Foreign Exchange
Market
Ing. Tomáš Heryán, Ph.D.
International Business Finance
FIU/NKIFA
• Widely used abbreviations: FX market or
FOREX
• The place where money denominated in
one currency is bought and sold with
money denominated in another currency
• The place where purchasing power in one
currency can be converted into purchasing
power in another currency
• The place where exchange rates of the
traded currencies are determined
Meaning of the foreign exchange market
Foreign Exchange Market (International Business Finance – presentation 03)
• The largest financial market made up of banks, commercial companies,
central banks, investment management firms, hedge funds, and retail
brokers and investors
• Foreign exchange means the money of a foreign country; that is, foreign
currency bank balances, banknotes, checks and drafts
• A foreign exchange transaction is an agreement between a buyer and a
seller that a fixed amount of one currency will be delivered for some other
currency at a specified date
Meaning of the foreign exchange market
Foreign Exchange Market (International Business Finance – presentation 03)
• Market size is USD 5.1 trillion daily and the U.S. dollar is the most
important currency on the foreign exchange market
– Most of trades on the wholesale market
• The most commonly traded currency pairs are EUR/USD and USD/JPY
• FX market is a global market with no specific location
– Several financial centres where most of trading is done
• Trading 24 hours a day
– Market activity first heightens when Europe and Asia are open and again when Europe
and the United States are open
– FX market never sleeps…
Size, composition and location of the FX market
Foreign Exchange Market (International Business Finance – presentation 03)
• Electronic platforms made foreign currency transactions easier
– Electronic brokerage systems, phone, SWIFT
• Market makers are crucial for trading on the FX market
• There is no central clearing of FX transaction
• Bank of International Settlements (BIS) plays a critical role in managing FX
transactions worldwide
Size, composition and location of the FX market
Foreign Exchange Market (International Business Finance – presentation 03)
World map of the FX market
Foreign Exchange Market (International Business Finance – presentation 03)
São Paulo
Rio de Janiero
Mexico
City
San
Francisco New
York
Toronto
Bombay
Melbourne
Sydney
Tokyo
Hong Kong
Singapore
London
Paris
Zurich
Frankfurt
Amsterdam
ViennaMadrid
Hamburg
Dusseldorf
RomeBasel
Brussels
Chicago
Share of global FX market trading in main centres
Foreign Exchange Market (International Business Finance – presentation 03)
36,9%
19,5%
7,9%
6,7%
6,1%
2,8%
1,9%
1,8%
1,5%
1,3% 13,6% United Kingdom
United States
Singapore
Hong Kong
Japan
France
Australia
Germany
Denmark
Canada
others
FX market never sleeps…
Foreign Exchange Market (International Business Finance – presentation 03)
… but it goes for a lunch
Foreign Exchange Market (International Business Finance – presentation 03)
Global FX market turnover by instrument
Foreign Exchange Market (International Business Finance – presentation 03)
Currency distribution of the FX market turnover (in % of transactions)
Foreign Exchange Market (International Business Finance – presentation 03)
1998 2001 2004 2007 2010 2013 2016
USD 87.3 90.3 88.7 85.6 84.9 87.0 87.6
EUR (DEM) (30.1) 37.6 37.2 37.0 39.1 33.4 31.4
JPY 20.2 22.7 20.3 16.5 19.0 23.0 21.6
GBP 11.0 13.2 16.9 15.0 12.9 11.8 12.8
AUD 3.1 4.2 5.5 6.7 7.6 8.6 6.9
CAD 3.6 4.5 4.2 4.2 5.3 4.6 5.1
CHF 7.1 6.1 6.1 6.8 6.4 5.2 4.8
CNY 0.0 0.0 0.1 0.5 0.9 2.2 4.0
CZK 0.3 0.2 0.2 0.2 0.2 0.4 0.3
FX market turnover by currency pair (in % of transactions)
Foreign Exchange Market (International Business Finance – presentation 03)
1998 2001 2004 2007 2010 2013 2016
USD/EUR (DEM) (20) 30 28 27 28 24 23
USD/JPY 18 20 17 13 14 18 18
USD/GBP 8 11 14 12 9 9 9
USD/AUD 3 4 5 6 6 7 5
USD/CHF 5 5 4 5 4 3 4
USD/CAD 3 4 4 4 5 4 4
USD/CNY 1 2 4
USD/others 12 17 16 15 11 13 12
EUR/JPY --- 3 3 3 3 3 2
• Investment currency in many capital markets
• Reserve currency held by many central banks
• Transaction currency in many international commodity markets
• Invoice currency in many contracts
• Intervention currency employed by monetary authorities in market
operations to influence their own exchange rates
• Vehicle currency that expedites transactions between currencies of limited
circulation
Why U.S. Dollar is so widely traded?
Foreign Exchange Market (International Business Finance – presentation 03)
• International banks
– Around 100 large commercial banks worldwide provide the core of the FX market and
actively participate
– „Make a market" in FX, trading FX on behalf of bank customers (MNCs, money
managers, exporters, importers, private traders)
– Most interbank trades are speculative or arbitrage transaction
• Nonbank dealers
– Wholesale currency traders who are NOT commercial banks, e.g. investment banks
(Solomon Smith Barney, Merill Lynch, JP Morgan, Goldman Sachs, etc.)
– Establish their own trading centers to trade directly in the FX market, and account for
28% of the interbank (wholesale) volume
FX market participants
Foreign Exchange Market (International Business Finance – presentation 03)
• FX brokers
– Brokers/intermediaries who track quotes offered by many dealers in the global market,
and then match buyers and sellers for a fee (bid/ask spread), and "make a market,"
without taking a position themselves (no currency inventory)
– More and more trading (50-70%) now takes place through automated electronic trading
systems, making the role of FX brokers unnecessary
• Central banks
– If a country has a fixed ex-rate (Argentina until recently, Hong Kong), or a pegged rate
(China), the central bank (or currency board) has to make regular interventions to support
the fixed/pegged ex-rate
• Individuals and firms
– Use the FX market incidentally to their underlying commercial or investment purpose
FX market participants
Foreign Exchange Market (International Business Finance – presentation 03)
Top 10 FX market traders in 2014
Foreign Exchange Market (International Business Finance – presentation 03)
• A foreign exchange rate is the price of one currency expressed in terms of
another currency
• A foreign exchange quotation (or quote) is a statement of willingness to buy
or sell at an announced rate
• Each currency pair has a double exchange rate (to buy, to sell)
• Most foreign currencies in the world are stated in terms of the number of
units of foreign currency needed to buy one dollar
– Several exceptions exist, e.g. Euro, British pound, Australian dollar
Exchange rate
Foreign Exchange Market (International Business Finance – presentation 03)
• Exchange rates are given as a bid and ask (also referred to as offer)
• Bid exchange rate
– Price (i.e. exchange rate) in one currency at which a dealer will buy another currency
• Ask exchange rate
– Price (i.e. exchange rate) at which a dealer will sell the other currency
• Spread
– The difference between bid and ask rates
• Dealers bid (buy) at one price and ask (sell) at a slightly higher price,
making their profit from the spread between the buying and selling prices
• A bid for one currency is also the offer for the opposite currency
Two-way quotation of exchange rates
Foreign Exchange Market (International Business Finance – presentation 03)
Two-way quotation of exchange rates
Foreign Exchange Market (International Business Finance – presentation 03)
EUR / USD
1.1741 / 1.1743
Counter
currency
Base
currency
Bid
exchange
rate
Ask
exchange
rate
Spread = Ask – Bid = 1.1743 – 1.1741 = 0.0002 (2 pips)
Spread (%) = (Ask – Bid) / (Ask) = 0.0002 / 1.1743 = 0.017 %
Trader buys
Client sells
EUR
Trader sells
Client buys
EUR
• Direct quote gives the home currency price of one unit of foreign currency
– For example 26.10 Czech korunas for 1 euro written as 26.10 CZK/EUR (European
convention) or EUR/CZK 26.10 (American convention)
• Indirect quote tells how many units of foreign currency can be purchased by
one unit of domestic currency
– For example 0.0383 euros for 1 Czech koruna written as 0.0383 EUR/CZK (European
convention) or CZK/EUR 0.0383 (American convention)
• Direct quote is the reciprocal of the indirect quote
• In this pair of definitions, the home or base country of the currencies being
discussed is critical
• The form of the quote depends on what the speaker regard as “home”
Direct vs. Indirect quotation
Foreign Exchange Market (International Business Finance – presentation 03)
• Depreciation of home currency
– Value of home currency falls relative to the foreign currency
– Using direct quotation, depreciation of home currency means increase of the exchange
rate !!!, e.g. change from 26.10 CZK/EUR to 27.00 CZK/EUR
• Appreciation of home currency
– Value of home currency raises relative to the foreign currency
– Using direct quotation, appreciation of home currency means decrease of the exchange
rate !!!, e.g. change from 27.10 CZK/EUR to 26.20 CZK/EUR
• It is better to speak about value of currency than change of the exchange
rate when using direct quotes
Interpretation of changes in exchange rates
Foreign Exchange Market (International Business Finance – presentation 03)
• Spot transactions
– Purchase of foreign exchange, with delivery and payment between banks to take place,
normally, on the second following business day
– The date of settlement is referred to as the value date
• Forward transactions (outright forward)
– Requires delivery at a future value date of a specified amount of one currency for a
specified amount of another currency
– The exchange rate is established at the time of the agreement, but payment and delivery
are not required until maturity (several standard maturity dates)
• Swap transactions
– Simultaneous purchase and sale of a given amount of foreign exchange for two different
value dates with the same counterparty
Main instruments on the FX market
Foreign Exchange Market (International Business Finance – presentation 03)
• The simplest FX instrument for immediate exchange of funds and execution
• Pricing on the spot market is by the actual demand and supply of the
currency in the market
• Spot exchange rate movements are highly impredictable even during a
single trading day
– Relying solely on spot trading may be risky
• Standard size of one trade is about USD 10 mil.
• Trading is very fast and hectic, the stakes are high
• Trading jargon widely used among traders to make communication as short
and efficient as possible
Spot FX trading
Foreign Exchange Market (International Business Finance – presentation 03)
• Contract settled today for future delivery/receipt of foreign exchange
• Agree today on price (forward exchange rate) and quantity (size of the
trade) and settlement at fixed future date
– Most typical are 30-day, 60-day, 90-day, 180-day, 360-day deliveries
• Forward rates are typically quoted in terms of points
– It is not a foreign exchange rate as such
– Rather, it is the difference between the forward rate and the spot rate
• Forward rate – spot rate = swap exchange rate
– Forward > spot : currency is trading at forward premium (is more expensive in future)
– Forward < spot : currency is trading at forward discount (is cheaper in future)
Forward FX contracts
Foreign Exchange Market (International Business Finance – presentation 03)
Quotation of the forward exchange rate
Foreign Exchange Market (International Business Finance – presentation 03)
USD/GBP USD/EUR CHF/USD
Spot 1.6604 1.6614 1.1575 1.1590 1.3820 1.3830
1 month 14 12 17 18 43 42
2 months 24 22 33 35 87 85
3 months 33 30 50 53 130 127
6 months 53 50 109 112 249 246
12 months 66 62 230 235 481 476
• Add the premium to the spot rate
– If the bid-ask combination in swap rate is smaller-bigger number
• Deduct the discount from the spot rate
– If the bid-ask combination in swap rate is bigger-smaller number
Forward premium / discount
Foreign Exchange Market (International Business Finance – presentation 03)
• The forward premium or discount is the difference between the forward
exchange rate and the spot exchange rate, expressed as a percentage of the
spot rate
• It is a standard to present the premium or discount annualized
Fn = forward exchange rate
S = spot exchange rate
n = number of days in the forward contract (delivery period)
100
360



nS
SF
premium n
• If you have agreed to buy the respective asset (forward or spot), you are
„long“
• If you have agreed to sell the respective asset (forward or spot), you are
„short“
• If you have agreed to buy currency via FX forward, you are long in this
currency
• If you have agreed to sell currency via FX forward, you are short in this
currency
Long and short forward positions
Foreign Exchange Market (International Business Finance – presentation 03)
Payoff profiles of the forward contract
Foreign Exchange Market (International Business Finance – presentation 03)
0
S180(USD/CAD)
F180(USD/CAD) = 1.27
short positionloss
profit
long position If, in 180 days the spot price rises the
short loses and the long makes a profit
If, in 180 days the spot price falls the
short makes profit and the long loses
The short entered into the forward
agreeing to sell USD in 180 day at
USD/CAD 1.27 and the long to buy
USD at the same price
Payoff profiles of the forward contract
Foreign Exchange Market (International Business Finance – presentation 03)
0
S180(USD/CAD)
F180(USD/CAD) = 1.27
short positionloss
profit
long position If, in 180 days the spot price rises to
USD/CAD 1.31 the short position
losses and the long position makes a
profit
S180(USD/CAD) = 1.31
profit
loss
• Hedging
– Operations to minimize foreign exchange risk
• Arbitrage
– Non-risk operations to exploit differences in exchange rates
– Triangular arbitrage, covered interest rate arbitrage
• Speculation
– Risky operations to bet on particular exchange rate development
– Leverage tradinf
– Carry trade, short selling
• Investment
– Operations to invest in currencies as a class of assets
Purposes of trading on the FX market
Foreign Exchange Market (International Business Finance – presentation 03)
THANK YOU FOR YOUR
ATTENTION
J