<h4>The Gold Standard</h4>
<strong> </strong>

Until 1914, bank notes represented gold held by governments. The pound sterling, for example, was officially linked to a given amount of gold, which the Bank of England promised to pay, if so requested. Many other countries also adopted the gold standard in the 1880’s so that the value of their currencies was fixed against a common standard, gold. The money supply and government spending in each country were restricted by the amount of gold in the country’s official reserves. Currency stability helped the development of international trade during this period.

The gold standard was suspended in 1914, with the outbreak of the Great War. When the war ended, only the United States could afford to return to the gold standard. The economic depression in the 1930’s caused the final collapse of the system.

The gold standard was also reintroduced in the UK, but abandoned in 1932.
<h4>Bretton Woods Agreement, 1944</h4>
Towards the end of the 1939-1945 World War, concerted international efforts were made to rebuild the global economy. As the world’s strongest economy; the United States played the leading role.

One product of the international co-operation was the Bretton Woods Agreement of 1944, named after the town in New Hampshire where the agreement was made. This marked a return to a fixed rate regime. Under the terms of the agreement:
<ul>
	<li>The US      dollar’s value against the gold was fixed (at $35 an ounce) and the US      government undertook to buy or sell gold in exchange for dollars at this      fixed rate.</li>
</ul>
<ul>
	<li>Each      member country set a parity value for its currency against the US dollar      and gold, and undertook to use central bank intervention to maintain the      exchange rate within 1% of its parity.</li>
</ul>
In effect the world’s economies had returned to a gold standard to a US dollar acting as the major reserve currency (i.e. currency held in the official reserves of the other countries) as well as the world’s major trading currency. Other governments could hold US Dollars as official reserves with the reassurance that if they wanted to exchange the dollars for gold, the US government would do this for them, at the fixed rate of $35 an ounce.

From time to time, the exchange rate of a major currency had to be devalued against the US dollar (and so against all other traded currencies). However, the Bretton Woods system functioned reasonably well until the late 1960’s but it was clearly dependent for its continuing effectiveness on the stability of the US dollar’s value.

In the early 1970s the growing US trade and budget deficits, due largely to the Vietnam war and the cost of space exploration, combined with the sudden increase in the world price of oil, led to the final breakdown of the system. The US government suspended the convertibility of the US dollar into gold in 1971.

History of the Forex Markets

Due to the huge expansion in international trade from the early 1970’s, there was a huge growth in demand for foreign currencies to settle trade transactions. The availability of currencies for trading, and so the development of the FX markets itself, was facilitated by the development of the Eurodollar/Eurocurrency market.

Eurocurrency is money deposited with a bank outside the currency’s country of origin. The Eurocurrency markets or Euromarkets are markets for borrowing and lending currencies outside their countries of origin.

A Eurodollar, for example, is created when the owner of a US dollar deposit with a bank in the US transfers the money to an account with a bank outside the US. These deposits are lent to other customers by the bank, creating Eurodollar market activity.

A Eurocurrency deposit has the essential characteristic that the bank receiving the deposit must be resident outside the country of origin of the currency. For example, US dollars deposited with a bank in London are Eurodollars, regardless of whether the depositor resides inside or outside the US.

An organsisation wishing to borrow Yen, for example could borrow on the Japanese domestic money market from a Japanese bank, or in the Eurocurrency market, for example, by borrowing euro yens from a bank in Paris.

Until the late 1950s, US dollars deposited with banks outside the US were quickly repatriated because the banks taking the deposits invested the money in the US money markets. From the late 1950’s however as the dollar superseded sterling as the main international trading currency, the demand for US dollars by non-US residents increased. Dollars deposited in Europe were increasingly lent to borrowers in Europe, and the Eurodollar market grew. The supply of Eurodollars was increased  by the US balance of trade deficit in the late 1950’s and early 1960’s , which created a flow of dollars into the hands of non-US residents.

The Euromarkets were further boosted in the 1960’s and 1970’s by domestic banking restrictions, particularly in the US, resulting in:
<ul>
	<li>Increasing      demand for Eurodollars from the European subsidiaries of US corporations,      which were unable to borrow dollars in the US.</li>
</ul>
<ul>
	<li>Higher      interest rates on Eurodollars than the domestic dollar deposits. US banks      used their European branches to move dollars into the euro market, thereby      circumventing restrictive US domestic banking regulations.</li>
</ul>
Although restrictive regulations in the US were eased in the early 1970’s the Eurodollar market was sufficiently well established by then to survive and compete with the domestic US markets. In the 1970’s the Eurodollar market played a key role in recycling the petro dollars of oil-producing countries. Large dollar loans were made to countries suffering a balance of payments deficit as a consequence of the large increase in oil prices at that time.

Although the Euromarkets originated with the Eurodollar, and the Eurodollar remains the most heavily–traded currency, there are markets for other Eurocurrencies (euro deutschemarks, euroyen etc.)
<h4><strong>Euromarkets and the FX markets</strong></h4>
<strong> </strong>

The Euromarkets are for borrowing and lending currencies, whereas the FX markets are for buying and selling them. However, there is a very close connection between the two markets.
<ul>
	<li>The      difference between spot rates of exchange and forward rates of exchange in      the FX markets are accounted for by the interest rate differentials      between the currencies in the Euromarkets.</li>
</ul>
<ul>
	<li>There      is little difference between a Eurocurrency loan and a forward swap in the      FX markets. A forward swap is an agreement to buy one currency in exchange      for a second currency and a simultaneous agreement to sell back the      currency at a future date, but at a different rate of exchange. The      difference between the exchange rate for the initial purchase and      subsequent sellback is accounted for by the interest rate differential      between the Eurocurrencies.</li>
</ul>

The Development of the Eurodollar Market

<strong>Spot Transaction: Definition</strong>

<strong> </strong>

A spot FX transaction is a purchase or sale of one currency for another, for delivery usually two business days after the dealing date (the date on which the contract is made).

<strong>Value Date for Spot Transactions</strong>

<strong> </strong>

The exchange rate at which a spot transaction is made is the ‘spot rate’, because this is the day when each party to the transaction will deliver the funds with good value to the counterparty’s account.

Business days do not include Saturdays, Sundays or bank holidays in either of the countries of the two currencies concerned.
<ul>
	<li>If a      spot deal is made on Monday, Tuesday or Wednesday, delivery (value date)      will be two days later on Wednesday, Thursday or Friday respectively.</li>
</ul>
<ul>
	<li>If a      spot deal is made on Thursday or Friday, delivery will be two business      days later on Monday, or Tuesday respectively.</li>
</ul>
<ul>
	<li>If the      spot date falls on a public holiday in one of the centers of the two      currencies involved, spot settlement is deferred and the next working day      is taken as the value date. This must be the case, because settlement in      any currency takes place in that currencies country of origin. For      example, if a spot USD/EUR deal is transacted on Tuesday 26 November, it      would be normally be for value Thursday 28 November. If this date is a      holiday in Germany or the US however, all USD/EUR spot transactions on      Tuesday 26 November are for value Friday 29 November.</li>
</ul>
There are some exceptions to the general rule:
<ul>
	<li>A      transaction in USD/CAD is for immediate settlement usually implies      delivery on the next working day after the dealing day. This is referred      to as ‘Funds’. The large volume of foreign exchange between these two      currencies has led to the evolution of an efficient system, and there is      no time difference between the main money centers, New York and Toronto. A      spot price (value two working days after the dealing date, as usual) can      normally requested as an alternative to Funds.</li>
</ul>
<ul>
	<li>FX      markets in the Middle East are closed on Friday but open on Saturdays. A      USD/SAR transaction could therefore have a split settlement date, with the      US dollars delivered on the Friday and the Saudi riyals delivered on the      Saturday.</li>
</ul>
<ul>
	<li>The      spot value date for cross-currency deals (transactions involving two      currencies not including the US dollar) might be deferred by the US public      holidays.</li>
</ul>

Understanding Spot FX Transactions

Interbank spot rates are the current selling and buying prices for spot transactions.

In forex trading, the way in which the exchange rate is quoted for each particular pair of currencies has become standardized around the world. However, an exchange rate may be quoted differently in the domestic market compared to the international FX market.
<h4><strong>Base Currencies and Variable Currencies</strong></h4>
Spot rates are quoted as one unit of base currency against a number of units of variable currency (or quoted currency). The base currency is therefore the currency against which others are quoted.

X units of Variable Currency =1 unit of Base Currency

By convention when an exchange rate is named, the base rate is spoken or written first, and the variable currency second.

<strong>Examples</strong>

<strong> </strong>
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td width="197" valign="top"><strong> </strong></td>
<td width="197" valign="top"><em><span style="text-decoration: underline;">Base Currency </span></em><strong> </strong></td>
<td width="197" valign="top"><em><span style="text-decoration: underline;">Variable /Quoted Currency</span></em><strong> </strong></td>
</tr>
<tr>
<td width="197" valign="top">US dollar/EUR<strong> </strong></td>
<td width="197" valign="top">USD<strong> </strong></td>
<td width="197" valign="top">EUR<strong> </strong></td>
</tr>
<tr>
<td width="197" valign="top">Sterling/Yen                              <strong> </strong></td>
<td width="197" valign="top">GBP<strong> </strong></td>
<td width="197" valign="top">JPY<strong> </strong></td>
</tr>
</tbody>
</table>
If the spot rate for USD/EUR (dollar/euro) is 0.7763 Deutschemarks to one dollar, this would be written:

USD/EUR 0.7763

We can apply the same principal to other exchange rates. For example, look at the spot rates below:

SGD/JPY 63.3091

AUD/CAD 0.9272

You should be able to recognize, without knowing anything else about the currencies that these rates are:

63.3091 Japanese Yen to 1 Singapore dollar

0.9272 Canadian Dollars to 1 Australian dollar
<h4><strong>Direct and Indirect Quotes</strong></h4>
<strong> </strong>

In the international markets, some currencies, by convention, are taken as the base currency for quoting exchange rates. Most currencies are quoted against the US Dollar.

Within a domestic market, it is sometimes more convenient to quote exchange rates the other way round.
<ul>
	<li>A      direct rate is a rate that gives a variable amount of domestic currency      against a fixed amount of foreign currency.</li>
	<li>An      indirect rate is a rate that gives a variable amount of foreign currency      per fixed amount (normally one unit) of domestic currency.</li>
</ul>
<strong>Example 1</strong>

<strong> </strong>

The exchange rate between the Japanese Yen and Singapore dollar is SGD/JPY 63.3091.

For an FX dealer in Japan:
<ul>
	<li>The      direct rate is 63.3091 Japanese yen to 1 Singapore      dollar escudos to 1 peseta (or 6330.91 Japanese yen to 100 Singapore      dollars)</li>
	<li>The      indirect rate is 1/63.3091 = 0.0158 Singapore      dollar to 1 Japanese yes.</li>
</ul>
The indirect rate is the inverse of the direct rate.

<strong>Example 2</strong>

A market marker quotes a European customer a USD/EUR rate of 0.7763/67, but the customer asks for the rate to be quoted as EUR/USD. What should the rate be?

<strong>Analysis</strong>

The EUR/USD rate is the inverse of the USD/EUR rate.

<strong>Buy EUR/sell USD:</strong>

USD/EUR rate = 0.7767

EUR/USD rate = 1/0.7767 = 1.2875

<strong> </strong>

<strong>Sell EUR/buy USD:</strong>

USD/EUR rate = 0.7763

EUR/USD rate = 1/0.7763         = 1.2882

The EUR/USD rate is therefore 1.2875/1.2882

Forex Trading: Reading FX Quotes

The last two digits of an exchange rate are the points or pips. The rest of the rate is called big figure.

As a general rule, a pip is one-hundredth of a ‘cent’, for example USD 0.0001, EUR 0.0001, CAD 0.0001.

There are exceptions: for example, when quoting the dollar/yen rate, a pip is one hundredth of a yen (JPY 0.01)

Exchange rates are usually quoted to five figures. The first three digits of the quote are the big figures.

<strong>Examples</strong>

<img class="aligncenter size-full wp-image-819" title="pips-big-figure" src="https://financetrain.com/wp-content/uploads/2010/08/pips-big-figure.png" alt="" width="465" height="128" />

Dealers often assume everyone knows what a big figure in major currencies is at the time.

Deals are often conducted without any mention of the big figure, and only the pips are quoted. It is good practice, however, always to state the big figure to avoid the possibility of errors, for example when the market is moving rapidly.

Forex Quotes: Pips and the Big Figure

Exchange rates are commonly expressed as two rates, the bid price and the offer price, for example:

USD/AUD 1.1240-1.1245 or

USD/AUD 1.1240-45 or

USD/AUD 1.1240/45

Rates shown in the financial press are the average (mid-point) of the bid and offer rates.
<ul>
	<li>The      bid price is the rate at which the bank quoting the price, the market      marker will buy the base currency from a customer, the market user.</li>
</ul>
<ul>
	<li>The      offer price is the rate at which the market maker will sell the base      currency to a customer/market user.</li>
</ul>
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td colspan="2" width="590" valign="top">Market Maker (Quote   the prices)</td>
</tr>
<tr>
<td width="295" valign="top">Buys base currency

Sells variable currency</td>
<td width="295" valign="top">Sells base currency

Buys variable currency</td>
</tr>
<tr>
<td width="295" valign="top">Bid</td>
<td width="295" valign="top">Offer</td>
</tr>
<tr>
<td width="295" valign="top">Sells base currency

Buys variable currency</td>
<td width="295" valign="top">Buys base currency

Sells variable currency</td>
</tr>
<tr>
<td colspan="2" width="590" valign="top">Market User   (Customer)</td>
</tr>
</tbody>
</table>
This may be confusing initially, but you must know the rule thoroughly.

It may help you to think of the base currency as a commodity being traded. The market maker will want to buy the commodity (base currency) at the lowest price possible and sell the commodity (base currency) at the highest price possible.

Hence,
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td width="295" valign="top">Buy base currency/commodity</td>
<td width="295" valign="top">Sell base currency/commodity</td>
</tr>
<tr>
<td width="295" valign="top">BID</td>
<td width="295" valign="top">OFFER</td>
</tr>
<tr>
<td width="295" valign="top">Lower figure</td>
<td width="295" valign="top">Higher figure</td>
</tr>
</tbody>
</table>
To avoid confusion, currency traders usually apply this rule and think in terms of base currency: ’buying Canadian dollars’ would automatically be translated in the dealers head to ‘selling US dollars’, since the US dollar/ Canadian dollar rate is quoted with the US dollar as base currency.

By market convention, the bid rate is quoted on the left hand rate and the offer rate is on the right hand side.

The market user (customer) whether a corporate customer, institutional investor, commercial bank, or central bank will always get the worst of the bargain. The market maker will always quote the price (bid rate or offer rate) that is most favourable to himself.

When a dealer receives a call from another bank for a price, he is acting as market maker. If he then calls another bank to close the position (i.e. to transact an opposite deal) he is acting as a market user, taking the price quoted to him.

<strong>Example</strong>

A multinational wants to buy USD 5 million in exchange for Singapore dollars. A bank quotes 1.3607-1.3615 for the USD/SGD rate.

The market maker is selling the base currency, dollars and so the rate to apply to the transaction is 1.3615, and the multinational will pay SGD 6.8075 million for the dollars (5 million x 1.3615)

Forex: Bid and Offer Rates

The spread (also called dealers spread or the bid-offer spread) is the difference between the bid price and offer price. This represents the market markers margin. In the case of prices from brokers, it is the difference between the highest bid and the cheapest offer. Most currencies are quoted with spreads of 3 to 5 pips.

The spread represents an opportunity for the market marker to make a profit, provided the exchange rates do not move. For example, suppose that a dealer buys USD 1 million from a customer in exchange for Singapore Dollars at a USD/SGD rate of 1.5725, and then immediately sells the dollars to another customer at a rate of 1.5730. The cash flows on the value will be:
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td width="197" valign="top">Bank Receives:</td>
<td width="197" valign="top">USD 1,000,000</td>
<td width="197" valign="top"></td>
</tr>
<tr>
<td width="197" valign="top">Bank Pays:</td>
<td width="197" valign="top"></td>
<td width="197" valign="top">SGD   1,572,500</td>
</tr>
<tr>
<td width="197" valign="top">Bank Pays:</td>
<td width="197" valign="top">USD 1,000,000</td>
<td width="197" valign="top"></td>
</tr>
<tr>
<td width="197" valign="top">Bank Receives:</td>
<td width="197" valign="top"></td>
<td width="197" valign="top">SGD 1,573,000</td>
</tr>
<tr>
<td width="197" valign="top"><strong>Balance:</strong></td>
<td width="197" valign="top">NIL</td>
<td width="197" valign="top">SGD 500</td>
</tr>
</tbody>
</table>
The dealer has made a profit of SGD500 (or 5 points on USD 1 million at SGD100 per point per million dollars) and has a square or flat in dollars.

There is of course no guarantee that the dealer will be able to make this profit, as market rates are constantly changing. However, the wider the spread quoted, the greater the likelihood of closing the position at profit.

The dealer’s spread is compensation for the risk he takes when making a market, and for the costs of providing the service to customers. The size of the spread will be related to the amount of risk attached to any given deal.
<h3><strong>Positions</strong></h3>
<strong> </strong>

Banks that deal in FX are said to have a long, short or square position in each currency they trade.
<ul>
	<li>A <em>long      position</em> is a market position where the bank has bought a currency in      excess of immediate requirements, normally with a view to selling it later      at a profit.</li>
</ul>
<ul>
	<li>A <em>short      position</em> is a market position where the bank has sold currency that it      does not own, normally with a view to buying it later, when required (i.e      sales of the currency exceed purchases). If the banks short position is      speculative, it is is expecting the currency’s value to fall.</li>
</ul>
<ul>
	<li>A <em>square      or flat position</em> exists when the bank is neither long nor short in      currency.</li>
</ul>
<h3><strong>Market Volatility and the Bid-Offer Spread</strong></h3>
If the exchange rate of a particular currency pair is volatile, i.e. normally moves rapidly and erratically, and large changes are common then there is a greater risk that the dealer will be unable to cover his position at a profit. He will therefore widen the spread so that a larger movement must take place before he is in a loss-making position.
<h3><strong>Market Liquidity and the Bid-Offer Spread</strong></h3>
In a highly liquid market such as USD/EUR, USD/JPY or GBP/USD, a dealer can cover his position quickly, with one of a larger number of counterparties and without his, activity having an impact on the exchange rate. His risk is therefore less, and a narrower spread can be quoted. The normal spread for interbank deals in major currencies is 3 to 5 points.

In illiquid markets, there is a risk that some time may be taken to execute a deal and that the deal itself will adversely affect the market price. Spreads therefore tend to be considerably wider.

Bid-Offer Spreads and the Market Position

Cross rates are rates between two currencies where neither is the US dollar.

A cross rate can be calculated from the respective rate for each of the currencies against the dollar.

<strong>Example</strong>

Consider the following rates:

USD/SEK   6.6270-6.6275

USD/SGD   1.4143-1.4148

From these rates for the Swedish krona and Singapore dollar against the US dollar, we can calculate a cross rate for the krona against the Singapore dollar.

The first step is to decide which is to be the base currency. Either can be the base currency (and cross rates are published both ways in the financial press, i.e. with each currency as the base). In most cases, however, the market convention is that the currency with the higher value per unit is the base, so that the cross rate will be a number greater than 1 ½ Singapore dollars and over 6 ½ kronas, so the Singapore dollar must have greater unit value than the krona.

We shall therefore take the Singapore Dollar as the base currency to obtain a cross rate for SGD/SEK.

<strong>Bid Price</strong>

<strong> </strong>

The bid price in the cross rate is the rate at which the market maker will:
<ul>
	<li>Buy      Singapore dollars, and</li>
	<li>Sell      kronas</li>
</ul>
If this transaction were carried out in two stages, via the US dollar, the market maker would:
<ul>
	<li>Buy      Singapore dollars in exchange for US dollars. The USD/SGD rate is      1.4143/48. Since US dollars, the base currency, are being sold, the market      maker would quote the offer price 1.4148.</li>
	<li>Sell      kronas in exchange for US dollars. The USD/SEK rate is 6.6270/75.Since US      dollars (base currency) are being purchased, the market maker would quote      the bid price, 6.6270.</li>
</ul>
The bid price for SGD/SEK is therefore:

= 6.6270/1.4148 = 4.6841

<strong>Offer Price</strong>

The offer price in the cross rate is the rate at which the market maker will:
<ul>
	<li>Sell      Singapore dollars, and</li>
	<li>Buy      kronas</li>
</ul>
If this transaction were carried out in two stages via the US dollar, the market maker would:

Sell Singapore dollars and buy US dollars. The USD/SGD rate is 1.4143/48.Since USD is the base, the bid rate of 1.4143 would be quoted

Buy kronas and sell US dollars. The USD/SEK rate is 6.627/75.Since USD is the base, the offer rate of 6.6275 would be quoted.

The offer price for SGD/SEK is therefore:

= 6.6275/1.4143 = 4.6861

<strong>Solution SGC/SEK cross rate</strong>

<strong> </strong>

This gives us a cross rate of SGD/SEK 4.6841-4.6861 (4.6841/61).

Forex Rates: Understanding Cross Rates

If we look at two sets of currency pairs with different base currencies you can still adopt the same procedure to find a cross currency quote, provided that you remember the basics.

For example, suppose cable (GBP/USD) is 1.6175 and USD/CAD 1.3639/42.

We can now find the GBP/CAD cross rate as follows.

-

-

<img class="aligncenter size-full wp-image-866" title="cross-rates1" src="https://financetrain.com/wp-content/uploads/2010/08/cross-rates1.gif" alt="" width="543" height="182" />

GBP will be taken as the base currency for the cross rate quotation
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td width="151" valign="top">Bid Price</td>
<td width="439" valign="top">Market maker buys GBP, sells CAD

Buy GBP, sell USD at 1.6175

Sell CAD, buy USD at 1.3639

Bid price = 1.6175 X 1.3639 =2.2061</td>
</tr>
<tr>
<td width="151" valign="top">Offer Price</td>
<td width="439" valign="top">Market maker sells GBP, buys CAD

Sell GBP, buy USD at 1.6178

Buy CAD, sell USD at 1.3642

Offer price =1.6180 X 1.3642=2.2073</td>
</tr>
<tr>
<td width="151" valign="top">Cross rate</td>
<td width="439" valign="top">GBP/CAD rate is 2.2061-2.2073</td>
</tr>
</tbody>
</table>
Notice that in this example, since the GBP/USD rate is quoted with GBP as base, we need to multiply rather than divide to arrive at the cross rate.
<h3><strong>Rules for Calculating Cross Rates</strong></h3>
<strong> </strong>

<strong><img class="aligncenter size-full wp-image-867" title="cross-rate2" src="https://financetrain.com/wp-content/uploads/2010/08/cross-rate2.gif" alt="" width="545" height="347" /></strong>
<h3>Other Aspects of Cross Rates</h3>
In making the above calculations, we have used two spreads, representing liquidity and volatility risk in two markets. This spread is not necessary if a position can be covered directly in one market. Spreads will be wider for less-actively traded cross currency pairs, because the market maker will split deals into two dollar positions, with equal and opposite notional dollar values, and cover them in the respective markets.

Most interbank FX transactions do not involve cross rates, i.e. do not involve the exchange of two non-dollar currencies. Some cross rates, however are increasingly traded by banks in addition to US dollar-based rates.

Cross Rates and Different Base Currencies

In this post, we will discuss some of the common market practices in foreign exchange markets.

<strong> </strong>

<strong>Choice Prices</strong>

<strong> </strong>

A choice price is one where the market marker quotes a single rate at which the market user can choose to buy or sell. This is sometimes done where the amount is small, but the counterparty relationship is a good one. Alternatively, if the market maker already has a profitable position he may be content either to close that position or to increase it at the same price.

In practice, choice prices are more frequently used to manipulate the market user. The convention is that it is extremely bad etiquette to turn down a choice price; the market user is morally obliged to deal. If the market maker is certain that the customer is a buyer of base currency, for example, he may quote a high choice price. This not only gives the market marker a deal at a good price. This not only gives the market marker a deal at a good price, but also shows the market user that his intentions are transparent.

Choice prices are also quoted to counterparties who call persistently for prices but never deal. Market makers do not like to be used as a market information service by other banks

<strong>Liquidity</strong>

The market for a currency is said to be liquid when customers can readily buy or sell any quantity of the currency. A feature of liquid markets is competition between market makers, resulting in narrow spreads between bid and offered prices. Liquidity in most currencies varies from one FX centre to another, and between the spot and forward markets. For example, there is a liquid spot market for the Spanish peseta in Madrid, Paris and London , but I other centers, especially outside Europe ,the peseta market is much less liquid and customers will have more difficulty in finding a bank willing to buy or sell the currency at a competitive price.

Interbank trading in currencies does have one significant benefit for trade-related and investment-related FX transactions. The high volume of speculative   interbank trading creates much greater liquidity in the market, which narrows the bid-offer spreads. This offsets to some extent, the problems of volatility in exchange rates created by speculative interbank trading.

<strong>Nostro Accounts</strong>

A bank that trades actively in the FX makers has to maintain currency bank accounts (nostro accounts) in all the currencies in which it trades, to meet payment requirements as these fall due. Current accounts are therefore maintained with correspondent banks in other countries. For example, a UK bank will keep a US dollar current account with a US correspondent bank, a Deutschemark current account with a German correspondent bank, a Hong Kong dollar account with a correspondent in Hong Kong, etc.

A banks trading desk is ‘long’ in a currency where the total open position (current balance plus money due in at forward dates: minus money payable at forward dates) is positive, and is ‘short’ in a currency when the total open position is negative.

A bank’s trading desk is long in a currency where the total open position (although new FX market transactions can be made to maintain its required position). Buying a currency lengthens the bank’s position in that currency: selling a currency shortens the position.

Banks do not always want to have a position (long or short) in currencies in which they trade, and can ‘square’ temporary positions through the FX ‘swap’ transactions. For example, if a UK bank does not wan to be long in Spanish pesetas, but has a pesetas dealing desk, it can buy a quantity of pesetas ‘spot’ and simultaneously sell them forward. This will give the bank a working balance in pesetas to meet its short term payments requirements, but the spot purchases and matching forward sale avoids the need to hold a long position in the peseta.

<strong>Dealing Activity</strong>

Within each FX centre, a bank will have a specialist spot market trader for each currency in which it deals. For example, ABC Bank in London will have a spot market trader for each currency in which it deals. For example, ABC Bank in London will have a spot trader for sterling against US dollars, another for euros and another for yen. The trader keeps a book of the purchases and sales of the currency transacted o behalf f the bank. If the aim is to keep a square position, buying and selling equal quantities of the currency, the trader will adjust bid and offered spot prices according to demand and supply from customers.

For example, suppose a German bank is quoting 1.3665-1.3670 for the US dollar/euro rate, and wished o maintain its current position in dollars. If it then transacts a deal involving the sale of, say, USD 5 million in exchange for euros, it will want to buy dollars to restore its position.

It could therefore alter its quoted rates to say, 1.3667-1.3672, i.e., raise the value of the dollars against the euros, hoping that its new rate will attract sellers of dollars. However, the market is very competitive and banks must avoid the risk of setting rates that are significantly out of line with other banks..

The job of the spot trader is to make markets in his currency. When a call is received from a customer asking for a quotation, the call is handled by a customer-dealer, who will ask for a spot price quotation from the trader in the currency. If the transaction is agreed, the trader is informed, so that he can keep his book up to date.
<ul>
	<li>If      the dealer buys a currency, he will normally look to lay off the purchase,      selling the currency to another bank or corporate buyer.</li>
</ul>
<ul>
	<li>Spot      prices vary according to supply and demand in the market, so if a dealer      wants to lay off a deal to earn a profit, speed is essential. Dealers will      therefore commonly sell currency immediately after buying it, and vice      versa.</li>
</ul>
Speed is critical when deciding which rate to offer.
<ul>
	<li>If a bank is long in the currency, the dealer will offer a spot rate more attractive more attractive to a buyer of that currency than a seller.(i.e. he will lower the rate).</li>
</ul>
<ul>
	<li>If a bank is short in the currency, it will be eager to buy and will offer higher spot rates.</li>
</ul>
<ul>
	<li>If the bank already has a square position, the rate being offered will depend on the dealers view of how easily and quickly he can lay off a deal.</li>
</ul>

Common Practices in Foreign Exchange Markets

Market participants are categorized on the basis of their role and the nature of their dealings in the marketplace. These will influence their risk appetite, policies and controls in managing risk with each participant in the market.

Market participants should, in addition to clearly understanding their own role in the market, know the role in the marketplace of the other party to the transaction and ensure their expectations are aligned.

The following categories of counterparties are based on the ‘Guidelines of Transactions Involving Intermediaries’ produced by the New York Foreign Exchange Committee.
<h3><strong>Counterparties</strong></h3>
Any individual, corporation, partnership or trust, government or other entity that engages regularly in one or more types of transactions as principal with a dealer.

Counterparties can be sophisticated or unsophisticated end users. Their risk appetite can vary, ranging from high to very low. The reason they enter into financial transactions will usually be either to hedge underlying market risks or to speculate on future changes in the marketplace.
<h3><strong>Dealers</strong></h3>
With respect to any transaction, a person who presents themselves as being in the business of entering into similar transactions as principal with counterparties.

Dealers trade with counterparties to receive margin income. Dealers have a responsibility to ensure the counterparty understands the risks and that the transactions they are entering into are suitable for them.

Dealers trade with other dealers in order to lock in margin income from counterparty dealings, speculate on future changes in market prices, arbitrage discrepancies in the alignment of prices between related markets, or to hedge balance sheet exposures.
<h3><strong>Discretionary Intermediaries</strong></h3>
An intermediary who has the authority to bind a counterparty to a transaction with a dealer without transaction-specific approval by the counterparty.

Discretionary intermediaries must have prior approval from the counterparty to enter into the particular type of transaction for the purposes that it intended.

Discretionary intermediaries must establish that the counterparty has the authority and capacity to enter into the transaction and understands the risk.

The intermediary is responsible for advising the dealer as to the allocation of the transactions.

Discretionary intermediaries derive their income from the fees paid by the counterparty.
<h3><strong>Non-discretionary Intermediaries</strong></h3>
An intermediary who enters into transactions with a dealer on behalf of a counterparty only pursuant to transaction-specific approval by the counterparty.

Non-discretionary intermediaries must establish that the counterparty has the authority and capacity to enter into the transaction and understands the risks.

Non-discretionary intermediaries derive their income from the fees paid by the counterparty.
<h3><strong>Broker</strong></h3>
An intermediary who brings together market participants seeking to enter into particular types of transactions. Brokers generally bring together dealers with other dealers, intermediaries and counterparties.

In the foreign exchange markets regulators do not generally permit brokers to trade on the ‘house’ account – that is, where the broker is a counterparty to the transaction. In jurisdictions where regulators do permit house account trading these dealings must be at arms length from their broking activities.

Brokers derive their income from fee income arranging the transaction.  In the foreign exchange market the brokerage fee is generally paid by both parties to the transaction.

Foreign Exchange Market Participants

The Foreign Exchange Market

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COURSE

The Foreign Exchange Market

Lessons