Chapter 5

The Foreign
Exchange Market
 Learning Objectives

• Examine the what, when, where, and why of

currency trading in the global marketplace
• Understand the definitions and distinctions among
spot, forward, swap, and other types of foreign
exchange financial instruments
• Learn the forms of currency quotations used by
currency dealers, financial institutions, and agents
of all kinds when conducting foreign exchange
transactions
• Analyze the interaction among changing currency
values, cross exchange rates and opportunities
arising from intermarket arbitrage

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 Functions of the Foreign
Exchange Market

• Foreign exchange market provides physical

structure through which the money of one country
is exchanged for that of another country
• The rate of exchange between currencies is
determined and transaction physically completed

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 Functions of the Foreign
Exchange Market

• Foreign exchange transaction is an agreement

between buyer and seller that a fixed amount of
one currency will be delivered for some other
currency at a specified date.

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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 by
exchanging money is necessary-international trade
– Obtain/provide credit for international trade
transactions - bankers’ acceptance and letters of
credit to finance international trade
– Minimize exposure to the risks of exchange rate
changes – provides ”hedging” facilities to transfer
the risk

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 Structure of the Foreign
Exchange Market

• The foreign exchange market consists of two

tiers
– the interbank or wholesale market, and
– the client or retail market
• Single tier market – electronic
• Participation:
– Commercial purposes, liquidity seekers and profit
seekers
• Profit seekers much better informed for future
market movements, looking profit from future
movements

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 Structure of the Foreign
Exchange Market

• Five broad categories of institutional participants

operate in the market:
– Bank and nonbank foreign exchange dealers
– Individuals and firms conducting commercial or
investment transactions
– Speculators and arbitragers
– Central banks and treasuries
– Foreign exchange brokers

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 Bank and Nonbank Dealers

• They profit from buying foreign exchange at a “bid”

price and reselling it at a slightly higher “ask” price
or– currency trading
• Competition among the dealers narrows the spread
and makes market “efficient”
• Dealers in the FE 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
• Currency trading gives a high profit for many
institutions
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 Bank and Nonbank Dealers

• Small-to-medium-size banks and institutions often

buy from and sell to larger institution in order to
offset retail transactions or to seek short-term profits
not to be a market maker

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 Individuals and Firms

• Individuals (such as tourists) and firms (such as

importers, exporters and MNEs), international
portfolio investors conduct commercial and
investment transactions in the foreign exchange
market.
• Some of the participants use the market to
“hedge” foreign exchange risk.

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 Individuals and Firms

• Forward and option contracts

• Forward contract is an agreement to exchange
currencies of different countries as a specified
future date and at a specified forward rate
• Option contract is a derivative financial
instrument that gives the right but not the
obligation to exchange money denominated in one
currency into another currency at a pre-agreed
exchange rate on a specified date

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 Speculators and Arbitragers

• Speculators and arbitragers operate for their own

interest-True profit seekers
• Dealers seek profit from the spread between bids
and offers
• Speculators seek all their profit from exchange
rate changes
• Arbitrages gain profit from exchange rate
differences in different markers
• speculators and arbitrage works for major banks

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 Central Banks and Treasuries

• Use the market to acquire or spend their country’s

currency reserves as well as to influence the price
at which their own currency trades – Foreign
exchange intervention
• Support the value of their currency because of
their government’s policies or obligations
• Their motive is not to profit but rather influence
the foreign exchange value – benefit the interest
for their citizens

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 Foreign Exchange Brokers

• Agents who facilitate trading between dealers

without themselves becoming principals in the
transaction
• Charge small commission for the service
• Brokers maintain access to hundred dealers
worldwide via open telephone line

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 Transactions in the Foreign
Exchange Market

• Transactions within this market can be executed

on a spot, forward, or swap basis
• Spot rate: price at which foreign exchange can be
purchased or sold in a spot transaction

• 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
– £10,000,000 $1.8420/£ (Monday) = $18,420,000
(Wednesday)
– The settlement date is often referred to as the value date

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 Exhibit 5.2 Foreign Exchange
Settlement in Europe

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 Transactions in the Foreign
Exchange Market

• An forward transaction requires delivery at a future

value date of a specified amount of one currency for
a specified amount of another currency.
• The exchange rate agreed at the time of the
agreement
• But payment and delivery not required until maturity
• Maturities: 1, 2, 3, 6 and 12 months
• Payment is on the second business day after
maturity
• Thus, maturity on March 18, value date of May 20

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 Transactions in the Foreign
Exchange 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
• two parties exchange currencies for a certain
length of time and agree to reverse the
transaction at a later date.
• Normally spot to forward
• Both purchase and sale are conducted with the
same counterparty.

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 Transactions in the Foreign
Exchange Market

• Some different types of swaps are:

– spot against forward
• Dealers buy a currency in the spot market (spot rate)
and simultaneously sells to the same bank in the
forward market (at the forward exchange rate)
– forward-forward swaps
• Sells £20,000,000 forward for dollars for delivery in 2
months at $1.8420/£
• Buys £20,000,000 forward for delivery in 3 months at
$1.8400/£
– Nondeliverable Forwards (NDF)

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 Foreign Exchange Rates &
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 &
Quotations

• Every currency exchange involves two currencies,

(CUR I) and (CUR 2)
– CUR 1/CUR 2
• The currency to the left in the base currency or
the unit currency
• The currency to the right of the slash is called the
price currency or quote currency
– EUR/USD1.2174
– EUR1 = USD 1.2174

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 Foreign Exchange Rates and
Quotations
• 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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 Market Conventions

European Terms
• Quoting of the specific currency per one U.S. dollar.
• U.S. 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)
• Most interbank quotations around the world are
stated in European terms

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 Exhibit 5.6 Foreign Currency
Quotations

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 Foreign Exchange Rates &
Quotations

• France (EURO) is home currency

Direct quote - Price (Home currency) and unit

(foreign currency)
– EURO 0.8214 = USD1.00 direct quote on the dollar

An indirect quote – Price (foreign currency), unit

(home currency)
– USD 1.2174 = EUR 1 an indirect quote on the dollar

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 Foreign Exchange Rates &
Quotations
• Interbank quotes are given as a
– bid- price at which a dealer will buy another currency, or
– ask- price at which a dealer will sell another currency
• Dealer bid (buy) at one price and ask (sell) at a
slightly higher price = profit
• Dealers make their profit from the spread between
the buying and selling prices
• A bid for one currency is also the offer for the
opposite currency
• Traders seeking to buy dollars with euros
simultaneously offering to sell euros with dollars
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 Exhibit 5.8 Exchange Rates: New
York Closing Snapshot (cont.)

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 Foreign Exchange Rates &
Quotations
• Many currency pairs are only inactively traded, so
their exchange rate is determined through their
relationship to a widely traded third currency (cross
rate)
• A Mexican importer needs Japanese yen to pay for
purchases in Tokyo.
• Both the Mexican peso (MXN) and the Japanese yen
are commonly quoted against the US dollar

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 Foreign Exchange Rates &
Quotations

Currency per
USD

Japanese yen USD/JPY 104.85

Mexican peso USD/MXN 13.1073

• A Mexican importer needs Japanese yen to pay for

purchases in Tokyo.
• The Mexican importer can buy one US

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 Foreign Exchange Rates &
Quotations

• A Mexican importer needs Japanese yen to pay for

purchases in Tokyo.

Japanese Yen = 1 U.S. Dollar = ¥104.85/$

Mexican Peso = 1 U.S Dollar = Ps13.1073/$

= ¥7.9994/Ps
Or
Ps0.125/ ¥

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 Foreign Exchange Rates &
Quotations
• Measuring a change in the spot rate for quotations
expressed in home currency terms (direct
quotations):
%∆ = Ending rate – Beginning Rate x 100
Beginning Rate
• Quotations expressed in foreign currency terms
(indirect quotations):
%∆ = Beginning Rate – Ending Rate x 100
Ending Rate

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 Foreign Exchange Rates &
Quotations
• Assume that Mexican peso has recently changed in
value from USD/MXN 10.00 to 11.00. Your home
currency is the US dollar. What is the percent change
in the value of the Mexican peso?
• When the foreign currency (the price, Ps) of the home
currency (the unit,$) is used, Mexican pesos per US
dollar in this case, the formula for the percent change
(%) in the foreign currency becomes – (indirect
quotations, foreign currency term):

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 Percentage Change in Spot Rate

• When the foreign currency (the price) for a home

currency (the unit) is used- (indirect quotation)

• Ps10.00/$-Ps11.000/$ ⃰ 100 =-9.09%

$11.00Ps/$
• The Mexican peso fell in value 9.09% against the
dollar

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 Percentage Change in Spot Rate

• Home currency term

Home currency (the price) for a foreign currency
(the unit) is used- (direct quotation)

$0.09091/Ps-$0.1000/Ps ⃰ 100 =-9.09%

$0.1000/Ps

A fall in the value of the peso by 9.09%

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 Foreign Exchange Rates &
Quotations

• Forward rates are typically quoted in terms of

points or pips, the last digits of a currency
quotation .
• A forward quotation 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 &
Quotations

• Example: Refer exhibit 5.11

• Japanese Yen -143 bid and -140 ask
• The first number (-143) refers to points away from
the spot bid
• Second number refer (-140) refers to points away
from the spot ask
• Given the outright quotes of 118.27 bid and
118.37 ask, 3month forward rates are:

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 Foreign Exchange Rates &
Quotations

Bid Ask
Outright spot JPY118.27 JPY118.37

Plus point (3 month) 1.43 1.40

Outright forward JPY116.84 JPY116.97

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 Exhibit 5.11 Spot and Forward
Quotations for the Euro and Japanese
Yen

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 Foreign Exchange Rates &
Quotations

• 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 &
Quotations

• Foreign Currency terms (indirect quotes) (i.e.

quote expressed in foreign currency terms)
Spot - Foward 360
f FC
 x x 100
Foward days
• Home Currency terms (direct quotes) (i.e. quote
expressed in home currency terms)

Forward - Spot 360

f  H
x x 100
Spot days

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 Foreign Exchange Rates &
Quotations

Foreign currency (price)/ home currency (price)/

home currency (unit) Foreign currency (unit)

Spot rate ¥118.27/$ USD/JPY 0.0084552

3-month forward ¥116.84/$ USD/JPY 0.0085587

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 Foreign Exchange Rates &
Quotations

• Example: Foreign currency terms

118.27 - 116.84 360

¥
f  x x 100   4.90% p.a.
116.84 90
Means that Japanese yen is selling forward at a
premium of 4.90% against the U.S. dollar

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 Foreign Exchange Rates &
Quotations

• Example: (Home currency terms)

• Result is identical to the previous premium
calculation: a positive 4.90% premium of the yen
against the dollar

0.0085587-0.0084552 360
f 
$
x x 100   4.90% p.a.
0.0084552 90

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 Summary of Learning
Objectives
• Reciprocals. Suppose that Australia is the
home country.
• Determine whether the following quotes
are direct or indirect, and convert indirect
(direct) quotes to direct (indirect) quotes:

a. Euro: AUD1.4462/EUR.
b. Canada: CAD0.9812/AUD.)

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 Summary of Learning
Objectives
a. Direct; EUR0.6915/AUD.

b. Indirect; AUD1.0192/CAD.

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 Summary of Learning
Objectives
Cross Rates. Calculate the cross rates for
the following currencies:

a. Find the cross rate JPY/CAD from the spot

rates JPY104.8/USD and CAD1.06/USD.
b. Find the cross rate MXN/BRL from the spot
rates MXN2.81/USD and USD0.42/BRL.

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 Summary of Learning
Objectives
a. JPY98.87/CAD.

b. MXN1.1802/BRL.

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 Summary of Learning
Objectives
TUTORIAL

Q1, 2, 7, 10

PROBLEM 1, 2, 8

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