CHAPTER 5 IBF301 by Vu Thi Thuy Linh

The Market for Foreign Exchange

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Function and Structure of the FX Market

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The Spot Market

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The Forward Market

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A forward contract is an agreement to buy or sell an asset in the future at

prices agreed upon today.

If you have ever had to pre-order a new-released iphone, then you have

entered into a forward contract.

FX Market Participants

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Correspondent Banking

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Relationships

Introduction

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

Spot Rate Quotations

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Cross-Exchange Rate Quotations

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Alternative Expressions for the Cross-Exchange Rate

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The Bid-Ask Spread

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Spot FX Trading

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The Cross-Rate Trading Desk

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Triangular Arbitrage

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Spot Foreign Exchange Market Microstructure

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(1) Direct quotation: S($/j)
◦ the U.S. dollar equivalent
◦ e.g. “a Japanese Yen is worth about a penny”
(2) Indirect Quotation: S(j/$)
◦ the price of a U.S. dollar in the foreign currency
◦ e.g. “you get 100 yen to the dollar”
(3)
S($/j) =1/S(j/$)

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A cross-exchange rate is an exchange rate between a currency pair where neither currency is the U.S. dollar.
1) Direct: S(j/k) =S($/k)/S($/j)
2) Indirect: S(j/k) =S(j/$)/S(k/$)

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S( j/k) = S($/k) × S( j/$)
S(k/j) = S(k/$) × S($/j)

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- The bid price is the price a dealer is willing to pay you for something.
- The ask price 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.
- The bid-ask spread represents the dealer’s expected profit.

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- In the interbank market, the standard size trade is about U.S. $10 million.
- A bank trading room is a noisy, active place.
- The stakes are high.
- The “long term” is about 10 minutes.

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Sb(j/k) = Sb($/k) × Sb(j/$)
Sa(k/j ) = Sa(k/$ ) × Sa($/j)

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Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars.

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The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate.

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+) Market Microstructure refers to the mechanics of how a marketplace operates.

+) Bid-Ask spreads in the spot FX market:
- increase with FX exchange rate volatility and
- decrease with dealer competition.

+) Private information is an important determinant of spot exchange rates.

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International commercial banks communicate with one another with:

- SWIFT: The Society for Worldwide Interbank Financial Telecommunications.

- CHIPS: Clearing House Interbank Payments System

- ECHO Exchange Clearing House Limited, the first global clearinghouse for settling

interbank FX transactions.

Forward Rate Quotations

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- The forward market for FX involves agreements to buy and sell foreign currencies in the

future at prices agreed upon today.

- The forward price may be the same as the spot price, but usually it is higher (at a

premium) or lower (at a discount) than the spot price.

- Forward exchange rates are quoted on most major currencies for a variety of maturities.

- Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward

contracts.

Long and Short Forward Positions

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- If you have agreed to sell anything (spot or forward), you are “short”.

- If you have agreed to buy anything (forward or spot), you are “long”.

- If you have agreed to sell FX forward, you are short.

- If you have agreed to buy FX forward, you are long.

Non-deliverable Forward Contracts

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For many of these currencies (such as the Chinese yuan and Russian ruble), trading in non-deliverable forward (NDF) contracts exists.
A non-deliverable forward contract is settled in cash, usually U.S. dollars, at the difference between the spot exchange on the maturity date of the contract and the NDF rate times the notional amount of the contract.

Forward Cross Exchange Rates

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Forward Premium

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Swap Transactions

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