrawn

Interbank FX traders useabbreviations in expressing spotquotations

big figure and small figure


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Cross-Exchange Rate Quotations

A cross exchange rate is an exchangerate between a pair where neither

currency is the U.S. dollarIt can be calculated from the U.S. $

exchange rates for the two currencies,

using either European or Americanterm quotations


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For example, the / cross rate can becalculated from American termquotes

s(/) = s($/) / s($/)

= 1.9077 / 1.3112

= 1.4549


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For example, the / cross rate can becalculated from European termquotes

s(/) = s(/$) / s(/$)

= 0.7627 / 0.5242

= 1.4550


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The cross rate trading deskBanks frequently handle this trade for

its customers by selling British poundsfor U.S. dollars and then selling U.S.dollars for Swiss Francs.

suppose a bank operates in more thanone foreign currencies, its trading

room would be organized withdifferent currency trade desk

Refer Example 5.2


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Triangular Arbitrage opportunity

it is the process of trading out of U.S.$ into a second currency, then

trading it for a third currency, which inturn traded for U.S. $

The purpose is to earn arbitrage

profit Refer Example 5.3


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The Forward Market

Forward Rate Quotations Long and Short Forward positions

(refer example 5.4)

Forward Cross-Exchange Rates

Swap Transactions

Forward Premium


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The Forward Market (cont)

Forward Rate Quotations it can be direct or indirect, one being

the reciprocal of another

from U.S. perspective direct quote isin American terms

s($/SF)= 0.8470

f1($/SF)= 0.8485f3($/SF)= 0.8517

f4($/SF)= 0.8573


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Swap Transactions it can be classified as outright or

swap transactions

an outright forward transaction is anuncovered speculative position in acurrency, even though it might be apart of currency hedge to the bank

customer to the other side of thetransaction


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Swap Transactions

Swap transaction is the simultaneoussale (purchase) of spot FX against

forward purchase (sale) ofapproximately an equal amount of theforeign currency

Refer Example 5.5


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Thank You

5 the Market for Foreign Exchange

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