Foreign Exchange Market

The Foreign Exchange Market (Forex, FX, or currency market) is a market in which currencies are bought and sold. It is distinct from a financial market where currencies are borrowed and lent. The primary purpose of the foreign exchange market is to permit transfers of purchasing power denominated in one currency to another, enabling the trading of one currency for another. This is essential for international trade and investment, allowing, for instance, a U.S. business to pay for goods from the European Union in Euros, even if their income is in U.S. dollars. Assisting clients with foreign exchange transactions is one of the services commercial banks provide.

The foreign exchange market is the largest financial market in the world by virtually any standard. A survey in 2013 placed the average foreign exchange trading volume at US$5.3 trillion daily. In 2016, this was estimated at $4.74 trillion daily, equivalent to over $600 in daily transactions for every person on earth. This daily volume compares significantly to trading volumes on major stock exchanges.

Characteristics of the Foreign Exchange Market

The foreign exchange market is unique due to several characteristics:

• Not a Physical Place: It is described as an OTC (Over the counter) market, meaning there is no specific physical location where participants meet. Instead, it is an electronically linked network of banks, foreign exchange brokers, and dealers, who assist in trades and are connected via telecommunications like telex, telephone, computer terminals, and automated dealing systems.
• Geographically Dispersed: The market is not confined to a single country but is dispersed throughout leading financial centres globally, including London, New York, Singapore, Hong Kong, Tokyo, Paris, Zurich, Amsterdam, Toronto, Frankfurt, and Milan. London and New York account for more than half of the world’s currency trading. London remains the world’s largest foreign exchange trading centre.
• Round-the-Clock Operation: Currency trading takes place 24 hours a day, except for weekends. Trading is continuous from Sunday GMT until Friday GMT.
• Predominantly Interbank Market: Most currency transactions occur within the worldwide interbank market. This is the wholesale market where major banks trade with each other and accounts for approximately 95% of foreign exchange transactions.
• Huge Trading Volume and High Liquidity: The massive trading volume makes it the largest asset class globally, leading to high liquidity.
• Variety of Factors Affecting Exchange Rates: Exchange rates are influenced by a range of factors.
• Low Margins and High Leverage: Compared to some other fixed-income markets, relative profit margins can be low, and leverage is often used to enhance potential profit and loss.

Functions of the Foreign Exchange Market

The foreign exchange market performs important functions beyond just converting currency:

• Transfer Function: Facilitating the conversion of one currency into another, enabling the transfer of purchasing power between countries. This is done through various credit instruments like telegraphic transfers, bank drafts, and foreign bills.
• Credit Function: Providing credit for foreign trade.
• Hedging Function: Furnishing facilities for hedging foreign exchange risks. This function is crucial for managing the risks associated with fluctuating exchange rates.

Participants in the Foreign Exchange Market

The foreign exchange market has a multi-layer structure with various participants. These can be broadly categorized into five major groups:

1. Commercial Banks: These provide the core of the FX market and actively “make a market” by standing ready to buy or sell foreign currency for their own account. They serve their retail clients (bank customers) in conducting foreign commerce or making international investments.
2. Bank Customers: This broad group includes multinational corporations (MNCs), money managers, and private speculators who use the market for foreign exchange needs related to international business or investment.
3. Nonbank Dealers: Large nonbank financial institutions such as investment banks, mutual funds, pension funds, and hedge funds. Their size and trading frequency make it cost-effective for them to trade directly in the interbank market. Investment management firms, for instance, use the market to facilitate transactions in foreign securities and some have specialist currency overlay operations aimed at generating profits and limiting risk. In 2016, nonbank dealers accounted for 50% of FX trading volume.
4. Foreign Exchange Brokers: These assist in bringing together buyers and sellers of foreign exchange.
5. Central Banks: Central banks are also participants in the market.

The market can be viewed as a two-tier market: the wholesale or interbank market (where banks trade with each other) and the retail or client market (where banks serve their customers). Retail or bank client transactions account for a smaller portion (approximately 7% in 2016) compared to interbank trades.

Structure and Segments of the Foreign Exchange Market

As an OTC market, the FX market is a worldwide linkage of traders connected via a network of telephones and computer terminals. Companies typically exchange currency through a commercial bank over a telecommunications network. Major vendors of quote screen monitors used in trading currencies include Thomson Reuters and ICAP.

The foreign exchange market has two main segments:

1. Spot Market: In the spot market, currencies are traded for nearly immediate delivery. This delivery is typically paid or received two business days after the transaction is entered into. The spot market involves buying and selling currencies at the current spot rate. Concepts related to the spot market include spot rate quotations (direct vs. indirect quotes, American vs. European quotes), cross-exchange rates (the exchange rate between two non-dollar currencies derived from their relationship with the dollar), the bid-ask spread (the difference between the price a dealer will buy and sell a currency), spot FX trading, and triangular arbitrage (exploiting inconsistencies in cross-exchange rates to make a riskless profit).
2. Forward Market: In the forward market, contracts are made today to buy or sell currencies for future delivery, specifically dates beyond the spot settlement date. A forward contract is a vehicle for buying or selling a stated amount of foreign exchange at a stated price per unit at a specified future time. The forward market involves forward rate quotations and swap transactions. There are also Non-Deliverable Forward Contracts (NDFs), which are cash-settled, short-term forward contracts on thinly traded or non-convertible foreign currencies, where the profit or loss is calculated based on the difference between the agreed-upon forward rate and the spot rate at settlement for a notional amount.

Foreign Currency Derivatives

Derivative contracts play a significant role in the foreign exchange market, especially for hedging risk and speculation. Their price is partially derived from the value of the underlying currency. Key types include:

• Foreign Currency Futures (FC Futures): These are obligations, not just a right, to buy or sell a specified foreign currency in the present for settlement at a future date. Currency futures contracts are conceptually similar to forward contracts but have standardized features, such as available currencies, delivery dates, and contract size. They are exchange-traded on organized exchanges rather than over-the-counter. Examples of markets trading currency futures include the CME Group.
• Foreign Currency Options (FC Options): These provide the right, but not the obligation, to buy or sell a foreign currency at a certain specified price on or before a specified date. Options provide a hedge against financial and economic risks. They can be obtained through exchanges or the over-the-counter market. Factors affect currency option premiums. Currency options can be used by MNCs for hedging. FX Call Options give the holder the right to buy a notional amount of currency at a specific strike rate under predefined conditions.
• Currency Swaps: These are useful tools for hedging long-term interest rate and currency risk. The market for currency swaps is discussed in relevant chapters.

Both forward and futures contracts are classified as derivative or contingent claim securities because their values depend on the underlying currency. MNCs and individuals use currency derivatives to hedge their exposure to exchange rate risk or to speculate on future exchange rate movements. When comparing currency options and forward contracts for hedging, there are advantages and disadvantages to each.

Exchange Rates and Quotations

A foreign exchange rate represents the value of one currency compared to another. Exchange rates are determined in the foreign exchange market.

• Direct Quote: States the value of a foreign currency in terms of the home currency. If the direct rate of the euro is $1.25, it means 1 euro equals $1.25.
• Indirect Quote: States the value of the home currency in terms of a foreign currency. Using the previous example, the indirect rate of the euro (from a US perspective) is the value of a dollar in euros, which would be 1/$1.25 = €0.80 per dollar.
• American Quote: Refers to quoting per unit of any currency in terms of U.S. Dollars.
• European Quote: Refers to quoting per unit of American Dollars in terms of any other currency – an indirect quotation where the value of the foreign currency is stated per unit of the U.S. Dollar.

The Bid rate is the rate at which an Exchange Dealer will buy currency, also known as the buy rate. The Ask rate (or Offer rate) is the rate at which the Exchange Dealer will sell currency. The Bid-Ask spread is the difference between the bid and ask price.

Cross-exchange rates, such as the rate between the Polish zloty and the Japanese yen, are calculated based on their dollar values. Forward cross-exchange rates are calculated analogously to spot cross-rates.

The Role of SWIFT

SWIFT (Society for Worldwide Interbank Financial Telecommunication) is a crucial communications network for international financial market transactions. It is a cooperative society owned by banks in Europe and North America and is registered in Brussels, Belgium. SWIFT is purely a messaging system used by Foreign Exchange Dealers/Traders to carry out their business transactions. It links effectively more than 25,000 financial institutions worldwide, each allotted bank identified codes. Messages are transmitted internationally via operating centers in Brussels, Amsterdam, and Culpeper, Virginia. To avoid miscommunication regarding currencies, SWIFT assigns 3-letter codes to the currencies of each country, which are used internationally in cross-border communications.

International Financial Management and the FX Market

International financial management involves managing finance in an international business environment. Factors that differentiate international financial management from domestic financial management include foreign exchange, political risk, market imperfection, and enhanced opportunity and risk. Globalization has led to a significant increase in raising capital from international markets. New derivative financial instruments are continuously introduced in the international financial scenario to cater to the needs of multinational organizations and foreign investors.

Instruments and Products in International Finance

Various financial instruments are traded in the international markets that interact with the foreign exchange market:

• Floating Rate Notes (FRNs): Issued up to seven years maturity, with interest rates adjusted to reflect prevailing exchange rates. They can provide cheaper money than foreign loans.
• Euro Commercial Papers (ECPs): Short-term money market instruments with maturities less than one year, usually designated in US Dollars. They are typically issued at a discount.
• Foreign Euro Bonds: Bonds issued in the domestic capital markets of various countries are known by different names, such as Yankee Bonds in the US, Swiss Frances in Switzerland, Samurai Bonds in Tokyo, and Bulldogs in the UK. The international bond market is a significant part of international finance. Types include straight fixed-rate issues, Euro-Medium-Term Notes, Floating-Rate Notes, Equity-Related Bonds, and Dual-Currency Bonds.
• Euro Convertible Bonds: Debt instruments giving holders the option to convert them into a pre-determined number of equity shares. They carry a fixed interest rate and may include call or put options for the issuer or holder.
• Currency ETFs (Exchange-Traded Funds): Funds designed to give investors access to FX spot changes, local institutional interest rates, and collateral yield. Shares representing fractional ownership of the fund trade on an organized exchange. They allow investors to take positions in various currencies.
• Non-deliverable Forward Contract (NDF): A cash-settled, short-term forward contract on a thinly traded or non-convertible foreign currency.
• Credit Instruments: Foreign exchange operations of banks primarily involve the purchase and sale of credit instruments. These instruments used in foreign remittances differ in speed and associated risk, leading to different exchange rates.

International capital markets also include the international money market, which deals with short-term instruments, and international stock markets, which involve trading ownership in publicly owned corporations. The international money market is a market for short-term money and financial assets that are near substitutes for money, generally for periods up to one year. Some money market instruments include Call/Notice Money, Treasury Bills, Term Money, Certificate of Deposit, and Commercial Papers. The capital market finances long-term investments, with transactions over a year.

Foreign Exchange Risk Management

Operations in foreign exchange are exposed to various risks. Foreign exchange risk exposure refers to the risk that exchange rate fluctuations will negatively impact cash flows or the value of assets/liabilities. Management of foreign exchange risk is a key aspect of international financial management. Hedging currency risk is a technique used to manage this exposure. Techniques can be external, involving various financial products. Money Market Hedging, for example, involves an agreement to exchange a certain amount of one currency for a fixed amount of another at a particular date to mitigate risk from currency value changes by the time of payment. Other techniques include using forward contracts, currency futures, and currency options. Comparing currency options and forward contracts reveals differences in how they are used for hedging payables depending on expectations and uncertainty about future exchange rates.