Chapter 1 Spot Exchange Market

7/23/2019 Chapter 1 Spot Exchange Market

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• The FOREX market provides the physical and institutional

structure through which

– The money of one country is exchanged for that of another

country

– The rate of exchange between currencies is determined

– Foreign exchange transactions are physically completed

• A foreign exchange transaction is an agreement between a

buyer and a seller that a fixed amount of one currency will be

delivered for some other currency at a specified rate

Foreign Exchange Markets



Foreign Exchange Markets

• There are six main characteristics of the FOREXmarkets which will be discussed

– The geographic extent

–

The three main functions – The market’s participants

– Its daily transaction volume

– Types of transactions including spot, forward and

swaps – Methods of stating exchange rates, quotations, and

changes in exchange rates



Functions of the FOREX Market

• The FOREX market is the mechanism by which participants

– Transfer purchasing power between countries

• This is necessary as international trade and capital transactions

normally involve parties living in countries with different national

currencies

– Obtain or provides credit for international trade transactions

• Inventories in transit must be financed

– Minimize exposure to exchange rate risk

•FOREX markets provide instruments utilized in “hedging” ortransferring risk to more willing parties



The Spot Market for Foreign Exchange

• Spot Market

– A market for the immediate purchase and deliveryof currencies.

• Spot Exchange Rates – Market prices of foreign exchanges in the spot

market that are the rates pertaining to the tradingof foreign-currency-denominated deposits among

major banks in amounts of $1 million and more.



Order placed order placed

Order Proceed Open Bid Order Proceed

Double auction

Industry Commercial bank Commercial bank Industry

Order placed inside spread shown Order placed inside spread shown

Central Bank

Exchange Broker



Inter-bank foreign exchange is the largest financial market with a turnover of almost one trillion dollars.

The foreign exchange market is an informal arrangement of the

larger commercial banks and a number of foreign exchange

brokers. They are linked together by telephone, telex, and a satellite communications network called

Computer based communications system based in Brussels,

Belgium links banks and brokers in every financial centres and keep them in almost constant contact 24 hours a day.



Bank that purchased foreign currency have to pay the bank that sold the foreign currency.The payment generally takes place via a ; an institution at which banks keep funds that can be moved from one bank’s account to another’s to settle interbank

transactions. When foreign exchange is trading against dollar, the clearing house is called : , located in New York.

CHIPS is a computerized mechanism through which banks hold US $ to pay each other when buying or selling foreign exchange. System is owned by large New York clearing banks, over 150 members and handled over 150,000 transactions a day, worth hundreds of billion of $.

Exchange rates between interbanks determined in the market. Exchange rates faced by the banks’ clients are based on these interbank rates. Clients are charged slightly more than the going interbank , pay slightly less than the interbank

.Foreign exchange rates can be given two ways.

Number of US$ per foreign currency unit: U.S. $ equivalent Number of units of foreign currency per U.S. $: European terms

1 Sri Lanka Rupee = 0.009339 US Dollar - 1 US Dollar (USD) = 107.080 Sri Lanka Rupee (LKR) -



Quote Conventions

• It is important to remember that in countriesother than in the United States, all exchange rates

with the dollar are usually given as direct rates.

• There are two exceptions that give the indirect

rates in countries other than the United States:

– British pound (has always been quoted as dollar price

of one pound).

–

Euro (convention adopted quotes the foreign currencyvalue of one euro).



• Denote the spot rate as S

• For most currencies, use 4 decimal places in calculations

– With exceptions: i.e. S(¥/$)=109.0750, but S($/¥)=0.009168

• If we are talking about the US, always quote spot rates as the dollar price

of the foreign currency

– i.e. as direct quotes, S($/€), S($/C$), S($/£), etc

• Increase in the exchange rate the US dollar is depreciating

– Costs more to buy 1 unit of foreign currency

•Decrease in the exchange rate the US dollar is appreciating – Costs less to buy 1 unit of foreign currency

The Spot Market - Conventions



Quotation Conventions



Bid-Ask Quotes

• Bid price: the exchange rate at which the

dealer is willing to buy a currency.

•

Ask (offer) price: the exchange rate at whichthe dealer is willing to sell a currency.

• Midpoint price = (ask + bid)/2



Bid-Ask Quotes

• Consider the following direct quote in the

United States:

($/Euro) 0.9838 –

0.9841• The bid price is 0.9838 $/Euro

• The ask price is 0.9841 $/Euro

•

The midpoint price is 0.98395 $/Euro



Direct Exchange Quotes

• A direct exchange rate is the domestic price of foreign currency.

• A direct quote is a home currency price of a unit of aforeign currency

• Let “DC” be the domestic currency, and “FC” bethe foreign currency.

• A direct quote could be represented as:0.5 DC : 1 FC, for example.



More on Direct Quotes

• For example, the Japanese quote the U.S.

dollar exchange rate as 150 Yen/$ (150 yen

per dollar) — a direct rate in Japan.

• Quotations are usually given with five digits.

For example,• 150.51 Yen/$

• 0.6079 pounds sterling/$



Indirect Foreign Exchange Quotes

• An indirect exchange rate is the amount of foreign currency equivalent to one unit of domestic currency.

•

An indirect quote is a foreign currency price in a unit of the home currency

• For example, 2 FC: 1 DC

– Note this conveys the same information as our

previous example. – Another example: 0.0067$/Yen would be an indirect

quote in Japan.



Cross Rates• A cross rate is the exchange rate between two countries

inferred from each country’s exchange rate with a thirdcountry.

• Many currencies pairs are inactively traded, so theirexchange rate is determined through their relationship to

a widely traded third currency – Example: A Mexican importer needs Japanese yen

to pay for purchases in Tokyo. Both the Mexicanpeso (MXP) and Japanese yen (¥) are quoted in US

dollars• Assume the following quotes:

Japanese yen ¥110.73/$

Mexican peso MXP 11.4456/$



¥9.6745/MXP

MXP11.4456/$

110.73/$

dollarpesos/USMexican

dollaryen/USJapanese= = ¥

Foreign Exchange Rates & Quotations

• Cross Rates

– The Mexican importer can buy one US dollar for

11.4456 Mexican pesos and with that dollar buy

¥110.73; the cross rate would be



Summary of Learning Objectives

• The three functions of the foreign exchange market (FOREX)

are to transfer purchasing power, provide credit, and minimize

foreign exchange rate risk

• The FOREX is composed of two tiers: the interbank market

and the client market. Participants within these tiers include

bank and nonbank foreign exchange dealers, individuals and

firms conducting commercial and investment functions,

speculators and arbitragers, central banks and treasuries and

foreign exchange brokers




• Geographically, the FOREX market spans the globe, withprices moving and currencies traded every hour of everybusiness day

• A foreign exchange rate is the price of one currency expressed

in terms of another currency• A foreign exchange quotation is a statement of willingness to

buy or sell currency at an announced price

• Transactions within the FOREX market are executed either ona spot basis requiring delivery two days after the transactionor on a forward basis requiring settlement at some designatedfuture date




• Quotations can also be direct or indirect . A direct quote is the

home currency price of a unit of foreign currency, while an

indirect quote is the foreign currency price of a unit of the

home currency

• Direct and indirect are not synonymous for American and

European terms, because the home currency will change for

calculation purposes

Chapter 1 Spot Exchange Market

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