The foreign exchange market is an interbank market, in that there is no designated market-place; instead transactions are conducted over the telecommunications system using telephones and computer screens. As a consequence, the foreign exchange (or FX) market is truly global, with all the major commercial banks around the world and the treasury departments of many companies participating. In addition, central banks enter the market in the execution of their monetary and exchange rate policies. There is also a system of brokers who act as intermediaries to supplement the direct contact between participants. As the trading day progresses, the centre of activity moves from one time zone to another, making it possible t trade internationally 24 hours a day.

The transactions in the FX market emanate from international trade, international investment, the hedging of exchange risks, the establishment of speculative positions or arbitraging between mispriced sections of what is a vast market.

The various participants can therefore be classified as hedgers, speculators or arbitragers. The hedgers are trying to lay off risk and therefore to provide just those risks that the speculators wish to take on. The arbitragers ensure that mispricing is quickly eliminated, thereby ensuring that the price at which the risk is transferred is a fair one.

A foreign exchange transaction can be classified as a spot, a forward or a swap transaction. Spot transactions are those that require delivery of the currency within two working days of the transaction date. Forward transactions require delivery at some previously agreed point in time, more than two working days hence, at a rate of exchange agreed when the transaction is initiated. Swap transactions are the simultaneous combination of a spot transaction and a forward transaction in the reverse direction for the same amount.

The quotation of exchange rates

There are four types of exchange rate that are relevant to this: the spot rate, the forward rate, the cross rate and the swap rate. Spot rates relate to spot transactions; forward rates relate to forward transactions; cross rates are exchange rates between two currencies determined by each currency’s relationship with a third currency — e.g. if one French franc is worth $0.1838 and one pound Sterling is worth $1.7900, the £/Ffr rate is 9.7300 ($1.7900/Ffr 0.1838); and swap rates, also known as forward margins or points, are the amounts by which the spot rate is adjusted in order to derive the forward rate. This is illustrated later; it is the market practice to quote exchange rates to four decimal places.

It is also market practice to quote spot and forward rates for most currencies bilaterally against the US dollar, and to derive the exchange rate between two non- US currencies as a cross rate. Exceptions to this are the DM/yen and the £/DM exchange rates.

Methods of quoting exchange rates

There are two methods of quoting exchange rates: the direct method quotes the foreign exchange as so much domestic currency per unit of foreign currency. This is the method of quotation used in Asia, continental Europe and North America in the interbank market. For example, the Deutschmark may be quoted in New York as 0.61-0.63 dollars per DM. Thus traders would buy one DM at 0.61 dollars and sell one DM at 0.63 dollars. They therefore make their profit by buying low and selling high.

The indirect method gives the quotation in terms of an amount of foreign currency per unit of home currency. This is the method of quotation used in London. For example, the US dollar may be quoted as, say, 1.9988-2.0000 per pound Sterling. Traders would bid for dollars at 2.0000 per pound and would sell dollars at 1.9988 to the pound. Thus they make a profit by buying high and selling low. The bid—offer spread represents the gross profit margin for the market maker, and a transactions cost to other market participants.

When not available separately, direct quotations can easily be derived from indirect quotes. For example, if the forward DM is quoted indirectly as 2.98 DM per pound, the direct quote is 1/2.98 = 0.3355 or £0.3555 per DM.

Although both direct and indirect quotations are used in the forward market according to the practice of the particular market, futures generally and options always use direct quotations for the exchange rate data input.

More about: Inside of the foreign exchange market

• Inside of the foreign exchange market continue...
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• International Investing Concerns and Limitations Part 2
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• Regulation of Managed Futures Funds in Europe Part 7
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• Key Points and bottom lines in Currency Forward Rates
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