Foreign Currency Market

To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country’s currency or in U.S. dollars, which are accepted all over the world.

When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi riyals, even though the United States is not involved in the transaction.

The foreign exchange market, or the FX market, is where the buying and selling of different currencies takes place. The price of 1 currency in terms of another is called an exchange rate.

The market itself is actually a worldwide network of traders, connected by telephone lines and computer screens—there is no central headquarters. There are three main centers of trading, which handle the majority of all FX transactions—United Kingdom, United States, and Japan. Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market.

Trading goes on 24 hours a day: at 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day. The foreign exchange market is a 24/5 market—most currency trading occurs 24 hours per worldwide business day. The trading week starts when Monday morning first arrives in New Zealand and ends when it is late afternoon on Friday in San Francisco. Since New Zealand is just across the International Dateline, it is still Sunday in most of the world when it is Monday morning in New Zealand. So, for someone living on the east coast in the United States, the currency markets start opening about 5 p.m. Eastern Standard Time on Sunday.

The FX market is fast paced, volatile and enormous—it is the largest market in the world. In 2001 on average, an estimated $1,210 billion was traded each day—roughly equivalent to every person in the world trading $195 each day.

Foreign Exchange Market Participants

There are 4 types of market participants—banks, brokers, customers, and central banks.

With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.

Foreign Exchange Trading

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they predict the market correctly, they can profit from it; otherwise, they'll probably lose.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating that a currency is heading down, selling it short, then buying it back at a lower price later.

To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make a determination. If they determine that a currency is underpriced, then the trader will expect the price to rise, but if it is overpriced, then the currency will probably decrease in value with respect to another currency.

Currency Trading Between Banks

Banks are a major force in the FX market and employ a large number of traders. Trading between banks is done in 2 ways—through a broker or directly with each other.

Brokers

If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About 1/3 of transactions are arranged in this way.

Direct

Mostly, banks deal with each other directly. A trader makes a market for another by quoting 2 prices: the price at which he is willing to buy and the price at which he is willing to sell. The difference between the 2 price quotes is the spread, and is usually less than 10 pips. (1 pip = 1/10,000th of a currency unit for most currencies.)

Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal 1 unit of those currencies.

The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by 4 currencies: the U.S. dollar, the Euro, the Japanese yen and the British pound. Together these account for over 80 percent of the market.

It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.

Types of Transactions

Spot Transactions

This type of transaction accounts for almost 1/3 of all FX market transactions. Two parties agree on an exchange rate and trade currencies at that rate.

Spot Transaction: How it works

A trader calls another trader and asks for a price of a currency, say British pounds. This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell.
The second trader provides the first trader with prices for both buying and selling (2-way price).
When the traders agree to do business, one will send pounds and the other will send dollars.

By convention the payment is actually made 2 days later, but next day settlements are used as well.

Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks. Exchange rate fluctuations can effectively raise or lower prices and can be a financial planning ordeal for companies and individuals.

Exchange Risks in Spot Transactions

Suppose a U.S. company orders machine tools from a company in Japan.

Tools will be ready in 6 months and will cost 120 million yen. At the time of the order, the yen is trading at 120 to a dollar. The U.S. company budgets $1 million in Japanese yen to be paid when it receives the tools (120,000,000 yen¸ 120 yen per dollar = $1,000,000) .

There is no guarantee that the rate will remain the same 6 months later.

Suppose the rate drops to 100 yen per dollar:

Cost in U.S. dollars would increase (120,000,000, 100 = $1,200,000) by $200,000.

Conversely, if the rate goes up to 140 yen to a dollar:

Cost in U.S. dollars would decrease (120,000,000¸ 140 = $857,142.86) by over $142,000.

One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses 6 months’ interest and risks losing out on a favorable change in exchange rates.

Forward Transactions

One way to deal with the FX risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future and the transaction occurs on that date, regardless of what the market rates are then. The date can be a few days, months or years in the future. (See FX Forwards and Futures for more info.)

Futures

Foreign currency futures are forward transactions with standard contract sizes and maturity dates — for example, 500,000 British pounds for next November at an agreed rate. These contracts are traded on a separate exchange set up for that purpose.

Swap

The most common type of forward transaction is the currency swap. In a swap, 2 parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

Swap Transaction: How It Works

Suppose a U.S. company needs 15 million Japanese yen for a 3 month investment in Japan. It may agree to a rate of 150 yen to a dollar and swap $100,000 with a company willing to swap 15 million yen for 3 months After 3 months, the U.S. company returns the 15 million yen to the other company and gets back $100,000, with adjustments made for interest rate differentials.

In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that cannot be affected by any changes in the market rates. These tools allow the market participants to plan more safely, since they know in advance what their FX will cost. It also allows them to avoid an immediate outlay of cash.

Options

Most forward transactions require performance at the specified time. An option is similar to a forward transaction, but it gives its owner the right to buy or sell a specified amount of foreign currency at a specified price, called the strike price, at any time up to a specified expiration date, but without the obligation to do so. Options differ from other future arrangements for FX transactions because there is no obligation for the holder of the option to exercise it.

Depending on whether the option rate or the current market rate is more favorable, the owner may exercise the option or let the option expire, choosing instead to buy/sell currency in the market. This type of transaction allows the owner more flexibility than a swap or futures contract. Options can be sold and resold many times before the expiration date. Options serve as an insurance policy against the market moving in an unfavorable direction. A call option allows the holder to buy currency at a specified rate—the strike price. A put option allows the holder to sell currency at the strike price.

Option: How It Works

Suppose a trader purchases a 6-month call on 1 million euros at 0.88 U.S. dollars to a euro.

During the 6 months the trader can either purchase the euros at the 0.88 rate, or purchase them at the market rate. After 6 months, the option expires.