Lecture 5: The Foreign Exchange Market

Understanding Foreign Exchange Quotes

Where is this Financial Center?

La Defense in Paris: The View the Other Way

The Role of Big Banks in the FX Market Large global banks (e.g., Deutsche Bank and UBS) are

involved in the interbank (i.e., wholesale) FX markets through: (1) Their “external” clients” (Other large banks,

exporters, importers, multinational firms, central banks, large non-bank financial institutions) Acting in a broker capacity at the request of these clients.

(2) Their own banks (trading to generate profits). Acting in a “dealer” (i.e., trading) capacity Taking positions (long and short) in currencies to make a profit.

In dealing with external clients, these large banks are performing a “market maker” function: Quoting prices upon demand to other parties in the

interbank market, and Buying and selling currencies at their quoted prices.

“Making the Market” in FX The market maker function involves two primary

foreign exchange activities: (1) A willingness of the market maker to provide the

market with “on-going” (i.e., continuous) two way quotes upon request: (1) Provide a price at which they will buy a currency (2) Provide a price at which they will sell a currency

This function provides the market with transparency (2) A willingness of the market maker to actually buy

and/or sell at the prices they quote: Thus the market maker offers “firm” prices into the market!

This function provides the market with liquidity.

Base and Quote Currency Recall that a foreign exchange quote is simply

the ratio of one currency to another. Thus, a “complete” market maker quote consist

of two ISO designations (e.g., EUR/USD or USD/JPY): The first ISO currency quoted in the sequence is

referred to as the base currency. The second ISO currency quoted is referred to as the

quote currency. For examples above:

EUR/USD: EUR is the base currency and USD is the quote currency.

USD/JPY: USD is the base currency and JPY is the quote currency.

Bid and Ask Quotes A market maker always provides the market with

two prices, specifically a price at which the market maker will buy a currency and a price at which they will sell a currency.

Example: EUR/USD: 1.2102/1.2106 The first number quoted by the market maker is the

market maker’s buy price for 1 unit of the base currency ($1.2102). This is the market maker’s bid quote (or buy price)

The second quoted number is the market marker’s sell price for 1 unit of the base currency ($1.2106). This the market maker’s ask quote (or sell price)

Bid Ask Example Example: GBP/USD: 1.5535/1.5537. Assume you’re dealing with the market maker:

Questions: (1) How much will you pay for 1 pound; (2) how much will you get when you sell 1 pound; (3) how much will you pay for 1 U.S dollar; (4) how much will you get when you sell 1 U.S. dollar?

Answers:

Bid Ask Example Example: GBP/USD: 1.5535/1.5537. Assume you’re dealing with the market maker:

Questions: (1) How much will you pay for 1 pound; (2) how much will get when you sell 1 pound; (3) how much will you pay for 1 U.S dollar; (4) how much will you get when you sell 1 U.S. dollar?

Answers: (1) You can buy pounds for $1.5537 (ask price). (2) You will get $1.5535 for each pound you sell (bid

price). (3) You can buy 1 USD for 1/1.5535 = 64.37 pence. (4) When you sell 1 USD you will receive 1/1.5537 =

64.36 pence.

Bid Ask European Terms Example Assume the following USD/JPY: 76.35/76.45 (Note:

now the base currency is the dollar and the quote currency is the yen)

Assume you’re dealing with the market maker: Questions: (1) How much will you pay for 1 dollar; (2) how much will you get when you sell 1 dollar; (3) how much will you pay for 1 yen; (4) how much will you get when you sell 1 yen?

Answers:

Bid Ask European Terms Example Assume the following USD/JPY: 76.35/76.45 (Note: now the

base currency is the dollar and the quote currency is the yen) Assume you’re dealing with the market maker:

Question: (1) How much will you pay for 1 dollar; (2) how much will get when you sell 1 dollar; (3) how much will you pay for 1 yen; (4) how much will you get when you sell 1 yen?

Answers: (1) You can buy dollars for 76.45 (ask price). (2) You will get 76.35 for each dollar you sell (bid

price). (3) You can buy 1 yen for 1/76.35 = 0.0130975 cents. (4) When you sell 1 yen you will receive 1/76.45 =

0.0130804

Bid Ask Spreads The Bid Ask spread is the “profit” that a market maker

bank will make on a “round” transaction (i.e., buying and selling an equal amount at the stated price).

Regardless of the type of quote (American terms or European terms), the ask price is always higher than the bid. That is, what they will sell the base currency for is always

higher than what they will buy the base currency at.

Assume the following GBP/USD quote: 1.7921/1.7929 What is the dollar spread to the market maker on a “round”

transaction (assume 10 million pound transactions)? Ask $1.7929 x £10,000,000 = $17,929,000 (price to sell pounds) Bid $1.7921 x £10,000,000 = $17,921,000 (price to buy pounds) Spread (Commission) = $ 8,000 (on round transaction)

Pips (or Points) Pips (sometimes called points) refer to the smallest unit by which the

prices for the currency pair may vary. Pip stands for percentage in point.

In the example: GBP/USD: 1.5535/1.5537, the difference in the bid quote and ask quote lies in the fourth decimal place, or 2 pips. A Pip for a 4 decimal place quoted currency is actually 0.0001 of an exchange

rate Traditionally most currencies were quoted out to 4 decimal places, with

the Japanese Yen being the major an exception, being quoted only to the second decimal point (and thus a pip is 0.01 of an exchange rate).

Today, however, many currency pairs which were traditionally quoted to 4 decimal places are now sometimes being quoted out to 5 decimal places and the pairs which have former been quoted to 2 decimal places are quoted out to 3 and 4 decimal places. The reason is that new electronic platforms (e.g., ForexStreet) have entered the forex market and price competition has become greater. In response to this competition, many trading platforms have added an additional decimal place to their quotes.

Observations About Bid/Ask Spreads Bid and ask spreads (pip spreads) widen or narrow in

response to a number of factors, including: Bid/ask spreads increase with exchange rate volatility and

uncertainty. Bid/ask spreads decrease with increases in market maker

competition. Bid/ask spreads smaller in wholesale (interbank) market than in

retail market (and tourist market). Example: GPB/USD for September 26, 2011 Wholesale: 1.55145/1.55158; pip spread = 1.03 Retail: 1.5512/1.5516; pip spread = 4 Tourist retail (Wells Fargo quote): 1.4489/1.6152; pip spread = 1663 pips

Bid/ask spreads can differ slightly among market markets. As market makers attempt to adjust their positions and thus make dealing with

them more or less attractive.

Which Way is the Currency Moving? Remember when viewing a foreign exchange quote,

assign a value of 1 to the base currency (the base currency is the first in the ISO pair). The quotes you see refer to one unit of this base currency.

Thus, whenever bid or ask prices are moving up, that means that the base currency is getting stronger (relative to the quote currency) and the quote currency is getting weaker.

Conversely, whenever bid or ask prices are moving down, that means that the base currency is getting weaker (relative to the quote currency) and the quote currency is getting stronger.

Example: Which way is the Currency Moving?

Currency Sept 23 Sept 24 Foreign Currency

USD

EUR/USD 1.3475 1.3455

GBP/USD 1.5511 1.5518

USD/JPY 76.56 76.45

USD/CHF 0.9051 0.9059

Example: Which way is the Currency Moving?

Currency Sept 23 Sept 24 Foreign Currency

USD

EUR/USD 1.3475 1.3455 EUR weakened

USD strengthened

GBP/USD 1.5511 1.5518 GBP strengthened

USD weakened

USD/JPY 76.56 76.45 JPY strengthened

USD weakened

USD/CHF 0.9051 0.9059 CHF weakened

USD strengthened

Let’s Look at Real Time Currency Quotes Go to the following web-site: http://www.fxstreet.com/ At this site, go to:

Rates and Charts Go to Retail Rates Live

Select currency as USD Observe ISO quotes Observe bid and ask quotes. Understand what currency and at what price the market maker is

buying or selling (base currency). Understand what price you (a non-market maker) would buy or sell

the base currency to the market maker. Observe changes in bid and ask quotes.

If these are going up, the base currency is strengthening and the quote currency is weakening. Reverse is true if these are going down.

Next, link to: Interbank FX Rates Live and observe majors and G7 (note quotes to 5 decimal places)