Exchange Rates and FX Market

• Exchange rate is the price of one currency in terms of another, such as £1.20/€, where 1 euro equals £1.20.
• Exchange rates fluctuate constantly.

Key Terminology

• Depreciation: A currency weakens, making it less valuable, requiring more of it to buy a unit of foreign currency (e.g., $1.50/£ becomes $1.40/£).
• Appreciation: A currency strengthens, making it more valuable, requiring less of it to buy a unit of foreign currency (e.g., $1.20/£ becomes $1.40/£).
• Devaluation of currency refers to a drop in foreign exchange value of a pegged currency.

Currency Codes

• GBP: Great British Pound
• CHF: Swiss Franc
• ZAR: South African Rand
• CAD: Canadian Dollar
• JPY: Japanese Yen
• SEK: Swedish Krona

FX Market Function and Structure

• The foreign exchange (FX) market is the largest financial market globally, with approximately $5.6 trillion in daily transactions.
• The FX market facilitates international trade by enabling businesses to perform transactions outside their local currency.
• It operates 24/7 from Monday to Friday.
• FX market structure grew from commercial banks assisting clients with international commerce.
• Corporate clients use it to import merchandise invoiced in a foreign currency.
• Exporters use it to dispose of foreign currency received from importers.
• Financial investors use it to speculate on currency appreciation.
• FX markets are over-the-counter (OTC) markets.
• Trades are negotiated between dealers (banks) and private customers, mainly via phone.

FX Market Participants

• There are 3 trading sessions: European, Asian, and U.S.
• FX trading is global and continuous.
• Main currencies are traded mostly during their market hours.
• Currency pairs with dollar have higher volume during the U.S. trading session.
• The market is confined to 18 currency pairs.
• The eight most traded currencies are USD, CAD, EUR, GBP, CHF, NZD, AUD, and JPY.

Spot Market

• Transactions can be spot, forward, or swap.
• A spot transaction involves immediate delivery, with cash settlement usually within 2 business days.
• A forward transaction involves delivery at a future date, like 1, 3, 6, 9, or 12 months.

Spot Rate Quotations

• Foreign exchange rate is the price of one currency in terms of another.

• An FX quotation indicates a willingness to buy or sell at an announced rate.

• S(j/k) is the spot price of one unit of currency k in terms of j, and its inverse is 1 / S(k/j).

• 87% of FX transactions involve the U.S. dollar.

• Professional dealers express quotations as the foreign currency price of one dollar or the dollar price of a unit of foreign currency.

• Currency trading is done in pairs.

• Currencies are priced to 4 decimal places, except for JPY pairs, which are priced to 2 or 3 decimal places.

• Spot rate quotations can be direct (home currency price of a unit of foreign currency, e.g., £1.50/$) or indirect (foreign currency price of a unit of home currency, e.g., $1.50/£).

Cross Rates

• A cross rate is the exchange rate between two currencies, calculated from their $ exchange rates.

Bid-Ask Spread

• Interbank FX traders buy currency for inventory at the bid price and sell at the higher ask price.
• A bid is the price a dealer is willing to buy a currency; bid price equals the dealer's buying price or the client's selling price.
• An ask is the price a dealer will sell a currency; ask price equals the dealer's selling price or the client's buying price.
• The bid-ask spread is the difference between the bid and ask prices.
• Dealers profit from the spread, buying at the bid and selling at the ask, where ask > bid.

Spot FX Trading

• Quotations are to four decimal places and valid for a few seconds.
• Dealers trade in and out of positions every 10 minutes.
• In the interbank market, a standard trade is about $10 million.

Cross-Rate Trading

• Currency against currency trading is exchanging two non-dollar currencies (e.g., selling £ and buying CHF).
• The bid price to the customer is Sb(CHF/£) = Sb($/£) x Sb(CHF/$).
• The ask price is Sa(£/CHF) = Sa(£/$) x Sa($/CHF).

Forward Market

• The forward market requires future delivery and payment at a rate agreed upon today.
• Banks quote for maturities of 1, 3, 6, 9, and 12 months, and maturities exceeding 1 year are becoming more common.
• A forward contract is an agreement to buy/sell an asset in the future at prices agreed upon today.
• Currencies more expensive to buy forward relative to the spot price are at a premium for the denominator currency, where forward > spot indicates a forward premium.

Long and Short Forward Positions

• Short position: agreed to sell something

• Long position: agreed to buy anything

• Short or long positions depend on FX rates in the future.

• Speculation occurs by going long/short and buying/selling currencies at low/high forward prices.

Speculating on Forward Markets

• If the spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£, one might buy £ forward for $1.90/£, believing the spot exchange rate will be $1.92/£ in three months.
• If this belief is correct, the profit is $0.02 = $1.92 - $1.90.
• If the spot exchange rate falls to $1.86/£, the loss is -$0.04 = $1.86 - $1.90.