Chapter 15

The Foreign Exchange Market: Participants and Mechanics

Summary
The foreign exchange markets operate through a highly sophisticated network of
telecommunications systems that link the numerous FX dealers and brokers located in
all of the major cities of the world. Participants in the FX market also include those
who have underlying commercial and financial transactions denominated in foreign
currencies. This includes importers and exporters, and those investing or borrowing
from overseas in a currency other than their home currency. In addition, there are
speculators who buy and sell foreign currencies in the expectation of making profits
from favourable exchange rate movements, and there are those who arbitrage
exchange rate and/or international interest rate differentials across the different
international markets. Central banks also enter the FX markets as buyers and sellers of
foreign currency. A central bank may enter the FX market in order to meet its
governments foreign currency requirements or, from time to time, in an attempt to
influence the value of a currency in the market.
The FX markets operate somewhere around the globe twenty-four hours a day.
The markets are dynamic, with exchange rates changing in response to the continuous
flow of economic, political, financial and social news and information into the
markets. It is estimated that over USD1.5 trillion passes through the FX markets each
day, facilitated by FX dealing rooms that use sophisticated, technology-based
computer and communication systems.
The contracts that are traded in the FX markets are distinguished by their
maturity or delivery dates. Spot and forward contracts are the most common contracts
traded. Spot transactions have a value date that is two business days from today; that
is, they require delivery of the foreign currency and financial settlement two business
days from the contract date. Forward contracts specify a value date more than two
business days from today.
Because of the technology-based nature of the trade in foreign currencies,
universal conventions are adopted in the markets. The first-named currency in an FX
quote is called the unit of the quotation, or the base currency. The base currency
represents one unit of the currency. The second-named currency is known as the terms
currency. FX dealers, or price-makers, quote two-way rates: the first and lower rate is
the one at which the dealer buys the unit of the quotation; the second and higher rate
is the one at which the dealer sells the unit. FX dealers will typically only quote the
final two points, as it is presumed that market participants are aware of the big
numbers that precede them. A point is the final decimal place in a quote. The spread is
the difference between the bid and offer rates.
It is possible to derive a range of additional exchange rates on the basis of the
few published rates; for example, transposed and cross-rates can be calculated. To
transpose a quote from, say, a direct (USD/AUD) to an indirect quote (AUD/USD),
the rule is to reverse the quote and then inverse by dividing into 1. As all currencies
are quoted against the USD, it is often necessary to calculate a cross-rate that does not
incorporate the USD. For example, to cross two direct quotes, place the new unit
currency quote first, followed by the second quote. Simply divide opposite bid and
offer rates.
The convention adopted in the quotation of forward rates is that the dealer
quotes the forward points rather than the outright forward rates. To obtain the outright
rate, the forward points are added to, or subtracted from, the spot rate. In calculating
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the forward points, the dealer uses the spot rate and the differential rates of interest in
the money markets of the two countries whose currencies are quoted. The currency of
the relatively high interest-rate country will be priced at a forward discount; the
relatively low interest-rate currency will be quoted at a forward premium. Real-world
complications were touched on, such as different interest-rate days conventions (for
example, the USA uses a 360-day year), interest-withholding tax, two-way quotations,
and the effects of compounding periods, all of which affect the calculation of forward
points and a forward exchange rate.
Finally, the European Monetary Union was discussed, and the significant
impact it has had on the structure and operation of the FX markets. Twelve foreign
currencies have been replaced by a single currency, the euro. The euro has become a
major currency traded in the FX markets.
Review questions suggested answers
The following suggested answers incorporate the main points that should be
recognised by a student. An instructor should advise students of the depth of analysis
and discussion that is required for a particular question. For example, an
undergraduate student may only be required to briefly introduce points, explain in
their own words and provide an example. On the other hand, a post-graduate student
may be required to provide much greater depth of analysis and discussion.
1.
Describe the functions, structure and operation of the international FX
markets. Include in your answer the main locations of the markets, and explain
the roles of FX dealers and FX brokers.

the FX market is a global market that facilitates transactions in international

currencies 24-hours a day
the FX markets exist whenever and wherever financial transactions are conducted
which are denominated in a foreign currency
major FX markets include London, New York, Tokyo, Singapore, Hong Kong,
Sydney, Bahrain, Frankfurt, Paris and Zurich
the FX market facilitates the exchange of value from one currency to another
the FX market allows market participants to buy and sell foreign currencies
important reasons that there is an enormous demand to buy and sell foreign
currencies include:
- financial flows arising from international trade in goods and services
- cross-border capital transactions - investment and borrowing
- speculative transactions - profiting from exchange rate movements
- central bank transactions with the markets
the FX markets operate through the use of sophisticated electronic communication
and information systems
trading in FX is conducted using telephone, telex and SWIFT (society for
worldwide interbank financial telecommunications)
SWIFT is an electronic system that facilitates financial transactions for member
institutions in the global market
when carrying out transactions, internationally adopted FX market conventions
have developed
transactions are normally conducted through an FX dealer or an FX broker

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FX dealers financial institutions that quote buy and sell prices, and act as
principals in the FX market
FX brokers obtain the best prices in the FX market, and match FX dealers buy
and sell orders, for a fee

2.
Importers, exporters, investors and borrowers may all be participants in
the FX markets. Explain why each of these parties would be involved in FX
market transactions.
Firms conducting international trade transactions (importers and exporters):
businesses that export goods or services in the international markets generally
receive payments in a foreign currency
also businesses that import goods and services need to pay for those goods and
services, usually in a foreign currency
the dominant currency of international trade is the USD, but other currencies, such
as the GBP, JPY and the EUR, are also quite prominent
typically, an exporter is likely to sell foreign currency received and buy the local
currency through an FX market
importers have to buy foreign currency in order to pay for their imports
Investors and borrowers in the international financial markets:
deregulation of the international financial markets has resulted in an enormous
increase in the volume of capital flows around the world
large corporations, financial institutions and governments raise funds in the
international capital markets
borrowers with good credit ratings are able to diversify their funding sources in
the international capital markets, such as the euromarkets
a large proportion of funds borrowed in the international markets is converted
from the currency borrowed back into the home currency, using the FX market
other corporations and financial institutions invest overseas
for example, funds managers for pension or superannuation funds will invest a
proportion of their investment portfolios in international stocks and debt securities
the funds managers need to purchase FX in order to make the investments
dividend or interest payments received by the funds managers will be
denominated in a foreign currency. The managers may sell on the FX markets to
convert the receipts back into the home currency, for distribution to fund members
3.
Distinguish between speculative and arbitrage transactions in the FX
market. Describe arbitrage transactions using an example of a locational
arbitrage and a triangular arbitrage.
Speculative transactions:
speculative FX transactions are motivated by the pursuit of a profit
the sheer volume of speculative transactions implies that, at times, speculators are
able to move the market price of a currency
such transactions are always accompanied by an element of risk
for example, with an expectation that the AUD will depreciate against the USD, a
speculator might buy the USD (sell the AUD) now. If correct, a profit will be
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made by converting the USD back into AUD after the AUD has depreciated.
However, if the AUD appreciates instead, the speculator will lose
a speculator may take a long position or a short position
long position holding FX in expectation of a future sale
short position entering into a forward contact to sell FX that is currently not held

Arbitrage transactions:
arbitrage transactions are possible when price differences appear between markets
the arbitrageur is able to carry out simultaneous buy and sell transactions in two
markets, to effect a risk-free profit
locational arbitrage: an arbitrage opportunity whereby the exchange rate quoted by
two or more dealers, between two currencies, is different. The arbitrageur will buy
the currency from the dealer quoting the lowest price and simultaneously sell the
currency through the dealer quoting the highest price on that currency
triangular arbitrage: occurs when exchange rates between three or more currencies
are out of perfect alignment. Again, the arbitrageur will simultaneously buy and
sell a combination of currencies to take advantage of the price differences
arbitrage profit opportunities generally do not exist for long. The buy/sell actions
of the arbitrageurs bring the prices back into equilibrium
4.
Many developed economies operate within a floating-exchange-rate
regime. Where a country has a floating exchange rate, consider the circumstance
in which the central bank of that country might conduct transactions in the FX
market.
The central banks of nation-states enter the FX markets periodically, for one or other
of the following reasons:
to acquire foreign currency to pay for their government's purchases of imports,
such as defence equipment, and to pay interest on, or to redeem, the governments
overseas borrowings
to change the composition of the central banks holdings of foreign currencies, as
part of its management of official reserve assets. Official reserve assets are central
banks holdings of foreign currencies, gold and international drawing rights
to influence the exchange rate. Central bank intervention in the FX market would
not exist if the value of a currency was determined purely by market forces, that
is, a so-called clean float. However, central banks may, at times, be significant
buyers or sellers of a currency, when it considers the exchange rate is moving too
rapidly, and is trading well outside rates that can be supported by economic
fundamentals. If the goal is to slow down an appreciation of the exchange rate, the
central bank will sell its local currency. In another example, if the Reserve Bank
wished to support the AUD to stop it depreciating and perhaps assist it to
appreciate, it would buy AUD and sell foreign currency
5.
Outline the features of the main types of contracts that are created in the
FX markets, distinguishing between short-dated, spot and forward transactions.

an FX transaction is described by its value date, that is, the day that the currency is
delivered and settlement is made

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spot transactions the FX contract value date is two business days from the date
of the initial order. The exchange rate is determined today, but delivery occurs in
two business days. For example, if a company places an order with an FX dealer
to buy USD1 million at a rate of AUD/USD0.6032 on a Tuesday, then the dealer
will deliver USD1 million on the Thursday and the company will pay AUD1 657
824.93 also on the Thursday
forward transactions the FX contract value date occurs at a specified date
beyond the spot date, for example an order to sell EUR in three months. Again, the
exchange rate is set today that will apply at spot plus three months. If today is 24
March, then the three-month forward value date will be 26 June, providing that is
a business day (if not, the date will be moved forward to the next business day)
tod transactions an FX contract with settlement and delivery today
tom transactions an FX contract with settlement and delivery tomorrow

6.
The FX dealing room of a major bank notes that it is long in the USD, but
is short in the EUR. Explain what is meant by these positions?

if the dealer is long in USD, it means that it is holding surplus USD on its account;
that is, the USD are in excess of its currency requirements to meet existing FX
contracts
if the dealer is short the EURO, it means that the dealer has entered into a forward
contract to sell the EUR, when in fact it currently does not hold any EUR in its FX
portfolio. The dealer may be holding the short position in an expectation that the
EUR will depreciate before the forward value date. The dealer will then buy the
actual EUR at the lower price on the value date, and sell at the higher price
specified in the forward contract

7.
The FX market has a well-established set of language conventions. These
conventions have been developed to allow the efficient communication of market
data. Explain and illustrate this statement with reference to the language
conventions used in the spot FX markets.

assume the following quote AUD/USD0.6052 56

the first-named currency in the quote is the base currency, or the unit of the quote;
that is one AUD equals USD0.6052 56
the second-named currency is the terms currency, the USD. The terms currency is
valued relative to the base currency
the quote is a two-way price, that is, a bid price (buy) and an offer price (sell)
the first number is the bid price AUD/USD0.6052
the second number is the offer price AUD/USD0.6056
the market convention is to drop common numbers between the bid/offer price
the bid/offer is from the perspective of the dealer, that is, the dealer will buy
1AUD for USD0.6052, or sell 1AUD for USD0.6056
the difference between the dealers bid/offer prices is the spread
the spread in the example is 4 points (a point is the last decimal place in a quote)

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8.
Using the context of the currency pair USD/JPY, explain the terms base
currency, unit of the quotation, terms currency, direct quotation, and
indirect quotation.

9.
(a)

(b)

base currency the first-named currency in an FX quote, expressed as one unit in

terms of the second currency. In the USD/JPY example, the base currency is the
USD and is expressed as 1USD will be bought/sold for the amount of JPY that
will be given in the quote
unit of the quotation is the base currency, that is, 1USD
terms currency the second-named currency in the quote, that is, the JPY
direct quotation when the USD is the base currency of the unit of the quotation
as in the USD/JPY example
indirect quotation when the USD is the terms currency and the other currency is
the base currency in the quotation. In that case, the above quote would be
transposed to JPY/USD
An FX dealer is quoting spot USD/SGD1.785056.
Explain from the perspective of the dealer what the FX quote indicates.
the price maker FX dealer will buy USD1 for SGD1.7850. The party that has
entered into the FX contract with the dealer will sell USD1 and receive
SGD1.7850
also, the dealer will sell USD1 for SGD1.7856, whereas the customer will receive
USD1 and pay the dealer SGD1.7856
the dealer will make 4 points between its bid and offer transactions
Transpose the quotation.
the USD/SGD1.7850 56 is a direct quote; the USD is the base currency
it is possible to transpose the direct quote to an indirect quote (SGD/USD)
rule: reverse, then invert
USD/SGD1.7850 1.7856
Reverse the bid/offer prices
1.7856 1.7850
take the inverse, that is, divide both numbers into 1
SGD/USD0.5600 0.5602

10.
A toy manufacturer in Thailand is exporting goods to New Zealand. In
order to ascertain the firms exposure to foreign exchange risk the company
needs to calculate the THB/NZD cross-rate. An FX dealer quotes the following
rates:
USD/NZD
1.854070
USD/THB
41.6042.80
Calculate the THB/NZD cross-rate.

most currencies are quoted against the USD, therefore it is necessary to calculate
the cross rate to obtain the THB/NZD quote
crossing two direct FX quotations

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- place the currency that is to become the unit of the quotation first
- divide opposite bid and offer rates, that is:
- to obtain the bid rate: divide the base currency offer into the terms currency bid
- to obtain the offer rate: divide the base currency bid into the terms currency offer
therefore, place the USD/THB quote first:
USD/THB 41.60 42.80
USD/NZD 1.8540 - 70
To determine the THB/NZD cross rate:
1.8540 / 42.80 = 0.0433
1.8570 / 41.60 = 0.0446
THB/NZD 0.0433 - 46

11.
An Australian manufacturer generates receipts in JPY from exports to
Japan. At the same time, the company imports component parts from the USA,
incurring commitments in USD. The company needs to determine its net open
position to the JPY. Rates are quoted at:
USD/JPY
107.23 107.46
AUD/USD
0.5546 0.5556.
Calculate the AUD/JPY cross-rate.

it is possible to use two methods to calculate this cross-rate: i) transpose the

AUD/USD rate to a direct USD/AUD rate, and then use the two direct quote
method (see question 10), or ii) use the direct and indirect quote method
crossing a direct and an indirect FX quotation:
- to obtain the bid rate multiply the two bid rates
- to obtain the offer rate multiply the two offer rates
to determine the AUD/JPY cross-rate:
107.23 x 0.5546 = 59.47
107.46 x 0.5556 = 59.70
AUD/JPY 59.47 59.70

12.
An importer has entered into a contract under which it will require
payment in GBP in one month. The company is concerned at its exposure to
foreign exchange risk, and decides to enter into a forward exchange contract
with its bank. Given the following (simplified) data, calculate the forward rate
offered by the bank.
AUD/GBP (spot):
0.515676
One-month Australian interest rate:
6.75%
One-month United Kingdom interest rate:
4.25%

the quote is from the perspective of the dealer, relative to the base currency
the importer needs to buy GBP, therefore it will sell AUD to the dealer. The dealer
is therefore buying AUD, so need to use the bid rate
Note: both countries use a 365 day year; assume 30 day contract

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S [1 + (It x contract days/days in year)]

[1 + (Ib x contract days/days in year)]
where:

S = spot rate
Ib = interest rate of base currency
It = interest rate of terms currency

Therefore, based on the above data:

0.5156 [1 + (0.0425 x 30/365)]
[1 + (0.0675 x 30/365)]
= 0.5156 (1.003493 / 1.005548)
= AUD/GBP0.5145
13.
When considering interest rate differentials and forward foreign
exchange rate calculations between the USD and the GBP, what important
adjustments need to be taken into account?

the USA uses a 360-day year convention, while the UK uses a 365-day convention
need to recognise this variation in the forward exchange contract formula

14.
Internationalisation of financial markets and the development of
sophisticated technology information and support systems mean that foreign
exchange dealers must have access to up-to-date information systems. Identify
two global information providers typically used by FX dealers, and briefly
describe the type of information that may be available.

in a physical sense, the FX market consists of a vast and highly sophisticated

global network of telecommunications systems
to facilitate FX transactions, it is essential that the various dealing rooms around
the globe have access to the same information at each moment in time
the information sought by the FX dealing rooms will be the current buy and sell
rates for the various currencies, plus economic, political and social news that may
affect the values of any particular currency
there are a number of global networks that provide such information, including
Reuters, Bloomberg and the Dow Jones Telerate networks
these organisations facilitate the efficient flow of information into the FX markets
FX dealing rooms typically access more than one information provider

15.
The European Monetary Union has had a significant impact on the
structure and operation of the FX markets. Discuss the process of monetary
union in Europe, and the issues relevant to the FX markets that are implied in
the above statement.

the Maastricht treaty seeks to create economic and monetary union within Europe
15 countries are members of the EU; 12 countries participate in EMU
EU and EMU are set to expand as new members are progressively allowed to join
EMU has seen the removal of 12 foreign currencies from the FX market

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the euro was introduced for financial transactions in January 1999

euro notes and coins were introduced in January 2002
the euro has become a hard currency, used for international trade and financial
transactions
central banks around the world support the euro by holding the euro as part of
their foreign reserves
the removal of 12 currencies and the introduction of one major currency has
increased the liquidity in the FX market
the introduction of the euro has removed foreign exchange risk for trade and
financial transactions, denominated in euro, that are carried out between member
states

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