Lecture 5: The Foreign Exchange Market Understanding Foreign Exchange Quotes

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The Role of Global Banks in the FX Market Large global banks (e.g., Deutsche Bank) are involved in the interbank (i.e., wholesale) FX markets through:  (1) Their “external” clients” (Other large banks, exporters, importers, multinational firms, central banks, large non-bank financial institutions) Acting in a broker capacity at the request of these clients.  (2) Their own banks (trading to generate profits). Acting in a “dealer” (i.e., trading) capacity (Taking positions (long and short) in currencies to make a profit).  In dealing with external clients, these large banks are performing a “market maker” function: Quoting prices upon demand to other parties in the interbank market, and Buying and selling currencies at their quoted prices.

“Making the Market” in FX The market maker function 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.

Base and Quote Currency Recall that a foreign exchange quote is simply the ratio of one currency to another. Thus, a “complete” market maker quote consist of two ISO designations (e.g., EUR/USD or USD/JPY):  The first ISO currency quoted in the sequence is referred to as the base currency.  The second ISO currency quoted is referred to as 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 A market maker always provides the market with two prices, specifically a price at which they will buy a currency and a price at which they will sell a currency. Example: EUR/USD: /  The first number quoted by the market maker is the market maker’s buy price for 1 unit of the base currency ($1.2102). This is the market maker’s bid quote (or buy price)  The second quoted number is the market marker’s sell price for 1 unit of the base currency ($1.2106). This the market maker’s ask quote (or sell price)

Bid Ask Quote Example Example : GBP/USD: / Assume you’re dealing with the market maker; Questions:  (1) How much will you pay for 1 pound;  (2) how much will get when you sell 1 pound;  (3) how much will you pay for 1 U.S dollar;  (4) how much will you get when you sell 1 U.S. dollar? Answers:

Bid Ask Quote Example Answers Example : GBP/USD: / Assume you’re dealing with the market maker; Questions:  (1) How much will you pay for 1 pound; $  (2) how much will get when you sell 1 pound; $  (3) how much will you pay for 1 U.S dollar; 1/ =.6437 (64.37 British cents)  (4) how much will you get when you sell 1 U.S. dollar? 1/ =.6430 (64.36 British cents)

Bid Ask European Terms Example Assume the following USD/JPY: 76.35/76.45 (Note: now the base currency is the dollar and the quote currency is the yen) Assume you’re dealing with the market maker;  Question: (1) How much will you pay for 1 dollar;  (2) how much will get when you sell 1 dollar;  (3) how much will you pay for 1 yen;  (4) how much will you get when you sell 1 yen? Answers:

Bid Ask European Terms Answers Assume the following USD/JPY: 76.35/76.45 (Note: now the base currency is the dollar and the quote currency is the yen) Assume you’re dealing with the market maker;  Question: (1) How much will you pay for 1 dollar; yen  (2) how much will get when you sell 1 dollar; yen  (3) how much will you pay for 1 yen; 1/76.35 = (U.S. cents)  (4) how much will you get when you sell 1 yen? 1/76.45 = (U.S. cents)

Bid Ask Spreads The Bid Ask spread is the “profit” that a market maker bank will make on a “round” transaction (i.e., buying and selling an equal amount at the stated price). Regardless of the type of quote (American terms or European terms), the ask price is always higher than the bid.  That is, what they will sell the base currency for is always higher than what they will buy the base currency at. Assume the following GBP/USD quote: /  What is the dollar spread to the market maker on a “round” transaction (assume 10 million pound transactions)? Ask $ x £10,000,000 = $17,929,000 (price to sell pounds) Bid $ x £10,000,000 = $17,921,000 (price to buy pounds) Spread (Commission) = $ 8,000 (on round transaction)

Bid Ask Spread: European Terms Assume the following USD/CAD quote:  / Note the ask price is higher What is the spread on a round transaction assuming a $1,000,000 USD transaction.  Ask price x $1,000,000 = 1,021,000 CAD  Bid price = x $1,000,000 = 1,020,000 CAD  Spread = 1,000 CAD

Foreign Exchange Pips (or Points) Pips (sometimes called points) refer to the smallest unit by which the prices for the currency pair may vary.  Pip stands for percentage in point. In the example: GBP/USD: /1.5537, the difference in the bid quote and ask quote lies in the fourth decimal place, or 2 pips.  A Pip for a 4 decimal place quoted currency is actually of an exchange rate Most currencies are quoted out to 4 decimal places. Today, some currencies are being quoted out to 5 decimal places because of competition among electronic trading platforms (e.g., FXStreet).

Observations About Bid/Ask Spreads Bid and ask spreads widen or narrow in response to a number of factors. For example:  Spreads increase with exchange rate volatility and uncertainty.  Spreads decrease with increases in market maker competition.  Spreads are smaller in wholesale (interbank) market than in retail market (and tourist market). Example: GPB/USD for September 26, 2011 Wholesale: / ; pip spread = 1.3 Retail: /1.5516; pip spread = 4 Tourist retail (Wells Fargo quote): /1.6152; spread = cents  Spreads can differ slightly among market markets. As market makers attempt to adjust their positions and thus make dealing with them more or less attractive.

Which Way is the Currency Moving? Remember 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. Thus, whenever the bid and ask prices are moving up, that means that the base currency is getting stronger (relative to the quote currency) and the quote currency is getting weaker (relative to the base currency). Conversely, whenever the bid and ask prices are moving down, that means that the base currency is getting weaker (relative to the quote currency) and the quote currency is getting stronger.

Example: Which way is the Currency Moving? Weakening or Strengthening? CurrencyOctober 4, 2012 October 5, 2012 Move of Foreign Currency Move of USD EUR/USD GBP/USD USD/JPY USD/CHF

Example: Which way is the Currency Moving? Weakening or Strengthening? CurrencyOctober 4, 2012 October 5, 2012 Move of Foreign Currency Move of USD EUR/USD EUR strengthening USD weakening GBP/USD GBP weakening USD strengthening USD/JPY JPY weakening USD strengthening USD/CHF CHF strengthening USD weakening

Let’s Look at Real Time Currency Quotes Go to the following web-site: At this site, link to: Rates and Charts  Go to Retail Rates Live Select currency as USD Observe ISO quotes Observe bid and ask quotes. Understand what currency and at what price the market maker is buying or selling (base currency). Understand what price you (a non-market maker) would buy or sell the base currency to the market maker. Observe changes in bid and ask quotes.  If these are going up, the base currency is strengthening and the quote currency is weakening. Reverse is true if these are going down.  Next, link to: Interbank FX Rates Live and observe majors and G7 (note quotes to 5 decimal places)

Let’s Look at Real Time Currency Charts Again, go to the following web-site: At this site, link to: Rates and Charts  Go to Streaming Forex Charts Observe different currency pairs: Make sure you know which currency in the pair is strengthening and which is weakening. Observe different time scales from ticks out to monthly.

Candle Stick Charting of FX Patterns Examples Go to FXStreet.com At this site, link to: Rates and Charts Go to Streaming Forex Charts Under chart type go to Candle Stick