Foreign Exchange Market Basics

Elements of an FX Cash Flow

• Direction: Inflow or Outflow
• Currency Involved: Currency bought and currency sold
• Value Date: Spot or Forward
• Domicile: Locus of Settlement

Currencies in an FX Transaction

• Commodity Currency: A currency from a country with large reserves of a specific valuable item or commodity
• Terms Currency: The currency in which an exchange rate is quoted
• Reciprocal Currency: A currency pair involving the USD, but the USD is not the base currency (e.g., EUR/USD, GBP/USD, NZD/USD, AUD/USD)
• K.A.P.E. mnemonic for reciprocal currency:
  • K – Kiwi – NZD/USD
  • A – Aussie – AUD/USD
  • P – Pound – GBP/USD
  • E – Euro – EUR/USD

Understanding a Two-Way Quote

• A quote is the price at which an asset can be traded or the most recent price agreed upon
• A two-way quote indicates both the current bid price and the current ask price of a security
• Bid price: The maximum price a buyer is willing to pay for a security
• Ask price: The minimum price a seller is willing to take for the same security
• Spread: The difference between the bid and ask prices, indicating liquidity

Determining Forward Value Date

• Fix the Spot Date:
  • Transaction Date: June 16
  • Spot Value Date (T+2): June 18
• Rules in determining the Forward Value Date:
  • Date-to-Date Rule: 1-month Forward July 18
  • Month-end to month-end Rule:
    • Transaction Date: June 28
    • Spot Value Date (T+2): June 30
    • 1-month Forward: July 31

Foreign Exchange

• Foreign Exchange (FX): The trading of one currency for another
• Forex market: The largest, most liquid market in the world, with trillions of dollars traded daily
• Major financial centers: Sydney, Singapore, Tokyo, Frankfurt, London, and New York
• No centralized location; rather, an electronic network of banks, brokers, institutions, and individual traders

Parties Involved in an FX Transaction

• Market makers (Quoting Party): Professional traders who offer to sell securities at a given price (ask price) and bid to purchase securities at a given price (bid price)
• Price takers (Calling Party): Parties who trade on existing orders, buying at a price maker's offer or selling at a price maker's bid

Test your knowledge of the foreign exchange market, also known as the forex market, where currencies are traded. Learn about the largest and most liquid market in the world, where trillions of dollars are exchanged daily. Take this quiz to understand the basics of forex trading.