Foreign exchange transaction = 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.
The FOREX markets provide the physical and institutional structure through which:
- The money of one country (currency) is exchanged for that of another country.
- The rate of exchange between currencies is determined.
- Foreign exchange transactions are physically completed.
Main characteristics of FOREX markets:
1. The geographic extent: 24/7 worldwide on business days.
2. Functions of FOREX markets:
FOREX markets provide the mechanism by which participants:
- Transfer purchasing power between countries. Necessary for international trade and
capital transaction which can only be invoiced in one currency.
- Provides credit for international trade transactions because in transit inventory
between countries must be financed.
- Minimize exposure to exchange rate risk, provided “hedging” facilities.
3. Market participants operating in the wholesale and/or retail markets:
The FOREX markets consist of two tiers: the interbank or wholesale market / the client- or
retail (‘over the counter’)
,4. Types of transaction in the interbank market:
Transaction within this market can be executed on a spot, forward, or swap basis.
- Spot transaction = required almost immediate delivery of foreign exchange.
- Forward transaction = requires delivery at a future value date of specified amount of
one currency for another.
- Swap transaction = the simultaneous exchange of one foreign currency for another
for two different value dates (a temporarily exchange).
(Outright) forward transactions:
- The exchange rate is established at the time of the agreement, but payment and
delivery are not required until maturity.
- Forward rates are contract quoted for value dates of one, two, three, six, nine, and
twelve months.
Swap transactions:
- Forward-forward swap.
- Non-deliverable forwards (NDFs): are only settled in the US.
Floating, fixed, managed exchange rates:
- Free floating currencies = no state intervention on FOREX markets: exchange rates
reflect supply and demand conditions. E.g. $, €, ¥ (yen).
- Fixed exchange rates = Central Bank buys or sells its currency at a fixed price in
order to stabilize the value to another currency. E.g. gold standard, EU currencies
before the €.
- Managed floating exchange rates. E.g. ¥ (Chinese yuan).
5. Size of the FOREX markets (transaction volume):
6. Methods stating foreign exchange rates and quotations.
Foreign exchange rate = the price of one currency expressed in terms of another currency.
Foreign exchange quote = a statement of willingness to buy or sell at an announced rate.
In the retail market (newspapers and exchange-shops), quotes are often given as the home
currency price of the foreign currency. £(GBP)1.770/$
, Exchange quotations: €2.75 / cup of coffee
- Price (base) = €2.75
- Unit = cup of coffee
The US dollar is the base currency of comparing currencies.
Quotes = professional dealers or brokers may state quotes in one of two ways:
- The foreign currency price of the unit one dollar. E.g. Sfr1,600/$ = I have to pay 1,600
Swiss francs for one dollar.
- The dollar price of a unit of foreign currency. E.g. $0.625/Sfr = I have to pay 0.625
dollars per Swiss franc.
Direct and indirect quotes:
- Direct quote = a home currency price of a unit of a foreign currency. E.g.
€0.8214/USD1.00 is a direct quote in Europe.
- Indirect quote = a foreign currency price in a unit of the home currency. E.g.
€0.8214/USD1.00 is an indirect quote in the US.
Interbank quotes are given as a bid and ask:
- The bid = the price at which a dealer will buy another currency.
- The ask / offer = the price at which a dealer will sell another currency.
Expressing forward quotations on a point basis:
- Forward outright quotes are different and typically quoted in terms of points.
- A point is the last digit of a quotation, with convention dictating the number of digits to
the right of the decimal. E.g. hence a point is equal to 0.0001 of most currencies (1
point is 1 dollar/10,000).
e.g. Swiss franc / $, 3 months forward; Bid = 14, Ask = 22 points.
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