2.1 the fx market

8/12/2019 2.1 The FX Market

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The Foreign Exchange Market

Ch. 6 ESM


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The Foreign Exchange Marketprovides:

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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Foreign exchangemeans the money of a foreign

country; that is, foreign currency bank balances,

banknotes, checks and drafts.

Aforeign exchange transactionis 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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Exhibit 6.2 Global Currency Trading:

The Trading Day


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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 ratechanges.


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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).

Four broad categories of participants operate within these

two tiers; bank and nonbank foreign exchange dealers,

individuals and firms conducting commercial or investment

transactions, speculators and arbitragers, and central banks

and treasuries.


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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 butnevertheless 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 theircountrys foreign exchange reserves as well as to influence the price atwhich their own currency is traded.

They may act to support the value of their own currency because ofpolicies adopted at the national level or because of commitmentsentered 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 theinterests 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 followingbusiness day.

The date of settlement is referred to as the

value date.


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An outright forward transaction (usually called justforward) requiresdelivery at a future value date of a specified amount of one currency for aspecified amount of another currency.

The exchange rate is established at the time of the agreement, butpayment 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 forwarddescribe the same transaction (theonly difference is the order in which currencies are referenced.)


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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 samecounterparty.

Some different types of swaps are:

spot against forward,

forward-forward,

nondeliverable forwards (NDF).


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Market Size

In April 2010, a survey conducted by the Bank

for International Settlements (BIS) estimated

the daily global net turnover in traditional

foreign exchange market activity to be $3.2trillion, up from $1.9tn in 2004.

This most recent period showed dramatic

growth in foreign exchange trading over that

seen in April 2001.


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Exhibit 6.3 Top 10 Geographic Trading Centers in the Foreign Exchange

Market, 19922007

(daily averages in April, billions of U.S. dollars)


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Exhibit 6.4 Global Foreign Exchange Market Turnover, 1989-

2010 (average daily turnover in April, billions of U.S. dollars)


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Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign

Exchange Market, 1991-2010 (average daily turnover in April)


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Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair

(daily average in April)


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Foreign Exchange Rates and

Quotations

A foreign exchange rateis 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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Quotations

Most foreign exchange transactions involve theUS 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 interms of the number of units of foreign currencyneeded to buy one dollar.


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Quotations

For example, the exchange rate between USdollars 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, mostinterbank quotations around the world arestated in European terms.


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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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Quotations Foreign exchange quotes are at times described as either director

indirect.

In this pair of definitions, the home or base country of the currencies

being discussed is critical.

A directquote is a home currency price of a unit of foreign currency.

An indirectquote 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 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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Many currency pairs are only inactivelytraded, so their exchange rate is determinedthrough their relationship to a widely tradedthird currency (cross rate).

Cross rates can be used to check onopportunities for intermarket arbitrage.

This situation arose because one banks(Dresdner) quotation on / is not the same acalculated cross rate between $/ (Barclays)and $/(Citibank).


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Citibank quote - $/ $1.2223/

Barclays quote - $/ $1.8410/

Dresdner quote - / 1.5100/

Cross rate calculation:

$1.8410/

$1.2223/ = 1.5062/

=


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Exhibit 6.8A Triangular Arbitrage


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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 rateBeginning Rate

Quotations expressed in foreign currency terms (indirect

quotations):

% = Beginning RateEnding Rate

Beginning Ratex 100

Ending Rate x 100


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Mini-Case Questions: The Venezuelan Bolivar Black

Market

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 tohis problem.

2.1 the fx market

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