Lecture notes on foreign exchange markets, FX rates, FX rate structure, FX rate momements and corporate FX risks, with added detail and worked examples.
Accounting & Finance
Financial Analysis, Information and Markets
Foreign Exchange
The Foreign Exchange (FX) Market
The FX Market is where pairs of currencies can be bought and sold in exchange for one
another, i.e.
£ UK Pounds (Sterling)
$ US Dollars
€ Euros
¥ Japanese Yen
The FX market is an Over the counter (OTC) market whereby buying and selling is
actually carried out by banks and brokers so there isn’t actually an exchange like with
stock markets.
FX Rates
FX rates are stated as the number of foreign currency units per units of the domestic
currency. As such if the US Dollar Sterling ($/£) rate is stated at 1.6000, then $1.6
(foreign) is equivalent to £1.
To convert a domestic currency amount to foreign currency – multiply it by the FX rate,
e.g. Where we are calculating the dollar amount of £10,000 with a US Dollar Sterling ($/
£) rate of 1.6000:
£10,000 => 10,000 x 1.6 = $16,000.
To convert a foreign currency to domestic currency – divide by the FX rate, e.g. Where
we are calculating the sterling amount of $16,000 with a US Dollar Sterling ($/£) rate of
1.6000:
$16,000 => 16,.6 = £10,000
FX Rate Structure
, In simple terms, FX rates come stated as two numbers, the bid (buy) and the offer
(sell). Rates are typically quoted to 4 decimal places. The 4 th decimal place (each
10,000th) is known as the “pip”, which is common language when quoting FX rates.
The bid is the dealing rate when selling the domestic currency and buying the foreign
currency. A simple way to understand this would be if you or I wanted to buy some US
Dollars for a holiday with sterling – we would use the bid rate. In the context of
international trade, the bid rate would be used when an organisation is importing
(buying). The reason for this is that the bid rate is always lower than the offer rate.
The offer is the dealing rate when buying the domestic currency and selling the foreign
currency. A simple way to understand this would be if you or I had some US Dollars and
wanted to exchange them to sterling. In the context of international trade, the offer rate
would be used when an organisation is exporting (selling). The reason for this is that the
offer rate is always higher than the bid rate.
Essentially, the bid rate is the rate at which FX is bought and the offer rate is the rate at
which FX is sold. The rates are offered by banks and brokers at their discretion.
The difference between the bid and the offer rate is known as the spread. Somewhere
in between the bid and the offer is the actually exchange rate. The spread is where the
bank or broker makes their money and avoids risk.
The bid and offer can be quoted at spot rates or forward rates.
The spot rate is the rate at which two parties deal and settle today. The deal is the
agreement between the two parties on the rate and the settlement is the tangible
exchange of currency whereby one party buys a currency from the other party for the
other currency and vice versa – when money (FX) exchanges hands.
The forward rate is the rate at which two parties deal at today but settle in the future.
Essentially, the rate is fixed today, but the money (FX) exchange hands at an agreed
time (usually months) in future when the rate is extremely likely to have changed.
Forwards can be beneficial where a party needs security in a rate to a certain degree,
even where the agreed forward rate may be higher than the actually rate at the agreed
forward settlement date. It is also useful when purchasing goods via trade credit: The
rate is agreed, so the buyer of goods knows their costs when it comes to paying the
trade credit back (or for hedging purposes mentioned in a separate paper), but doesn’t
have to part with the currency now (can potentially part with it once good have been
sold within the trade credit duration).
When dealing in forwards, the difference in rate from the spot rate (today’s settlement
rate) and the forward rate is known as either the pm or the ds.
The pm is the premium of the spot rate over the forward rate, stated in pips. In simple
terms, the pm is how much higher the spot rate is than the forward rate, where the
forward rate is less than the spot rate. Pm could be seen as a discount for buying in the
future.
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