A Guide to Foreign Exchange Markets K. Alec Chrys talHE economies ofthe free world are becoming increasingly interdependent. U.S. exports now amount to almost 10 percent ofGross Nati ona l Produ ct. For both Britain and Canada, the figure currently exceeds 25 percent. Imports are about the same size. Trade ofthis mag nitude would not be possible wi thout the abili ty to buy and sell currencies. Curre ncies must be bought and sold because the acceptable means ofpay- ment in other countries is not the U.S. dollar. As a result, impo rters , exporters, travel agents, tourists and many others with overseas business must change dol- lars into foreign currency and/or the reverse. The trading ofcurrencies takes place in foreign ex- chang e market s whose major function is to facilitate international trade and investment. Foreign exchange markets, however, are shrouded in mystery. One reason for this is that a considerable amount offoreign exchange market activity does not appear to be related directly to the needs ofinternational trade and invest- ment. The purpose ofthis paper is to expl ain how these markets work. 1 The basics offoreign exchange will first K. AlecChrystal, professorofeconomics-elect, Universi tyofSheffield, England, isavisitingscholarattheFederalReserveBankofSt. Louis. Leslie Baili sKoppelprovidedresearchassistance. Theauthorwishesto than k Jose phHernpen, CenterreBank, St. Louis, forhisadviceon thispaper. 1 For further discussion of foreign exchange markets in the United States, see Kubarych (1983). See also Dutey and Giddy (1978) and McKinnon (1979). be described. This will be followed by a discussion ofsome ofthe more important activities ofmarket partici- pants. Finally, there will be an introduction to the analysis ofa new feature ofexchange markets — cur- rency options. The concern ofthis paper is with the structure and mechanics offoreign exchange markets, not with the detemiinants ofexchange rates them- selves. THE BASICS OF FOREIGN EXCHANGE MARKETS There is an almost bewildering variety offoreign exchange markets. Spot markets and forward markets abound in a number ofcurrencies. tn additio n, there are div erse price s quoted for these currencies. This section attempts to bring order to this seeming dis- array. Spot) Forward, Bid, AskVirtually every major newspaper, such as the Wall StreetJournal or the London Financial Times, prints a daily list ofexchange rates. These are expressed either as the number ofunits ofa partic ular curren cy that exchan ge for one U.S. dollar or as the number ofU.S. dol lars that exchan ge for one unit ofa particular cur- rency. Sometimes both are list ed side by s id e s ee table Il. For maj or curren cies, up to four different price s typically will be quoted . One is the “spot” pric e. The others may be ‘30 days forward,” 90 days forward,” 5
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increasingly interdependent. U.S. exports now amount
to almost 10 percent of Gross National Product. For
both Britain and Canada, the figure currently exceeds
25 percent. Imports are about the same size. Trade of this magnitude would not be possible without the
ability to buy and sell currencies. Currencies must be
bought and sold because the acceptable means of pay-
ment in other countries is not the U.S. dollar. As a
result, importers, exporters, travel agents, tourists andmany others with overseas business must change dol-
lars into foreign currency and/or the reverse.
The trading of currencies takes place in foreign ex-
change markets whose major function is to facilitate
international trade and investment. Foreign exchange
markets, however, are shrouded in mystery. One
reason for this is that a considerable amount of foreign
exchange market activity does not appear to be related
directly to the needs of international trade and invest-
ment.
The purpose of this paper is to explain how these
markets work.1
The basics of foreign exchange will first
K. Alec Chrystal, professor of economics-elect, University of Sheffield, England, is a visiting scholar at the Federal Reserve Bank of St. Louis. Leslie Bailis Koppel provided research assistance. The author wishes to thank Joseph Hernpen, Centerre Bank, St. Louis, for his advice on this paper.1
For further discussion of foreign exchange markets in the United
States, see Kubarych (1983). See also Dutey and Giddy (1978) andMcKinnon (1979).
be described. This will be followed by a discussion of
some of the more important activities of market partici-
pants. Finally, there will be an introduction to the
analysis of a new feature of exchange markets — cur-
rency options. The concern of this paper is with the
structure and mechanics of foreign exchange markets,
not with the detemiinants of exchange rates them-
selves.
THE BASICS OF FOREIGN EXCHANGE
MARKETSThere is an almost bewildering variety of foreign
exchange markets. Spot markets and forward markets
abound in a number of currencies. tn addition, there
are diverse prices quoted for these currencies. This
section attempts to bring order to this seeming dis-
array.
Spot) Forward, Bid, Ask
Virtually every major newspaper, such as the Wall
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 thatexchange for one U.S. dollar or as the number of U.S.
dollars that exchange for one unit of a particular cur-
rency. Sometimes both are listed side by side see
table Il.
For major currencies, up to four different prices
typically will be quoted. One is the “spot” price. Theothers may be ‘30 days forward,” 90 days forward,”
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 futuredate (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 of goods in foreigncurrency 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
the buying and selling price is sometimes known as the
bid-ask spread.” The spread partly reflects the banks’costs and profit margins in transactions; however, ma-
jor banks make their profits more from capital gains
than from the spread.2
‘rhe market for bank notes arid travelers checks is
quite separate from the interbank foreign exchange
market. For smaller currency exchanges, such as an
individual going on vacation abroad might make, the
spread is greater than in the interbank market. ‘Ibis
presumably reflects the larger average costs — includ-
ing the exchange rate risks that banks face by holding
banknotes in denominations too small to be sold in the
interbank market — associated with these smaller ex-changes. As a result, individuals generally paya higher
price for foreign exchange than those quoted in the
newspapers.
tNotice the Wall Street Journal quotes only a bank selling price at aparticular time. The Financial Times quotes the bid-ask spread andthe range over the day.
\ii ix~ttiipIrtil tlit’ iirigr ol 51)01 V\rllZIilizi’ rates a%ail
able is presented ui table Z. which .sIiow% prires or
cli’iitsrhic’iiuiiLs and St(i’liIiL4 (ILIOttLI ~~ithin a one—Iii,tir
iit’iiiitl cii) \c,\c’n)l,i’r-25 1983 I lien’ are t~~(i ii1,cii’tant
h)OiiitS 1(1 t’iijti(i’. I ii’,! all c’’~ec’pltlici,,c’ iii tin’ lirsi lie
‘‘I’ I~ir’s qtiott’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
prices have a hid-ask spread ol cinI~0 I ccitt ~vhiich i’.
oiiI~ahlotil 0.07 percent cit the price or 57 on S 10.000
On Ifli. the ~pic’~id per dollar-s norih ~~oiks out 1cr hi’
abont hall that on sterling ‘54 on .410.000
Sc.’c’oi)(l. tIt’ ~Ilces c1
iiciti’d I,,’ local hank,. lorsriiall. n’
ct’tzul. ti-arisat-ticins which ‘,er~eonly as a uuiclr and doriot rierev,arl\ nrpiesciit prices on actual clc’als. iii—
‘. oItc’ a iiiiic1 I.ii-ger- h,icl—~tsL spi’t’.ttl I hic’se rtails
1,rvzccls ,.ar; tc-c,r)) Ii;,iik Ic, bank. but are i elated to ‘and
larger than the inlethztnk iate’,. Iii sonic cases. thin
In practice, the spread w I va~during Inc day depending uponmarket corrditiops Fnr example the slorl,np spreadmay he as litheas 001 cents at ti~iesana or averages about 0.05 cents Spreadsqenert-;yw,’i h~arger on ‘ess wioeiy traded cijrrcnc es
interest rates denominated in dollars and interest rates
denominated in, say, pounds being somewhat differ-
ent. However, real returns on assets of similar quality
should be the same if the exchange rate r-isk is covered
or’ hedged in the forward market. Wet’e this not true, it
would be possible to borrow in one cur-i-ency and lend
in another at a profit with no exchange risk.
Suppose we lend one dollar for a year in the United
States at an interest rate of r,,~.The amount accumu-
lated at the end of the year per dollar lent will be I + r~,8
(capital plus interest) - If, instead of making dollar loans,
we converted them into pounds and lent them in the
United Kingdom at the rate r~4
k,the amount of pounds
we would have for each original dollar at the end of the
year would be Sf1 + r~k(,where S is the spot exchange
rate (in pounds per dollar( at the beginning of the
period. At the outset, it is not known if 1 + r~,5dollars is
going to be worth more than 5(1 + r~k(pounds in ayear’s time because the spot exchange rate in a year’s
time is unknown. This uncertainty can be avoided byselling the pounds forward into dollar’s. ‘[hen the rela-
tive value of the two loans would no longer depend on
what subsequently happens to the spot exchange rate.
By doing this, we end up with (1 + r~,k(dollars per
original dollar invested. This is known as the ‘cov-
ered,’ or hedged, return on pounds.
Since the covered return in our example is denomi-
nated in dollars, it can reasonably be compared with
the U.S. interest rate. If these returns are very different,
investors will move funds where the retur-n is highest
on a covered basis. This process is interest arbitrage. It
is assumed that the assets involved are equally safeand, because the returns are covered, all exchange risk
is avoided. Of course, if funds do move in large volume
between assets or between financial centers, then in-
terest rates and the exchange rates (spot and forwardi
will change in predictable ways. Funds will continue to
flow between countries until there is no extra profit to
be made from interest arbitr-age. This will occur when
the returns on both dollar-- and sterling-denominated
assets are equal, that is, when
If (1+r~8
) = n+r~kL
Speculation
Arbitrage in the foreign exchange markets involve
little or- no risk since transactions can be complete
rapidly. An alternative source of profit is available from
ourguessing other market participants as to what f
ture exchange rates will be. This is called speculation
Although any foreign exchange transaction that is no
entirely hedged forward has a speculative elemen
only deliberate speculation for’ profit is discussed here
Until recently, the main foreign exchange specul
tors were the foreign exchange departments of bank
with a lesser role being played by portfolio managers
other financial institutions and international corpora
tions. The 1MM, however, has made it much easier’ fo
individuals and smaller businesses to speculate. A hig
proportion of 1MM transactions appears to be specul
tive in the sense that only about 5 percent of contract
lead to ultimate delivery of foreign exchange. Th
means that most of the activity involves the buying an
selling of a contract at d~ffcrent times and possibldifferent prices prior to maturity. It is possible, how
ever, that buying and selling of contracts before matu
rity would arise out of a str-ate~’to reduce risk. So it
not possible to say that all such activity is speculative
Speculation is important for the efficient working
foreign exchange markets. It is a form of arbitrage tha
occurs across time rather than across space or btween markets at the same time. Just as arbitrage in
creases the efficiency of markets by keeping price
consistent, so speculation increases the efficiency
forward, futures and options markets by keeping thos
markets liquid. Those who wish to avoid foreign echange risk may thereby do so in a well-develope
market. Without speculators~,r’iskavoidance in foreig
exchange markets would be more difficult and, imany cases, impossible.”
Risk Reduction
Speculation clearly involves a shifting of risk from
one party to another. For example, if a bank buys fo
This result is known as covered interest parity. It holds
more or less exactly, subject only to a margin due totransaction costs, so long as the appropriate dollar’ and
sterling interest rates are compared.8
8Since there are many different interest rates, it obviously cannot holdfor allot them. Where (1) does hold is if the interest rates chosenareeurocurrencydeposit rates of the same duration. In otherwords, itfor
r~,we take, say, the three-month eurodollar deposit rate in Paris afor rUkwe take the three-montheurosterling deposit rate in Paris, th(1) will hold lust about exactly. Indeed, if we took the interest rate aexchange rate quotes all from the same bank, it would be remarkabif (I) did not hold. Otherwise the bank would be offering to pay youborrow from it and lend straight backl That is, the price of borrowiwould be less than the covered return on lending. A margin betweborrowing and lending rates, of course, will make thiseven less likso that in reality you would lose.
9This is not to say that all speculative activity is necessarilybeneficia
11w lotion rig iflti-nst ate anti n_change -alt- hid- ask spii’ad tin tin’ loin aid tate ~\otilII lii—
iIliiltatinns ale laken rum the London 1-iciniujal 1-1927 1 41)42.
I lOWS ol Si’pti9TthlT 8,1
9M3 litHe 1-. - \o~~let us see it nf’ nouilrl do hettei- to irv,.vst in a
( losing three—month eiiilister ing deposit iw a three—mouth
i,~change Hate Sj_n 3\tp~lil_ L12.1~%.~.1:iJ c-iir-tirlollai’ tte})t)sit t~lien! the (lOhlairs to he iTht9~’i’d
ili,llai-s pt-c- I-PUll- I 11)20 IT-- 22 discount war-i sold Ion~aitIinto stl’i log I hi’ ii’ttun F~~~-t100
potlIlCi iirtestitt ill (or SteIIiIl!4 is 2 369 annual iilti’i’r’st
iatt (II !P ti,.’ \\Iil,iiZls the iettii’n oil a eo~’eu’e.dcoin—inti’wst Rates. ltiix;stui ici~ I lilOdt)ilai -
—-—-— —- clolIztide1
iosit is
1 -\liiiilll ( )ilei- 9’’i,.
Rati’ i.-49t02.25I - tOO ‘~ - -- 1 i12 17 — mu
1 hi, uitei-est i-aU’ on the tIli’I!t’-illIJntii i’uiIltlollzii I I11~I2(lepllsit is a lii tie hcghei- 7 pecrent than that on an
- - liii is wi- could 1101 niakt’ a piulit out ol i:ovei’erleurusteruig dV
1)OsIt II hit’ c—.u’harige rule rt-malns . . -
- - Hltt’ti’st .trInii’age l)i~spite tile tail that dollar jji -
unchanged. it nould hi’ Imliet- to hold dollais, it the -
- tni’t’st rates art’ higher- till! iliscotirit till ton~ai-ddot—c!\tliatIgl’ i-ate tails, the t’oi’o-.teruig deposit would -
lw’s ill the lr,i’n art o1,Eiikeh 111(51115 they buy teweihi- pr-Ierahle SIi~}lose von decide to cm ti the e~ - . . _ -
- - . Iornanl jiouncis Asaiesolt. till-il! us no bent-lit to‘-hange rsk in sellicig the dollars tornarl into . - . . -
the opi~iation I i-an-,aclion costs toi’ iiinst 111111—piJililds. let its I lltliifltl’e liii’ i-ettii-ii to IIIJI(IIIlg Li
- - . - viduals ~~otitd hi, i~\ cii greater 111811 those ahtj~e ar~sic-i-hog deposit vt Itil the return ti) holiling a cloliw - -
- . thi’\. noi,ild hire a lie-get- hId ask spli-ati 111,11) thattIi’posil sold lornard into step mg !asstiiliit’ig that
i1
tiotid (ill ihi’ nitt’ihank market‘ on stat I xvii h sterling-.
- - cotist-i~tientI~- hi-ti’ is 10 ht’i’ielit lot tht~tvpi’aII ‘Vu unpor;int points i iced to lit, tlai lied atjr,tit - - - -
- en t-stoi- from nlakmg a i-ut eI’NI ui hedged etirlirLir-—till ahote data I- i-st 11111 interest iati~sart- arinrial— - . -
- ltlll\ deposit. tile rvttiiii ~tilt lit’ at least as high On aI/eli SI) the~alt, not t~hdinould actually In- eai-iit-d . -
- iit’I)Osit iii tht’ t’iiiii’iit’v inn 111th tOil starl and n-ishour a three-month pei-u;d liii- ri;implc. the tiuli!— - .. - -
III (‘11(1 u~i that is. ii oil ilat-li dollars aunt wish toinhiilth i-ate equivalent to au ajintiat -alt- ul 1W - - -
- - —
(‘11(1 ti}i ‘‘ ith dollars. niakt’ a enu-ollollar deposil-
Iipt~ier1t t~2-Is pei-~i-nt. - - -
ton hate stei’luig am! ttisii to (lId IiJ) t-t-nh stel-Ictlg.~‘econd, till’ Ii itt aid exehiangi’ rates need 501111 naki- a etiiister ing deposit ttvt;ti han, sti-ili ig arId
n_pianauioul I lit- dollLo- is at a discount against stir— ttisl) to thu till ill thillai’s lilt-i-i’ IS likely to lie 19th’ or
1mg Ibis ineatm the lijinac (I ilcihlin hovs 1155 stei— miii ditiereni-v hetnei-n holding a eiuiiisit-rhing up—
hug. So tte han- to mid the tlisroiiiit onto the spot
posil sold toi-nai-d into dtihliii’s In liuivirig diillais
pi~-~- to r41’t the torn-aid pun- heraose till- pu-ire is spoi nOd lioldi ig a t-tirodohlar deposit. ( )l clitilse iithe iltilllIfl’l ut doilztis per
1iotind. not the -eu’i st’ you hold ad tilIl’rrtl!rtl (leplJSit 81111 i-tc-haiigt’
\otuce also tint the llisl-IJtlrlt is tiit-asur’d iii tiiu-— i-aU’s sohisequemlv change, tin- irstilt will lie ten’
lions ol a ll’ilt 1101 ti-actions ol a (1()llai~So the dilli-it-ut
nar d lot eign i’srhange horn a i-usurullcr it 1111 cases its muumive tlu risk ul losses tile to une’tpertcll I’’
t’\pOsl.lI-c lii risk tthili till- rtcstomer reduces his I ton— rhunge I ate i-han~es ( )ne si uple wat to ito this is to
ncr lhc-c-e is 111)1 .1 ti\r-d amount ot risk that ills to hi’ eflsnr-e that assets and liatiitrties dcnurni sited in each
‘shai-ed (lilt Some siraleLies niat molt i-a net ‘cdiii’ operating riurrcnrt are equal. this is kulo\t las 11181111
tool lit risk all around iui,~. loi sample 1 hank that sells sterling lounard liii
1-ristorner- ni_n sonuitanrotrslv tim sterin~ Iou’nard In
general rote liriauicial inslituterns -or other this i-u-nt. the tlank is n_posed to I_eu-u e’¼1-hangi-rate
liinis:. ir1
Ierati ig n—i tar-il-It cii rio-rent es. ttill Ii to risk.
REFERENCES Federal Reserve Bank of New York. “Summary of Results of USForeign Exchange Market Turnover Survey Conducted in Apr
Belongia, Michael T. “Commodity Options: A New Risk Manage- 1983” (September 8, 1983).ment Toot for Agricultural Markets,” this Review (June/July 1983), Garman, Mark B., and Steven W. Kohlhagen. “Foreign Currencpp. 5—15. Option Values,” Journal of International Money and Finance (D
cember 1983), pp. 231—37.Black, Fisher, and Myron Scholes. “The Pricing of Options andCorporate Liabilities,” Journal of Political Economy (May/June Giddy, tan H. “Foreign Exchange Options,” Journal of Futures Ma1973), pp. 637—54. kets (Summer 1983), pp. 143—66,
Chrystal, K. Alec. “On the Theory of International Money” (paper Krugman, Paul, “Vehicle Currencies and the Structure of Intemnpresented to UK. International Economics Study Group Confer- tional Exchange,”Journal of Money, Credit and Banking (Augusence, September1982, Sussex, England). Forthcoming in J. Black 1980), pp. 513-26.and C, S. Dorrance, eds., Problems of International Finance (Lon- Kubarych, Roger M. Foreign Exchange Markets in the Unitedon: Macmillan, 1984). States. (Federal Reserve Bank of New York, 1983).
Dufey, Gunter, and Ian H. Giddy. The International Money Market McKinnon, Ronald I, Money in International Exchange: The Con(Prentice-Hall, 1978). vertible Currency System (Oxford University Press, 1979),