Foreign Exchange Rate Overview

Foreign Exchange Rate

• Exchange rate: the price of one currency expressed in units of another.
• Exchange rate regimes: fixed, floating, or managed.
• Foreign exchange market: a financial market where currencies are bought and sold.
  • Largest financial market globally.
  • Average daily trading volume was $2.11 trillion in April 2022.
• Devaluation: decrease in the value of a currency fixed to gold or another currency.
• Depreciation: decrease in the value of a floating currency.
• Appreciation: an increase in the value of a floating currency.

Organization of the FX market

• Over-the-counter (OTC) trading: transactions occur through phone, telex, or SWIFT (Society for Worldwide Interbank Financial Telecommunications).
• Participants:
  • Wholesale level (95%): major banks.
  • Retail level: business customers.
• Types of FX markets:
  • Spot market: immediate delivery or delivery within 2 business days.
  • Forward market: delivery happens on a specified future date (after 2 business days).

Institutions involved in the FX market

• Large global banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) act on behalf of:
  • External clients (primarily global firms: exporters, importers, multinational firms).
  • Their own banks (trading to generate profits).
• Global banks establish market tone through a market maker function.

Making the Market in FX

• Market maker functions:
  • Providing continuous two-way quotes upon request.
  • Buying and selling at quoted prices.
• Market makers offer transparency and liquidity to the market.

ISO Currency Designations

• All currencies have ISO abbreviations (e.g., USD, JPY, EUR).
• Exchange rate is the ratio of one currency to another.

Base and Quote Currency

• Base currency: first currency in an ISO pair (e.g., EUR/USD).
• Quote currency: second currency in an ISO pair (e.g., USD/JPY).

Spot Rate Quotes

• Direct FX quote: number of local currency units (LCUs) needed to buy one foreign currency unit (FCU) (e.g., Sfr1.6000/$).
• Indirect FX quote: reciprocal of the direct FX quote (e.g., $0.6250/Sfr).
• Bid quote: price at which a bank is willing to buy.
• Ask quote: price at which a bank is willing to sell.

Bid and Ask quotes

• Market makers always provide both a buy and sell quote for a currency.
• Bid quote is always lower than the ask quote.

Reading and Understanding Quotes

• Assign a value of 1 to the base currency.
• Prices quoted refer to one unit of the base currency.
• When bid/ask prices increase, base currency strengthens and quote currency weakens.

Forward Rate Quotes

• Forward rate is set at a premium or discount to the spot rate.
• Forward premium: forward rate higher than spot rate.
• Forward discount: forward rate lower than spot rate.

Cross rates

• Exchange rate where neither currency is USD. (e.g., EUR/JPY).

Currency Derivatives

• Contracts whose price is derived from the value of an underlying currency.
• Examples include forwards/futures and options.
• Used for speculation and hedging exchange rate risk.

Currency Forward contract vs. Future contract

• Forward:
  • Agreement between a corporation and a financial institution.
  • Exchange specified amount of currency at a specified rate on a specific date.
• Future:
  • Similar to forward contracts but highly standardized.

Currency Options

• Contract giving the buyer the right (but not the obligation) to buy or sell currency at a fixed rate for a fixed time period.
• American options: exercised anytime until expiration.
• European options: exercised only at expiration.
• Exercise price (or strike price): fixed rate at which the option holder can buy or sell.
• Premium: price of the option charged by the seller.

Foreign Exchange Terminology

• Exchange rate: The price of one country's currency expressed in units of another country's currency.
• Fixed Exchange Rate System: A system where the government fixes the exchange rate of its currency against another currency or a commodity like gold.
• Floating Exchange Rate System: This system allows the currency's value to fluctuate freely in the foreign exchange market.
• Managed Exchange Rate System: In this system, the government intervenes to influence the exchange rate, but it doesn't fix it at a specific level.
• Foreign Exchange Market: A financial market for trading foreign currencies. It's considered the world's largest financial market based on trading volume, averaging $2.11 trillion per day in April 2022.
• Devaluation: A decrease in the value of a currency that's pegged to gold or another currency.
• Depreciation: A decrease in the value of a floating currency.
• Revaluation: An increase in the value of a currency that's pegged to gold or another currency.
• Appreciation: An increase in the value of a floating currency.

Organization of the FX Market

• Over-the-Counter (OTC) Trading: No specific location for transactions; Trades conducted over the phone, telex, or SWIFT (Society for Worldwide Interbank Financial Telecommunications).
• Participants:
  • Wholesale Level (95%): Major banks dominate this level of trading.
  • Retail Level: Businesses and individual customers participate in this level.
• Market Types:
  • Spot Market: Immediate delivery or delivery within 2 business days.
  • Forward Market: Delivery takes place at a specific future date (after 2 business days).

Institutions Involved in the Foreign Exchange Market

• Large Global Banks: Play a significant role in the FX market, acting as market makers on behalf of:
  • External Clients: Corporations involved in international trade (exporters, importers, multinationals).
  • Their Own Banks: Trading currencies to generate profits.

Making the Market in FX

• Market Maker Function: Global banks perform two key activities:
  • Quote Provision: Providing continuous two-way quotes for buy and sell prices, promoting market transparency.
  • Liquidity Provider: Willing to buy or sell at their quoted prices, ensuring market liquidity.

ISO Currency Designations

• ISO (International Standards Organization) Currency Codes: Each currency has a unique abbreviation (e.g., USD, JPY, GBP, EUR, AUD).

Base and Quote Currency

• Foreign Exchange Quote: Expresses the value of one currency against another, with two ISO designations.
• Base Currency: The first currency listed in the quote (e.g., EUR in EUR/USD).
• Quote Currency: The second currency listed in the quote (e.g., USD in EUR/USD).

Spot Rate Quotes

• Direct FX Quote: Shows the number of local currency units (LCUs) required to buy one unit of foreign currency (FCU) (e.g., Sfr1.6000/$ means 1.600 Swiss Francs per dollar).
• Indirect FX Quote: The reciprocal of the direct FX quote (e.g., $0.6250/Sfr means 0.6250 dollars per Swiss Franc).
• Bid Quote: The price at which a bank is willing to buy a currency.
• Ask Quote: The price at which a bank is willing to sell a currency.

Bid and Ask Quotes

• Market Maker Quotes: Always provide both a bid and ask price for a currency.
• Bid Price: The price at which the market maker will buy the base currency (e.g., 1.2102 in EUR/USD: 1.2102/1.2106).
• Ask Price: The price at which the market maker will sell the base currency (e.g., 1.2106 in EUR/USD: 1.2102/1.2106).
• Relationship: The Bid price is always lower than the Ask price.

Reading and Understanding Quotes

• Base Currency Value: Assign a value of 1 to the base currency.
• Quote Interpretation: Quotes refer to one unit of the base currency (e.g., an ask price of 1.2811 for EUR/USD means you'll pay $1.2811 for 1 euro).
• Currency Strength: When Bid/Ask prices rise, the base currency is strengthening, and the quote currency is weakening.

Forward Rate Quotes

• Forward Premium: If a currency's forward rate is higher than its spot rate.
• Foward Discount: If a currency's forward rate is lower than its spot rate.

Cross Rates

• Cross Rate: An exchange rate for two currencies where neither is the USD (e.g., EUR/JPY).

Currency Derivatives

• Currency Derivative: A contract whose value is linked to an underlying currency.
• Types: Forwards/Futures contracts and options contracts.
• Uses: Speculation on future exchange rate movements and hedging exchange rate risk.

Currency Forward Contract vs. Future Contract

• Forward: Agreement between a corporation and a financial institution to exchange a specific amount of currency at a specified future date and rate.
• Future: Similar to forward contracts but highly standardized and traded on an organized exchange.

Currency Options

• Currency Option: Grants the holder the right (not the obligation) to buy or sell a specific amount of currency at a fixed exchange rate for a specific period.
• Types:
  • American Option: Can be exercised anytime before expiration.
  • European Option: Exercised only at expiration.
• Key Features:
  • Exercise Price (or Strike Price): The fixed exchange rate at which the option holder can buy or sell currency.
  • Premium: The price the option writer charges the buyer.

Foreign Exchange Rate Terminology

• Exchange rate: The price of one country's currency expressed in units of another currency.
• Exchange Rate Systems:
  • Fixed: The government sets a fixed exchange rate for its currency and intervenes to keep it stable.
  • Floating: The exchange rate is determined by market forces of supply and demand.
  • Managed: The government intervenes in the market to influence the exchange rate.
• Foreign exchange market: A global marketplace where currencies are bought and sold.
  • It is the largest financial market in the world, with daily trading volumes exceeding $2.11 trillion.
• Devaluation: A decrease in the value of a currency that is pegged to another currency or gold.
• Depreciation: A decrease in the value of a floating currency.

Organization of the Foreign Exchange Market

• Over-the-counter (OTC) Market: No specific location, transactions occur via phone, telex, or SWIFT.
• Participants:
  • Wholesale Level: Primarily major banks (e.g., Deutsche Bank, HSBC, UBS, Citibank) account for 95% of trading.
  • Retail Level: Includes businesses and individuals.
• Market Types:
  • Spot market: Immediate delivery or delivery within 2 business days.
  • ** Forward market:** Delivery occurs at a specified future date (after 2 business days).

Institutions Involved in the Foreign Exchange Market

• Large global banks act as market makers:
  • Facilitate transactions for their "external" clients (exporters, importers, multinational firms) by meeting their foreign currency needs.
  • Engage in "dealer" trading to generate profits by taking positions in currencies.
  • These banks play a key role in setting market direction through their "market maker" function.

Market Making in FX

• Market Maker Responsibilities:
  • Continuous Two-Way Quotes: Provide ongoing buy and sell prices for currencies, increasing market transparency.
  • Liquidity Provision: Willingness to buy or sell at quoted prices, enabling market liquidity.

ISO Currency Designations

• Every currency has an International Standards Organization (ISO) abbreviation (e.g., USD, JPY, GBP, EUR).
• Exchange rates are expressed as ratios using ISO designations (e.g., USD/JPY, EUR/USD).

Base and Quote Currency

• Base Currency: The first currency quoted in an exchange rate pair; its value is assumed to be 1.
• Quote Currency: The second currency quoted; it represents the value of one unit of the base currency.

Spot Rate Quotes

• Direct FX quote: Shows the amount of local currency (LCU) needed to buy one unit of the foreign currency (FCU) (e.g., 1.6000 Swiss francs per dollar (Sfr1.6000/$)).
• Indirect FX quote: The reciprocal of the direct quote, showing the amount of foreign currency you get for one unit of the local currency (e.g., 0.6250 dollars per Swiss franc ($0.6250/Sfr).

Bid and Ask Quotes

• Bid Quote: The price at which the bank is willing to buy currency.
• Ask Quote: The price at which the bank is willing to sell currency.
• The bid quote is always lower than the ask quote.

Reading and Understanding Quotes

• When viewing a quote, consider the base currency as having a value of 1.
• The quote represents the value of one unit of the base currency against the quote currency.
• If the bid and ask prices are moving up, the base currency is strengthening, and the quote currency is weakening.
• If the bid and ask prices are moving down, the base currency is weakening, and the quote currency is strengthening.

Forward Rate Quotes

• Forward Premium: A forward rate is higher than the spot rate.
• Forward Discount: A forward rate is lower than the spot rate.

Cross Rates

• Cross rates are exchange rates where neither currency is the US Dollar (e.g., EUR/JPY).

Currency Derivatives

• Currency Derivatives: Contracts whose value is derived from the value of an underlying currency.

• Types:

  • Forwards and Futures: Agreements to buy or sell a specified amount of currency at a predetermined rate on a future date.
    • Forward: Personalized, negotiated between two parties.
    • Future: Standardized, traded on exchanges.
  • Options: Contracts that give the buyer the right (but not the obligation) to buy or sell a currency at a specified price (strike price) within a certain period.
    • American Option: Can be exercised anytime before the expiration date.
    • European Option: Can only be exercised on the expiration date.

• Derivatives are used for:

  • Speculation: To profit from anticipated exchange rate movements.
  • Hedging: To mitigate exchange rate risk.