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Organizations and participants
Michala Moravcová
Department of Finance, Masaryk University
International Finance
The Foreign Exchange Market
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1. The Organization and Structure of the Foreign Exchange Market
2. Currency Quotes and Prices
3. Interbank Market
Contents
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Exhibit 2.1 The Structure
of the Foreign Exchange
Market (FOREX)
• Most important cities:
• London, New York, Tokyo
• ForEx (or FX) operates 24 hrs/day
• OTC market
• Interbank market (39%)
• Corporations (9%)
• Other financial institutions (53%)
• Most trades are $1M or more!
• Only large banks and corporates has
direct access to the market
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• Size of the market
• Largest financial market in the world (measured by the dollar volume of trades)
• $5.3 trillion a day (as of April 2013)
• Compared to only $36 billion on NYSE (in 2013)
2.1 The Organization of the Foreign Exchange Market
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Exhibit 2.2 Foreign Exchange Trading Activity Across the
World
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Source: https://www.bis.org/statistics/rpfx19.htm
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• Types of contracts traded
• Spot
• Future transactions: swaps, forward contracts
• Derivatives: futures and options
• Conventions
• Transactions completed/settled within 2 business days (T+2)
• Exception 1: Exchanges between US Dollar, Mexican Peso, and Canadian Dollar (T+1)
• Exception 2: Holidays don’t count in U.S. dollar transactions
• Exception 3: Fridays are not business days in Middle East but Saturdays/Sundays are so – non-Middle
Eastern currencies settle on Fridays and Middle Eastern currencies settle on Saturdays
2.1 The Organization of the Foreign Exchange Market
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• Foreign exchange dealers
• Who?
• Commercial banks
• Investment banks
• Brokerage firms (Intermediary – does not put own money at risk, match buyers and sellers)
• Market makers – provide liquidity. Stand ready to buy and sell the currencies in which
they specialize.
• They make it easier for buyers and sellers to come together
• Liquidity
• Ease with which one can sell an asset at its fair value
• Low transaction costs
• Other participants in the forex market
• Central banks
• Multinational corporations
2.1 The Organization of the Foreign Exchange Market
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• The competitive marketplace
• No product differentiation – money is money
• Has been a lot of players (past)
• Top 4 account for less than 30%
• Top 20 less than 75%
• Recently, there has been consolidation (2014)
• Top 4 account for over 40%
• Top 20 over 90%
• Still exceedingly competitive with no signs of any dominant leader in this market
2.1 The Organization of the Foreign Exchange Market
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Exhibit 2.3 The Top 20
Dealers in the Foreign
Exchange Market
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Exchange rate:
• is the relative price of two monies, such as the Japanese yen price of the U.S. Dollar
• price of one currency in terms of another
• abbreviations are used (the International Organization for Standardization ISO sets
standards)
• common symbols are used: $ for the U.S. dollar, £ for the pound, € for the euro, ¥ for
the yen.
Foreign exchange quotations:
• EUR/USD or EURUSD → the first currency is the base currency and the second currency is the
numerator or quote currency.
→ how many dollars you can buy with 1 euro / how many dollars you need
to buy 1 euro
2.2 Currency Quotes and Prices
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• Exchange rate quotes (relative prices can be expressed in 2 ways)
• Direct – quoting FX rate with domestic currency first, i.e., numerator of fraction
• For American, the “interesting” part is in $’s:
• $1.60 = £1 (This is called the American quote - dollar price of a foreign currency
• Indirect – quoting foreign currency first
• For American, the “interesting” part is in £’s:
• $1 = £0.625 (Often called the European quote - the amount of foreign currency needed to buy dollars
• Direct and indirect: inverse of each other
• 𝐷𝑖𝑟𝑒𝑐𝑡 =
!
"#$%&'()
Currency Quotes and Prices
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Exhibit 2.4 Currencies and Currency Symbols
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Exhibit 2.4 Currencies
and Currency Symbols
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Exhibit 2.5 U.S. Dollar
Currency Quotes from
Tuesday, July 21, 2015
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Think of direct and indirect quoting
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• Vehicle currencies and currency cross-rates
• Vehicle currency
• a currency that is actively used in many international financial transactions around the world
• Used due to transaction costs of making markets in many currencies being too high
• U.S. Dollar primary vehicle currency (85% of all transactions)
• Cross-rates
• Exchange rates between two currencies that do not involve the dollar
2.2 Currency Quotes and Prices
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Exhibit 2.6 Representative Cross-Rate Quotes from July
21, 2015
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• Triangular arbitrage
• An arbitrage process involving three currencies
• Keeps cross-rates in line with exchange rates quoted relative to the U.S. dollar
• Occurs when one can trade three currencies and make a profit (versus two)
• €/£ < €/$×$/£
• Notice that the $ signs on the RHS cancel out
• Trader might start with euros, buy pounds with the euros, then simultaneously sell those pounds
for dollars and sell those dollars for euros (if he ends up with more euros than he had in the
beginning of the process, he makes risk free profit. Not possible in perfectly competitive markets).
• To be an effective arbitrage, the transactions must all be conducted simultaneously.
• Market forces will bring the market into equilibrium
2.2 Currency Quotes and Prices
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Exhibit 2.7 Triangular
Arbitrage Diagram
• David starts with EUR 10 000 000 and buys GBP:
EUR 10 000 000 x (GBP 0.86543/EUR) = GBP 8 654
300
• sell GBP 8 654 300 for dollars:
GBP 8 654 300 x USD 1.5386/GBP = USD 13 315 506
• sell the USD 13 315 506 for euros:
USD 13 315 506 x EUR 0.76388/USD = EUR 10 171
449
• Profit:
EUR 10 171 449 – EUR 10 000 000 = EUR 171 449
• Rate of return:
1.71% = EUR 171 449/EUR 10 000 000
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2.3 Inside the Interbank
Market I: Bid-Ask
Spreads and Bank Profits
• Bid-ask spreads
• Bid: Rate at which banks will buy the base currency
• Ask: Rate at which banks will sell base currency
• Bid–ask spread: the difference between bid and ask
rate
• Bid price is always less than the ask price
• What are the dollar per yen bid and ask rates? Bid
rate is buy yen with dollars from the market. Ask
rate is the dollar price at which the bank trader is
willing to sell yen for dollars to the market. Buying
yen from the market is equivalent to selling dollars
to the market, the dollar per yen bid rate must be
the reciprocal of the yen per dollar ask rate
• Always keep in mind that you transact with the
bank to your disadvantage.
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2.3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits
• Bid-ask spread
• Bid: Rate at which banks will buy the base currency
• Ask: Rate at which banks will sell base currency
• Bid–ask spread: the difference between bid and ask rate
• Bid price is always less than the ask price
• Example EUR/CZK rate:
• Bid = 24.10. ASK = 24.15 Spread = 0.05
• Bank buys 1 Euro for 24.10 CZK (Bid) and sell 1 Euro for 24.15 CZK (Ask)
• You buy 1 Euro for 24.15 CZK (Ask) and sell 1 Euro for 24.15 CZK (Ask)
• Always keep in mind that you transact with the bank to your disadvantage.
• EUR/CZK bid price = 1/(CZK/EUR) ask price
Bank buys 1 Euro from market = bank sell CZK to market
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• Magnitude of bid-ask spreads
• Interbank market
• Pip is fourth decimal point in a currency quote, or 0.0001 (1.3095 vs. 1.3097 = 2 pips)
• The most liquid currencies trade at less than 10 pips
• Higher spreads for less liquid currencies (volatility)
• Physical exchange
• 5% or more
• Banks have to have inventory, which means it is not interest bearing
• Banks must transact with brokers
• Use credit cards to exchange when in another country – this is the best possible rate for you
• Differs across the day
2.3 Inside the Interbank Market I: Bid-Ask Spreads and
Bank Profits
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• Treasurer of a U.S. company purchases pounds with dollars to hedge a British
goods purchase.
• Directly after, he is told that they no longer need to purchase the goods, so he sells the £
back for $
• Assume that the bid-ask spread is 4 pips.
• If the ask rate is $1.50/£, the bid rate is $1.4996/£ and the percentage spread is:
• Percentage spread = (ask-bid)/midpoint
• [($1.50/£) – ($1.4996/£)] ÷ ($1.4998/£) = 0.0267%
• If the treasurer bought £1M at $1.50/£ (ask rate), the cost would be:
• £1𝑀×($1.50/£) = $1,500,000
• Selling back:
• £1𝑀×($1.4996/£) = $1,499,600
• A loss of $400 on the two transactions, or 0.0267% of $1.5M
2.3 Inside the Interbank Market I: Bid-Ask Spreads and
Bank Profits
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• Communication systems
• Society of Worldwide Interbank Financial Telecommunications (SWIFT)
• Links more than 7500 banks in 200 countries
• Clearing House Interbank Payments System (CHIPS)
• Clearing house in U.S. for dollars
• Fedwire
• Links computers of more than 7500 institutions that have deposits with the U.S. Federal Reserve
• Trans-European Automated Real-time Gross Settlement Express Transfer (TARGET2)
• Euro counterpart to Fedwire
2.4 Inside the Interbank Market II: Communications and
Fund Transfers
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• Cross-currency settlement (or Herstatt) risk
• The risk that a financial institution may not deliver the currency on one side of a completed
transaction
• How this risk is addressed:
• Bank of International Settlements (BIS) has studied this and encouraged the restriction of
transaction amounts to limit this form of risk
• Simultaneity of both transactions – to this end, Continuous Linked Settlement, owned by 71 of the
world’s largest financial groups, acts as a global clearing house
• Netting arrangements
2.4 Inside the Interbank Market II: Communications and
Fund Transfers
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Exhibit 2.10 Netting
Arrangements
• Situation
• Citigroup owes JPMorgan Chase $50M
from a foreign exchange deal
• JPMorgan Chase owes Citigroup $30M
from another foreign exchange deal
• Bank of America Owes Citigroup $30M
from a foreign exchange deal
• JPMorgan Chase owes Bank of America
$20M from another foreign exchange
transaction
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Exhibit 2.10 Netting
Arrangements
• Situation
• Citigroup owes JPMorgan Chase $50M
from a foreign exchange deal
• JPMorgan Chase owes Citigroup $30M
from another foreign exchange deal
• Bank of America Owes Citigroup $30M
from a foreign exchange deal
• JPMorgan Chase owes Bank of America
$20M from another foreign exchange
transaction
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• Appreciate / depreciate
• The value of a currency increases/decreases in terms of another
• Devalue / Revalue
• The value of a currency is changed by the domestic government
• Exchange rate between the dollar and the yen changes from ¥ 120/$ to ¥ 100 /$.
It takes fewer yen to purchase the dollar, the yen is said to have strengthened , or
appreciated, in value relative to the dollar and vice versa.
2.5 Describing Changes in Exchange Rates
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• Rate of change:
• The rate of appreciation or depreciation of one currency relative to another can be calculated
as the percentage rate of change of the exchange rate:
•
("#$%&'()
&'(
• Refers to the currency in the denominator of the exchange rate (for $/£, we’re talking about £)
• Rate will not necessarily be the same if you calculate the rate for the £ and the rate for the $
due to perspective
• The denominators are different
• Continuously compounded rates of appreciation reconcile the difference in the two rates:
• 𝑂𝑙𝑑 ×𝑒* = 𝑁𝑒𝑤
• The rate of appreciation on a compound monthly basis
• ($2.00/£ (1 + (a/12))12 = ($2.50/£)
• Annualized compound monthly rate of appreciation of the pound is 22.56%.
2.5 Describing Changes in Exchange Rates
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1. What is the structure of the foreign exchange market? Is it like the New York
Stock Exchange?
2. What is a spot exchange rate contract? When does delivery occur on a spot
contract?
3. What is an appreciation of the dollar relative to the pound? What happens to
the dollar price of the pound in this situation?
4. What is a depreciation of the Thai baht relative to the Malaysian ringgit? What
happens to the baht price of the ringgit in this situation?
Questions
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