CH 5: The Market for Foreign Exchange

The Bid-Ask Spread

The bid price is the price a dealer is willing to pay you for something.

The ask is the amount the dealer wants you to pay for the thing.

The Bid-Ask spread is the difference between the bid and ask prices.

(Ask-Bid)/Ask *100 = % spread

Spot Foreign Exchange Microstructure

Market microstructure refers to the mechanics of how a marketplace operates.

Bid-Ask Spreads in the Spot FX market:

1. Increase with FX exchange rate volatility

2. Decrease with dealer competition

Textbook notes

The Spot Market

Direct quotation - From the U.S perspective, the price of one unit of foreign currency in U.S dollar

Indirect quotation- From the U.S. perspective, the price of one U.S. dollar in the foreign currency.

Trading in the Spot market involves the immediate purchase and sale of currencies.

Spot and forward foreign exchange markets are over-the-counter (OTC) markets. Does not take place in a central marketplace.

The 3 major market segments are: Australasia, Europe, and North America.

ISO 4217 is the international standard.

Economies are considered to be in the dollar zone of their currencies co-move with the U.S. dollar and are relatively stable against the U.S. dollar.

Foreign exchange markets: Allow the conversion of purchasing power from one currency to another. Enables banking and credit across currencies.

FX Market Participants

The foreign exchange market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.

The spot and forward foreign exchange markets are over-the-counter (OTC) markets; trading does not take place in a central marketplace where buyers and sellers congregate.

The 3 major market segments can be identified: Australasia, Europe, and North America

The economies with currencies that co-move more with the U.S dollar and are relatively stable against the U.S dollar would be considered the dollar zone.

Can be viewed as a two-tier market: Wholesale or interbank and the other tier is the retail or client market.

Participants can be classified into 5 groups:

1. International banks (buy and sell foreign currencies for own account)

2. Bank customers (conduct foreign commerce or international investment)

3. Non-bank dealers (smaller commercial and investment banks)

4. FX brokers (match dealers’ orders to buy and sell currencies for a fee)

5. Central banks

International banks provide the core of the FX market. Why? Because they are willing to buy foreign currency with their own account. However, most international banks are speculative or arbitrage transactions.

Speculative transactions are financial transactions conducted with the primary goal of profiting from short-term price fluctuations in assets such as stocks. High risk, high reward.

Arbitrage transactions involve simultaneously buying and selling an asset in different markets to take advantage of price differences and earn a risk-free profit.

Hedging transactions are undertaken to manage foreign exchange risk. Involves taking an offsetting position in a related asset to balance out potential losses from an initial investment.

Intervention is the process of either using foreign currency to buy own currency to decrease supply and increase value OR selling one’s own currency for foreign currency to increase its supply and lower price.

The Society for Worldwide Interbank Financial Telecommunication (SWIFT) allows International banks to communicate instructions.

Spot FX Trading

The spot market involves the almost immediate purchase or sale of foreign exchange.

FX market is liquid.

Spot quotations are only good for a few seconds.

Direct quotation - Referring to the price of one unit of a foreign currency in terms of the domestic currency. E.g., The U.S. dollar equivalent “Japanese yen is worth about a penny”

Indirect quotation - The price of one domestic currency in terms of a foreign currency. E.g., “you get 100 yen to the dollar”

The retail bid-ask spread is wider than the Interbank spread, with Lower Bid and higher ask prices.

Interbank FX traders buy currency for inventory at the bid price and sell from inventory at the ask price. Allows dealers to make a profit.

Triangular Arbitrage

Triangular Arbitrage is the process of trading U.S dollars for a second currency and subsequently trading this for a 3rd currency. This 3rd currency is then traded for U.S dollars. The purpose is to earn arbitrage profit when the quoted exchange rate is not in alignment with the implied cross-exchange rate.

Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask rate than the cross-rate spread.

Implied cross-rate bid discipline - If the direct quote is not consistent with cross-exchange rates, a triangular arbitrage is possible.

Arbitrage is a zero risk, profit guaranteed.

The Forward Market

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

Forward premium/dicount is the amount over/under the spot exchange rate for a forward rate that is often expressed as an annualized percent deviation from the spot rate.

MNCs and financial institutions use forward contracts to either hedge foreign currency exposure or to speculate in the foreign exchange market.

Long and Short Forward Positions:

If you agree to sell anything (spot or forward) you are short.

If you agreed to sell forex forwards you are short.

If you agreed to buy forex forward you are long.

If you agreed to buy anything (forward or spot) you are long.

Quotations are nonstandard or broken-term, and maturing is also available.

Usually never the same as spot price.

A non-deliverable forward contract is settled in cash, at the difference between the spot exchange on the maturity date and the NDF rate times the notional amount of the contract.

SWAP Transactions

An outright forward transaction is an uncovered speculative position in a currency. From the bank’s standpoint.

SWAP transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A forward swap transaction is the simultaneous sale (or purchase) and purchase (or sale) of approximately equal amounts of the foreign currency.

Quoting forward rates in terms of forward points is convenient for 2 reasons:

1. Forward points may remain constant for long periods of time, even if spot rates fluctuate.

2. In SWAP transactions, the actual spot and outright forward rates are often of no consequence.

As in the spot market, the bid-ask spread in the forward retail market is wider than the interbank spread.

Banks will also typically require their clients to maintain a compensating balance to cover the cost of the bank’s advisory services.

Exchange-Traded Currency Funds

An ETF is a portfolio of financial assets in which shares representing fractional ownership of the fund trade on an organized exchange.

• It allows small investors the opportunity to invest in portfolios that would have been difficult to construct individually.

Last Thoughts

The FX market is the largest and most active financial market.

The Retail market is where international banks service their customers who need foreign exchange to conduct international commerce.

**Non-dollar currency transactions must satisfy the Bid-ask spread determined from the cross-rate formula Or a triangular arbitrage opportunity exists.

If an exchange rate follows a random walk, the future exchange rate ie expected to be the same as the current exchange rate