Chapter 8 - Markets For Foreign Exchange

CHAPTER 8:
Markets for
Foreign Exchange
Ferdinand L. Martinez
FOREIGN EXCHANGE
 Money denominated in the currency of another
nation or group of nations.
 It can be in the form of cash, funds available on

credit and debit cards, traveler’s checks, bank
deposits, or other short-term claims
Exchange rate- the price of a currency—

specifically, the number of units of one currency that
buy one unit of another currency
Bank for International Settlement (BIS)
• A financial organization centered in Basel
Switzerland, owned and controlled by 60
member central banks.
PLAYERS ON FOREX
MARKET
Reporting dealers- also known as

“money center banks” that actively
participate in local ang global foreign
exchange and derivative markets.
PLAYERS ON FOREX
MARKET
 Financial Institutions- they are not classified as

reporting dealers. They include smaller
commercial banks, investment banks and
securities houses.
PLAYERS ON FOREX
MARKET
Non financial institutions- comprises of

any counterparty other than those
described above and include any non
financial end- user.
FOREIGN EXCHANGE
Foreign Exchange
Market
2 major segments
Over-the-counter market Exchange traded market

(OTC) - Securities exchange
- Commercial banks and other
financial institutions
FOREIGN EXCHANGE
 Foreign exchange is traded using

electronic methods, customer direct,
interbank direct or voice broker.
ELECTRONIC METHOD
 Trades are matched up for foreign

exchange dealers using electronic
systems.
Example: EBS, Thomas Reuters, Bloomberg

CUSTOMER DIRECT
 Trades between a reporting dealer and

either non-reporting dealer or customer,
without a third party being involved.
INTERBANK DIRECT
Trades between dealers via telephone or

direct electronic trading.
It is a global network utilized by financial

institution to trade currencies between
themselves.
VOICE BROKER
“interdealer brokers”
Trade via telephone communication with a

foreign exchange voice broker.
GLOBAL OTC
INSTRUMENTS
Spot transactions- involve the exchange
of currency at an agreed-upon rate for
delivery within two business days.
Outright forward transactions- involve

the exchange of currency on a future date
beyond two business days. It is the single
purchase or sale of a currency for future
delivery.
GLOBAL OTC
INSTRUMENTS
 FX swap- one currency is traded for another
on one date and then swapped back later.
Most often, the first or short leg of an FX swap
is a spot transaction and the second or long
leg a forward transaction.
 Currency swaps deal more with interest-

bearing financial instruments (such as a bond)
and involve the exchange of principal and
interest payments
GLOBAL OTC
INSTRUMENTS
 Futures contract- is an agreement between

two parties to buy or sell a particular currency
at a particular price on a particular future date,
as specified in a standardized contract to all
participants in a currency futures exchange
rather than in the over-the-counter market.
SIZE, COMPOSITION AND
LOCATION OF THE FOREIGN-
EXCHANGE RATE
Hedge funds
 funds typically used by wealthy individuals and
institutions that are allowed to use aggressive
strategies unavailable to mutual funds.
 Pooled investment fund that trades in relatively
liquid assets and is able to make extensive use
of more complex trading, portfolio construction
and risk management technique.
Using the U.S. Dollar on the
Foreign-Exchange Market
 The U.S. dollar is the most important currency on
the foreign-exchange market; it is widely traded
because;
• It’s an investment currency in many countries.
• It’s a reserve currency held by many central banks.
• It’s a transaction currency in many international commodity
markets.
• It’s an invoice currency in many contracts.
• It’s an intervention currency employed by monetary
authorities in market operations to influence their own
exchange rates.
Frequently Traded
Currency Pairs
Another way to consider foreign currency trades is

to look at the most frequently traded currency pairs.
The dollar is part of four of top seven currency pairs
traded:
• >The dollar/euro is number one.
• >The dollar/yen is number two.
THE EURO
 The euro is also in four of the top ten currency

pairs. The euro is gaining ground, particularly
in Eastern European countries. It is slowly
rising in importance as a trading currency, even
outside of Europe.
 The biggest market for foreign exchange is
London, followed by New York, Tokyo and
Singapore.
MAJOR FOREIGN- EXCHANGE
MARKETS
KINDS OF FOREIGN-EXCHANGE MARKET

• The Spot Markets
• The Forward Markets
• The Option Markets
• The Future Markets
SPOT MARKET
• the spot market is for foreign-exchange

transactions that occur within two business days.
But in some transactions, a seller extends credit
to the buyer for a period longer than that.
FOREIGN-EXCHANGE TERMS
• Bid- the rate which traders buy foreign exchange

• Offer- the rate at which traders sell foreign currency
• Spread- the difference between bid and offer rates
• American Terms/Direct quote- the number of dollars
per unit of foreign currency
• European Terms/Indirect quote- the number of units of
foreign currency per dollar
THE FORWARD MARKET
• In forward contract, two parties agree to do a

trade at some future date, at a stated price and
quantity. No security deposit is required as no
money changes hands when the deal is signed.
OPTION MARKETS
• An option is the right, but not the obligation, to

buy or sell a foreign currency within a certain
time period or on a specific date at a specific
exchange rate. It can be purchased OTC from a
commercial or investment bank or on an
exchange.
FUTURE MARKETS
• A foreign currency futures contract resembles a

forward contract insofar as it specifies an
exchange rate some time in advance of the
actual exchange of currency. However, a future
is traded on an exchange, not OTC.
The Foreign-Exchange
Trading Process
 When a company sells goods or services
to a foreign customer and receives foreign
currency, it needs to convert it into the
domestic currency.
 When importing, the company needs to
convert domestic to foreign currency to
pay the foreign supplier.
 This conversion usually takes place
between the company and its bank.
Major Exchanges that deal in foreign
currency derivatives are:
• CME Group
• NASDAQ OMX
• NYSE Life.
Commercial Bills of
Exchange
• draft or commercial bill of exchange-
one party directs another party to make
payment.
• sight draft -requires payment to be made
when it is presented.
• time draft -permits payment to be made
after the date when it is presented. It is a
guaranteed payment to the seller by an
issuing bank
Letters of Credit
• Letter of credit -obligates the buyer’s

bank to honor a draft presented to it and
assume payment; a credit relationship
exists between the importer and the
importer’s bank.
• Confirmed letter of credit- the exporter
has the guarantee of an additional bank—
sometimes in the exporter’s home country,
sometimes in a third country.
Speculators -take positions in foreign-exchange
markets and other capital markets to earn a profit.
Speculation is the buying or selling of a
commodity—in this case, foreign currency— that
has both an element of risk and a chance of great
profit.
Arbitrage -is the buying and selling of foreign
currencies at a profit due to price discrepancies.
Interest arbitrage -involves investing in interest-
bearing instruments in foreign exchange in an
effort to earn a profit due to interest rate
differentials.

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CHAPTER 8:

 It can be in the form of cash, funds available on

Exchange rate- the price of a currency—

Reporting dealers- also known as

 Financial Institutions- they are not classified as

Non financial institutions- comprises of

Over-the-counter market Exchange traded market

 Foreign exchange is traded using

 Trades are matched up for foreign

Example: EBS, Thomas Reuters, Bloomberg

 Trades between a reporting dealer and

Trades between dealers via telephone or

It is a global network utilized by financial

Trade via telephone communication with a

Outright forward transactions- involve

 Currency swaps deal more with interest-

 Futures contract- is an agreement between

Another way to consider foreign currency trades is

 The euro is also in four of the top ten currency

KINDS OF FOREIGN-EXCHANGE MARKET

• the spot market is for foreign-exchange

• Bid- the rate which traders buy foreign exchange

• In forward contract, two parties agree to do a

• An option is the right, but not the obligation, to

• A foreign currency futures contract resembles a

• Letter of credit -obligates the buyer’s

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