Foreign Exchange Market: Participants, Transactions, and Rates

Posted on Dec 18, 2024 in Economy

Foreign Exchange Market

The foreign exchange market provides a source of credit (letters of credit).

Market Participants

  1. Bank and Nonbank Foreign Exchange Dealers: Bank and nonbank traders and dealers profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” (also called an “ask”) price. Competition among dealers worldwide narrows the spread between bids and offers. Dealers in the foreign exchange departments of large international banks often function as “market makers.” They are ready at all times to buy and sell currencies and maintain an “inventory” position in those currencies set by bank policy. Small- to medium-size banks and institutions are likely to participate but not to be market makers in the interbank market. They often buy from and sell to larger institutions in order to offset retail transactions with their own customers or to seek short-term profits for their own accounts.
  2. Individuals and Firms Conducting Commercial and Investment Transactions: Importers and exporters, international portfolio investors, multinational corporations, tourists, and others use the foreign exchange market to facilitate the execution of commercial or investment transactions. Their use of the foreign exchange market is necessary, but incidental, to their underlying commercial or investment purpose. Some of these participants use the market to hedge foreign exchange risk as well.
  3. Speculators and Arbitragers: Seek to profit from trading within the market itself.
  4. Central Banks and Treasuries: Use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded, a practice known as foreign exchange intervention. They may act to support the value of their own currency because of national policies or because of commitments to other countries under exchange rate relationships or regional currency agreements. Consequently, the motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens. In many instances, they do their job best when they willingly take a loss on their foreign exchange transactions. As willing loss-takers, central banks and treasuries differ in motive and behavior from all other market participants.
  5. Foreign Exchange Brokers: Are agents who facilitate trading between dealers without themselves becoming principals in the transaction. They charge a small commission for this service. They maintain instant access to hundreds of dealers worldwide via open telephone lines. At times, a broker may maintain a dozen or more such lines to a single client bank, with separate lines for different currencies and for spot and forward markets. It is a broker’s business to know at any moment exactly which dealers want to buy or sell any currency. This knowledge enables the broker to find an opposite party for a client without revealing the identity of either party until after a transaction has been agreed upon. Dealers use brokers to expedite the transaction and to remain anonymous, since the identity of participants may influence short-term quotes.

The Three Components of FX Trade

  • Trade transaction agreement—the interaction of dealers, brokers, and aggregators. Instructions for foreign exchange trades are executed through the Society for Worldwide Interbank Financial Telecommunication (SWIFT). The SWIFT network sends payment orders, but it does not facilitate the actual settlement. Settlement of a foreign exchange trade is made by correspondent accounts that the banks and institutions have with each other.
  • Electronic communication and notification for payment settlement. Continuous Linked Settlement (CLS) is a specialist bank that provides settlement services to its members for foreign exchange trades.
  • Final settlement of the currency trade. Payment versus Payment is a settlement service where both sides’ payment instructions for an FX transaction are settled simultaneously.

Spot Transactions

The purchase of foreign exchange with delivery and payment between banks taking place normally on the second following business day (D+2).

  • Value Date = The date of settlement
  • Clearing House Interbank Payments System (CHIPS): Most dollar transactions in the world are settled through the computerized CHIPS in New York, which calculates net balances owed by any one bank to another and facilitates payment of those balances by 6:00 p.m. that same day in Federal Reserve Bank of New York funds.

Structure of the Foreign Exchange Market: Trading Platforms and Processes

There are two forms:

  1. Official Trading Floor:
    1. Electronics Platforms: Providers Reuters, Telerate, EBS, and Bloomberg
    2. Telephone (decreasing)
  2. Closing Price (Fixing): Official Price. Business firms in countries with exchange controls, like mainland China, often must surrender foreign exchange earned from exports to the central bank at the daily fixing price.

Swap Transactions

A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Both purchase and sale are conducted with the same counterparty.

  1. Spot Against Forward: The most common type of swap is a “spot against forward.” The dealer buys a currency in the spot market (at the spot rate) and simultaneously sells the same amount back to the same bank in the forward market (at the forward exchange rate). Since this is executed as a single transaction with just one counterparty, the dealer incurs no unexpected foreign exchange risk.
  2. Forward-Forward Swaps: A more sophisticated swap transaction is called a forward-forward swap.

The currency composition of trading indicates a number of global shifts:

  1. The U.S. dollar increased its presence in global currency trades.
  2. The Japanese yen and the European euro both showed declines.
  3. The Chinese renminbi’s proportion, although small, has recently doubled.

Market Conventions

  1. European Terms: Quoting the quantity of a specific currency per one U.S. dollar. This has been the market practice for most of the past 60 years or more.
  2. American Terms: Quoting the quantity of U.S. dollars per one unit of a specific currency. Exceptions that use American Terms:
    • Euro
    • U.K. pound sterling
    • Australian dollar
    • New Zealand dollar

Cash Rates: Forward rates of one year or less maturity.

Swap Rates: Forward rates for longer than one year maturity.

Forward Foreign Exchange Rates

Spot price = Supply and demand

Forward Price = Spot Price +/- Spread

The arbitrage relationship (making profits by buying in the cheapest country and selling in the most expensive one) can be influenced by:

  1. Arbitration costs
  2. Currency exchange fees
  3. Import/export restrictions
  4. Restrictions on the free movement of capital markets

Pa x (1+Ga) = Pb(1+Gb)x Ta,b(1+ta,b)

𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒 = 𝑆𝑝𝑜𝑡 𝑟𝑎𝑡𝑒(usd/eur) (1 + 𝑖usd × 𝑇) (1 + 𝑖eur × 𝑇)

The premium or discount will ALWAYS be in the base currency

  1. PREMIUM: If Forward Rate > Spot Rate. Implies that the quote currency has a higher interest rate than the base currency.
  2. DISCOUNT: If Forward Rate < Spot Rate. Implies that the quote currency has a lower interest rate than the base currency.
  • PREMIUM Euro to USD: Forward rate > Spot rate. Direct Quote: directly observable. Swap point quotation: swap points are positive. USD has higher interest rates than EUR.
  • DISCOUNT Euro to DKK: Forward rate < Spot rate. Direct Quote: directly observable. Swap point quotation: swap points are negative. DKK has lower interest rates than EUR.

Forms of natural hedging:

  1. Buying and selling in the same currency (no exchange rate risk). Customers and suppliers using the same currency.
  2. Financing in the currency in which you invoice (you obtain financing in the currency in which you are going to collect the goods).
  3. Revision of prices according to the variation of the exchange rate (the price of the goods is updated according to the exchange rate at the time of collection/payment).

If the Forward Market Rate (FMP) and Equilibrium Forward Rate (FET):

If FMP > FET: Borrow in the currency that is depreciating (quote currency) and invest in the one that is appreciating (base currency).

If FMP < FET: Borrow in the currency that is depreciated (base currency) and invest in the currency that is appreciated (quote currency).

Exchange Rates Futures

Characteristics of Derivatives

  • Leverage: Investment in excess of the amount of the contract (leverage effect).
  • Possibility of investing in long positions (buying or bull markets) or short positions (selling or bear markets) for hedging and speculation.
  • Companies use derivatives as a hedging instrument for Risk Management in the Investment and Financing of companies.

History of Derivatives

  • In the 17th century, derivative contracts with tulip bulbs as the underlying asset were traded in the Netherlands.
  • In Japan, organized markets emerged to trade contracts for the future delivery of rice (underlying asset).
  • In the 19th century, the first modern derivatives market was created in Chicago, where contracts on commodities (corn) were traded, and in 1973 the first financial derivative on exchange rates was created.
  • Subsequently, Derivatives Markets were created in the main world financial markets (Chicago, London, New York, Frankfurt), where derivatives on raw materials (commodities) and financial assets (exchange rates, shares, etc.) are traded.

Markets

  1. Organized Markets (there is regulation): Options and Futures.
  2. Non-Organized Markets (private contracts without regulation). They are known as OTC (Over the Counter) markets. They include forwards and swaps.

Futures

  • These are financial instruments that allow to know when the future is acquired the exchange rate at which currencies can be bought or sold at the time of maturity of the futures contract.
  • The nomenclature of the futures is the base currency: If a trader buys a USD/EUR future, being the EUR the base currency, he is buying EUR and implicitly selling USD (quote currency).
  • Futures involve an obligation to purchase the currency at maturity at the exchange rate fixed at the time the futures contract is purchased.

The exchange rates in futures contracts are the same as forwards and are formed through the Interest Rate Parity (page 2)

Differences between forward and future:

Forwards are private agreements between two parties: they are a zero-sum game, where the gain of one is the loss of the other, so the loser always has an incentive not to pay (default). There is, therefore, credit risk. The futures contract has NO credit risk: Clearing House which is in charge of monitoring all transactions. How is the risk eliminated? – Contribution of initial margin (at the time of contracting the future) and maintenance margin (in the event that the initial margin decreases). – Contracts are valued and settled each day (against the margins provided).

Clearing House

Counterparty risk management:

  1. Warranties: Initial and Maintenance. For each contract (purchase or sale), the Clearing House requires the participants in the futures contract to deposit guarantees to cover eventual losses (adverse price movements).
  2. Daily profit and loss settlement: Each day open positions in futures contracts are valued at closing prices, with gains credited to the margin and losses generated on the same day charged to the margin.
  3. Reposition of Guarantees: The Clearing House requires each party to replenish collateral. In the event that the client is unable to pay, the clearing house unwinds the positions so that the maximum loss incurred is one day’s loss.

Currency futures are one of the most suitable financial instruments for foreign currency speculation due to 2 characteristics: 1. The high degree of financial leverage caused by the fact that the margin to enter the market is usually relatively small. 2. Liquidity of futures contracts

Future Arbitrage Transaction

They arise because financial assets are mispriced. There are 2 types of arbitrage: 1. Direct Arbitrage (Cash and Carry): Overvalued futures contract. Sale of the future and Purchase of the currency in spot (maturity). 2. Indirect Arbitrage (Reverse cash and Carry): Undervalued Futures Contract. Purchase of the Future and Selling the currency at spot (maturity)