Foreign Exchange Fundamentals

Foreign Exchange Fundamentals
Corporate Finance Institute®

What Is FX
FX (Foreign Exchange) is the conversion of one currency to another.
Sell domestic currency Buy foreign currency
Exchange Rate
The price at which one

currency is converted into
Buy domestic currency Sell foreign currency
another.

Most Liquid Market
FX market is the deepest and the most liquid market in the world.
Average daily trading Very deep market – can

volume exceeded $6.6 easily absorb $1 billion
trillion USD equivalent a USD equivalent trades
day in 2019. (called a ”yard”).
Source: Bank for International Settlement. (2019). Triennial Central Bank Survey - Global foreign exchange market turnover in 2019. Retrieved from
https://www.bis.org/statistics/rpfx19_fx_annex.pdf

Perfect Market
01
Freedom of Entry and Exit
02
Product Homogeneity
03
Perfect Market
Profit Maximization
04
Freedom of Information

Foreign Exchange History

History of FX Markets
Foreign exchange markets were developed to overcome inefficiencies with the barter system (allowing
inter-jurisdictional trade).

Gold and Silver
These markets focused on products that held equal value in both jurisdictions, notably gold and silver.
The preference between gold and silver was normally a function of a metal’s domestic availability and
production.
Silver
Greece & East Asia
Gold Rome

Exchange of Coinage
The exchange of coinage would be assessed on weight and purity to establish an exchange rate.
Traders would be mindful to ensure that coins contained the correct amount of silver and were not
adulterated with other metals of lesser value.

Debasement Methods
Debasement Methods
Clipping Sweating Plugging
Sides of a coin are clipped off. Coins are shaken in a bag to A hole is punctured in a coin
collect the dust and loose and then hammered flat until
metal. the hole is filled.

The Great Debasement
Debasement could be enacted by monetary authorities.
Henry VIII Debasement Risks
• Excessive public deficits • Due to debasement risks,

• “The Great Debasement” FX prices were based more
on the precious metal
content of the coins.
23 carats 20 carats
92.5% 25%

Fiat Money and Gold Standard
Fiat Money Gold Standard
• Government-issued money (banknotes and coins), • British Government-issued notes, which were freely
which has no intrinsic value and fully convertible into gold on demand
• Depends on the perception of the issue • Eventually, only a portion of the note issuance was
• Less confidence with inflation, excessive deficits, and backed by gold (more currency in circulation)
war • Widespread usage across large industrial nations

The Gold Standard
With domestic currencies fixed against the price of gold, it is possible to determine the relative value of
currencies, thereby creating an exchange rate.
U.S. Government British Government
$20.67 USD/oz £4.24 GBP/oz
$20.67 USD/oz
÷ = GBP/USD 4.87
£4.24 GBP/oz

The Gold Standard: Conversion
1 GBP =
U.S. Dollars Canadian Dollars Dutch Guilders
GBP/USD 4.87 GBP/CAD 4.87 GBP/NLG 12.11
French Francs German Marks Austro-Hungarian

Krones
GBP/FRF 25.22 GBP/DEM 20.43 GBP/AHK 24.02

The Gold Standard: Drawbacks
The gold standard, despite resolving many deficiencies with non-asset-backed fiat currencies, had
drawbacks.
Global money supply expands at the rate of gold production.
01 Periods of global inflation
02 Periods of global deflation

The Gold Standard Continued
After the First World War, the international monetary system limped on.
Initially, nations prevented the

Eventually returned to the gold standard.
free exchange of foreign currency
Weak Economies
• Gold continued to flow out

• Domestic money supply shrunk
• Deflationary effects lowered economic growth

The Gold Standard Timeline
1925 1928 1931 1934 1935 1936
UK reintroduces Countries rejoin, Countries leave: United States Countries leave: Tripartite Agreement:
gold standard forming the gold devalues the
bloc: USD, but keeps
gold standard
• The rest of the

countries leave
the gold bloc

Bretton Woods
Bretton Woods Conference (1944) Gold

$35 USD/oz
• New Hampshire, USA

• The allied nations designed a new international monetary
order that would replace the pre-war gold standard U.S. Dollars
Expectations
• Domestic currencies can fluctuate up to 1%

• Nations expected to maintain the exchange rate
through domestic economic policies
• Balance of payment deficits: contract the economy
• Balance of payment surpluses: expand the economy

Bretton Woods: Drawbacks
Balance of Payment Surpluses Balance of Payment Deficits
Nations failed to expand their Nations found it difficult to

economies and preferred to contract their economies.
hoard as much gold as possible.
More frequent forced devaluations,

compared with few revaluations.

Bretton Woods: Drawbacks
Similar to the gold standard, the annual increase in the global money supply was dependent on annual
gold production.
U.S. Dollar supply increases through government deficits added to the international
money supply.
Deficits became so large that they undermined the international monetary order.
Bretton Woods system ended in 1971 when President Nixon took “the dollar off gold.”

Exchange Rate Regimes

Free Float
A free float is an exchange rate regime where a domestic currency can be traded without any
limitations or influence from the monetary authorities.
Freely floated exchange rate allows the market to

determine the external value of a domestic value.
Governments and central banks do not use interest

rates or direct intervention to influence FX rates.
Currency value is derived purely from market

demand and supply.

Managed Float (Dirty)
A managed dirty float is where monetary authorities regularly intervene in FX markets to influence
price movements to achieve its own undisclosed policy objectives.
Authorities may make public statements to influence

the market’s view on currency movements.
Central bank may influence rates through interest

rate changes or open market operations.
Governments may instruct domestic companies to

purchase or sell foreign currency in the market.

Managed Float (Transparent)
A managed transparent float is where authorities announce any interventions in the marketplace,
along with the monetary tools used.
Compared to a dirty float, monetary authorities are more

active and transparent in their market interventions.
Announce preferred pricing parameters such as

limiting daily volatility or absolute price levels.
Use similar methods of market intervention, including

formal restrictions on currency trading.

Pegged/Fixed Exchange Rate
A pegged or fixed exchange rate is where the value of one currency’s price is fixed in relation to
another currency.
There may be provisions provided for price movements

around the fixed value.
Exchange rate maintenance requires rigorous use of

monetary tools (interest rate and direct intervention).
Capital controls can be utilized but must be balanced

against implications for trade and investment.

Crawling Peg
A crawling peg would allow a currency to be fixed to another currency for a period but acknowledge
that the peg would be adjusted over time.
Allows a currency to be fixed to another currency,

acknowledging an adjustment to the peg over time.
For example, exchange rate would depreciate by 1%

per annum, providing a “pegged pathway”.
Gives monetary authorities more credibility when

markets feel an absolute peg cannot be maintained.

Currency Basket
A currency basket is an exchange rate regime whereby the monetary authority decides to peg its
currency to a mix of currencies with different weightings.
Currency mix and weighting of a currency basket can be

disclosed or undisclosed.
Examples of disclosed currency baskets would be the

ECU and Special Drawing Rights (SDRs).
Examples of undisclosed or partially disclosed

countries are Singapore (SGD) and China (RMB).

Currency Basket (Disclosed)
Value Weight
Belgian Francs 3.301 8.183%
German Marks 0.6242 31.915%
Danish Krones 0.1976 2.653%
Spanish Peseta 6.885 4.138%
French Francs 1.332 20.306%
Example of the ECU*:
British Pounds 0.08784 12.452%
Sept. 21, 1989 to Dec. 31, 1999
Greek Drachmas 1.44 0.437%
Irish Punts 0.008552 1.086%
Italian Lira 151.8 7.840%
Luxembourg Francs 0.13 0.322%
Dutch Guilders 0.2198 9.87%
*ECU = European Currency Unit Portuguese Escudos 1.393 0.695%

Currency Basket (Undisclosed)
Weight Weight
USD 0.224% THB 0.0291%
EUR 0.1634% ZAR 0.0178%
JPY 0.1153% KRW 0.1077%
HKD 0.0428% AED 0.0187%
Example of the CFETS*: GBP 0.0316% SAR 0.0199%
Currency weights since AUD 0.044% HUF 0.0031%
January 1, 2017 NZD 0.0044% PLN 0.0066%
SGD 0.0321% DKK 0.004%
CHF 0.0171% SEK 0.0052%
CAD 0.0215% NOK 0.0027%
MYR 0.0375% TRY 0.0083%
*CFETS = China Foreign Exchange Trade System RUB 0.0263% MXN 0.0169%

The Impossible Triangle
Exchange Rate
Stability
Impossible
Triangle
Monetary Policy Free Capital

Independence Mobility

Market Participants
Central Banks
Central Banks Level of active involvement will depend on foreign exchange regime.
International
Free Floating FX
Banks
International
Investors
Market Participants
Day Traders More Active

Central Banks
Multinational
Corporations
Domestic
Corporations
MARKET
Managed FX
Private
Investors • Facilitate government purchase
of foreign armaments
Tourists
• Speculative purposes

International Banks
Central Banks The main participants in foreign exchange markets.
International
Banks
International 01
01 63%
63%
Investors
Market Participants
of market volume.
Day Traders
Provide trading
Multinational
Corporations 02
02 venues and
platforms.
Domestic
Corporations
MARKET
Private Facilitate customer

Investors
03
03 FX needs and take
on FX positions.
Tourists

International Investors
Use FX to facilitate the purchase and sale of assets across jurisdictions.

Central Banks
May also use the market to hedge current FX exposures or rebalance
International multi-national portfolios.
Banks
International
Investors
Market Participants
Pension Funds Private Family Offices
Day Traders
Multinational Hedge Funds Individuals

Corporations
Domestic
Corporations Sovereign Wealth Funds Prime Brokerage
Private
Investors
• Allows non-bank clients to gain
better pricing and liquidity
Tourists

Day Traders
Central Banks Expanding due to the ease of access to international markets.
International
Banks
International
Financial asset transactions can be initiated
Investors
Market Participants
at the click of a button.

Day Traders
Multinational In addition, the leveraged nature of day

Corporations
trading has expanded FX product needs.
Domestic
Corporations
Private
Investors
Tourists

Multinational Corporations
Central Banks Balance varying income and expenditure levels in different currencies.
International
Banks
01
01 02
02
Raising debt in one Financing production
International currency. costs in one currency.
Investors
Market Participants
Day Traders
Capital investment is Export income in
Multinational in another currency. another currency.
Corporations
Domestic
Corporations As multinational corporations increase in foreign operations,
Private so does the complexity of balancing foreign exchange.
Investors
Tourists

Domestic Corporations
Central Banks Engage in importing and exporting goods and services.
International
Banks
International
01
01 Domestic corporations import to sell
domestically.
Investors
Market Participants
Day Traders
02
02 Manufacturers may import production
materials.
Multinational
Corporations
Domestic
Corporations 03
03 Domestic producer may export some
production.
Private
Investors
Tourists 04
04 Domestic companies may purchase capital
goods from abroad.

Private Investors
Central Banks Diversify their domestic portfolio and purchase foreign financial assets.
International
Banks
International
Investors
Market Participants
Day Traders
Multinational
Corporations
Domestic
Corporations
Private
Investors
Tourists

Tourists
Central Banks Purchase foreign currency when traveling abroad.
International
Banks
International
Investors
Market Participants
Day Traders
Multinational
Corporations
MARKET
Domestic
Corporations
Private
Investors
Individual transactions are aggregated by card issuing
Tourists
bank and transacted in the foreign exchange market.

Foreign Exchange Brokers
Specialized Foreign Interbank Foreign

Exchange Firms Exchange Brokers
Helps small companies and private Helps international banks execute

individuals manage FX needs. transactions between banks.
• Aims to find two banks with

• Lower transaction costs
opposite FX requirements
• Facilitate purchase of foreign • Digitalization has allowed trades
properties to be executed automatically
• Voice brokers are still highly
• Assist in importation of goods
effective for custom-made
requests
Interbank vs. Retail
Interbank Retail
International
Investors
Central Banks Multinational

Corporations
Domestic
Corporations
Day Traders
International
Banks
Tourists
Specialized Brokers

Market Participants
Four key segments:
1. Domestic and International Banks (63%) 2. Central Banks (1%)

• For their own accounts or for customers, • Intervening to support or suppress the
includes market-makers and prime brokerage value of its domestic currency
3. Corporates (7%) 4. Speculators + Investors (21%)

• Need to pay invoices or hedge their exposure • High-net-worth individuals (HNWI), hedge
• "Cost-reduction strategies” funds, or proprietary trading desks

All Market Participants
Retail Client Banks Client Banks Retail
Large Large
Retail International International Retail
Banks Banks
Interbank
Market
FX Brokers FX Brokers
Large Large
Retail International International Retail
Banks Banks
Retail Client Banks FX Brokers Client Banks Retail

Foreign Exchange Platforms
Foreign exchange platforms represent the market infrastructure that facilitates the execution of foreign
exchange transactions.
Retail Digital Bank to Bank Interbank

In Person Telephone
Platforms Digital Platforms Platforms


In Person Telephone
• Prices are transparent while transaction costs are high

• Transaction costs are passed to consumers through
1. Flat transaction fee
2. Charging a spread between execution and wholesale rates


In Person Telephone
• Calls can be placed by individuals and companies to banks or

between banks to manage FX exposures
• Often followed by digital confirmation to log and process the trade


In Person Telephone
• Electronic trading platforms provided by international banks

• Provide live prices that can confirm and process transactions at the
click of a button
• Transaction cost can be manipulated by adjusting transactions
fees to allow banks to differentiate
Source: Autobahn Deutsche Bank


In Person Telephone
• Some banks have specialized in the provision of certain currencies

while offloading others directly into the market
• International Banks have installed in-house digital platforms into
client banks, capturing more market share
Source: UBS Neo


In Person Telephone
• Specialist trading platforms such as EBS and Refinitiv only accessible

to interbank counterparties
• Refinitiv system allowed banks to directly call and ask for a price
• Interbank liquidity relationships are built open reciprocity
Source: Refinitiv FXall

Chicago Mercantile Exchange (CME)
01
01 Contracts traded digitally and
executed only during CME hours.
02
02 Contracts have fixed notional
values (such as 125,000 EUR).
03
03 Contracts expire on specific dates.
Limitations
• Notional amounts are fixed

• Settlement dates are pre-specified
Source: CME Group

Settlement Process
Foreign Exchange Settlement Process
During the initial settlement process, each counterpart will send each other their trade confirmation.
Check the following points to ensure trades agree:
01
01 Currency pair
02
02 The side
03
03 The rate
Although most errors are easily amended,
delays in correcting some errors can cause
04
04 The delivery date
significant losses.
05
05 Counterpart banking details

SWIFT
Once the trade is in agreement, the delivery process can begin.
Society for Worldwide Interbank Financial Telecommunications (SWIFT) code

SWIFT
provides the exact details for settlement.
Timely Settlement Failure to Send Funds
• Counterparty NOSTRO
• Funds received to account becomes overdrawn.
appropriate accounts as
requested. • Punitive interest charges on
overdrawn amount.

ISDA
An International Swaps and Derivatives Association (ISDA) agreement covers failure to deliver in
extreme cases.
The non-defaulting counterparty can Legal recourse to defaulting party for

terminate remaining exposures. associated costs.
People’s Republic of China Once authorities allowed ISDAs, the RMB became one of the most traded currencies.

Market Drivers
Short Term Drivers
Short Term
Economic News Individual

Central Banks Speculation Technical Analysis
and Releases Capital Flows
• Trade data • Individual • Open market • Intraday • Observing

transactions of operations positions defined price
• Interest rate financing range
decisions foreign • Fulfilling • “Squaring”
purchases international (ensure net • Traders
• Employment commitments zero position) participate
data daily where price
ranges are
breached

Medium Term Drivers
Medium Term
Capital Flows Interest Rate Policy Balance of Payments Taxation
• Funds to purchase or • Domestic interest • Net flows of imports • Tax regimes may
sell financial assets rates and exports influence capital flow
• Foreign direct • Foreign interest rates • Surplus nations have • Low tax jurisdictions
investment positive currency may attract capital
demand
• High tax jurisdictions
• Deficit nations have may dissuade capital
negative currency
demand

Long Term Drivers
Long Term
Inflation Deflation
• Increases in the price level of • Decreases in the price level of

goods/services. goods/services (negative inflation).
• Decrease in purchasing power. • Increase in purchasing power.
Stagflation
• High inflation and slow economic growth.

• Over the longer-term, differences in domestic
price levels will influence exchange rates.

Long Term Drivers
Long Term
Foreign Currency Debt Load
National currencies with high debt levels are prone to depreciative effects.
1. Weak domestic economy will prompt debt repayment concerns.

2. Weak domestic currency leads to struggle in foreign debt repayment.
3. Capital repatriation can lead to greater currency weakening.

Purchasing Power Parity
Purchasing power parity: the prices for the same goods should be the same across different regions
when adjusted for exchange rates.
Global price ($USD) of a Big Mac
(Jan. 2021)
However:
Inflation is not considered.
Many goods/services cannot be freely

transferred across countries or regions.
Source: Statista

Regulatory Environment
Regulatory Environment
Association Cambiste Internationale (ACI)
• Founded in 1955 in Paris
• Trade body representing the interests of the foreign

exchange market
• Created FX Global Code and ethical code of conduct to self

Not subject to
regulate markets
formal regulation.
• Breach of the code can lead to the withdrawal of memberships

and trading licenses (no legal sanctions)

Regulation
Pre-Banking Crisis Post Banking Crisis
Self- Proprietary
Regulation Positions
• Imposed regulations • Speculative nature

on the FX market represented moral
hazard for
Self regulation was • Breaches of governments
sufficient. restrictions are
legally sanctionable • Banks may hold FX
positions for market
Proprietary positions • Defined market making purposes
were acceptable. practices that were
no longer tolerable

Spoofing
Spoofing is a type of market manipulation carried

out in two primary methods:
Influence demand/supply perception by placing

large market order with no intention to execute.
Precede trades of large volume directly through

banks, with opposite buy/sell orders in market.

Spoofing
EUR/USD Buy Orders Sell Orders EUR/USD Buy Orders Sell Orders
$0.8047 0 600,000 $0.8047 0 600,000
$0.8046 0 700,000 $0.8046 0 700,000
$0.8045 0 500,000 $0.8045 0 500,000
$0.8044 0 800,000 $0.8044 0 800,000
$0.8043 0 900,000 $0.8043 0 900,000
$0.8042 800,000 0 $0.8042 800,000 0
$0.8041 500,000 0 $0.8041 500,000 0
$0.8040 300,000 0 $0.8040 300,000 0
$0.8039 150,000 0 $0.8039 150,000 0
$0.8038 350,000 0 $0.8038 350,000 0
$0.8037 900,000 0 $0.8037 6,500,000 0

Front Running
Can I buy Sure, I will

The practice of executing trades using advanced
500 EUR at put that
knowledge of client orders. 1.2000? order in.
Client FX Broker
Orders can be placed slightly in advance of a
client’s defined order.
A trader may sell a currency when informed First Order: FX broker bids for 10 EUR at 1.2001.
that a customer wishes to sell.
Second Order: FX broker places the order for 500 EUR for
their client.

Information Sharing
XYZ is
Thanks for
The sharing of sensitive market information planning to
letting me
between banks is prohibited. sell $200MM
know!
USD.
FX Broker A FX Broker B
An information cartel may share information on
various bank’s order books.
Select few banks would see outstanding market First: FX broker B lets his clients know to purchase USD now
as it is expected to increase.
orders and can influence future prices.
Second: FX broker B suggests to wait while he offloads USD
to purchase after a devalue.

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Corporate Finance Institute®

FX (Foreign Exchange) is the conversion of one currency to another.

Sell domestic currency Buy foreign currency

The price at which one

Corporate Finance Institute®

Average daily trading Very deep market – can

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Greece & East Asia

Corporate Finance Institute®

Corporate Finance Institute®

Clipping Sweating Plugging

Corporate Finance Institute®

Debasement could be enacted by monetary authorities.

Henry VIII Debasement Risks

• Excessive public deficits • Due to debasement risks,

Corporate Finance Institute®

Fiat Money Gold Standard

Corporate Finance Institute®

U.S. Government British Government

$20.67 USD/oz £4.24 GBP/oz

Corporate Finance Institute®

U.S. Dollars Canadian Dollars Dutch Guilders

GBP/USD 4.87 GBP/CAD 4.87 GBP/NLG 12.11

French Francs German Marks Austro-Hungarian

GBP/FRF 25.22 GBP/DEM 20.43 GBP/AHK 24.02

Corporate Finance Institute®

Global money supply expands at the rate of gold production.

01 Periods of global inflation

02 Periods of global deflation

Corporate Finance Institute®

Initially, nations prevented the

• Gold continued to flow out

Corporate Finance Institute®

1925 1928 1931 1934 1935 1936

• The rest of the

Corporate Finance Institute®

Bretton Woods Conference (1944) Gold

• New Hampshire, USA

• Domestic currencies can fluctuate up to 1%

Corporate Finance Institute®

Balance of Payment Surpluses Balance of Payment Deficits

Nations failed to expand their Nations found it difficult to

More frequent forced devaluations,

Corporate Finance Institute®

Corporate Finance Institute®

Corporate Finance Institute®

Freely floated exchange rate allows the market to

Governments and central banks do not use interest

Currency value is derived purely from market

Corporate Finance Institute®

Authorities may make public statements to influence

Central bank may influence rates through interest

Governments may instruct domestic companies to

Corporate Finance Institute®

Compared to a dirty float, monetary authorities are more

Announce preferred pricing parameters such as