11F251/2 FINACIAL

THEORY, POLICY AND

INSTITUTIONS

TOPIC 3: FOREIGN EXCHANGE MARKET

VIKTAR DUDZICH
TOPIC 3: FOREIGN EXCHANGE MARKET

HIGHLIGHTS
 Exchange rates and foreign exchange;
 Introduction to the exchange rate regimes;
 Global foreign exchange markets;
 Operations on the foreign exchange markets;
 Technical aspects of foreign exchange quotation and trading;
 Practical applications.
Introduction
 As we know from everyday life, countries have different
currencies, which can be (with some exceptions) exchanged
between themselves.
 Foreign currencies (or foreign exchange – FX) are widely
used by individuals (for travelling, savings etc.), companies
engaging in international trade, and financial institutions.
 As individuals, we can buy or sell foreign exchange through
banks and exchange offices, while companies have a wider range
of opportunities.
 FX trading is a special segment of financial markets, which
combines the features of money and investment assets, while
being neither of that directly.
Basic terminology
 The relation between the values of two countries’ currencies is
the exchange rate. I.e., an exchange rate is the number of units
of one countries’ currency needed to buy a unit of another
country’s currency or vice versa.
 In most countries, exchange rates are not stable (especially in
the long-term) and are subjected to changes due to economic
factors, speculative supply and demand for currencies, market
sentiment etc.
 The strengthening of the currency (which means that for one unit
of the country’s currency, you could buy more units of another
country’s currency than before) is called appreciation.
 The weakening of the currency (i.e., the currency becomes
cheaper when expressed in other country’s currency) is called
depreciation.
Depreciation and
appreciation
It’s important to understand that the
currency’s depreciation or appreciation isn’t
equal to the numerical increase or decrease
of this currency’s exchange rate.
As you can see in the chart on the right,
the Czech crown depreciated to the US
dollar – in the beginning of the period you
could have bought ~ 22 crowns for 1 dollar,
by the end of the period 1 dollar could have
brought you more than 25 crowns. While
the numerical value of the dollar-crown
exchange rate increased, the Czech crown
weakened (depreciated) in relation to dollar.
 Accordingly, dollar appreciated to crown.
Depreciation and
appreciation
Note – on the top right we have a
USD/EUR exchange rate, and in the chart,
we can see the appreciation of dollar in
relation to euro (by the beginning of the
period, one dollar could get you 0.81
eurocents, while later it’s 0,83). But when
the exchange rate is recorded as EUR/USD,
it decreases while it’s appreciation of dollar
and depreciation of euro.
Thus, the concurrence between
depreciation/appreciation and the numerical
increase/decrease of the exchange rate
depends on the manner the exchange rate
is quoted - i.e., if it’s a number of units of
currency A for one unit of currency B; or a
number of units of currency B for one unit of
currency A.
Basic terminology – exchange
rate regimes
 When analyzing foreign exchange markets, we should keep in
mind that the individual countries’ exchange rates behave very
differently – most importantly due to different exchange rate
arrangements implemented by the countries’ central banks.
 These arrangements (or the way the country manages its
currency in regard to FX markets) are called exchange rate
regimes.
 We should differentiate between two basic types of exchange
rate regimes - fixed (pegged, stabilized etc.) and flexible
(floating).
Exchange rate regimes
 Under flexible regime, the exchange rate is determined by the
supply and demand for the currency. When the supply exceeds the
demand, the currency weakens; when the demand exceeds the
supply, the currency strengthens.
 Most of the global currencies used for international trade exist
under flexible exchange rate regimes.
 On the other side, fixed or pegged regimes presume the stability of
exchange rate. The exchange rate may be fixed to certain currency
and kept stable; or may be sustained inside predefined intervals.
 The exchange rate regime stability is maintained by the central
bank and its interventions. Central bank foreign exchange
interventions consist of selling domestic currency when the
demand for it exceeds the supply (in order to prevent it from
appreciating) and of buying domestic currency when the supply of
it exceeds the demand – thus, the currency wouldn’t depreciate.
Euro is an example of currency with flexible exchange rate with high volatility over time
UAE dirham is fixed to the US dollar – the exchange rate remained unchanged for years
 Exchange rate regimes

In fact, there are much more different

exchange rate regime types (see table on
the right) - policy-makers differentiate between
various types of fixed/pegged regimes;
furthermore, floating exchange rate can be
independent - when the central bank
interventions are not allowed, and managed –
with central bank intervening into the rate when
it considers appropriate.
One methodological remark: when we speak
of currency weakening/strengthening in
fixed exchange rate regimes conducted by
the central bank’s decision, the correct
term for it is devaluation/revaluation.
Foreign exchange markets
 Most of the foreign exchange is traded OTC; organized trading with
FX is either related to some FX-based derivatives or takes place in
less developed countries.
 Globally, banks, central banks and other financial institutions trade
with foreign exchange between themselves via inter-bank market,
while individuals and non-financial companies usually rely on their
banks or other FX dealers/brokers (this division stands the same way
as in other financial markets).
 Markets with foreign exchange are truly global, with trading taking
place in all major financial centers across the globe - the largest
turnover is on the markets of Great Britain, the US, Japan, Singapore
and Hong Kong.
 This being said, FX markets are functioning basically non-stop – when
the trading in Europe stops, it starts in the US. When the US goes to
sleep, Asian markets open up and so on.
 Daily FX turnover in the financial
centers
1998 2001 2004 2007 2010 2013 2016 2019

Great Britain
685 542 835 1 483 1 854 2 726 2 406 3 576

USA 383 273 499 745 904 1 263 1 272 1 370

Japan 146 153 207 250 312 374 399 376
Singapore 145 104 134 242 266 383 517 640
Hong Kong 80 68 106 181 238 275 437 632

Poland 3 5 7 9 8 8 9 9
Czech republic 5 2 2 5 5 5 4 7
Hungary 1 1 3 7 4 4 3 4
Slovakia 0 1 2 3 0 1 2 1

Bil.$
The most traded currency pairs
(%) April April April April April April April

2001 2004 2007 2010 2013 2016 2019

USD/EUR 30 28 27 28 24 23 24
USD/GBP 11 14 12 9 9 9 10
USD/JPY 20 17 13 14 18 18 13
USD/CHF 5 4 5 4 3 4 4
USD/CAD 4 4 4 5 4 4 4
USD/AUD 4 5 6 6 7 5 5
USD/oth. . 17 18 19 11 10 12 35
EUR/JPY 3 3 2 3 3 2 2
EUR/GBP 2 2 2 3 2 2 2
EUR/CHF 1 1 2 2 1 1 1
EUR/oth. . 2 2 4 3 3 3 3
Exchange rate
quotation
 The institutions providing their
customers with access to FX trading
usually list or quote two exchange
rates for each currency pair: bid/buy
(or the exchange rate for which you
can sell a unit of foreign currency)
and ask/sell (or the exchange rate
for which you can buy a unit of
foreign currency).
 It universally stands that < , which
means that the counterparty is
willing to buy a unit of foreign
currency for less than it’s willing to
sell a unit of foreign currency.
 We could also encounter , which is a
simple average of buy and sell and is
used for some specific operations.
Direct and indirect quotation
 When exploring the exchange rate quotations, we distinguish
between two basic approaches to quotation - so-called direct
quote and indirect quote.
 Under direct quote, the exchange rate is expressed as a fixed
number of units of foreign currency in variable number of units of
domestic currency – i.e., what number of units of domestic currency
is needed to buy (or can be bought for) a single unit of foreign
currency.
 On the contrary, indirect quote is a form of exchange rate
quotation, when a fixed amount of domestic currency is expressed
in a variable amount of foreign currency - i.e., what number of units
of foreign currency is needed to buy (or can be sold for) a single unit
of domestic currency.
 Direct and indirect quotation
Direct quote from Czech point of view Indirect quote from Czech point of view

You need 21,43 CZK to buy a single US dollar You need 3,47 Russian rubles to buy a single unit of CZK
Base and counter currency
 There are other approaches to exchange rate listing similar to direct and
indirect quotations.
 The most well-known one is the differentiation between base and
counter currency.
 In direct quotation, the foreign currency is the base currency, and the
domestic currency is the counter currency. In indirect quotation, it’s the
other way around: the domestic currency is the base and the foreign
currency is the counter.
 In other words, base currency is the one “fixed” in the exchange rate
quotation, while the counter currency is the one that’s varying when
the exchange rate changes.
 For most of the world’s currencies, the US dollar is the base currency.
That means that the exchange rates are quoted as XXX units of some
country’s currency for one American dollar.
 For the EU non-eurozone countries, euro is the base currency. For the
Commonwealth nations, GBP is regarded as base currency.
More types of
quotation
 The quotations such as in the
table on the right (i.e., the
quotations consisting of
complete entry of the exchange
rate) are called outright.
 We can also encounter so-
called small figures quotation,
when the quotation consists
only of last two or three digits
of the exchange rate entry.
 For example, for the CZK/GBP
ER from the table, the small
figures quotation would be
825/304.
Bid-ask spread
 The difference between bid and ask
rates is spread. It may be viewed as
the revenues of dealers/market-
makers, which buy currencies for bid
rate and sell them for ask rate.
 The spread could be expressed as a
fraction of exchange rate (- ) or as
percentage.
 Spread could also be listed in so-called
pips, which are the smallest units of
movement in the specific currency
pair’s exchange rate.
Bid-ask spread

 The size of spread is one of the most crucial factors in

the FX trading. It is influenced by a number of both
economic and technical parameters.
 The spread is much higher when the trades are
conducted in cash due to transaction costs, and could
reach several %.
 Much more popular virtual trading involves lower
spread, usually being just a fraction of %.
Bid-ask spread

 Generally, spread depends on the following factors:

1) Trading volume and popularity of the currency pair – more traded
currency pairs have the lower spreads.
2) The traded amount of each specific trade - the large-volume
transactions bear lower spread.
3) The expected volatility of the exchange rate – with rising volatility
spread increases.
4) The credibility of the client – more credible clients can negotiate
lower spread.
5) The dealer’s/market-maker’s specific situation – when he has an
excess of certain currency, he would be trading it with lower
spread; it would be the opposite in case of shortage.
Reasons for entering FX markets
 Subjects on the FX markets can have different motivation for
buying and selling foreign currencies via FX markets.
 If we exclude dealers, brokers and market-makers (which, in fact,
are the FX market), we may outline the potential reasons for FX
trading as follows:
1) Simple exchange – individuals and companies may purchase
or sell foreign currencies for entrepreneurial or personal
reasons; they don’t enter FX markets to reach profit but to
secure foreign exchange for their other needs.
2) Profit-making – professional speculators and arbitragers trade
via FX markets to reach profit.
3) Hedging – financial institutions and regular businesses may
wish to hedge their FX assets or liabilities with help of FX
market.
Arbitrage vs speculation
 The two general types of profit-making strategies on the FX markets could be
labelled as speculation and arbitrage.
 A speculator buys or sells foreign currencies in order to benefit from the
exchange rate’s future development. For example, today’s CZK/USD exchange
rate is 24 CZK/USD. One assumes that the dollar will depreciate and buys
Czech crowns. If his assumptions come true (and the exchange rate would
change to 21 CZK/USD), he would reach profit due to buying the crowns
cheaper than he will be able to sell it when the exchange rate will have
changed.
 An arbitrager takes advantage of different spreads offered by different
dealers for a particular currency: arbitrage means buying cheaper from one
party and selling for more to the other.
 Arbitrager reaches profit from the exchange rates known in advance – his
trades don’t bear currency risk. On the contrary, speculator works with
currency risk, because his trades are only profitable if his assumptions about
the future come true.
Foreign exchange arbitrage
 Let’s turn to an imaginative empirical example that may be of help
to understand the essence of FX arbitrages.
 Three banks quote the following exchange rates for CZK/EUR:
bid ask
Bank A: 25,678 25,973
Bank B: 25,789 25,843
Bank C: 26,012 26,154
We possess a capital of 1000 euros. Given the quoted rate, can we
conduct a profitable arbitrage?
Foreign exchange arbitrage

 For the arbitrage to be profitable, we need to buy the currency

cheaper than it could be sold to some other subject. As we have
euros, we are going to buy Czech crowns. Therefore, we need the .
The highest bid is from the bank C (it means that bank C is willing to
give the largest amount of crowns per euro).
 We will receive = 26 012 CZK.
 As our base capital is in euros, we need to convert the received CZK
back to euros in a way that our final capital is larger than the one we
started with. Can it be done given the listed exchange rates?
 We bought the CZK for the rate of 26,012 CZK/EUR, while we can buy
euros back for less from either bank B or bank A using the exchange
rate ask (which is the amount of CZK needed to buy a unit of euros).
Foreign exchange arbitrage
 Bank B appears to be a more profitable option – it is selling euros
just for 25,843 CZK each. With the capital of 26 012 CZK, we can
get:
26 012 CZK / 25,843 CZK/EUR = 1006,54 EUR.
 It is more than we had in the beginning. The profit itself doesn’t
seem to be high, but note: in real life, all those operations are
done virtually and within seconds – actually, most of the
arbitrages are performed by computer algorithms and trading
bots.
 This was an example of bilateral arbitrage - the one with only
two currencies involved, where we just needed to notice if one of
the banks is willing to sell the currency cheaper than the other is
ok with buying. Let’s turn to more complicated example.
And one more foreign exchange
arbitrage
 Three banks quote the following exchange rates (for simplicity
purposes, we abstract away from the bid-ask spread).
Bank A: USD/EUR 1,203
Bank B: CZK/USD 20,179
Bank C: CZK/EUR 25,013
Check if there is an opportunity for a profitable arbitrage if you possess
the capital of 1000 USD.
This time, it is a multilateral arbitrage – three currencies (and three
exchange rates) are involved. To check for the opportunity of arbitrage
means to convert dollars (which we hold in the beginning) to both other
currencies step by step and, in the end, to buy the dollars back and
hope that the final sum would be larger than the starting one.
Multilateral arbitrage

 What would be our course of actions? As there are three

currencies, we have exactly two ways.
1) Convert dollars to euros; than convert euros to CZK;
subsequently sell CZK for dollars.
2) Convert dollars to CZK; change crowns for euros and,
afterwards, convert euros back to dollars.
If the exchange rates allow arbitrage, one of these options would be
profitable - we will have more dollars in the end than in the
beginning.
Knowing the exchange rates, it would be just a relatively plain
mathematical application.
Multilateral arbitrage
 Option 1: USD  EUR  CZK  USD
a) 1000 USD / 1,203 USD/EUR = 831,26 EUR
b) 831,26 EUR x 25,013 CZK/EUR = 20 792 CZK
c) 20 792 CZK / 20,179 CZK/USD = 1030,39 USD
This option proved to be profitable. This means that the other one
would not, but let’s check it just for completeness.
 Option 2: USD  CZK  EUR  USD
a) 1000 USD x 20,179 CZK/USD = 20 179 CZK
b) 20 179 CZK / 25,013 CZK/EUR = 806,74 EUR
c) 806,74 EUR x 1,203 USD/EUR = 970,51 USD
To conclude, such exchange rates allow multilateral arbitrage if you
choose the first course of actions.
Recapitulation
 Individuals, businesses and financial organizations buy and sell
foreign currencies via so-called FX markets for entrepreneurial,
personal and business purposes.
 FX markets are OTC and truly global – the trading takes place all
over the world 24h/day.
 The price of the currency in units of other currency is its exchange
rate. Some countries have fixed exchange rates controlled by their
central banks, while others let their exchange rates float, meaning
that they are influenced primarily by supply and demand for the
currency.
 The strengthening (increase of value) of the currency is labelled as
appreciation (or revaluation in case of fixed exchange rate);
weakening of the currency is depreciation (or devaluation in case
of fixed exchange rate).
Recapitulation
 On the FX markets, the transactions take form of spots, futures,
forwards, swaps, options etc. – similarly to other financial markets.
 Globally, foreign exchange swaps are the most popular type of
transactions, followed by spots.
 The reasons for entering the FX markets may be simple change,
hedging and profit-making.
 As for the latter, we should distinguish between speculation and
arbitrage.
 Speculation assumes buying or selling a currency in hope that in future
its exchange rate would change in a favorable way and the speculator
reaches profit. Speculation is uncertain and bears risk.
 Arbitrage doesn’t bear risk or uncertainty because it’s based on making
profit from the differences between exchange rates known in advance -
basically buy cheaply in one place and consequentially sell for more in the
other.