Exhaustive Notes on the Foreign Exchange Market

Core Importance of Foreign Exchange (FX) in Investment

• Impact on Returns: When investors hold foreign assets, their total returns are determined by two primary variables: the performance of the asset itself and exchange rate movements.

• Study References:     * CFA curriculum 2026 Level I: Capital Flows and FX Market.     * CFA curriculum 2026 Level II: Currency Exchange Rates: Understanding Equilibrium Value.     * CFA curriculum 2026 Level III Core: Currency Management: An Introduction.     * Kidwell Chapter 12.

FX Market Structure and Organisation

• Market Scale: The FX market is the world’s largest financial market.

• Daily Turnover: According to the BIS Triennial Survey (April 2025), the daily turnover is $USD\,9.5\,trillion$, which is larger than all global equity markets combined.

• Structural Features:     * Over-the-counter (OTC): There is no centralised exchange for FX trading.     * Decentralised: Operations take place through a global network of banks, brokers, and electronic venues.     * 24-Hour Market: The market follows the sun, starting in Sydney, moving through Tokyo and London, and ending in New York.     * Electronically Driven: As of the BIS 2025 survey, $58\%$ of execution is done electronically.

• Turnover by Trading Centre: FX trading is heavily concentrated in a few global hubs:     * United Kingdom: $38\%$     * United States: $19\%$     * Singapore: $12\%$     * Hong Kong SAR: $7\%$     * Japan: $4\%$     * Dominance Concentration: The top four centres account for approximately $75\%$ of global turnover. London dominates due to its historical role in international banking and its time-zone overlap with both the US and Asia.

• Turnover by Currency: Since every trade involves two currencies, the total shares sum to $200\%$     * USD: $89\%$     * EUR: $29\%$     * JPY: $17\%$     * GBP: $10\%$     * CNY: $9\%$     * AUD: $6\%$

• USD as the Global Vehicle Currency: The US Dollar is on one side of roughly $89\%$ of all trades. Its dominance is driven by:     * Trade Invoicing: Most global commodities (oil, metals) are invoiced in USD, even if the trading parties are not American.     * Reserve Currency: According to the IMF (2024), approximately $58\%$ of central bank reserves are held in USD.     * Deep Capital Markets: US Treasury and money markets remain the most liquid in the world.     * Self-Reinforcing Cycle: High participation leads to deeper liquidity, which results in lower transaction costs. This attracts further trading, deepening liquidity more.     * Practical Implication: Trading an illiquid cross pair like AUD/JPY is often cheaper to execute via two liquid USD legs (AUD/USD + USD/JPY) because the combined spreads of the liquid pairs are lower than the spread on the direct cross pair.

Market Participants and Counterparties

• Reporting Dealers ($47\%$ of turnover or $USD\,4.4\,tn$ daily):     * Includes large commercial banks, investment banks, and securities houses such as JP Morgan, Deutsche Bank, UBS, Citi, Barclays, HSBC, and Goldman Sachs (based on Euromoney FX Survey, 2022).     * They act as market makers, trading to fill client orders and managing their own inventory risk.     * The top 10 dealers handle between $60\%$ and $70\%$ of total FX volume.

• Interdealer Trading Mechanics: Dealers primarily earn money from the bid–ask spread rather than holding currency positions. Large positions expose dealers to exchange rate risk. Consequently, dealers quickly pass on positions to others.     * The Flow Multiplier Effect: A single client order of $EUR\,100M$ from a corporate entity might trigger multiple inter-dealer trades (e.g., Dealer A to Dealer B, Dealer B to Dealer C, Dealer C to a Fund). In this scenario, the single $EUR\,100M$ flow generates $EUR\,400M$ in total turnover.

• Other Financial Institutions ($49\%$ of turnover or $USD\,4.6\,tn$ daily):     * Non-reporting banks ($23\%$ share / $USD\,2.2\,tn$): Service their own clients and manage internal balance-sheet exposures.     * Institutional investors ($13\%$ share / $USD\,1.3\,tn$): Pension funds, insurers, and mutual funds that trade FX to settle and hedge cross-border investments.     * Hedge funds and PTFs ($8\%$ share / $USD\,0.8\,tn$): Engage in speculative strategies like carry trades, momentum, and high-frequency trading (HFT).     * Official sector ($1\%$ share / $USD\,0.1\,tn$): Includes central banks (for intervention and reserves management) and sovereign wealth funds.

• Non-financial Customers ($5\%$ of turnover or $USD\,0.4\,tn$ daily):     * Corporates: Exchange foreign revenue and costs stemming from real economic activity such as imports, exports, and subsidiary earnings. For these entities, FX is a by-product of business, not a core goal.     * Retail traders: Speculative traders using online platforms. While small in aggregate, they face significantly wider spreads than institutional players.

FX Instruments and Trading

• Turnover by Instrument:     * FX Swaps: $USD\,4.0\,tn$ ($42\%$)     * Spot Transactions: $USD\,3.0\,tn$ ($31\%$)     * Outright Forwards: $USD\,1.7\,tn$ ($18\%$)     * FX Options: $USD\,0.6\,tn$ ($7\%$)     * Currency Swaps: $USD\,0.2\,tn$ ($2\%$)

• The Dominance of Forward-Dated Instruments: Contrary to popular belief, most FX activity isn't spot trading. Forward-dated instruments (swaps and forwards) account for $60\%$ of total turnover.

Exchange Rate Basics and Quotations

• Quotation Standards: There is no global standard; it is based on historical convention.

• Formula: $\text{Base currency / Price currency} = X$

• Interpretation: One unit of the base currency costs X units of the price currency.     * EUR/USD = 1.0800: 1 EUR costs 1.0800 USD.     * AUD/USD = 0.6500: 1 AUD costs 0.6500 USD.     * USD/JPY = 150.00: 1 USD costs 150.00 JPY.

• Note of Caution: Markets may interpret AUD/USD as either 0.6500 USD per 1 AUD or 1.5385 AUD per 1 USD depending on the source; always verify the quote meaning.

• Bid–Ask Spread:     * Bid: The price at which the dealer buys the base currency (client sells).     * Ask (Offer): The price at which the dealer sells the base currency (client buys).     * Formula: $\text{Spread} = \text{Ask} - \text{Bid}$     * Formula: $\text{Percentage spread} = \frac{\text{Ask} - \text{Bid}}{\text{Ask}} \times 100\%$     * The Pip: The smallest price increment. Typically $0.0001$ for most pairs and $0.01$ for JPY pairs.

• Spread Variation by Scale:     * Large Interbank ($millions$): EUR/USD spread of 1–2 pips; AUD/USD spread of 2–3 pips.     * Mid-size Institutional: EUR/USD 2–5 pips; AUD/USD 3–8 pips.     * Small Retail (online): EUR/USD 10–30 pips; AUD/USD 15–40 pips.     * Airport Kiosk: EUR/USD 200–500 pips; AUD/USD 300–600 pips.

• Factors Widening Spreads: Lower liquidity (e.g., USD/TRY), higher volatility, extreme transaction sizes, off-peak hours, and retail counterparties.

Transaction Types and Examples

• Spot Transactions: Currencies are exchanged at current market prices with settlement usually occurring two business days after the trade ($T+2$).     * Example Case: An Australian importer must pay a US supplier $USD\,1\,million$.     * Spot Quote: AUD/USD = 0.6498 / 0.6502.     * Buying USD involves selling the base (AUD), so the dealer buys AUD at the bid ($0.6498$).     * Calculation: $\text{AUD per USD} = \frac{1}{0.6498} = 1.5389$     * Total Cost: $USD\,1,000,000 \times 1.5389 = AUD\,1,538,935$

• FX Swaps: Combines a spot exchange today with a reverse exchange at a pre-agreed forward rate in the future.     * Usage: Used for rolling hedges (extending a maturing forward) and short-term funding (collateralised borrowing/lending).     * Difference from Currency Swaps: Currency swaps (cross-currency) involve periodic interest payments over longer durations.     * Example Case: A fund manager with USD wants to invest in a 3-month European T-bill ($EUR\,5M$ face value, price $EUR\,4,962,779$).     * Spot EUR/USD = 1.0800; 3-month forward = 1.0750.     * Spot leg: Buy EUR 4,962,779 / sell USD. Pays $USD\,5,359,801$ ($4,962,779 \times 1.0800$).     * Forward leg: T-bill matures; receives $EUR\,5,000,000$. Sell EUR 5M / buy USD at forward rate. Receives $USD\,5,375,000$ ($5,000,000 \times 1.0750$).     * Net USD Return: $5,374,000 - 5,359,801 = USD\,15,199$. The T-bill yield offsets the forward discount.

Covered Interest Rate Parity (CIP)

• Definition: A no-arbitrage principle stating that investing domestically must yield the same return as converting to a foreign currency, investing abroad, and converting back via a forward contract.

• "Covered" Status: Because prices are locked in at the start, there is no exchange rate uncertainty.

• The Two Paths starting with 1 AUD:     * Path A (Domestic): $1 \times (1 + i_d)$     * Path B (Foreign): $\text{Convert to foreign at spot} \times (1 + i_f) \times \text{Convert back at Forward}$

• Worked Derivation (AUD 1.5385 per USD quote):     * $i_{AUD} = 4\%$, $i_{USD} = 5\%$     * Path A: $1 \times 1.04 = 1.04\,AUD$     * Path B: $1\,AUD \div 1.5385 = 0.6500\,USD$. Invest at $5\% \rightarrow 0.6500 \times 1.05 = 0.6825\,USD$. Convert at Forward $F$.     * Result: $0.6825 \times F = 1.04 \Rightarrow F = \frac{1.04}{0.6825} = 1.5239\,AUD\,per\,USD$

• Alternative Quote (0.6500 USD per AUD):     * Path A: $1.04\,AUD$     * Path B: $1\,AUD \times 0.6500 = 0.6500\,USD$. Invest at $5\% \rightarrow 0.6825\,USD$. Convert at Forward $F$.     * Result: $0.6825 \div F = 1.04 \Rightarrow F = \frac{0.6825}{1.04} = 0.6563\,USD\,per\,AUD$.     * Verification: $\frac{1}{0.6563} \approx 1.5239\,AUD\,per\,USD$

• Interpretation: Since F (1.5239) < S (1.5385), the USD is at a forward discount. This discount exactly offsets the higher interest rate of the USD, eliminating risk-free profit. A forward premium occurs if the foreign interest rate is lower than the domestic rate.

Currency Risk in Investment Portfolios

• Nature of FX Risk:     * Generally not compensated: Unlike equity risk, there is no technical consensus that bearing currency risk provides a positive expected return.     * Volatility: Major pairs move $8\%\text{--}12\%$ per year, which can surpass the risk of foreign government bonds.     * Correlation: Positive correlation with foreign assets amplifies total risk; negative correlation provides a natural hedge.

• Return Decomposition:     * Exact Formula: $(1 + R_{DC}) = (1 + R_{FC})(1 + R_{FX})$     * Approximation: $R_{DC} \approx R_{FC} + R_{FX}$     * Definitions: $R_{DC}$ is domestic-currency return; $R_{FC}$ is asset return in foreign currency; $R_{FX}$ is the change in value of the foreign currency.     * Foreign Currency Change Formula: $R_{FX} = \frac{S_{d/f, 1} - S_{d/f, 0}}{S_{d/f, 0}}$

• Impact Scenarios for an Australian Investor in US Equities:     * Currency Helps: US equity return $+10\%$. AUD/USD moves $0.6500 \rightarrow 0.6200$ (AUD depreciates). $R_{FX} = +4.84\%$. $R_{DC} = (1.10)(1.0484) - 1 = +15.32\%$.     * Currency Hurts: US equity return $+5\%$. AUD/USD moves $0.6500 \rightarrow 0.7150$ (AUD appreciates). $R_{FX} = -8.39\%$. $R_{DC} = (1.05)(0.9161) - 1 = -3.81\%$. The currency loss cancels the asset gain.

Hedging Strategies and Derivatives

• Forward Contracts: Sells the foreign currency forward to lock in a rate.     * Hedge Ratio (h): $\text{h} = \frac{\text{Notional of forward contract}}{\text{Market value of foreign-currency asset}}$         * $h = 1.0$: Full hedge (exposure eliminated).         * h < 1.0: Underhedged.         * h > 1.0: Overhedged.     * Example: Australian fund holds $USD\,10M$ equities. Sells $USD\,10M$ forward at $AUD\,1.5239$. If the portfolio grows to $USD\,11M$, $h = 10/11 = 0.91$ (underhedged). If it drops to $USD\,9M$, $h = 10/9 = 1.11$ (overhedged).

• Currency Options: Provide asymmetric protection.     * Protective Put: Buying a put on the foreign currency sets a guaranteed minimum conversion rate (strike). If the spot is worse than the strike, exercise; if better, let it expire to keep the upside. Cost involves the option premium.     * Risk Reversal (Collar): Buy a put and sell a call on the foreign currency. The put provides a floor; the sold call sets a cap (ceiling) and generates a premium that reduces or eliminates the cost of the put.

• Strategy Summary and Trade-offs:     * Unhedged: Fully exposed to downside and upside. Cost: None.     * Forward Hedge: Downside and upside both eliminated. Cost: Bid–ask spread.     * Protective Put: Downside protected (floor), upside retained. Cost: Option premium.     * Risk Reversal: Downside protected (floor), upside capped (ceiling). Cost: Reduced or zero.

• Currency Management Spectrum:     * Unhedged: Acceptance of full FX exposure.     * Passive Hedging: Mechanic forward hedge at a fixed ratio (e.g., $100\%$).     * Discretionary Hedging: Varying the ratio within a band (e.g., $25\%\text{--}75\%$).     * Active Management: Deliberate FX positions intended to generate alpha.

• Costs of Hedging: These include bid–ask spreads, opportunity costs of missed favorable moves, rolling costs at maturity, and option premiums.