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Chapter Five
The Market for
Foreign Exchange

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 Overview
Function and Structure of FX
Market. FX Market Participants.
Spot Market.
Triangular
Arbitrage.
Forward Market.

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 Introduction
Exchange rate is the price of one country’s
currency in terms of another.
Foreign exchange (FX) market encompasses the
conversion of purchasing power from one currency
into another, bank deposits of foreign currency, the
extension of credit denominated in a foreign
currency, foreign trade financing, trading in foreign
currency options and futures contracts, and
currency swaps.
Market for foreign exchange is the largest financial
market in
the world by virtually any standard.
• Daily turnover of about $7.5 trillion in 2022.
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 Function and Structure of FX Market
FX is a multiple–tier market:
• Spot, Forward/Futures, and Options.
• Interbank and Retail.

Spot and forward FX markets are over–the–counter (OTC)

markets.
These are global, 24–hour markets with major market
segments in:
• Australasia (example, Sydney, Tokyo, Hong Kong,
Singapore, and Bahrain).
• Europe (example, Zurich, Frankfurt, Paris, Brussels,
Amsterdam, and London).
• North America (example, New York, Montreal, Toronto,
Chicago, San Francisco, and Los Angeles).
Currencies are typically priced and traded against the U.S.
dollar.
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 Shares of Reported Global Foreign
Exchange Turnover by Country
Exhibit 5.1 Shares of Reported Global Foreign Exchange
Turnover by Country, 2022

Note: Turnover is net of local interdealer double–counting.

Source: Tabulated from data in Triennial Central Bank Survey, Preliminary Results,
Bank for International Settlements, October 2022.
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 Average Electronic Foreign Exchange
Conversations per Hour (Monday to Friday, 2001)

Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in
the United States,” 2001, www.newyorkfed.org.

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 Average Daily Foreign Exchange Turnover
by Currency against All Other Currencies
Exhibit 5.3 Average Daily Foreign Exchange Turnover by Currency
against All Other Currencies, 2022
Currency Symbol Code Turnover (in $ billion) Percent
U.S. dollar $ USD $6,641 88
Euro € EUR 2,293 31
Japanese yen ¥ JPY 1,253 17
Pound sterling £ GBP 969 13
Chinese yuan ¥ CNY 526 7
Australian dollar A$ AUD 479 6
Canadian dollar C$ CAD 466 6
Swiss franc SFr CHF 390 5
Other currencies 1,999 27
Total—double counted 15,016 200
Total—not double counted 7,508 100

Note: Turnover is net of local interdealer double–counting.

Source: Tabulated from data in Triennial Central Bank Survey, Preliminary Results, Bank for International
Settlements, October 2022.

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 Average Daily Foreign Exchange
Turnover by Currency Pair
Exhibit 5.4 Average Daily Foreign Exchange Turnover by
Currency Pair, 2022

Note: Turnover is net of local interdealer double–counting.

Source: Tabulated from data in Triennial Central Bank Survey, Preliminary Results, Bank for
International Settlements, October 2022.
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 FX Market Participants
FX market is a two–tier market.
1. Interbank/Wholesale market (more than 90% of trading
volume):
• Large commercial and investment banks and securities
houses worldwide that actively “make a market” in
foreign exchange.
• Nonbank dealers such as mutual funds, pensions
funds, and hedge funds that have their own trading
rooms.
• FX brokers who match buy and sell orders but do not
carry
inventory and FX specialists.
2. Client/Retail market (less than 10% of trading
volume):
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 Correspondent Banking Relationships 1

• Interbank market is made up of a network of

correspondent banking relationships, with large
commercial banks maintaining demand deposit
accounts (that is, correspondent banking
accounts) with one another.
• Correspondent bank account network facilitates
the
efficient functioning of the FX market.
• International banks communicate with one
another using Society for Worldwide Interbank
Financial Telecommunications (SWIFT).
• Clearing House Interbank Payments System (CHIPS)
serves as a clearinghouse for most of the
interbank settlement.
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 Correspondent Banking Relationships 2

According to the BIS, the number of correspondent

banks fell by about 20 percent in the last decade
mainly due to.
• Shift in banks’ business strategies and risk
appetites stemming from tightened regulations
that followed the Global Financial Crisis.
• Additional cross-border payment options made
available
by technological advances.

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 Spot Market
Spot market involves almost immediate purchase or
sale of foreign exchange.
One can buy (take a long position) or sell (take a
short position) foreign exchange.

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 Spot Rate Quotations 1

Spot rate currency quotations can be stated in

direct or indirect terms.
Direct quotations refer to the price of one unit of
a foreign
currency in terms of the domestic currency.
• For example, from the perspective of an American
investor, 1 euro is equivalent to 1.1233 U.S. dollars
or €1 = $1.1233.
Indirect quotation is the price of one domestic
currency in terms of a foreign currency.
• For example, from the perspective of an American
investor, 1 U.S. dollar is equivalent to 0.8903 euros
or $1 = €0.8903.
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 Spot Rate Quotations 2

Most currencies are quoted in European terms,

meaning the
U.S. dollar is priced in terms of the foreign
currency (an indirect quote from the U.S.
perspective).
USD/CHF = USDCHF = USD to CHF = 0.88
However, it is the norm to quote some currencies
like the British pound (or the euro) in terms of the
U.S. dollar, or in what is referred to as American
terms (a direct quote from the U.S. perspective).
GBP/USD = GBPUSD = GBP to USD =
1.27 EUR/USD = EURUSD = EUR to
USD = 1.06
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 Exchange Rates 1

Exhibit 5.7 Exchange Rates

Currencies January 31, 2022

U.S.-dollar foreign-exchange rates in late New York

trading
Country/currency in US$ — Mon — Per US$
Americas
Argentina peso .0095 105.02
Brazil real .1883 5.3102
Canada dollar .7869 1.2708
Chile peso .001249 800.60

Colombia peso .000254 3942.5

Costa Rica colón .001556 642.73

Ecuador US dollar 1 1
Mexico peso .0485 20.635

Peru new sol .2601 3.845

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 Exchange Rates 2

Country/currency in US$ Per US$

Asia-Pacific
Australian dollar .7067 1.4150
1-mos forward .7068 1.4149
3-mos forward .7071 1.4143
6-mos forward .7077 1.4131

China yuan .1572 6.3612

Hong Kong dollar .1283 7.7974

India rupee .01340 74.622

Indonesia rupiah .0000696 14368

Japan yen .00869 115.11

1-mos forward .00869 115.09
3-mos forward .00870 114.98
6-mos forward .00872 114.70
Malaysia ringgit .2389 4.1855
New Zealand dollar .6576 1.5206

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 Exchange Rates 3

Country/currency in US$ Per US$

Philippines peso .01962 50.975
Singapore dollar .7400 1.3513
South Korea won .0008268 1209.5
Taiwan dollar .03593 27.835
Thailand baht .03009 33.238

Vietnam dong .00004 22649.7

Europe

Czech Rep. koruna .04616 21.666

Denmark krone .1499 6.6708

Euro area euro 1.1235 .8901

1-mos forward 1.1241 .8896
3-mos forward 1.1260 .8881
6-mos forward 1.1299 .8851
Hungary forint .00316 316.19
Norway krone .1124 8.8963

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 Exchange Rates 4

Country/currency in US$ Per US$

Poland zloty .24515 4.0791
Russia ruble .01293 77.312
Sweden krona .1073 9.3230
Switzerland franc 1.0785 .9272
1-mos forward 1.0793 .9265

3-mos forward 1.0815 .9247

6-mos forward 1.0857 .9211

Turkey Iira .0752 13.304

UK pound 1.3447 .7437

1-mos forward 1.3444 .7438

3-mos forward 1.3441 .7440
6-mos forward 1.3435 .7443
Middle East/Africa
Bahrain dinar 2.6527 .3770
Egypt pound .0636 15.722

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 Exchange Rates 5

Country/currency in US$ Per US$

Israel shekel .3159 .3770
Jordan dinar 1.4105 15.722
Kuwait dinar 3.3002 3.1653
Nigeria naira .00241 .7090
Saudi Arabia riyal .2665 .3030

South Africa rand .0650 415.26

UAE dirham .2723 3.7519

Source: Compiled using data from

Bloomberg.

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 Cross–Exchange Rates
Cross–exchange rate is an exchange rate
between a currency pair where neither
currency is the U.S. dollar.
The cross–exchange rate can be calculated from
the U.S. dollar exchange rates for the two
currencies, using either European or American
term quotations.
• S(j/k) = S($/k) × S(j/$).
• S(k/j) = S(k/$) × S($/j).

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 The Bid–Ask Spread
Bid price: Price at which Ask price: Price at which
the bank buys the the bank sells the
currency at. currency at.
• example, Dealer will • example, Dealer will
buy euros from you sell euros to you at
at the bid price of the ask price of
$1.25 per €. $1.26 per €.
• The bid–ask spread is the difference between the
bid and ask prices and represents the dealer’s
expected profit. The bid–ask spread level varies
across market levels and extremely narrow in the
interbank market.
• Average of the bid and ask rates are called mid-
rates.
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 Spot FX Trading
In the interbank market, the standard size of trade is
about U SD10 million.
Bid–ask quotes are normally four decimal
places. For example,
Bid Ask
S($/£) $1.3442 $1.344
7
• “1.34” is known as the big figure and assumed to be
known by all traders.
• Last two digits (.42) is the small figure.
• A dealer would likely quote these prices as “42 to
47.”

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 Cross–Rate Trading Desk
Currency against currency trade is when a US
customer wants to trade out a nondollar currency for
another nondollar currency.
• For example, a customer wants to trade out of
(= to sell) British pounds into (= to buy) Swiss
francs.
• Typically handled by the bank selling British
pounds for
U.S. dollars and then selling U.S. dollars for Swiss
francs.
• Handled at the cross–rate desk of the bank.
• 𝑆𝑏(𝑆𝐹𝑟/£) = 𝑆 𝑏 $/£ ×
𝑆 (𝑆𝐹𝑟/$)
𝑏
and then sells dollars at the bid.
£/𝑆𝐹𝑟 = £/$ × 𝑆
Incorporating bid–ask spreads into cross–
𝑎
𝑆 𝑎
The client / bank BUYS dollars at the ask
𝑆𝑎 $/𝑆𝐹𝑟
•
exchange rates would give and
usthen
twobuys valid
swiss francs at the ask.
alternative ways to proceed!
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 Cross–Rate Foreign Exchange
Transactions 1

Bank American American European European

Quotations Terms Bid Terms Ask Terms Bid Terms Ask
British pounds $1.3442/£ $1.3447/£ £0.7437/$ £0.7439/$
Euros $1.1230/€ $1.1235/€ €0.8901/$ €0.8905/$

A Bank Client in the US wants to sell £1,000,000 for euros. Let’s apply
alternative 1
(based on the bid).
1. On behalf of its client, the Bank will first have to sell pounds to
buy dollars, looking for the bid with the pound as the base
currency, which is $1.3442/£ (direct quote from US perspective).
The sale of pounds yields:
£1,000,000 × $1.3442/£ = $1,344,200.
2. On behalf of its client, the Bank will then sell dollars and to buy
euros, looking for the bid with the dollar as the base currency,
which is €0.8901/$ (indirect quote from US perspective) . The sale of
dollars yields:
$1,344,200 × €0.8901/$ = €1,196,472.
3. In conclusion, Bank Client sold British pounds for euros at a €/£ bid
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 Cross–Rate Foreign Exchange
Transactions 2

Bank American American European European

Quotations Terms Bid Terms Ask Terms Bid Terms Ask
British pounds $1.3442/£ $1.3447/£ £0.7437/$ £0.7439/$
Euros $1.1230/€ $1.1235/€ €0.8901/$ €0.8905/$

A Bank Customer in the US wants to sell €1,000,000 to buy pounds.

Let’s use alternative 2 (based on the ask).
1. On behalf of its client, the Bank will first sell euros and buy dollars
at the ask with the dollar as the base currency, which is €0.8905/$.
The sale of euros yields: €1,000,000 ÷ €0.8905/$ = $1,122,965.
2. On behalf of its client, the Bank will then sell dollars and buy
pounds at the ask with the pound as the base currency, which is
$1.3447/£. The sale of dollars yields: $1,122,965 ÷ $1.3447/£ =
£835,104.
3. In conclusion, the Bank Customer effectively bought British
pounds at a €/£ ask price of €1,000,000 ÷ £835,104 = €1.19746/£
From parts (a) and (b), we see the currency against currency bid-ask
spread for British pounds is €1.19647−€1.19746, the same as the bid-
ask spread computed in Example 5.2.
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 Triangular Arbitrage
An arbitrage is a zero–risk, zero–investment
strategy from which a profit is guaranteed.
The purpose of triangular arbitrage is to earn an
arbitrage profit by trading among three currencies
when the quoted cross–exchange rate is not in
alignment with the implied cross–exchange rate.
For a U.S. dollar–based investor, it involves trading
out of the
U.S. dollar into a second currency, then trading it
for a third currency, which is in turn traded for U.S.
dollars.

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 Triangular Arbitrage Example 1

Assume that you are a US trader monitoring the foreign

exchange market on Monday, October 16, 2024. You have
$1,000,000 to trade, and we are ignoring bid-ask spread and
transaction costs in this example.

Credit Suisse is making

market in Swiss franc against
the U.S. dollar.

JPMorgan is making market in

yen
against the U.S. dollar.

Mizuho Bank is making a direct

market between Swiss franc and
Japanese yen at ¥125.10/SFr.
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 Triangular Arbitrage Example 2

¥/SFr rate based on the dollar exchange rates from

$1.0785/SFr × ¥115.11/$ = ¥124.15/SFr

Credit Suisse and JPMorgan should be ¥124.15/SFr:

However, Mizuho Bank is quoting ¥/SFr rate (125.10)

that is higher than the implied rate (124.15).
Quoted cross–rate ≠ Implied cross–rate
¥125.10 / SFr  ¥124.15 / SFr
The exchange rates are clearly not aligned, giving
you an opportunity to earn an arbitrage profit.
Since the implied cross–rate indicates that 1 Swiss
franc is worth 124.15 Japanese yen and yet
Mizuho is quoting a higher rate for Swiss franc,
you want to buy Swiss francs from CS and
ultimately sell them to Mizuho for Japanese yen.
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 Triangular Arbitrage Example 3

You can place the following transactions simultaneously to avoid

risk and take advantage of this triangular arbitrage.
1. Sell $1,000,000 and buy SFr 927,213.72 from Credit Suisse
at
$1.0785/SFr.
$1,000,000 ÷ $1.0785/(1)SFr = SFr 927,213.72
2. Sell SFr 927,213.72 and buy ¥115,994,436.40 from Mizuho
at
¥125.10/SFr.
SFr 927,213.72 × ¥125.10/SFr = ¥115,994,436.40
3. Sell ¥115,994,436.40 and buy $1,007,683.40 from
JPMorgan at
¥115.11/$.
¥115,994,436.40 ÷ ¥115.11/$ = $1,007,683.40
As a result, you earn an arbitrage profit of $7,683.40.
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 Triangular Arbitrage Example 4

Exhibit 5.10 Triangular Arbitrage

Example

1
3

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 Spot Foreign Exchange Market
Microstructure
Market microstructure refers to the basic mechanics
of how a marketplace operates.
Studies have shown:
• Bid–ask spreads in the spot FX market increased
with FX exchange rate volatility and decreased
with dealer competition.
• Bid–ask spreads have a prolonged U shape and
are narrowest when London and NY are open,
while trading volume and exchange rate
volatility are both M–shaped with peaks at
London open and the NY open.
• Significant variation in liquidity across exchange
rates and over time.
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 The Forward Market
Forward market involves contracting today for the
future purchase or sale of FX.
• No money changes hands upon entering the
contract today.
• May be used to hedge FX exposure or to
speculate in FX market.
• Forward price is usually higher (at a premium) or
lower (at a discount) than spot price.
• Bank quotes for maturities of 1, 3, 6, 9, and 12
months are
readily available.

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 Forward Rate Quotations 1

Forward rate quotations use the following notations:

• FN (j/k) is the notation used to refer to the price of
one unit of currency k in terms of currency j for
delivery in N months.
• F notation is used to denote a forward exchange
rate.
• Like spot quotes, forward quotes are either
direct or indirect with one being the
reciprocal of the other.

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 Forward Rate Quotations 2

American term Swiss franc Example of

forward quotations. reciprocal
• S($ / SFr) = calculations:
1.0018 1 / 1.0018 = 0.9982
• F1 ($ / SFr)  1 / 0.9928 = 1.0018
1.0047
• F3 ($ / SFr) 
European
1.0104 term forward quotations are the
reciprocal of the American term quotes.
•
• F
S(SFr / $) = 0.9982
6 ($ / SFr)  1.0193
• F1 (SFr / $)  0.9953
• F3 (SFr / $)  0.9897
• F6 (SFr / $)  0.9811
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 Forward Premium
Common to express the premium or discount of a
forward rate as an annualized percentage
deviation from the spot rate.
• Forward premium (or discount) is useful for
comparing against the interest rate differential
between two countries.
• Forward premium or discount can be calculated
using
American or European term quotations.
• The formula for calculating the forward premium
N ($ / j)  S ($ / j)  360
• orf N ,  Fdiscount for currency j over N period in
j
American Sterms ($ / j) is:

days
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 Forward Cross-Exchange Rates

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 A Speculative Forward Position
Example 5.5: A Speculative Forward Position.
It is January 31, 2022. Suppose the $/SFr trader has just heard an
economic forecast from the bank’s head economist that causes him to
believe that the dollar (Swiss franc) will likely appreciate (depreciate) in
value against the Swiss franc (dollar) over the next three months.
He decides to act on this information and short Swiss francs using
the three- month $/SFr contract, currently at $1.0815/SFr. We will
assume that he sells SFr5,000,000 forward against dollars. In three
months, he will get 5,000,000*1.0815 = $5,407,500
Suppose the forecast has proven correct. Three months later, on April
30, 2022, spot $/SFr is trading at $1.0500. What is his profit? The trader
can now buy Swiss francs spot at $1.0500 and deliver it under the
forward contract at a price of
$1.0815. The trader has made a speculative profit of ($1.0815/SFr −
$1.0500/SFr)* SFr5,000,000= $0.0315/SFr*SFr5,000,000 = $157,500.
Now if the dollar depreciated and S3 was $1.1000, the speculator would
have lost ($1.0815 − $1.1000) = −$0.0185 per unit, for a total loss of
(SFr5,000,000)(−$0.0185/SFr) = −$92,500.
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 Long and Short Position on the Three-
Month Swiss Franc Contract
Exhibit 5.12 Graph of Long and Short Position on the
Three- Month Swiss Franc Contract

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 Non–Deliverable Forward Contracts
Due to government–instituted capital controls,
currencies of some emerging market countries are
not freely traded.
• Not possible to obtain these currencies offshore in
the spot market to settle a forward position.
• For many of these currencies, trading in non–
deliverable forward (NDF) contracts exists.
• An NDF contract, unlike a deliverable forward (DF),
is settled in cash at the difference between the
spot exchange on the maturity date of the contract
and the NDF rate times the notional amount of the
contract.

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 Swap Transactions
Forward trades can be classified as outright
or swap transactions.
• From the bank’s standpoint, an outright forward
transaction is an uncovered speculative position in
a currency, even though it might be part of a
currency hedge to the bank customer on the other
side of the transaction.
• Swap transactions provide a means for the
bank to mitigate the currency exposure in a
forward trade.

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 Exchange–Traded Currency Funds
Exchange–traded fund (ETF) is a portfolio of financial
assets in which shares representing fractional
ownership of the fund trade on an organized
exchange.
• Allow small investors the opportunity to invest in
portfolios of financial assets that they would find
difficult to construct individually.
• Assets invested in the global ETF industry reached
a new record of $10.27 trillion at the end of
December 2021.
• Currency ETFs were first offered by Guggenheim
Investments in 2005 and traded on the NYSE.

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