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A Brief Tutorial on FX Markets

Foreign exchange rates
A foreign exchange rate is the parity between two currencies i.e. the amount of one currency needed to sell (or buy) in order to buy (or sell) one unit of the other currency. There are two ways to express such a rate. The most common (or international way) quotes the amount of any currency that corresponds to one U.S.Dollar.

The other way is for example EURUSD and GBPUSD.

Bid and offer
Exchange rates in practice are quoted as two-way rates. Thus a dollar/swiss franc  quotation will read something like 0.90141/51. The bank or company which quotes this rate understands that it buys CHF (selling dollars) at 0.90151 and sells CHF (buying dollars at 0.90141). In other words it buys cheaper and sells dearer a given currency in exchange for the other one. Of course, the opposite is true for the person that asks for a quotation. The difference between the purchase and the sale rates is called “spread”. Such spreads vary in size according to market volatility.

Rate direction and currency direction
One needs to keep very clear in mind the idea of market direction. First of all, in the foreign extern market it is a mistake to say that the market is going up or down. In the stock market one can use this expression as stocks either go up or go down. However, in the FX market a rate as we said defines the parity of two currencies, hence at any time one goes up , so the other goes down. Therefore we can talk about the dollar going up or down but not about the market doing so. Another issue that often confuses people (even traders and bankers) is the difference between a currency moving up and its rate going up. We have to explain this in more detail as any misunderstanding can lead to painful surprises when trading in the real market. For simplicity reasons let us forget for the time being the bid/offer spread. So let us suppose that EURUSD move Up. In this case the rate goes up whereas the value of the Dollar goes down (simply because the value of the EUR goes up). In other words one needs more Dollars to exchange for one EUR.

Basis points or pips
A pip is the equivalent of 1/100 of 1% or one basis point.

Spot and forward rates
To some people these concepts are more easily understood as cash rates and futures. As a matter of fact we would not like to use the term “futures” here as this may lead to confusion with the typical futures contracts. Instead, let us use a more descriptive approach. A spot rate is the exchange rate which is valid for a transaction (purchase of currency A and sale of currency B) that must be concluded within the next two working days. Thus the value date (i.e. the day of actual delivery of currencies) of a transaction performed on a Monday is Wednesday. For Thursday it is Monday (weekend days are not counted). On the other hand, a forward transaction regards a deal which is concluded today and actual effect will take place on a fixed future date In the next paragraph we describe the relationship between a spot and a forward rate.

Interest rates, swap rates and forward rates
Many people, even in the financial sector think that a forward rate is an expectation or forecast of a future foreign exchange movement. This is a big mistake. Actually, a forward rate is nothing else but a mirror of the currently prevailing spot rate, allowing for the interest rate differential between the two currencies and the time period at the expiration of which the actual transaction will be concluded. So the spot rate is adjusted by the so called swap rate to give the forward rate. For the unsophisticated investor it is enough to say that the swap rate is there to compensate the low interest currency holder for the time period involved in a forward transaction.

The need for a forward market
The actual need for the existence of a foreign market is not speculation, today there is no clear-cut line between hedging and speculating. However, there are a couple of characteristic categories of people who use the forward market in order to cover for time lags. The first group includes exporters and importers. As receipts and payments do not usually coincide time wise, these people buy forward the currency that they will have to pay and sell forward the currency that they will receive. In this way they overcome undesirable market fluctuations and take care of future cash flows. The second group consists of people who use the forward market to preserve the value and nature of their assets without speculating against future trends. These operators use both the spot and forward market through swaps, which are explained below.

Swaps
A swap transaction (not to be confused with the swap rate) is a double-leg deal, in which one buys spot currency X selling currency Y and simultaneously sells forward currency X buying currency Y. Let us give an example to show the rational of such a transaction. Assume that an American investor has a future receipt in EUR. In addition, assume that he thinks that German bonds are presently a good investment. So he has dollar assets but does not hold cash in EUR. In plain words he needs EUR right now and cannot wait for the future receipt EUR to come. One solution would be to sell dollars and buy EUR in the spot market. However, suppose he does not wish in a foreign exchange adventure for he cannot forecast the exchange value of the future receipt. In this case he sells dollars against EUR spot getting his EUR and buying his bonds. Simultaneously he buys dollars forward against EUR matching the value date of the receipt. Upon expiration of the forward period, the investor cashes the receipt, pays back the EUR that he owes and gets his original dollars. Hence he has been able to overcome the time lag problem.

FX market and Money market
The last issue to be discussed in this brief walk is the non-difference between two markets that are the flip side of each other. We have already mentioned earlier that a swap rate is basically based on interest rate differentials. We have also explained in the previous paragraph the nature of a swap transaction. The investor who uses EUR bought in the forward market to buy German bonds has another option. He can place his dollars on deposit and borrow from the bank the EUR he needs. Hence, he will have a dollar deposit and a EUR loan. Indeed, the interest between what he gets and what he pays is also expressed through the swap rate Therefore, both ways lead to the same result. The only advantage going though the foreign exchange market rather than through the money market is simplicity i.e. usually it is faster and easier to obtain an FX facility rather than obtaining a loan, even one based on a collateralised deposit.

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