The Foreign Exchange Market

The Foreign Exchange Market

It provides the institutional structure through which money from one country is
exchanged for another country.
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.
Structure of the Foreign Exchange Market
The global foreign exchange market today is rapidly changing due to:
electronic trading platforms;
algorithmic trading programs and routines; and
increasing role of currencies as an asset class.
1. Global trading is a 24-hour-a-day process
2. Trading Platforms and Processes
The currency trading is conducted as individual to individual personal
transactions, open floor bidding and through electronic platforms.
The information related to foreign exchange rate and trading systems are
provided by Reuters, Telerate, EBS and Bloomberg.
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.
Market Participants
Participants in the foreign exchange market include liquidity seekers
and profit seekers.
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; and
◦ Foreign exchange brokers.
Market Participants: Bank and Nonbank
Foreign Exchange Dealers
Banks and nonbank traders profit from buying foreign exchange at a bid price
and reselling it at a slightly higher ask or offer 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.
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.
Market Participants: Central Banks and
Treasuries
Central banks and treasuries use the market to acquire or spend their country’s
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.
Market Participants: Foreign Exchange Brokers
Foreign exchange brokers are agents who facilitate trading between
dealers without themselves becoming principals in the transaction.
Dealers use brokers to expedite the transaction and to remain
anonymous, since the identity of participants may influence
short-term quotes.
Transactions in the Foreign Exchange Market
A spot transaction is the purchase of foreign exchange with delivery
and payment between banks taking place normally on the second
following business day.
forward transactions, and swap transactions.
The date of settlement is referred to as the value date.
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.)
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).
Size of Forex Market
The worth of the entire global forex trading market is estimated to
approximately $2.4 quadrillion – in other words, around $2409 trillion
According to BIS’s 2019 triennial survey, trading in FX markets reached an
incredible $6.6 trillion per day in April of 2019.
Retail Forex trading – that is to say, trading that is done by individuals, accounts
for only 5.5% of the entire Forex market
Five businesses maintain a 40% share of the global Forex market
JPMorgan - 9.81%; Deutsche Bank - 8.41%; Citi - 7.87%; XTX Markets - 7.22%;
UBS - 6.63%
Top 10 Geographic Trading Centers in the Foreign
Exchange Market, 1992-2013
Currency Composition
The “big three” (dollar, euro, and yen) continue to dominate global
currency trades, totaling roughly 92% of all trading surveyed.
Emerging market currencies (Mexican peso, Chinese renminbi,
Russian ruble) could soon change the dynamics of global currency
trading.
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.
Quotations may be designated by traditional currency symbols or by
ISO codes
Foreign Exchange Rates and Quotations
Every currency exchange involves two currencies: the base or unit currency (CUR1),
and the price or quote currency (CUR2):
CUR1 / CUR2
The quotation indicates the number of units of CUR2 required in exchange for
receiving one unit of CUR1.
For example, a quotation of
EUR / USD1.2174
designates the euro (EUR) as the base currency, the dollar (USD) as the price currency.
The exchange rate is USD 1.2174 = EUR 1.00.
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.
Foreign Exchange Rates and Quotations
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.
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).
Case
A Mexican Importer needs Japanese Yen to pay for imports from Japan.
Both Mexican PESO and Japanese Yen are quoted against USD.
The exchange rate between PESO to Yen can be identified by cross rate
Intermarket Arbitrage
Quoted rates

Cross rate calculation based on Citibank and Barclays Bank quotes

Which is .001 less than the Dressner Bank quote, which results in
triangular arbitrage.
Triangular Arbitrage by a Market Trader
Forward Quotations
Spot rates are typically quoted on an outright basis (meaning all
digits expressed) whereas forward rates are typically quoted in
points or pips (the last digits of a currency quotation).
Forward rates of one year or less maturity are termed cash rates; for
longer than one-year they are called swap rates.

F = S + Premium
Spot and Forward Quotations for the Euro and Japanese
Yen
Forward Quotations
The percent per annum deviation of the forward from the spot rate is termed
the forward premium.
As with the calculation of percentage changes in spot rates, the forward
premium—which may be either a positive (a premium) or negative value (a
discount)—depends upon the designated home (or base) currency.
Forward Premium/Discount
Indirect Quotation

Direct Quotation
Calculate the Forward Premium/Discount
Foreign Currency Price / Home Currency / Foreign
Home Currency Currency
Spot Rate JPY 118.27/USD USD/JPY 0.0084552
3 month forward rate JPY 116.84/USD USD/JPY 0.0085587
International Parity Conditions
Some fundamental questions managers of MNEs, international portfolio
investors, importers, exporters and government officials must deal with every
day are:
◦ What are the determinants of exchange rates?
◦ Are changes in exchange rates predictable?
The economic theories that link exchange rates, price levels, and interest rates
together are called international parity conditions.
These international parity conditions form the core of the financial theory that
is unique to international finance.
Prices and Exchange Rates
If the identical product or service can be:
◦ sold in two different markets; and
◦ no restrictions exist on the sale; and
◦ transportation costs of moving the product between markets are equal, then
◦ the product’s price should be the same in both markets.
This is called the law of one price.
Prices and Exchange Rates
A primary principle of competitive markets is that prices will
equalize across markets if frictions (transportation costs) do not
exist.
Comparing prices then, would require only a conversion from one
currency to the other:
P$ x S = P¥
Where the product price in U.S. dollars is (P$), the spot exchange
rate is (S) and the price in Yen is (P¥).
Prices and Exchange Rates
More specifically, with regard to RPPP:

“If the spot exchange rate between two countries starts in

equilibrium, any change in the differential rate of inflation
between them tends to be offset over the long run by an equal but
opposite change in the spot exchange rate.”
Nominal interest rate
The nominal rate of interest is the rate that is actually agreed and
paid. For example, it’s the rate homeowners pay on their mortgage
or the return savers receive on their deposits. Borrowers pay the
nominal rate and savers receive it.
Real interest rate
It’s not only the nominal payment that is important to both borrowers and
savers, but also how many goods, services or other things they could buy with
that money. Economists call this the purchasing power of money.
It usually decreases over time as prices rise due to inflation. Taking inflation into
account shows the real cost of borrowing and the real return on savings. This is
how it is calculated:

Real interest rate = nominal interest rate - inflation

Example
A saver who deposits €1,000 in an account for one year may get a
nominal rate of interest of 2.5%, and so receive €1,025 in a year’s
time.
However, if prices increase by 3%, he or she will need €1,030 to
purchase the same goods or services that, one year earlier, would
have cost €1,000. This means that the real return will actually have
been -0.5%.
This is the real interest rate, and it is calculated by subtracting the
rate of inflation (3%) from the nominal interest rate (2.5%).
Fisher Effect
The fisher effect is given by economist Irving Fisher
The Fisher effect states that nominal interest rates in each country are equal to
the required real rate of return plus compensation for expected inflation.
The Fisher equation says, for example,
that if the required real return is 3% and expected inflation is 10%, then
the nominal interest rate will be about 13% (13.3%, to be exact).
The logic behind this result is that $1 next year will have the purchasing
power of $0.90 in terms of today’s dollars.
Thus, the borrower must pay the lender $0.103 to compensate for the
erosion in the purchasing power of the $1.03 in principal and interest
payments, in addition to the $0.03 necessary to provide a 3% real return.
International Fisher Effect
The key to understanding the impact of relative changes in nominal
interest rates among countries on the foreign exchange value of a nation’s
currency is to recall the implications of PPP and the generalized Fisher
effect.
PPP implies that exchange rates will move to offset changes in inflation
rate differentials.
Thus, a rise in the U.S. inflation rate relative to those of other countries
will be associated with a fall in the dollar’s value.
It will also be associated with a rise in the U.S. interest rate relative to
foreign interest rates.
International Fisher Effect

In July, the one-year interest rate is 2% on Swiss francs and 7% on U.S. dollars.
1. If the current exchange rate is SFr 1 = $0.91, what is the expected future
exchange rate in one year?
2. If a change in expectations regarding future U.S. inflation causes the expected
future spot rate to rise to $1.00, what should happen to the U.S. interest rate?
The Forward Rate
The forward rate is calculated for any specific maturity by adjusting the current
spot exchange rate by the ratio of eurocurrency interest rates of the same
maturity for the two subject currencies.
For example, the 90-day forward rate for the Swiss franc/U.S. dollar exchange
rate (FSF/$90) is found by multiplying the current spot rate (SSF/$) by the ratio
of the 90-day euro-Swiss franc deposit rate (iSF) over the 90-day eurodollar
deposit rate (i$).
Formulaic representation of the forward rate:
Interest Rate Parity (IRP)
The theory of Interest Rate Parity (IRP) provides the linkage between
the foreign exchange markets and the international money markets.
The theory states: The difference in the national interest rates for
securities of similar risk and maturity should be equal to, but
opposite in sign to, the forward rate discount or premium for the
foreign currency, except for transaction costs.
Interest Rate Parity
Covered Interest Arbitrage
The spot and forward exchange rates are not, however, constantly in
the state of equilibrium described by interest rate parity.
When the market is not in equilibrium, the potential for “risk-less”
or arbitrage profit exists.
The arbitrager will exploit the imbalance by investing in whichever
currency offers the higher return on a covered basis.
Covered Interest Arbitrage (CIA)
Uncovered Interest Arbitrage (UIA)
In the case of uncovered interest arbitrage (UIA), investors borrow in countries
and currencies exhibiting relatively low interest rates and convert the proceed
into currencies that offer much higher interest rates.
The transaction is “uncovered” because the investor does not sell the higher
yielding currency proceeds forward, choosing to remain uncovered and accept
the currency risk of exchanging the higher yield currency into the lower yielding
currency at the end of the period.
Uncovered Interest Arbitrage (UIA): The Yen Carry
Trade