CHAPTER 5
THE FOREIGN EXCHANGE MARKET
2. Functions of the Foreign Exchange Market. What are the three major functions of
the foreign exchange market?
To transfer purchasing power from one country and its currency to another.
Typical parties would be importers and exporters, investors in foreign securities,
and tourists.
To finance goods in transit. Typical parties would be importers and exporters.
To provide hedging facilities. Typical parties would be importers, exporters, and
creditors and debtors with short-term monetary obligations.
3. Structure of the FX Market. How is the global foreign exchange market
structured? Is digital telecommunications replacing people?
One of the biggest changes in the foreign exchange market in the past decade has
been its shift from a two-tier market (the interbank or wholesale market, and the
client or retail market) to a single-tier market. Electronic platforms and the
development of sophisticated trading algorithms have facilitated market access by
traders of all kinds and sizes.
Participants in the foreign exchange market can be simplistically divided into two
major groups, those trading currency for commercial purposes, liquidity seekers, and
those trading for profit, profit seekers. Although the foreign exchange market began
as a market for liquidity purposes, facilitating the exchange of currency for the
conduct of commercial trade and in-vestment purposes, the exceptional growth in the
market has been largely based on the expansion of profit-seeking agents. As might be
expected, the profit seekers are typically much better informed about the market,
looking to profit from its future movements, while liquidity seekers simply wish to
secure currency for transactions. As a result, the profit seekers generally profit from
the liquidity seekers.
5. Foreign Exchange Transaction. Define each of the following types of foreign
exchange transactions:
a. Spot. A spot transaction is an agreement between two parties to exchange one
currency for another, with the transaction being carried out at once for
commercial customers and on the second following business day for most
interbank (i.e., wholesale) trades.
b. Outright forward. A forward transaction is an agreement made today to exchange
one currency for another, with the date of the exchange being a specified time in
the future – often one month, two months, or some other definitive calendar
interval. The rate at which the two currencies will be exchanged is set today.
c. Forward-forward swaps. A more sophisticated swap transaction is called a
“forward-forward” swap. A dealer sells £20,000,000 forward for dollars for
delivery in, say, two months at $1.6870/£ and simultaneously buys £20,000,000
forward for delivery in three months at $1.6820/£. The difference between the
buying price and the selling price is equivalent to the interest rate differential, i.e.,
interest rate parity, between the two currencies. Thus a swap can be viewed as a
technique for borrowing another currency on a fully collateralized basis.
10. Reciprocals. Suppose that Australia is the home country. Determine whether the
following quotes are direct or indirect, and convert indirect (direct) quotes to direct
(indirect) quotes:
a. Euro: AUD1.4462/EUR.
b. Canada: CAD0.9812/AUD.
a. Direct: EUR0.6915/AUD.
b. Indirect: AUD1.0192/CAD.
12. American and European Terms. With reference to interbank quotations, what is the
difference between American terms and European terms?
Most foreign currencies in the world are stated in terms of the number of units of
foreign currency needed to buy one dollar. For example, the exchange rate between
U.S. dollars and Swiss franc is normally stated
SF1.6000/$, read as “1.6000 Swiss francs per dollar”
This method, called European terms, expresses the rate as the foreign currency price
of one U.S. dollar. An alternative method is called American terms. The same
exchange rate above expressed in American terms is
$0.6250/SF, read as “0.6250 dollars per Swiss franc”
Under American terms, foreign exchange rates are stated as the U.S. dollar price of
one unit of foreign currency. Note that European terms and American terms are
reciprocals:
1
USD 0.6250 / SF
SFI.60000 / USD
With several exceptions, including two important ones, most interbank quotations
around the world are stated in European terms. Thus, throughout the world the normal
way of quoting the relationship between the Swiss franc and U.S. dollar is
SF1.6000/$; this method may also be called “Swiss terms.” A Japanese yen quote of
¥118.32/$ is called “Japanese terms,” although the expression “European terms” is
often used as the generic name for Asian as well as European currency prices of the
dollar. European terms were adopted as the universal way of expressing foreign
exchange rates for most (but not all) currencies in 1978 to facilitate worldwide trading
through telecommunications
13. Direct and Indirect Quotes. Define and give an example of the following:
a. An example of a direct quote between the U.S. dollar and the Mexican peso,
where the United States is designated as the home country.
A direct quote is a home currency price of a unit of foreign currency. An example,
using Mexico and the United States (home country) is: $0.1050/Peso.
b. An example of an indirect quote between the Japanese yen and the Chinese
renminbi (yuan), where China is designated as the home country.
An indirect quote is a foreign currency price of a unit of home currency. An
example, using Japan and China (home country) is: ¥14.75/Rmb.
14. Base and Price Currency. Define base currency, unit currency, price currency, and
quote currency.
Foreign exchange quotations follow a number of principles, which at first may seem a
bit confusing or non-intuitive. Every currency exchange involves two currencies,
currency 1 (CUR1) and currency 2 (CUR2):
CUR1 / CUR2
The currency to the left of the slash is called the base currency or the unit currency.
The currency to the right of the slash is called the price currency or quote currency.
The quotation always indicates the number of units of the price currency, CUR2,
required in exchange for receiving one unit of the base currency, CUR1.
For example, the most commonly quoted currency exchange is that between the U.S.
dollar and the European euro. For example, a quotation of
EUR / USD 1.2174
designates the euro (EUR) as the base currency, the dollar (USD) as the price
currency, and the exchange rate is If you can remember that the currency quoted on
the left of the slash is always the base currency, and always a single unit, you can
avoid confusion. Exhibit 5.6 provides a brief overview of the multitude of terms often
used around the world to quote currencies, through an example using the European
euro and U.S. dollar.