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A Guide to Foreign Exchange Markets

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A Guide to Foreign Exchange Markets A Guide to Foreign Exchange Markets K. Alec Chrystal HE economies of the free world are becoming be described. This will be followed by a discussion of increasingly interdependent. U.S. exports now amount some of the more important activities of market partici- to almost 10 percent of Gross National Product. For pants. Finally, there will be an introduction to the both Britain and Canada, the figure currently exceeds analysis of a new feature of exchange markets — cur- 25 percent. Imports are about the same size. Trade of rency options. The concern of this paper is with the this magnitude would not be possible without the structure and mechanics of foreign exchange markets, ability to buy and sell currencies. Currencies must be not with the detemiinants of exchange rates them- bought and sold because the acceptable means of pay- selves. ment in other countries is not the U.S. dollar. As a result, importers, exporters, travel agents, tourists and many others with overseas business must change dol- THE BASICS OF FOREIGN EXCHANGE lars into foreign currency and/or the reverse. MARKETS The trading of currencies takes place in foreign ex- There is an almost bewildering variety of foreign change markets whose major function is to facilitate exchange markets. Spot markets and forward markets international trade and investment. Foreign exchange abound in a number of currencies. tn addition, there markets, however, are shrouded in mystery. One are diverse prices quoted for these currencies. This reason for this is that a considerable amount of foreign section attempts to bring order to this seeming dis- exchange market activity does not appear to be related array. directly to the needs of international trade and invest- ment. Spot) Forward, Bid, Ask The purpose of this paper is to explain how these Virtually every major newspaper, such as the Wall 1 markets work. The basics of foreign exchange will first Street Journal or the London Financial Times, prints a daily list of exchange rates. These are expressed either as the number of units of a particular currency that exchange for one U.S. dollar or as the number of U.S. K. Alec Chrystal, professor of economics-elect, University of dollars that exchange for one unit of a particular cur- Sheffield, England, is a visiting scholar atthe Federal Reserve Bank of St. Louis. Leslie Bailis Koppel provided research assistance. The rency. Sometimes both are listed side by side see author wishes to thank Joseph Hernpen, Centerre Bank, St. Louis, for table Il. his advice on this paper. 1 For further discussion of foreign exchange markets in the United For major currencies, up to four different prices States, see Kubarych (1983). See also Dutey and Giddy (1978) and typically will be quoted. One is the “spot” price. The McKinnon (1979). others may be ‘30 days forward,” 90 days forward,” 5 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984 . c~ “ ~ ~ <~4~%\~ ~/ ~ / / /~r~ ~~~4$ /~ ~ /~ , ~ // ~\~‘ ~ 5/ ~ zc~’’ 444~ ,~ ~ ~~ ~ ~ ~ t ~\ “s~~ /~ ~ ~ 7~ ~ : ~~~~~~~± :~ ~~~~~ ~~ ~ .~ ~c ;4~~ ~ ;c ~ ~~ ~~:~Njc C ~~ ~jStC~c ,, ,C~ ic~~4a~~~~~~~~ iT~t’~l!I T~7 t::T~~:~~ I :~ Ct : ~ : <~~ C~ C~~ C t~~ C~ ~Ct T ~TC~ ~ ~:; ~C< ~~‘ ~CC~ ~4 / 1~ ‘ ~~ ~ ~ ,c~ ~ / ~\ \ \ ~A’ ~ ~‘~%~%\~r~ T~ /~ ~ ~~~‘~sr7~t~~ ~~ ~~ ~ ,\//s<~~\\~S~~ ~ C~~>QAfl~/r~ ~ \\ ~~ <~CC~/~~‘t~ N~ ~. ~ .~ ~ ~r~v~ ~,/ l*~~~c~?-a‘e;c40/s tSe~t44c4$4~N44t~~A~ ~C\ 4 ~ C i~~~~avesa~~ / ~ 5 ~ ~ ~:*C ~r4uIurau~IMm : ~ V ~ 7 ~— 5 —,~ /~/ ~~ C 7 *- /~ ~A ~ /~ ~C~ 4$4$e~4~44c~\ 7 w, ~ ~~e’ ~~/~//~ ~C /V‘~ ~ >~ C’ ffi~t~ ~fr~//’~ ~ 4~ ~ 44 :~ ;~ ~~C4~%~44$4$~C >~ ~44 ~~ ; ~, ~ ~2r~4!~1%:!C4,tC~ :~ ~ ~~4~/C ~ ~Th ~\ ~ ~ ~ C\~\~\~r\:~/ C ~C ~ ~ CC C C CC CC CC CCC CCCCCCC4 C,4/C CC C CCC FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984 and “180 days forward.” These may be expressed either in “European Terms” (such as number of $ per LI or in “American Terms” (such as number oIL per $1. (See the glossary for further explanation .1 The spot price is what you must pay to buy curren- cies for immediate delivery (two working days in the interbank market; over the counter, if you buy bank notes or travelers checks). The forward prices for each currency are what you will have to pay if you sign a contract today to buy that currency on a specific future date (30 days from now, etc.). In this market, you pay for the currency when the contract matures. Why would anyone buy and sell foreign currency forward? There are some major advantages from hav- ing such opportunities available. For example, an ex- porter who has receipts of foreign currency due at some future date can sell those funds forward now, thereby avoiding all risks associated with subsequent adverse exchange rate changes. Similarly, an importer who will have to pay for a shipment ofgoods in foreign currency in, say, three months can buy the foreign exchange forward and, again, avoid having to bear the exchange rate risk. The exchange rates quoted in the financial press (for example, those in table 1) are not the ones individuals would get at a local bank. Unless otherwise specified, the published prices refer to those quoted by banks to other banks for currency deals in excess of $1 million. Even these prices will vary somewhat depending upon whether the bank buys or sells. The difference between \ii ix~ttiipIrtil tlit’ iirigr ol 51)01 V\rllZIilizi’ rates a%ail the buying and selling price is sometimes known as the able is presented ui table Z. which .sIiow% prires or bid-ask spread.” The spread partly reflects the banks’ cli’iitsrhic’iiuiiLs and St(i’liIiL4 (ILIOttLI ~~ithin a one—Iii,tir costs and profit margins in transactions; however, ma- iit’iiiitl cii) \c,\c’n)l,i’r-25 1983 I lien’ are t~~(i ii ,cii’tant jor banks make their profits more from capital gains 1 2 h)OiiitS 1(1 t’iijti(i’. I ii’,! all c’’~ec’pltlici,,c’ iii tin’ lirsi lie than from the spread. ‘‘I’ I~ir’sqtiott’cI iii the interhank 1)1 ~vhioles~iIi’.iii~ii Let tor li-ansac—tion,. in ewess ol S L niihlioit. I he .‘,ti’rling ‘rhe market for bank notes arid travelers checks is prices have a hid-ask spread ol cinI~0 I ccitt ~vhiich i’. quite separate from the interbank foreign exchange oiiI~ahlotil 0.07 percent cit the price or 57 on S 10.000 market. For smaller currency exchanges, such as an On Ifli. the ~pic’~id per dollar-s norih ~~oiks out 1cr hi’ individual going on vacation abroad might make, the abont hall that on sterling ‘54 on .410.000 spread is greater than in the interbank market. ‘Ibis presumably reflects the larger average costs — includ- Sc.’c’oi)(l. tIt’ ~Ilces c iiciti’d I,,’ local hank,. lorsriiall. n’ 1 ing the exchange rate risks that banks face by holding ct’tzul. ti-arisat-ticins which ‘,er~eonly as a uuiclr and do banknotes in denominations too small to be sold in the riot rierev,arl\ nrpiesciit prices on actual clc’als. iii— interbank market — associated with these smaller ex- ‘. oItc’ a iiiiic1 I.ii-ger- h,icl—~tsL spi’t’.ttl I hic’se rtail changes. Asa result, individuals generally pay a higher s ,rvzccls ,.ar; tc-c,r)) Ii;,iik Ic, bank. but are i elated to ‘and 1 price for foreign exchange than those quoted in the larger than the inlethztnk iate’,. Iii sonic cases. thin newspapers. t In practice, the spread w I va~during Inc day depending upon Notice the Wall Street Journal quotes only a bank selling price at a market corrditiops Fnr example the slorl,np spread may he as lithe particular time. The Financial Times quotes the bid-ask spread and as 001 cents at ti~iesana or averages about 0.05 cents Spreads the range over the day. qenert-;yw,’i h~arger on ‘ess wioeiy traded cijrrcnc es 7 FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1984 4 may be of the order of4 cents orless on sterling, though channeled through brokers. If all interbank transac- the prices quoted in St. Louis involved average spreads tions at-c included, the figure rises to 59 percent. of 8 cents on sterling. The latter represents aspread of Most small banks and local offices of major banks do about 5½percent (about $530 per $10,000 transaction). not deal directly in the interbank foreign exchange ‘rhe equivalent spread for DM was 7 percent ($700 per market. Rather theytypically will have a credit line with $10,000 transaction). a large bank or their head office. Transactions will thus The spread on forward transactions will usually be involve an extra step (see figure IL The customer deals wider than on spot, especially for longer maturities. with a local bank, which in turn deals with a major For interbank trade, the closing spread on one and bank or head office. The interbank foreign exchange three months forward sterling on September 8, 1983, market exists between the major banks either directly was .15 cents, while the spot spread was .10 cents. This or indirectly via a broker. is shown in the top line of the Financial Times report in table 1. Of course, like the spot spread, the forward FUTURES AND OPTION MARKETS spread varies with time of day and market conditions. FOR FOREIGN EXCHANGE At times it may be as low as .02 cents. No information is available for the size of spread on the forward prices Until very recently, the interbank market was the typically offered on small transactions, since the retail only channel through which foreign exchange transac- market on forward transactions is very small.
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