FOREIGN EXCHANGE MARKET MECHANISM
Objective
1. Definition
2. Quotation Systems
a) Direct vs. Indirect
b) Spot Rate vs. Forward Rate
c) Bid vs. Ask
d) Outright vs. Point
e) Premium vs. Discount
f) Cross Rates
g) Appreciation vs. Depreciation
3. Potential Activities
a) Arbitrage
b) Hedging
c) Speculation
4. Spot Arbitrage: Location vs. Triangle
The Foreign Exchange Market
1.1 Participants:
a) Large Commercial Banks
b) Foreign Exchange Brokers
c) Commercial Customers
d) Central Banks
1.2 Size
1.3 Exchange rate is defined as price or value of a currency expressed in terms of units of
another currency. e.g. FF 2.00/$
2. Quotation Systems
2a. Spot Quotation: Whole sale price of one currency in terms of another
currency for immediate delivery.
(Two working days).
Forward Quotation: Whole sale price of one currency in terms of
another currency for future delivery, normally after 1,3 or 6 months.
2b. Direct Quotation: What is the unit of account?
Home Currency quoted for one unit of foreign currency. e.g. $7/DM
Indirect—1/Direct
Indirect Quotation: Foreign Currency quoted for one unit of home
currency.
2c. Bid: The Commercial Bank’s buying rate of a foreign currency.
Ask: The Commercial Bank’s selling rate of a foreign currency.
Always Ask rate > Bid rate
2d. Point Quotation: Quoted on point basis.
$0.3968/78 15/17 33/38 93/103 per SF
Outright Quotation: Bid Ask
Spot 0.3068 0.3978
0.0015 0.0017
30 Days 0.3983 0.3995
90 Days 0.4001 0.4016
180 Days 0.4061 0.4081
Swap Points: Difference between Spot and Forward rate.
1) Ascending order: Forward Premium
2) Descending order: Forward Discount
2e. Convert above quotation into Indirect quotation $/SF in US
Use reciprocal i.e. 1/bid=ask and 1/ask=bid
Bid Ask
Spot 2.5138 2.5202
30 Days 2.5031 2.5107
60 Days 2.4900 2.4994
180 Days 2.4504 2.4624
2f. Forward Premium vs. Forward Discount
• It must be annual basis
• If Forward rate > Spot rate => Forward Premium
