The Basics of the Foreign Exchange Market

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 (0.009034 versus 0.008999)
– 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 (2.0417 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:
http://www.oanda.com/site/help/iso_code.shtml
• 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: 1.2102/1.2106
– 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 example: EUR/USD: 1.2102/1.2106,
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 $1.2102
– This is the bid price for euros.
• The market maker will sell euros for $1.2106
– 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
1.2811, that means that if you were to buy one Euro (the base
currency) you are going pay $1.2811.
– If you see a market maker’s bid price for the USD/JPY of 120.10 that
means if you were to sell one dollar (the base currency) you are going
to get 120.10 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.