Chapter 6

The Foreign
Exchange Market and
Derivatives

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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 Activity: Average Electronic
Conversions Per Hour

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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:
Banks and Treasuries

Central

Central banks and treasuries use the market to acquire or

spend their countrys 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 Global Foreign

Exchange Market Turnover, 19892004 (daily averages in April,
bilions of US$)

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Exhibit 6.4 Geographic

Distribution of Foreign Exchange
Market Turnover, 1989-2004 (daily
averages in April, billions of
US$)

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Exhibit 6.5 Currency Distribution

of Global Foreign Exchange Market
Turnover (percentage shares of average
daily turnover in April)

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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 x 360 x 100
Forward
n

For quotations expressed in home currency

terms (Direct quotations) the formula becomes:
f = Forward Spot x 360 x 100
Spot
n

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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 banks
(Dresdner) quotation on / is not the same a
calculated cross rate between $/ (Barclays)
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
Arbitrage

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Triangular

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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 x100
BeginningRate
Quotations expressed in foreign currency terms
(indirect quotations):
% = Beginning Rate Ending Rate x100
EndingRate
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Mini-Case Questions:
Venezuelan Bolivar

The

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 Santiagos
choices and use it to recommend a
solution to his problem.
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Additional
Chapter
Exhibits

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