Chapter 1 - 1 IFM

The Market for Foreign
Exchange
Aditya Banerjee
The Market for Foreign Exchange
• The spot and forward foreign exchange markets are over-the-counter (OTC)
markets.
• Foreign exchange market is a worldwide linkage of bank currency traders,
nonbank dealers, and FX brokers, who assist in trades, connected to one
another via a network of telephones, computer terminals, and automated
dealing systems.
• The market for foreign exchange can be viewed as a two-tier market.
• International banks provide the core of the FX market.
• These international banks serve their retail clients, the bank customers
(Mostly MNCs).
• Nonbank dealers are large nonbank financial institutions such as investment
banks, mutual funds, pension funds, and hedge funds.
• FX brokers match dealer orders to buy and sell currencies for a fee, but do not
take a position themselves.
The Timing for Foreign Exchange Markets
• The foreign exchange market remains open 24 hours a day.
• Seen from perspective of India, this is how the timings look like:
Why do we study Foreign Exchange?
• It is a market worth trillions by trading size.

• As per BIS Triennial Report, Trading in FX markets reached $6.6
trillion per day in April 2019. (BIS is Bank for International
Settlements).
• The US dollar retains its dominant currency status, being on one
side of 88% of all trades by 2019.
• Some currency and their symbols:
• USD: US dollar ($)
• EUR: Euro (€)
• GBP: pound sterling (£)
• JPY: Japanese yen (¥)
• INR: Indian Rupee (₹)
More on the Foreign Exchange Market
• Which currency pairs are most traded (daily averages)?
• USD/INR is no. 11 on the daily average turnover list.

More on the Foreign Exchange Market
• How are currency pairs traded:
• The spot market: Market for immediate buy-sale of currency.
• The forward contracts: for buy-sale of forex at a future date at a pre-
determined exchange rate and amount.
• The forex swaps: an agreement to exchange currency between two
foreign parties. Includes swapping principal and interest payments on a
loan made in one currency for principal and interest in another currency.
• The forex options: option is a derivative financial instrument that gives
the right but not the obligation to exchange money denominated in one
currency into another currency at a pre-agreed exchange rate on a
specified date.
Foreign Exchange Market turnover by instrument (Daily average in
April 2019)
Who participates in the Foreign Exchange Market?
• A reporting dealer: A firm that must report its transactions and

positions in forex to the BIS. They deal in large forex transactions.
• Non reporting banks: Commercial banks, investment banks,

securities dealers and securities brokers. Sectoral classification
used in the OTC derivatives statistics that refers collectively to
banks and securities firms that are not reporting dealers.
• Other participants and Foreign Exchange Institutions: Traders

include governments and central banks, commercial banks, other
institutional investors and financial institutions, currency
speculators, other commercial corporations, and individuals.
Foreign Exchange Market turnover by counterparty (Daily average
in April 2019)
The Spot Market
• Involves almost the immediate purchase or sale of foreign exchange.
• Typically, cash settlement is made two business days (T+2)
• Consider the following quote:
$1 = ₹74.343
Base Currency Quote Currency
• Some quoting conventions:

USD/CHF or USDINR
• SWIFT codes: First currency is the base currency, while second currency is
the quoted currency.
• Most popular method of quoting:
$/£
• Read as Dollars per Pound. Many authors use this style to quote
currencies in their textbooks.
The Spot Market Direct and Indirect Quotes
• Direct Quotation: Price of one unit of a foreign currency in number

of units of home currency. For Example, in India:
• USD 1 = Rs. 74.343 (Direct Quote or ₹/$)
• Indirect Quotation: Price of one unit of home currency in number of
units of foreign currency. For Example, in India:
• Rs.1 = USD 0.0135 (Indirect Quote or $/₹)
• It is important to keep in mind which currency is Home currency and
which currency is Foreign currency.
• American Terms: a direct quote from the U.S. perspective
• European terms: an indirect quote from the U.S. perspective
Find Direct and Indirect Quotes
• Find Indirect quote:

• For India
• Find direct quote:

• For India
• Find Direct quote:

• For Europe
• Find direct quote:

• For USA
Cross Exchange Rates
• A cross-exchange rate is an exchange rate between a currency pair.
₹/£
• E.g.: $/£ = (How?)
₹/$
• Look at the cross rates table below and fill in the blanks:
Base Currency
EUR JPY GBP CHF CAD AUD HKD
USD 1.1870 0.0091 1.3904 1.1039 0.8016 0.7345 ??
EUR - 0.0077 ?? 0.9300 0.6753 0.6188 0.1084
JPY - - 152.5547 121.1171 ?? 80.5893 14.1177
GBP - - - 0.7939 0.5765 0.5283 0.0925
CHF - - - - 0.7262 ?? 0.1166
CAD - - - - - 0.9163 0.1605
AUD - - - - - - 0.1752
The Spot Market: Bid and Ask Quotations
• Interbank FX traders buy currency for inventory at the bid price and
sell from inventory at the higher offer or ask price.
• Remember: All bid (buy) and ask (offer/sell) quotations are from
the point of view of the bank/dealer/trader.
• Thus, if a trader quotes $1 = 74.337/ 74.349 it mean that you can
buy $1 from the trader at 74.349 (ask price). If you sell $1 to
trader, you will receive 74.337 (bid price)
• Always, Ask > Bid.
• The trader/dealer/bank that provides currency quotes always makes
profit from bid-ask difference.
How does Foreign Exchange Bid/Ask look like?
• Reciprocals in bid-ask
• Consider the following rates: $ per € Bid/Ask: 1.1794 / 1.1798

• Find €/$:
• Consider the following rates: INR/GBP (what is this?) Bid/Ask:
0.00972 / 0.00972
• Is it a direct quote or indirect quote for: a) India b) Britain
• Find the reciprocal of the quote (GBP/INR):
• Answers:
• Consider the following rates: $ per € Bid/Ask: 1.1794 / 1.1798
• Find €/$: 0.8476/0.8479
• Consider the following rates: INR/GBP (£ per ₹ or £/₹) Bid/Ask:
0.009712 / 0.009716
• Is it a direct quote or indirect quote for: a) India: Indirect b)
Britain: Direct (Why?)
• Find the reciprocal of the quote (GBP/INR): 102.9230/102.9654
The Spot Market: Cross Bid and Ask
• Consider the following rates:

• GBP/INR (₹ per £) Bid/Ask: 102.925 / 102.963
• EUR/INR Bid/Ask: 87.5570 / 87.5940
• Can you compute GBP/EUR (€ per £) bid/ask?
The Spot Market: Cross Bid and Ask
• Given:
• GBP/INR (₹ per £) Bid/Ask: 102.925 / 102.963
• EUR/INR (₹ per €) Bid/Ask: 87.5570 / 87.5940
• Answer is: 1.1750/1.17595
• Think of solving the problem in this way:
• For £1,000, how many € can you buy? (Do a cross between the
two rates)
• If you wanted to buy £1,000, how much € will you need?
• Always remember, for three currencies C1, C2, and C3:
• Bid C1 per C2 (C1/C2bid) = (C1/C3bid) × (C3/C2bid) = (C1/C3bid) ×
1/(C2/C3ask)
• (C1/C2ask) = (C1/C3ask) × (C3/C2ask) = (C1/C3ask) × 1/(C2/C3bid)
The Spot Market: Currency Arbitrage
• For now, ignore bid/ask quotations and consider the following

situation:
• Do you think any of the rates are ‘out of sync’? Are there any
profit opportunities?
• Assume you have to start with $1,000,000.
• For the given quotes:
• The cross rates between the first two quotes should be

approximately, EUR1.1721/GBP.
• This presents an opportunity since GBP is expensive and EUR is
cheaper in Dresdner Bank.
• The profit opportunity with $1,000,000 is $112.
• Consider the given quotes:
• Are there any arbitrage opportunities?

• Consider that you have SF12,000,000.
Three-Way Arbitrage with 2-way Quotes
• Consider the following rates:

• Indian Bank S quotes: EUR/INR Bid/Ask: 87.5570 / 87.5940
• Indian Bank H quotes: USD/INR Bid/Ask: 74.303/ 74.313
• British Bank B quotes: EUR/USD ($ per €) Bid/Ask: 1.1774/
1.1778
• Is any arbitrage opportunity available? Assume you have
₹10,000,000.
THANK YOU
THANK YOU

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The Market for Foreign

• It is a market worth trillions by trading size.

• USD/INR is no. 11 on the daily average turnover list.

• A reporting dealer: A firm that must report its transactions and

• Non reporting banks: Commercial banks, investment banks,

• Other participants and Foreign Exchange Institutions: Traders

• Some quoting conventions:

• Direct Quotation: Price of one unit of a foreign currency in number

• Find Indirect quote:

• Find direct quote:

• Find Direct quote:

• Find direct quote:

• Consider the following rates: $ per € Bid/Ask: 1.1794 / 1.1798

• Consider the following rates:

• For now, ignore bid/ask quotations and consider the following

• For the given quotes:

• The cross rates between the first two quotes should be

• Consider the given quotes:

• Are there any arbitrage opportunities?

• Consider the following rates:

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