Q2. What are foreign exchange markets? Who are the players in the foreign exchange market? What is meant by exchange rate quotations?
foreign exchange markets
The foreign exchange market is the largest and most liquid market in the world. The estimated worldwide turnover of this market is at around $1½ trillion a day, which is several times the level of turnover in the U.S. Government securities market, which is the world’s second largest financial market. The turnover in the foreign exchange market is equivalent to more than $200 in foreign exchange market transactions, every business day of the year, for every man, woman, and child on earth!
The foreign exchange market is a twenty four hour market. Each business day arrives first in the financial centers of Asia-Pacific —first Wellington, then Sydney followed by Tokyo, Hong Kong, and Singapore. A few hours later, while markets are still active in these Asian centers, trading begins in Bahrain and at other places in the Middle East. Later, when it is late in the business day in Tokyo, markets open for business in Europe. When it is early afternoon in Europe, trading in New York and other U.S. centers begin. Finally, completing the circle, when it is mid or late afternoon in the United States, the next day has arrived in the Asia-Pacific area, the first markets there have opened, and the process begins again.
The foreign exchange market consists of both an over-the-counter (OTC) market and an exchange-traded segment of the market. The OTC market is an international OTC network of major dealers – mainly but not exclusively banks – operating in financial centers around the world, trading with each other and with customers, via computers, telephones, and other means. The exchange-traded market covers trade in a limited number of foreign exchange products on the floors of organized exchanges.
The OTC market accounts for well over 90 percent of total foreign exchange market activity, covering both the traditional (pre-1970) products (spot, outright forwards, and FX swaps) as well as the more recently introduced (post-1970) OTC products (currency options and currency swaps). On the “organized exchanges,” foreign exchange products traded are currency futures and certain currency options.
the players in the foreign exchange market
There are three types of participants in the foreign exchange 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 the USA that is selling it capital goods; in this case, it would sell pounds and buy dollars. Commercial banks are by far the most active participants in the foreign exchange market. They 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 process is known as market making: the banks will at all times quote buying (bid rates) or selling rates (ask rates) for pairs of currencies – dollars to the pound, Japanese yen to the euro and so on. The market makers earn a profit on the difference between their buying and selling rates (spread). The third type of participant, the brokers, who 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 know which bank has the highest bid (buying) rate for a currency, and which the lowest offer (selling) rate.
exchange rate quotations
Direct and Indirect Quotes
Exchange rate quotes, as the price of one currency in terms of another, come in two forms:
a) “Direct” quotation is the amount of domestic currency per unit of foreign currency. Example: Rs. 77.30 / £ in India, $1.7676 / £ in US and
b) “Indirect” quotation is the amount of foreign currency per unit of domestic currency. Example Swedish Kroner 0.1763/Rs in India, 0.8251 Euro/$ in US.
European and American Terms
The phrase “American terms” means a direct quote from the point of view of someone located in the United States. For the dollar, that means that the rate is quoted in variable amounts of U.S. dollars per one unit of foreign currency (e.g., $1.2119 per Euro). The phrase “European terms” means a direct quote from the point of view of someone located in Europe. For the dollar, that means variable amounts of foreign currency per one U.S. dollar (or Euro 0.8251 per $1).
In daily life, most prices are quoted “directly,” so when you go to the shop you pay x dollars and y cents for one loaf (unit) of bread (in US). For many years, all dollar exchange rates also were quoted directly. That meant that the dollar exchange rates were quoted in European terms in Europe, and in American terms in the United States of America. However, in 1978, as the foreign exchange market was integrating into a single global market, for convenience, the practice in the U.S. market was changed – at the initiative of the international broker community – to conform to the European convention. Thus, OTC markets in all countries now quote dollars in European terms against nearly all other currencies (amounts of foreign currency per $1). That means that the dollar is nearly always the base currency, one unit of which (one dollar) is being bought or sold for a variable amount of a foreign currency. The only exceptions to this convention are quotes in relation to the euro, the pound sterling and the Australian dollar – these three are quoted as dollars per foreign currency.