THE FOREIGN EXCHANGE MARKET

The foreign exchange market enables companies, fund
managers and banks to buy and sell foreign currencies, if
necessary in large amounts. The motivations behind this
demand for foreign currency include capital flows arising
from trade in goods and services, cross-border
investment and loans and speculation on the future level
of exchange rates. The sums involved are very large:
estimated global turnover in all currencies in April 1998
was $1,490 billion, an increase of 26 percent over the
past three years. Deals are typically for amounts
between $3 million and $10 million, though much larger
transactions are often done.
Foreign exchange trading may be for spot or forward
delivery. Generally, spot transactions are undertaken
for an actual exchange of currencies (delivery or
settlement) two business days later (the value date).
Forward transactions involve a delivery date further
into the future, possibly as far as a year or more ahead.
By buying or selling in the forward market a bank can,
on its own behalf or that of a customer, protect the
value of anticipated flows of foreign currency, in
terms of its domestic currency, from exchange rate
volatility.
Unlike some financial markets, the foreign exchange
market has no single location - foreign exchange is not
dealt across a trading floor. Instead, trading is via
telephone and computer links between dealers in
different centres and, indeed, different continents.
London is the world’s largest foreign exchange centre:
average daily turnover is $637 billion. This is
approximately the same as the combined level of
trading in the United States, Japan and Singapore
(see Box 1).
London’s leading position arises partly from the large
volume of international financial business generated
here - insurance, bonds, shipping, equities,
commodities and banking. London also benefits from
its geographical location which enables firms located
here to trade not only with each other and with firms
based in Europe throughout the day, but also with the
US and the Far East, whereas their time difference
makes it difficult for firms in those two centres to trade
with each other. When banks in London begin trading
at 8 am they can deal with banks in Tokyo, Hong Kong
or Singapore whose trading day is just ending. From
about 1 pm onwards, London banks can trade with
banks in New York; before they close at 4 pm their
counterparties may be in Los Angeles or San Francisco.
This is important because the foreign exchange market
trades 24 hours a day: 66 percent of trades involving a
firm in London are transacted with a counterparty
located abroad.
THE PARTICIPANTS
Broadly speaking, there are three types of participant in the
market: customers, banks and brokers. Customers, such as
multinational corporations, are in the market because they
require foreign currency in the course of their cross border
trade or investment business. For example, an engineering
firm based in the United Kingdom might use the foreign
exchange market to buy the dollars it needs to pay to a firm in
America selling it raw materials; in this instance it would sell
sterling and buy dollars. Commercial banks are by far the
most active participants in the foreign exchange market
(see Box 4). Some deal with other financial institutions and
corporations who contact them, typically by telephone, to ask
for their rates, and may then buy foreign currency from, or
sell, to the bank at those rates. This is known as market
making: the banks will at all times quote buying or selling
rates for pairs of currencies - dollars to the pound, Japanese
yen to the dollar and so on. The market makers earn a profit
on the difference between their buying and selling rates, but
THE FOREIGN
EXCHANGE MARKET
AVERAGE DAILY FOREIGN EXCHANGE Box 1
MARKET TURNOVER IN THE MAIN CENTRES
April 1998 US$ Billions
United Kingdom 637
United States 351
Japan 149
Singapore 139
Germany 94
Switzerland 82
Hong Kong 79
France 72
Source: Surveys conducted by national central banks,
co-ordinated by the Bank for International Settlements
A P R I L 2 0 0 0
FACT SHEET
they have to be ready to change their prices very quickly in
order to avoid holding a currency whose value is falling
(depreciating), or being short of a currency which is rising
(appreciating). Banks also deal on behalf of corporations and
other, typically smaller, banks. The third type of participant,
the brokers, act as intermediaries between the banks. They
are specialist companies with computer links or telephone
lines to banks throughout the world so that at any time they
should know which bank has the highest bid (buying) rate for
a currency, and which the lowest offer (selling) rate. By
using a broker it should, therefore, be possible for banks to
find the best dealing rate currently available. The broker
does not deal on its own account, but charges a commission
for its services.
DEALING IN THE SPOT & FORWARD MARKETS
To execute a spot deal in the market, a dealer contacts his
counterpart at a market-making bank and asks for his price in,
for example “sterling-dollar” (i.e US dollars to the British
pound). The market maker normally quotes a two-way price -
that is he stands ready to bid for or offer up to some standard
amount. The difference between these two prices is known as
the spread. For the sake of convenience, the market
convention where trading is between banks is not to quote the
“big figures” (i.e pounds and pence, dollars and cents); instead,
dealers tend to quote only the points (the last two figures of the
price). For example, if the rate for pounds against the dollar
was £1 = US$ 1.6315-25 then the market maker would quote
“fifteen-twenty five”: he bids for pounds at $1.6315 and offers
them at $1.6325. If the market maker wishes to deal he will
hit, that is accept, one side of the price. Written confirmation
of this oral contract will be exchanged and instructions
concerning payment given, and passed on to the settlements
staff who ensure that the respective currency amounts are
transferred into the designated accounts on the value date.
Quotation of prices and dealing in the forward market are
rather different from spot dealing. Theoretically it is possible
for the forward price of a currency to equal its spot price. But
because the interest rate that can be earned by holding different
currencies usually varies, in practice the forward price is
normally higher or lower than (at a premium or a discount to)
the spot rate (see Box 2 for the method of calculation). For
convenience, forward prices are not quoted outright, and
instead dealers quote the differential (the premium or
discount). This practice has a number of benefits. Premiums
and discounts are subject to much less fluctuation than are spot
rates, so quoting the differentials requires far fewer changes to
published prices. Furthermore, foreign exchange swaps
(combining a spot purchase with a simultaneous forward sale,
or vice-versa) are based on the differentials with the actual spot
rate being of relatively little consequence.
Premiums and discounts reflect the interest rate differentials
between currencies at the time the deal is done; the
determination of the forward rate does not depend directly on
THE DETERMINATION OF FORWARD RATES Box 2
The forward rate is equivalent to the spot rate plus a
premium or minus a discount. The forward premium or
discount is determined by means of the following general
equation which is adjusted to take account of whether the
discount/premium or the bid/offered rate is being
calculated:
Spot rate x (interest rate differential, i.e. $ interest rate - EUR interest rate) x days/360
1 + (EUR interest rate x days/360)
To calculate, for example, the six month forward rate for
the Euro against the Dollar by determining the necessary
adjustment (premium/discount), the following information
is also needed:
BID OFFER
Spot exchange rate (€/=$US) 0.9720 0.9725
6 month $ interest rate 61/4% 63/8%
6 month Euro interest rate 35/8% 33/4%
So offer rate equation is:
0.9725 x (.06375 - .03625) x 182/360)
1 + (.003625 x 182/360)
= -.013280
And the bid rate equation is:
0.9720 x (.0625 - .0375) x 182/360
1 + (.0375 x 182/360)
= -.012056
So the forward rates are 0.9841 (bid) and 0.9858 (offered)
FUTURES AND OPTIONS Box 3
Currency futures are forward transactions with standard
contract sizes and maturity dates (e.g US dollars 125,000
for settlement in December) which are traded on a
formal exchange. Because futures contracts are
standardised, they are less flexible than forward
contracts. Dealing in futures also involves certain
transactions costs, such as the costs of being, or trading
through, a member of the exchange. But, futures do
provide the opportunity to deal in smaller amounts than
in the spot/forward markets and to obtain a considerable
exposure with a small capital outlay, since the initial
capital outlay is small relative to the contract size.
Currency options provide the buyer with the right, but
not the obligation, to sell or buy an amount of foreign
currency at an exchange rate and date specified in
advance. The buyer must pay a premium to the writer of
the option (which is often a bank). Currency options
allow the user to guarantee the buying price (call) or
selling price (put) of a currency without foregoing the
opportunity to benefit from favourable exchange rate
movements, as the user can buy or sell in the spot market
if the price is better. The writer of an option benefits
from the premiums received but, because it stands
committed to buy or sell currency at the pre-agreed
exchange, it faces the risk of losses arising from
exchange rate movements.
any estimation of what the future exchange rates in question
are likely to be. Thus, if a currency with a high interest rate
is sold forward in exchange for a currency with a lower
interest rate, then the seller continues to enjoy the benefit of
the higher interest rate for the period until the value date.
However, the buyer must wait to obtain the currency on
which it can earn the higher interest rate. This imbalance is
compensated by the purchaser receiving a discount on the
spot exchange rate in a deal undertaken for forward
settlement.
A forward transaction can be “closed out” at any time by
means of another forward transaction to sell or repurchase the
foreign currency for the original value date.
Forward transactions are a flexible and commonly used
method of protecting the value of future flows of foreign
currency in terms of the domestic currency of a firm or bank.
As the foreign exchange market has grown, so other
instruments such as futures and options (see Box 3) have
developed to facilitate the protection, or hedging, of foreign
exchange commitments.
THE DETERMINATION OF EXCHANGE RATES
In the long run, the demand for one country’s currency in
terms of another country’s currency is determined by real
economic factors. The exchange rate is influenced by relative
inflation, growth and interest rates and trade and investment
flows between countries. Foreign exchange dealers therefore
closely monitor announcements of new economic statistics on
the major world economies. When economic releases are out
of line with forecasts, dealers alter the rates they are quoting
to reflect the implied change in their assessment of the
currency’s value.
Since changes within and between different governments
often lead to changes in economic and financial policies,
political developments can also affect the foreign exchange
market. The market may therefore react to changes in public
opinion polls or other news items which have implications for
future political developments. But expected news, whether
economic or political, rarely moves exchange rates - the
effect will already have been anticipated or “discounted”.
Unexpected news, such as a country changing the regime it
favours for managing its currency, or unanticipated problems
in a nation’s economy, however, can lead to sudden and sharp
exchange rate movements.
Alongside these fundamental considerations, banks and
brokers undertake “technical analysis”, studying market
movements by means of charts showing the movement of
exchange rates over time. Charts can be used to extrapolate
from past movements. Technical analysis is based on the
underlying assumption that price movements follow broadly
predictable patterns which reflect market psychology, and
that past patterns can thus give an indication to possible
future trends.
THE MARKET IN LONDON Box 4
Participants
The vast majority of foreign exchange business in London
is accounted for by trading between banks: in April 1998,
domestic and international inter-bank transactions
accounted for 83 percent of trading, up from 75 percent in
1995. Of the remainder of banks’ trading activity, 9.5
percent was with other, non-bank financial institutions such
as pension funds and asset managers; non-financial
institutions, such as multinational corporations, account for
just over 7 percent.
The proportion of principals’ business handled by brokers
is now 27 percent, down from 35 percent in 1995.
However, electronic broking systems have continued to
take market share away from traditional, telephone-based,
voice brokers: the proportion of business conducted by
voice brokers has fallen to 16 percent, from 30 percent in
1995; the share of electronic brokers such as Reuters and
EBS has risen from 5 percent to 11 percent.
Spot transactions
Over the past 15 years, spot business has not grown as fast
as forward business: forward transactions now account for
65 percent of turnover, compared with 27 percent in 1986.
In the forward market, most of the transactions are swaps,
which are often used to hedge currency risk and manage
liquidity.
Currency composition
The most widely traded currency pairs are US$/€, US$/¥
and £/US$. A wide range of currencies are traded in
London; unlike other European financial centres, trading in
the domestic currency accounts for a small proportion of
turnover. Only 18 percent of turnover in the UK involves
sterling; this compares with domestic currency trading
accounting for 66 percent of turnover in Germany,
41 percent in France and 39 percent in Switzerland.
Market share of overseas banks
About 15 percent of the foreign exchange business in
London transacted by banks is done by UK institutions and
the remaining 85 percent by overseas banks. North
American principals are the most active, with a 49 percent
share, followed by UK principals (15 percent) and Japanese
(7 percent)
Source: Bank of England Survey, April 1998
Cross-border interbank 57.9%
(approx. $369.3 bn per day)
Domestic interbank 25.2%
(approx. $160.9 bn per day)
Other financial institutions 9.5%
(approx. $60.5 bn per day)
Non-financial institutions 7.3%
(approx. $46.6 bn per day)
Average daily turnover by counterparty
THE ROLE OF GOVERNMENT AND CENTRAL BANKS
Not only is the exchange rate influenced by real economic
variables, but its level and volatility also have an impact (both
direct and indirect) on these same economic factors. Even
modest changes in the value of a currency can have significant
effects on business and the national economy more generally.
If a currency were to weaken excessively, it would put
upward pressure on domestic inflation as imports and
internationally tradeable goods produced domestically rose in
price: the cost, in terms of the domestic currency, of buying
foreign currency is higher at a weaker exchange rate.
Conversely, a strengthening currency might lead to a fall in
import prices and lower domestic inflation: the cost of
buying foreign currency in terms of the domestic currency is
lower at a stronger exchange rate. Domestic producers
would need to contain their costs in order to remain
internationally competitive. Otherwise their profitability and
the level of growth and employemnt in the economy as a
whole might fall.
The pound (‘sterling’) is currently allowed to “float” freely
against all other currencies. This means that the authorities
are not committed to maintaining the market value of sterling
within a pre-announced range against any other currency.
Sterling was a member of the Exchange Rate Mechanism of
the European Monetary System from 8 October 1990 until
16 September 1992. During this period sterling’s ability to
fluctuate against the other participating currencies was
constrained by the central banks of participating countries,
who were committed to holding sterling within a margin of
6 percent on either side of its agreed central rates against each
of the other participating currencies.
The authorities have a number of means of influencing the
exchange rate. The Bank of England can intervene in the
foreign exchange market by buying or selling pounds which
would alter the supply of sterling relative to other currencies.
However, although intervention could be effective in
smoothing short-term fluctuations in the value of the pound,
it cannot resolve underlying economic problems, which have
to be addressed by more fundamental policy measures.
Although monetary policy can influence the level of the
exchange rate, the overall objective of monetary policy in the
UK is the achievement of domestic price stability, as defined
by the inflation target set by the Government.
The Government’s foreign exchange reserves are
approximately $35 billion; in addition, the Bank of England
has approximately $4 billion of holdings of foreign currency
and gold. A principal source of the reserves is borrowing by
the government in foreign currency. The other main source is
intervention. When the Bank of England intervenes to buy
foreign currencies (and sells sterling), the proceeds will be
added to the reserves. On the other hand, sales of foreign
currencies to protect the value of sterling will reduce the
reserves. However, this does not mean that the reserves have
been spent: the foreign exchange reserve “asset” has merely
been converted into a sterling one.
THE EFFECTIVE EXCHANGE RATE Box 5
An effective exchange rate is a measure of the value of a
currency against several other currencies (a “basket”) at
once. It is calculated as a weighted geometric average of
exchange rates and expressed as an index relative to a
base year. (In the chart below the base year is 1990,
when the sterling’s average level was 100). Because the
effective exchange rate is an average of a currency’s
exchange rates, it is often more useful when looking at
the value of a currency over a long period than a single
exchange rate (such as sterling-dollar). The higher the
index figure, the stronger the currency. In the chart
below the weight given to each currency in the basket is
derived from the trade flows in manufactured goods and
represents the relative importance of the country in
question as a competitor in export markets. The weights
are revised periodically to accommodate countries’
changing economic circumstances.