The Basics of the Foreign Exchange Market

Defining The Foreign Exchange Market The Foreign Exchange Market can be defined in terms of specific functions, or the institutional structure that: (1) Facilitates the conversion of one country’s currency into another. – Through the buying and selling of currencies. – Allows global firms to move in and out of foreign currency as needed. (2) Sets and quotes exchange rates. – This is the ratio of one currency to another. – These rates determine costs and returns to global businesses. (3) Offers contracts to manage foreign exchange exposure. – These hedging contracts allow global firms to offset their foreign currency exposures and manage foreign exchange risk. – Thus, they can concentrate on their core business.

Quick Review of Market Characteristics World’s largest financial market. – Estimated at $3.2 trillion dollars per day in trades. NYSE-Euronext currently running about $40 billion per day. Market is a 24/7 over-the-counter market. – There is no central trading location. – Trades take place through a network of computer and telephone connections all over the world. Major trading center is London, England. – 34% of all trades take place through London (New York second at 17%). Most popular traded currency is the U.S. dollar. – Accounts for 86% of all trades (euro second at 27%). Most popular traded currency pair is the U.S. dollar/Euro. – Represents 27% of all trades (dollar yen second at 13%) Currencies are either traded for immediate delivery (spot) or some specified future delivery (forward).

How does the FX Market Quote Currencies? (1) American Terms: – Expresses the exchange rate as the number of U.S. dollars per one unit of some foreign currency. For example, $2.00 per (1) British pound. (2) European Terms: – Expresses the exchange rate as the number of foreign currency units per one U.S. dollar. For example, 120 yen per (1) U.S. dollar. Most of the world’s currencies are quoted for trade purposes on the basis of European terms. – Exceptions include: British pound, Euro, Australian dollar. Newspapers, like the Wall Street Journal, however, usually quote both.

Quotes are Given by Time of Settlement Spot Exchange Rate: – Quotes for immediate transactions (actually within 1 or 2 business days) Forward Exchange Rate: – Quotes for future transactions in a currency (3 business days and out). Forward markets are used by businesses to protect against unexpected future changes in exchange rates. – Forward rate allows businesses to “lock” in an exchange rate for some future period of time.

Observing Changes in Spot Exchange Rates: What do they Mean? Appreciation (or strengthening) of a currency: – When the currency’s spot rate has increased in value in terms of some other currency. Depreciation (or weakening) of a currency: – When the currency’s spot rate has decreased in value in terms of some other currency.

Forward Rate Quotes As a rule, forward exchange rates are set at either a premium or discount of their spot rates. – If a currency’s forward rate is higher in value than its spot rate, the currency being quoted at a forward premium. For example: the Japanese 1 month forward is greater than its spot ( versus ) – If a currency’s forward rate is lower in value than its spot rate, the currency is being quoted at a forward discount. For example, the British pound 6 month forward is less than its spot ( versus 2.056).

What Institutions are Involved in the Foreign Exchange Market? Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) acting on behalf of: – (1) Their “external” clients” (primarily global firms: exporters, importers, multinational firms) Acting in a broker capacity at the request of these clients and meeting the foreign currency needs of these clients. – (2) Their own banks (trading to generate profits). Acting in a “dealer” (i.e., trading) capacity Taking positions in currencies to make a profit. In meeting the needs of their clients and their own trading activities, these global banks “establish” the “tone” of the market. – This is through a “market maker” function.

Making the Market in FX The market maker function of any global bank involves two primary foreign exchange activities: (1) A willingness of the market maker to provide the market with “on-going” (i.e., continuous) two way quotes upon request: – (1) Provide a price at which they will buy a currency – (2) Provide a price at which they will sell a currency This function provides the market with transparency (2) A willingness of the market maker to actually buy and/or sell at the prices they quote: – Thus the market maker offers “firm” prices into the market! This function provides the market with liquidity.

ISO Currency Designations All foreign currencies are assigned an International Standards Organization (ISO) abbreviation. – E.g., USD; JPY; GBP; EUR; AUD; HKD; CNY; MXN; SGD; ARS; THB; INR; RUB; ZAR; NZD; CHF; KRW – For individual countries see: Since the exchange rate is simply the ratio (i.e., value) of one currency against another, market makers express this relationship using the two currencies’ ISO designations. For Example: – USD/JPY – USD/MXN – EUR/USD – GBP/USD – EUR/JPY (this is a cross rate; since USD in not one of them)

Base and Quote Currency Given that a foreign exchange quote is simply the ratio of one currency to another, a “complete” market maker quote must have two ISO designations (e.g., EUR/USD or USD/JPY): – The first ISO currency quoted is called the base currency. – The second ISO currency quoted is called the quote currency. For examples above: – EUR/USD: EUR is the base currency and USD is the quote currency. – USD/JPY: USD is the base currency and JPY is the quote currency.

Bid and Ask Quotes Recall that a market maker always provides the market with two prices, both a buy and sell quote (or price) for a currency. For Example: EUR/USD: / – The first number quoted by the market maker is the market maker’s buy price ($1.2102). It is called the market maker’s bid quote (or buy price) – The second quoted number is the market marker’s sell price ($1.2106). It is called the market maker’s ask quote (or sell price) – Note: The bid quote is always lower than the ask quote.

What Currency is The Market Maker Buying and Selling? Given the e xample: EUR/USD: /1.2106, which currency is the market maker selling and which currency is the market maker buying? – Answer: Market makers are always quoting prices at which they will buy or sell ONE UNIT of the base currency (against the quote currency). – So in the above example: The market maker will buy euros for $ – This is the bid price for euros. The market maker will sell euros for $ – This is the ask price for euros.

Reading and Understanding Quotes When viewing a foreign exchange quote, assign a value of 1 to the base currency (the base currency is the first in the ISO pair). The quotes you see refer to one unit of this base currency. – For example, if you see a market maker’s ask price for the EUR/USD of , that means that if you were to buy one Euro (the base currency) you are going pay $ – If you see a market maker’s bid price for the USD/JPY of that means if you were to sell one dollar (the base currency) you are going to get for it. Also, whenever the bid and ask prices are moving up, that means that the base currency is getting stronger and the quote currency is getting weaker.