Forex markets

UNIVERSITY OF LJUBLJANA
FACULTY OF ECONOMICS
CONTENTS ENDwww.StudsPlanet.com Page 1

1. Definition and Organization of the Foreign Exchange Markets
2. Foreign Exchange Market Functions
3. Foreign Exchange Market Participants
4. Size and Structure of Foreign Exchange Market Transactions
5. Types of Foreign Exchange Market Transactions
6. Quotations of Currencies on Foreign Exchange Markets
CONTENTS AND PURPOSE
 purpose:
 enhance theoretical knowledge from the first two chapters with
practical issues of foreign exchange markets functioning
 principles for the analysis of the international business finance
problems

1. Definition and Organization of the Foreign
Exchange Markets
foreign exchange markets are markets on which
individuals, firms and banks buy and sell foreign
currencies:
 foreign exchange trading occurs with the help of the
telecommunication net between buyers and sellers of foreign
exchange that are located all over the world
 can actually talk about a single international foreign exchange
market for every single currency
 foreign exchange trading takes place at least in some of the world
financial centers in every moment
interbank-markets client markets

Clearing of currencies:
 service of exchanging one currency for another
Provision of Credit:
 trader that bought a certain good from the manufacturer, needs
time to sell this good to the final customer and to pay the
manufacturer with the money he received from the customer
2. Foreign Exchange Market Functions
Clearing of Currencies and Provision of Credit

Foreign Exchange Market and Insurance Against
Foreign Exchange Risk
hedging:
 activities with which the foreign exchange market participants
avoid exchange rate risk or activities with which they are closing
their open foreign exchange position
 closed foreign exchange position:
 size of the assets in a certain currency is equal to the size of the
liabilities in the same currency
 full insurance against exchange rate risk with respect to this currency
 open foreign exchange position:
 long: net assets in a certain currency
 short: net liabilities in a certain currency
 in the spot or forward foreign exchange market
 standardized forward contracts and options

Foreign Exchange Markets and Conscious Foreign
Exchange Risk Acceptance
activities in which economic agents consciously open their
foreign exchange positions – long or short – hoping to get
profits
in all foreign exchange market segments

3. Foreign Exchange Market Participants
Economic Agents and Types of Activities on
Foreign Exchange Markets
Client buys $
with €
Local bank
Main banks’
interbank market
Local bank
Client buys €
with $
Purchases and sales
of big multinational
companies
Brokers

bank clients (individuals, firms, non-banking financial
institutions):
 all those groups of legal and physical persons that need foreign
currency in doing their commercial or investment business
commercial banks:
 the most important group of foreign exchange market participants
 they buy and sell foreign currencies for their clients and trade for
themselves

brokers:
 agents that connects dealers interested in buying and selling
foreign exchange, but does not become an active client in the
transaction
 they provide their client, the bank, with the information about the
exchange rates at which banks are willing to buy or sell a
particular currency
central banks:
 foreign exchange market interventions are meant to influence the
exchange rate of the domestic currency in a way that is beneficial
for the domestic economy and, consequently, for the country
 it does not necessarily have a profit, it can also have a loss

Economic Agents and Motivation for the Foreign
Exchange Market Participation
arbitragers:
 they want to earn a profit without taking any kind of risk (usually
commercial banks):
 try to profit from simultaneous exchange rate differences in different
markets
 making use of the interest rate differences that exist in national
financial markets of two countries along with transactions on spot and
forward foreign exchange market at the same time (covered interest
parity)

Economic Agents and Motivation for the Foreign
Exchange Market Participation
hedgers and speculators:
 hedgers do not want to take risk while participating in the market, they
want to insure themselves against the exchange rate changes
 speculators think they know what the future exchange rate of a particular
currency will be, and they are willing to accept exchange rate risk with
the goal of making profit
 every foreign exchange market participant can behave either as a hedger
or as a speculator in the context of a particular transaction

4. Size and Structure of Foreign Exchange
Market Transactions
Table 4.1: Size and Structure of Transactions in the Foreign Exchange Markets,
1989 – 1998 (mia $)
1989 1992 1995 1998
Traditional foreign exchange
transactions
590 820 1190 1490
• Spot market transactions 350 400 520 590
• Forward market
transactions
240 420 670 900
Untraditional foreign exchange
transactions
- - 45 97
Source: Roberts, 1999, p. 33.
the biggest share of all financial markets in the world
Currency Percentage
$ 87
DEM 30
¥ 21
£ 11
FRF 5
CHF 7
Other 39
All currencies 200,00

5. Types of Foreign Exchange Market Transactions
Spot Foreign Exchange Transactions
almost immediate delivery of foreign exchange
buyer and seller establish the exchange rate at the time of
the agreement, payment and delivery are not required until
maturity
forward exchange rates:
 1, 3, 6, 9 months, one year
Outright Forward Transactions

Swap Transactions
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates:
 “spot against forward” swaps:
d
c
b
a *=
a – annual swap rate (%),
b – premium/discount during the time of the currency swap,
c – spot exchange rate, and
d - 1/part of the year, for which the currency swap is agreed upon
(if the contract is valid for a three-month period, then this is one
quarter of a year)
 “forward-forward” swaps

Futures
basic characteristics of futures:
 the amount of the currency that is being traded
 type of currency quotation
 contract expiration
 last day of trading with the contract
 settlement day
 margin requirements
information about futures trading
futures usage:
 arbitrage between outright forward contract and futures
 rarely used as an insurance instrument (rigidity!)

 similarities and differences between outright forward contract and
futures:
 both need to be executed unconditionally
 they are usually established for at most one year
Characteristic Futures Outright Forward Contract
Size of the contracts standardized for a given currency depends on the individual needs of the
client
Location and trade
activity
at the stock exchange or at a given
location; actively traded in an
organized market
with the provision of agents, connected
among each other with the help of
telecommunications; not traded in an
organized market
Duration of the
contract
standardized, but at most a year depends on the individual needs of the
client , but not more than a year
Contract has to be
executed
yes yes
Insurance and
Security of doing
Business with the
Instrument
insurance explicitly required (margin
requirements); high security of doing
business with the instrument
insurance not required explicitly
(implicit insurance are affiliations of
two partners up till now); lower
security than futures
Trade regulation regulated with the stock exchange
rules
regulation not explicitly determined

Characteristic Futures Outright Forward Contract
Contract partners not in direct contact in direct contact
Price determination based on supply and demand based on quotations
Determination of the
dayof the settlement
standardized depends on the individual needs of the
client
Accesibility of the
contract for non-
bank agents
accessible to anyone in practice accessible to big clients
with good ratings
Liquidity of the
instrument and the
contract amounts
high liquidity; small contract amounts
and small size of transactions
low liquidity; high contract amounts
and large size of transactions compared
to the size of futures
Costs of the
instrument
based on costs that the broker zaračuna
for the purchase of the instrument and
its sale later on
higher than for futures; based on the
difference in offer and bid price of the
currency that the bank offers the client
Currency quotation number of units of $ for one unit of a
foreign currency (American quotation)
number of domestic currency units for
one unit of a foreign currency
(European quotation)
Riskiness of the
instrument
very limited; stock exchange enters the
contract, explicitly required insurance
higher than for futures; for this reason,
business is done only with credible
partners
Profit yield/loss
payment
daily once; at contract execution or when the
contract expires

Options
basic characteristics of options:
 financial instrument that gives the buyer the right, but not the
obligation, to buy or sell a standardized amount of a foreign
currency, that is traded, at a fixed price at a particular time, or until
a particular time in the future
 call option and put option
 American and European options
 three different prices:
 exercise/strike price
 cost, price or value of the option
 underlying or actual spot exchange rate
“at-the-
money”
“in-the-
money”
“out-of-
money”

Options
types of options trading:
 in organized markets:
 standardized contracts with given strike prices, standardized durations
(1, 3, 6, 9, 12 months) and expirations
 only certain currencies, contract amounts are standardized
 over-the-counter trading:
 expiration date, strike price and contract amount depend on the
individual needs of the client
 counterparty risk!
 retail and interbank market
information about options trading

Usage of options:
 when the economic agent expects that the exchange rate trend of a
particular currency could change drastically
 when the economic agent does not know for sure that a certain
foreign exchange flow will occur in the future
 advantages:
 fixed option costs
 options do not need to be executed
Options

Profit/
loss
Limited
loss
Unlimited
profit
A. Buyer of a call
option
Profit/
loss
Limited
loss
Unlimited
profit
C. Buyer of a put
option
Profit/
loss
Limited
profit
Unlimited
loss
B. Seller of a call
option
Profit/
loss
Unlimited
loss
Limited
profit
D. Seller of a put
option

6. Quotations of Currencies on Foreign
Exchange Markets
quotation of a currency tells us at what price is a financial
mediator willing to buy or sell a certain currency
Currency Quotations in Spot Foreign Exchange
Markets
European and American quotation
direct and indirect quotation (which currency is regarded
as a domestic/basis currency)
100*
0
0
s
ss
s t −
=∆ 100*0
t
t
s
ss
s
−
=∆

Currency Quotations in Spot Foreign
Exchange Markets
American quotation European quotation
Definition:
number of units of $ needed to buy a unit of
a foreign currency
Definition:
number of units of a foreign currency needed
to buy $1
Direct quotation in the USA:
number of units of a domestic currency ($)
needed to buy a unit of foreign currency
Direct quotation outside the USA:
number of units of a domestic currency
needed to buy a unit of a foreign currency ($)
Indirect quotation outside the USA:
number of units of a foreign currency ($)
needed to buy a unit of a domestic currency
Indirect quotation in the USA :
number of units of a foreign currency needed
to buy a unit of a domestic currency ($)

Exchange Markets
bid price and offer/sell price quotation:
 bid price is the exchange rate at which a bank is willing to buy
another currency
 offer/sell price is the exchange rate at which the same bank is
willing to sell the currency in question
transaction costs:
 banks usually do not charge provision
 difference between the bid and offer/sell price represents the
bank’s profit and is called a margin or spread
priceoffer/sell
pricebid-priceoffer/sell
margin =

Exchange Markets
cross exchange rate:
 can be calculated with the help of the relationship of two
currencies with a third currency
triangular currency arbitrage:
 it enables profit earning because of inconsistency between
currency quotations in different financial centers
 buying a particular currency in one financial center and selling it
in another financial center

Currency Quotations in Forward Foreign
Exchange Markets
 outright quotation
 točkovna quotation, forward premium/discount:
 forward discount:
 when a currency is worth less (is cheaper relative to another currency) in the
forward foreign exchange market than in the spot foreign exchange market
 forward premium:
 when a currency is worth more (is more expensive relative to another currency)
in the forward foreign exchange rate market than in the spot foreign exchange
market
 annual forward premium and discount
100*
360
*
ns
sf
fUSD
−
= 100*
360
*
nf
fs
fUSD
−
=

Financial Times
Wall Street Journal
Publishing the Currency Quotations in the Leading
World Financial Newspapers

Forex markets

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