Foreign Exchange Market – Condensed Exam Notes

Features & Functions

  • Transfers purchasing power across countries; provides credit for international trade; minimizes exchange-rate risk.

Market Structure & Participants

  • Operates 24-hours, driven by supply–demand, information, expectations, negotiating power.
  • Five key participants:
    • Bank & non-bank dealers (market makers 1 bid / ask spread).
    • Commercial & investment transactors (trade/investment settlement).
    • Speculators (seek profit from rate moves) & arbitragers (profit from price differentials).
    • Central banks/treasuries (policy-motivated intervention; willing loss-takers).
    • FX brokers (match dealers, no principal risk).

Evolution & Size of the Market

  • Telephone era ⟶ computer era ⟶ electronic/multi-bank platforms; interdealer vs. customer split largely gone.
  • Daily turnover (BIS, 2016): \$5.1\text{ trillion}; London ≈ 37 % share; USD in 87.4 % of trades.

Key Transaction Types

  • Spot: delivery T+2; value date = settlement date.
  • Outright Forward: agreed rate today, delivery future (1–12 m typical).
  • Swap: simultaneous buy/sell for two dates (spot-forward, forward-forward, NDF).
  • Non-Deliverable Forward (NDF): cash-settled (usually USD) for restricted currencies.

Fundamental Terms

  • Quote format: \text{CUR}1/\text{CUR}2 (units of \text{CUR}2 per 1 \text{CUR}1).
  • American terms: USD price of foreign unit (e.g. \text{EUR}/\$).
  • European terms: foreign price of 1 USD (e.g. \$/\text{EUR}), dominant convention except EUR & GBP.
  • Direct quote = home-currency price of foreign unit; Indirect quote = foreign-currency price of home unit.
  • Bid = dealer buys base; Ask = dealer sells base; profit = bid–ask spread.

Cross Rates & Bid-Ask Logic

  • Cross rate derives from two actively quoted pairs; verify arbitrage:
    • Example: S(\$/€)=1.0500, S(\$/£)=1.2500 ⇒ S(£/€)=\frac{1.2500}{1.0500}=0.8400.
  • With spreads, cross-bid uses lower \$/£ (bid) & higher \$/€ (ask); cross-ask reverses.

Arbitrage & Speculation

  • Triangular arbitrage exploits inconsistent quotes among three banks; sequence A→B→C→A yields risk-free gain.
  • Condition for "no-arbitrage": bank cross quotes must fall within calculated bid–ask cross interval (e.g. €1.1418–1.1905 per £).

Forward Rates & Premium/Discount

  • Forwards quoted in points/pips added to spot.
  • Cash rates ≤1 y; swap rates >1 y.
  • Forward premium (annualized): p=\frac{F-S}{S}\times\frac{360}{n}.
    • Example: S(\$/€)=1.1321, F_{180}=1.1389 ⇒ p=1.20\%.
  • Long position = agree to buy; Short = agree to sell.

Microstructure Insights

  • Wider spreads with higher volatility; narrower with more dealer competition.
  • Private information materially influences spot pricing.