Foreign Exchange Market

The foreign exchange (FX) market is the world’s largest market, with a daily turnover of approximately USD 6.6 trillion in 2019. It operates 24 hours daily, facilitating international trade and cross-border capital flows with participants from various backgrounds.

Functions of the Foreign Exchange Market

1. Facilitating international trade: The FX market enables the exchange of goods and services in foreign currencies, essential for companies and individuals engaged in cross-border transactions.
2. Accounting for financial market transactions: Financial market transactions are a big part of FX market turnover. When investors move money into or out of foreign assets, they often have to convert currencies, which means they might face exchange rate risk. For example, if a Canadian investor buys Apple stocks in US dollars, they risk losing money if the stock value and the US dollar weaken compared to the Canadian dollar.
3. Providing flexibility for financial goals: The FX market offers products such as spot transactions, FX swaps, options, and forward contracts, providing flexibility for diverse financial objectives, including speculation and risk hedging.

Basic Conventions

Currencies are often referred to by standardized three-letter codes (e.g., USD for US Dollar, EUR for Euro) agreed upon through the International Organization for Standardization (ISO).

Note that there is a difference between an individual currency and an exchange rate. An individual currency is a single currency, for instance, the USD, whereas an exchange rate involves two currencies and is the price of one currency relative to another. It is the cost of one unit of the base currency in terms of the price currency, i.e., the number of units of the price currency that one unit of the base currency can buy.

Note that the three-letter code can be used to signify an individual currency or an exchange rate. For instance, EUR in a professional FX market is the exchange rate between the euro and the US dollar (EUR can also signify an individual currency). As such, it is important to understand the context in which the three-letter codes are used.

For the sake of avoiding this confusion, the exchange quoting convention in this discussion will be given by “A/B,” which implies the number of units of currency A that one unit of currency B will buy.

Nominal and Real Exchange Rates

Nominal exchange rates are the actual exchange rates in the market, expressed as the price of one currency in terms of another. It is expressed in the convention of “A/B,” referring to the number of units of currency A that one unit of currency B will buy. For example, a USD/EUR exchange rate of 1.1650 means 1 euro will buy 1.1650 US dollars.

The purchasing power parity (PPP) theory suggests that nominal exchange rates adjust to equalize the prices of identical goods in different markets. However, due to factors such as trade barriers, transaction costs, and differences in goods and services, nominal exchange rates often deviate from PPP.

Real exchange rates are indexes constructed by economists and other market analysts to assess changes in the relative purchasing power of one currency compared with another. In other words, real exchange rates adjust nominal rates using price levels in each country to compare relative purchasing power.

The real exchange rate goes up when the nominal exchange rate (how much domestic currency you get for one unit of foreign currency) and the foreign price level increases. It goes down when the domestic price level increases.

As such, the higher the real exchange rate is, the lesser foreign goods, in real terms, an individual can buy, and the lower that individual’s relative purchasing power will be compared with the foreign country.

Mathematically, the real exchange rate is the relative price levels in the domestic and foreign countries. The formula for the real exchange rate between domestic (d) and foreign (f) currencies is given by:

$$ \text{Real exchange rate (d/f)}=\frac{S_{d/f}\times P_f\ }{P_d}=S_{d/f}\times\left(\frac{P_f}{P_d}\right)$$

Where:

\(S_{d/f\ }\)= The spot exchange rate (quoted in terms of the number of units of domestic currency per one unit of foreign currency).

\(P_f\) = The foreign price level quoted in terms of the foreign currency.

\(P_d\)= The domestic price level in terms of the domestic currency.

Example: Calculating Real Exchange Rate

An analyst is studying the effects of exchange rates on purchasing power. She comes across the following data:

• Nominal spot exchange rate (USD/EUR) = 1.15
• Eurozone Consumer Price Index (\(CPI_{eur}\)) = 110
• US Consumer Price Index (\(CPI_{US}\)) = 100

The real exchange rate for an American consumer wanting to buy goods made in the Eurozone is closest to:

Solution

We know that:

$$ \text{Real exchange rate (d/f)}=S_{d/f}\times\left(\frac{P_f}{P_d}\right)$$

Therefore, for an American consumer, the real exchange rate is given by:

$$\begin{align}\text{Real exchange rate}\ \left(USD/EUR\right)&=S_{USD/EUR}\times\left(\frac{{CPI}_{EUR}}{{CPI}_{USD}}\right)\\&=1.15\times\frac{110}{100}=1.2650\end{align}$$

(Note: In the above equation, the real exchange rate (USD/EUR) has been quoted with the domestic currency of the American consumer, USD, as the price currency)

Change in Real Exchange Rate

The formula for the Change in the real exchange rate, which considers changes in both domestic and foreign price levels and the nominal spot exchange rate, is as follows:

$$\left(1+\frac{\Delta S_{d/f}}{S_{d/f}}\right)\times \frac{\left(1+\frac{\Delta P_f}{P_f}\right)}{\left(1+\frac{\Delta P_d}{P_d}\right)}-1$$

Where:

\(S_{d/f}\) = Spot exchange rate (quoted in terms of the number of units of domestic currency per one unit of foreign currency).

\(?S_{d/f}\)= Change in spot exchange rate.

\(P_f\) = Foreign price level quoted in terms of the foreign currency.

\(?P_f\)= Change in foreign price levels.

\(P_d\)= Domestic price level in terms of the domestic currency.

\(?P_d\)= Change in the domestic price level.

Example: Change in Real Exchange Rate

Consider two countries: Canada and the United States of America, where the US is the domestic country. The nominal exchange rate is CAD/USD = 1.25. If the price level in the USA increases by 4% and the price level in Canada increases by 2%, what is the new real exchange rate, assuming the nominal exchange rate remains unchanged?

Solution

Price level increase in the USA: 4%

Price level increase in Canada: 5%

Using the formula:

$$\left(1+\frac{\Delta S_{d/f}}{S_{d/f}}\right)\times \frac{\left(1+\frac{\Delta P_f}{P_f}\right)}{\left(1+\frac{\Delta P_d}{P_d}\right)}-1$$

Using the values from the example:

\(\Delta S_{USD/CAD}\ =0\)

\(S_{USD/CAD}=\frac{1}{1.25}=0.8\)

\(\Delta P_{CAD}\) =2%=0.02

\(P_{CAD}\) =100%=1

\(\Delta P_{USD}\) =4%=0.04

\(P_{USD}\)=100%=1

Plugging in the values:

$$\begin{align}&=\left(1+\frac{0}{0.8}\right)\times\left(\frac{1+0.02}{1+0.04}\right)-1\\&=\left(1\right)\times\left(\frac{1.02}{1.04}\right)-1\\ &\approx 0.98077-1=-0.01923\end{align}$$

The change in the real exchange rate is approximately -1.923%, which means the real exchange rate decreased by approximately 1.923%, meaning that an American’s real purchasing power relative to Canadian goods has decreased by 1.923%.

Although the nominal exchange rate remained the same, the varying inflation rates between the two countries caused the real exchange rate to decline, signifying a real depreciation of the USD against the CAD.

This real depreciation of the USD could be due to the higher inflation in the United States compared to Canada. When a country has a higher inflation rate relative to another country, the purchasing power of its currency decreases, which leads to a decrease in the real exchange rate.

Note: Real exchange rates are constructed by analysts to help them understand an economy’s national competitiveness and a currency’s real purchasing power.

Market Participants

The foreign exchange (FX) market consists of various participants ranging from multi-billion-dollar investment funds to individuals. These participants can be broadly categorized into the buy and sell sides.

Buy Side Participants

• Corporate accounts:  These comprise businesses of all sizes participating in FX transactions when they buy and sell goods and services across borders, engage in international mergers and acquisitions (M&A), invest in foreign assets, or borrow in foreign currencies.
• Real money accounts: These are investment funds managed by insurance firms, mutual funds, pension funds, endowments, ETFs, and other institutions. They typically have limitations on using leverage or financial derivatives.
• Leveraged accounts: This category includes hedge funds, proprietary trading firms, CTAs, high-frequency algorithmic traders, bank trading desks and any active trading account that accepts and manages FX risk to generate profits. This category is also known as the professional trading community.
• Retail accounts: This category includes private individuals, smaller hedge funds, active traders, and households utilizing electronic trading platforms for currency conversion or speculative activities.
• Governments: These include government bodies requiring FX for transactions or to achieve public policy objectives, such as purchasing military equipment, maintaining foreign bases, and administering public pension plans and insurance schemes.
• Central banks: These entities intervene in FX markets to impact domestic currency values, manage foreign reserves, or address unstable and dysfunctional market situations.
• Sovereign Wealth Funds (SWFs): These are government-owned entities primarily focusing on investment activities rather than public policy objectives and managing international capital inflows resulting from current account surpluses.

Sell-Side Participants

• Large money center dealing banks: These are the largest multinational banks, such as Deutsche Bank, Citigroup, UBS, and HSBC, which provide competitive price quotes across a broad range of FX products.
• Second and third-tier banks: These are regional or local banks lacking the economies of scale, global client base, or IT expertise required to offer competitive pricing across a wide range of currencies and FX products. They often outsource FX services to larger tier-one banks.

Note that the FX market is highly dynamic and complex, with participants having a mix of hedging and speculative motives. In the case of public sector participants, public policy motives may also be a factor. This dynamic and complex interaction of participants and trading objectives in the FX Market makes it difficult to precisely predict movements in FX rates or describe the FX market with simple characterizations.

Market Composition

The global foreign exchange (FX) market encompasses spot transactions, forward transactions, and FX swaps. The Bank for International Settlements (BIS) conducts a triennial survey to analyze the size and distribution of global FX market flows.

Key Components of the FX Market

• Spot transactions: Involve the immediate exchange of currencies at the prevailing exchange rate.
• Forward transactions: Entail the exchange of currencies at a specified future date and a pre-agreed exchange rate.
• FX swaps: These are the combination of spot and forward transactions utilized for hedging purposes and securing foreign currency at more advantageous rates.

Exchange Rate Quotations

Exchange rates represent the value of one currency in terms of another and can be quoted in two ways: direct and indirect.

A direct quote involves the domestic currency as the price currency and the foreign currency as the base currency, while an indirect quote is the reverse.

In the quoting convention A/B, one unit of currency B buys a certain number of units of currency A.  Currency A is the price currency, and B is the base currency. (Note that the base currency is normally set to a quantity of one.)

A direct currency quote considers domestic currency as the price currency and foreign currency as the base currency. For instance, a French investor will view EUR/USD as the direct euro-US dollar exchange rate quoted in terms of the number of euros per dollar with the EUR as the price currency and the dollar as the foreign currency. Specifically, if EUR/USD = 1.2310, implies that 1 USD costs 1.2310 EUR.

In the case of the indirect quote, the domestic currency is the base currency, and the foreign currency is the price currency. For instance, for the above French investor, the direct quote EUR/USD = 1.2310 has a corresponding indirect quote of 1/ EUR/USD = USD/EUR = 0.8123, and in this indirect quote case, the EUR (domestic currency) is the base currency, and the dollar (foreign currency) is the price currency. Therefore, an indirect quote of 0.8123 implies that 1EUR costs 0.8113 dollars.

The professional FX market does not use the terms ‘direct’ or ‘indirect’ due to the varying domestic and foreign currencies based on one’s location.

Instead, a set of market conventions has been developed, where major currencies and their exchange rate quote conventions are standardized.

Note that there is always a mix of direct and indirect quotes in common market usage, and a market participant must get familiar with how the conventions are used.

Two-sided Price

The professional FX market operates on a two-sided price mechanism, which includes banks providing a “bid” (buying price) and an “offer” (selling price) when a client asks for an exchange rate quote. As we already know, exchange rates involve two currencies, and the terms “base currency” and “price currency” clarify the transaction.

The two-sided price reflects buying or selling the base currency:

• It shows how much of the price currency the client would receive for one unit of the base currency (bid).
• It also indicates how much of the price currency the client needs to give to the bank to get one unit of the base currency (offer).

For instance, consider the bid/offer quote of CHF/EUR = 1.160-1.1622. In this case, the euro (EUR) is the base currency. A quote of 1.1620-1.1622 implies that the client will receive CHF1.1620 for selling EUR1 to the dealer and pay 1.1622 to buy EUR1.

The bid price is normally lower than the offer price, and banks profit from bid-offer spreads by buying currencies at a lower price and selling them at a higher price.

However, the bid-offer spreads are very low in the professional FX market due to competition and an efficient electronic FX system that connects buyers to sellers globally.

The majority of primary spot exchange rates are often expressed to four decimal points. However, the yen is an exception among the main currencies, with its spot exchange rates usually given to just two decimal points. For instance, while a USD/EUR rate might be displayed as 1.1601, a JPY/EUR rate would show as 1311.88.

Example: Calculating Bid/Offer Quote

If the bid/offer quote from a trader is 25.6250–25.6300 INR/USD, then the bid/offer quote in USD/INR terms would be closest to:

1. 03901–0.03902.
2. 03902–0.03901.
3. 039015–0.039015.

Solution

The correct answer is A.

An INR/USD quote represents the amount of Indian rupees the trader is bidding (offering) to purchase (sell) USD1. The trader’s bid to buy USD1 at INR25.6250 is similar to the trader handing over INR25.6250 to buy USD1. When you divide both terms by 25.6250, it means the trader is handing over (i.e., selling) INR1 to buy USD0.03902. This becomes the offer in USD/INR terms. The trader is willing to sell INR1 for a price of USD0.03902.

In USD/INR terms, the trader’s bid for INR1 is 0.03901, determined by inverting the offer of 25.6300 in INR/USD terms (1/25.6300 = 0.03901). It’s crucial to remember that in any bid/offer quote, irrespective of the base or price currencies chosen, the bid is always lower than the offer.

Percentage Appreciation/Depreciation of Exchange Rates

When describing exchange rate changes as a percentage appreciation or depreciation, it’s crucial to determine the price currency and the base currency.

For example, if KSH/USD =145, it implies that one unit of US dollar will buy 145 units of Kenyan shillings. Intuitively, if KSH/USD decreases, it implies that USD costs less or fewer KSH is needed to purchase the US dollar. In this case, the decline in KSH/USD implies that KSH has appreciated against the USD, or, in other words, the USD has depreciated against KSH.

Example: Appreciation and Depreciation of Exchange Rates

To calculate the percentage change, one must clearly understand the base and price currencies.  Take the Chinese Yuan (CNY) and South African Rand (ZAR) example. Assume that the ZAR/CNY exchange rate increased from 1.6459 to 1.8356. Therefore, the percentage appreciation will be:

$$\frac{1.8356}{1.6459}–1=11.5256\%$$

This represents an 11.5256 percent appreciation in the Chinese Yuan against the South African Rand. The ZAR/CNY exchange rate is expressed with the Chinese Yuan as the base currency and the South African Rand as the price currency. In other words, you now need more South African Rands to buy one Chinese Yuan.

The appreciation of the Chinese Yuan against the South African Rand can also be expressed as a depreciation of the South African Rand against the Chinese Yuan. However, in this case, the depreciation percentage will not be equal to the previous appreciation percentage of 11.5256%.

To calculate the depreciation percentage of the South African Rand when the exchange rate ZAR/CNY increased from 1.6459 to 1.8356, we need to invert the exchange rate from ZAR/CNY to CNY/ZAR, making the Chinese Yuan the price currency and the South African Rand the base currency. Here’s how you do it:

$$\frac{\frac{1}{1.8356}}{\frac{1}{1.6459}}–1=0.54480.6076-1=-10.3358\%$$

Question

Which of the following best describes a 4% appreciation in the ZAR/CNY exchange rate?

1. This represents a 4 percent appreciation in the South African Rand (ZAR) compared to the Chinese Yuan.
2. This represents a 4 percent appreciation in the Chinese Yuan (CNY) compared to the South African Rand.
3. This represents a 4 percent depreciation in the Chinese Yuan (CNY) compared to the South African Rand.

Solution

The correct answer is B.

A 4% appreciation in the ZAR/CNY exchange rate represents an appreciation of the base currency against the price currency. In this case, the Chinese Yuan appreciates against the South African Rand. Therefore, the appreciation represents a 4 percent increase in the Chinese Yuan relative to the South African Rand.