Chapter No. 2

Chapter 2
The Foreign Exchange Market

Objectives
• To describe the FX market.
• To identify participants and currencies.
• To describe the mechanics and technology
of FX trading.
• To introduce some exchange rate concepts.
• To illustrate FX position keeping.
• To describe the AUD FX market.
• To introduce some FX jargon.
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PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa
Slides prepared by Afaf Moosa 2
Definition
• The FX market is the market where national
currencies are bought and sold against one
another. Foreign exchange consists mainly
of bank deposits.

Characteristics
• It is the largest and most perfect market.
• It is needed because every international
transaction requires a foreign exchange
transaction.
• It is an over-the-counter (OTC) market.

Market Participants
• Foreign exchange traders buy and sell
currencies directly or indirectly.
• Arbitragers exploit exchange rate
anomalies; hedgers cover open positions;
and speculators take open positions.

Categories of Participants
• Customers
• Commercial banks
• Other financial institutions
• Brokers
• Central banks

Interbank Operations
• The FX market is dominated by interbank
operations.
• Participants in the interbank market are
market makers, other major dealers and
second-tier banks.

Size and Composition
• The size of the global FX market is
measured by the sum of daily turnover in
FX centres.
• A survey is coordinated by the BIS every
three years for this purpose.

Daily Turnover in the FX Market
(USD Billion)
1600
1200
800
400
0
1989 1992 1995 1998 2001
Spot Forward Total (including gaps)

The Geographical Distribution of FX
Market Turnover (Per Cent)
40
35
30
25
20
15
10
5
0
. . y
K S pa
n
or
e
an nd ng lia ce rs
U. U. Ja ap rla Ko st
ra an he
g rm z e
ng Fr Ot
in Ge it Au
S Sw Ho

FX Market Turnover by
Counterparty (Per Cent)
(a) By institutional type
Interbank Financial Institutions Others

FX Market Turnover by
Counterparty (Per Cent)
(b) By locality
Local Cross-border

Currency Composition of FX Market
Turnover (Per Cent)
(a) By single currencies
100
80
60
40
20
0
USD EUR JPY GBP CHF CAD AUD SEK HKD Others

Currency Composition of FX Market
Turnover (Per Cent)
(b) By currency pairs
35
30
25
20
15
10
0
USD/EUR USD/JPY USD/GBP USD/CHF USD/CAD USD/AUD USD/Other Other/Other

Traded Currencies
• The US dollar is the most heavily traded
currency.
• The euro and the yen are heavily traded
because of the importance of Europe and
Japan in the world economy.

Traded Currencies (cont.)
• The pound is heavily traded for historical
reasons.
• Currencies that are heavily traded in certain
financial centres and lack liquidity in others:
CHF, CAD.

Traded Currencies (cont.)
• Currencies that are traded locally, but
internationally are traded for international
trade purposes: AUD, NZD, HKD.
• Third world currencies: soft or exotic
currencies.

Components of an FX Transaction
• Price discovery
• Decision making
• Settlement
• Position keeping

FX Market Technology
• The telegraph
• The telephone
• The telex
• The fax

FX Market Technology (cont.)
• Screen-based information systems
• Screen-based automated dealing systems
• Automatic order matching systems
• Online FX trading

The Bilateral Spot Exchange Rate
• The exchange rate between two currencies
for immediate delivery.

A Spot Foreign Exchange
Transaction
Confirmation of exchange rate and amount
A B
(Monday)
B’s A’s
account account

Spot Rate Quotation
• S (x /y ) is the price (in terms of x) of one
unit of y :
1
S (x y ) =
S ( y x)

Exchange Rate Changes
• When the exchange rate changes from
S0(x/y) to S1(x/y)
S1  x y 
S x y 
 -1
S0  x y 
S  y x  
1
-1
1  S  x y 

Currency Conversion
• To convert from y to x, multiply by the
exchange rate.
• To convert from x to y, divide by the
exchange rate.

Exchange Rate Quotation in
Practice
• Direct quotation refers to the domestic
currency price of one unit of the foreign
currency.
• Indirect quotation refers to the foreign
currency price of the domestic currency.

The Bid and Offer Rates
• The bid rate is the rate at which the
quoting dealer is willing to buy. The offer
rate is the rate at which the quoting dealer
is willing to sell.
• The spread is
m = S a - Sb
Sa
m= - 1
Sb

A Foreign Exchange Spot
Transaction with Bid-Offer Spread
USD @ 1.8575
USD @ 1.8525
A B
AUD @ 0.5398 (1/1.8525)
AUD @ 0.5384 (1/ 1.8575)

Conversion Rules
1
Sb ( y / x ) =
Sa ( x / y )
1
Sa ( y / x) =
Sb ( x / y )

Points and Pips
• A point is one-hundredth of a cent, a
penny, etc.
• A pip is one-tenth of a point.

Cross Exchange Rates
• A cross exchange rate is the exchange rate
between two currencies derived from their
exchange rates against another currency.
S ( x / z)
S ( x / y) =
S ( y / z)

Bid and Offer Cross Rates
Sa ( x / z )
Sa ( x / y ) =
Sb ( y / z )
Sb ( x / z )
Sb ( x / y ) =
Sa ( y / z )

Cross Rates Matrix
• For n exchange rates
S ( x / z)
S(x / x )  i
i j S ( x / z)
j

FX Position Keeping
• A nostro account is held by a dealer at a
corresponding bank.
• A vostro account is held by a bank on
behalf of a foreign dealer

FX Position Keeping (cont.)
• A short position is created when a dealer
borrows a currency and sells it.
• A long position is created when a currency
is bought because it is expected to
appreciate.

• Position keeping is the monitoring of
positions in each currency.
• A position is the net cumulative total of a
currency holding arising from deals.
• A blotter is a schedule used to record the
details of transactions.

• Position squaring is realising profit/loss by
buying the short-position currency and
selling the long-position currency.
• Valuation is the calculation of unrealised
profit/loss using the average rate.

The Forward Exchange Rate
• The rate contracted today for the delivery
of a currency at a specified date in the
future.

Forward Value Date
• The date on which currencies involved in a
forward transaction are exchanged.
• Dates may be short, round or broken.

Outright and Swap Forward
Transactions
• An outright contract involves the sale or
purchase of a currency for delivery more
than two days into the future.
• A swap transaction involves a spot purchase
against a matching outright sale (or vice
versa).

Kinds of FX Swaps
• Forward swaps
• Forward-forward swaps
• Overnight swaps
• Tom/next swaps

The Forward Spread
F ( x / y) - S ( x / y) 12
m= ×100 ×
S ( x / y) N

Premium and Discount
• If F (x /y ) > S (x /y ), then y sells at a
premium.
• If F (x /y ) < S (x /y ), then y sells at a
discount.
• If F (x /y ) = S (x /y ), both currencies are
flat.

Outright and Swap Rates
• An outright forward rate is quoted as bid
and offer rates.
• A swap rate is quoted in terms of the points
representing the forward premium or
discount.

The AUD FX Market
• The market consists of the banking system
and non-bank dealers authorised by the
Reserve Bank of Australia (RBA).
• The market has grown since the flotation of
the AUD in 1983.

Reasons for the Growth of the AUD
Market
• Deregulation
• High interest rates in the 1980s
• Australia’s time zone
• Exchange rate volatility


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Chapter No. 2

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Chapter 2

The Foreign Exchange Market

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Spot Forward Total (including gaps)

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Interbank Financial Institutions Others

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AUD @ 0.5398 (1/1.8525)

AUD @ 0.5384 (1/ 1.8575)

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