- 1998: Volume 7, No. 1 Global Foreign Exchange Market

The global Foreign Exchange (forex) Market is the largest market in the world and plays an integral part in today's international commercial and financial trading environment. As new market oriented economies have opened their frontiers and the number of cross border transactions between financial institutions, corporations and individuals has risen dramatically over the last decade, the resulting volume of foreign exchange trading has exploded. Currently, it is estimated that over $1.5 trillion worth of forex transactions occur worldwide every business day. Over half of this daily trading volume takes place during the European market hours, while the American market accounts for about a third of the total volume and Asia is responsible for the remainder.

But what exactly is this global forex market? Although the forex market is an essential element in world trade, many people still do not fully comprehend what this massive market is or how it actually operates. A series of articles will attempt to answer this question by presenting a general overview of the elements, participants and mechanics that constitute the global foreign exchange market. This first article will provide an overview of each of the separate markets that make up the global foreign exchange market and then also describe the mechanics of how trading actually takes place on the interbank market.

Participating Markets within the Global Foreign Exchange Market Today's global foreign exchange market is actually composed of many markets operating together around the world at the same time. These markets include:

• The Bank Notes Market (including traveler's checks and money orders) that tourists are familiar with. Although not a true part of the forex market, the bank note market is the most visible example of exchange between two currencies. This market is characterized by wide buying and selling prices (the quotation spread) and by the actual physical delivery of the purchased currency.
• The Forex Interbank Market, which constitutes by far the largest segment of the whole forex market, consists of hundreds of commercial banks and financial institutions located around the globe dealing forex amongst themselves directly and on behalf of their customers via telephone, telex or other electronic (e.g. Reuters dealing) means. In this market, actual currency exchange takes place by debiting or crediting the currency account balances of the parties involved in a transaction at the banks where the parties maintain their particular currency accounts. The Interbank market relies on self-regulation and the principle and spirit of dealing price reciprocity between the market making (dealing) participants. This reciprocity forms the foundation upon which the essential price liquidity and 24-hour global operation, that characterize the interbank market, are built.
• The Forex Brokers Market, where participants in the interbank market use the services of a reputable intermediary currency broker to deal through. The brokers market provides a valuable alternative to direct interbank trading and enhances the efficiency and liquidity of the forex market generally.
• The Currency Futures Market, in which centrally located and regulated auction (open outcry) market exchanges deal forex in fixed contract quantities for fixed quarterly forward settlement dates during specific market hours. The futures market (most notably the IMM division of Chicago's CME and Singapore's SIMEX) is characterized by trades that are done on margin and that are usually offset before physical delivery of a currency is required. While only a fraction of the size of the interbank market, the futures market does play an important role in influencing the currency price directions within the broader forex market, and supplies additional liquidity and hedging availability to general market participants.
• The Forex Options Market, which includes both the over-the-counter (OTC) interbank options market and several open auction currency option exchanges (e.g. Philadelphia Options Exchange). The interbank OTC options market usually caters to bank customer demand for tailored deals requested for their specific financing purposes, while the option exchanges generally serve as option hedging and speculative trading vehicles.
• The Internet Currency Market (as represented by E-Forex's Internet Currency Exchange). This growing electronic trading alternative in the global forex market place connects Forex Rate Makers (market makers) with Rate Takers anywhere in the world at any time over the Internet medium. This new market is characterized by improved trade execution efficiency, lower transaction costs and more competitive currency pricing for a broader range of market participants.

Dealing Mechanics of Interbank Foreign Exchange Trading

In today's floating rate currency trading environment, understanding both the price quotations and the mechanics of how the forex market operates is essential. The following are examples of interbank currency price quotations:

USD/DEM	=	1.7500 - 1.7507
USD/CHF	=	1.4030 - 1.4037
USD/JPY	=	125.15 - 125.23
GBP/USD	=	1.6975 - 1.6982
USD/CAD	=	1.3500 - 1.3510
AUD/USD	=	0.7005 - 0.7015

The standard interbank forex market practice is to quote currency rates "against" the U.S. dollar (one U.S dollar against so much of another currency). In the above example, there is one U.S. dollar (USD) to 1.7500 German (Deutsche) marks (DEM) and one USD to 125.15 Japanese yen (JPY). In other words, the USD is always one of the two currencies involved in the quote.

Another standard interbank practice is to make quotations for most rates in "European Terms." When this method of quotation of comparing the USD and another currency is used, the quote states that one USD is equal to so many units of the other foreign currency (like the DEM and JPY examples above). In other words, the USD are being defined (or expressed) in terms of the other currency being quoted.

The alternative method of quoting, primarily used in three main cases, employs American or U.S. terms. A quote in American terms depicts how many USD equal one unit of some other currency (in the example above, one British pound sterling (GBP) equals USD 1.6975). Of the three major cases where American terms are used, two are exceptions to the standard interbank practice. Quotes involving the GBP and the Australian dollar (AUD) are supplied using American terms (GBP 1= USD 1.6975, and AUD 1 = USD 0.7000). The third case involves the currency futures market. All rates for currency futures are expressed in American terms. All Chicago CME currency futures contracts are quoted this way (e.g. DEM 1 = USD 0.5714).

It is important to emphasize that values supplied using European terms are equal to values supplied using American terms. One is the reciprocal of the other. The only difference between the two values is the basis chosen for the comparison, or the way in which the person supplying a quote has chosen to express the relationships between the two currencies. For example, USD/DEM = 1.7500 in European terms is the reciprocal of DEM/USD = 0.5714 in American terms.

While most forex rate quotations are expressed using USD against another currency, not all forex transactions involve USD. When a quotation involving two currencies other than USD is made, this rate is called a cross rate. A DEM/JPY (DEM 1 against some number of JPY) quote is an example of a cross rate. Use of cross rates has grown substantially over the last several years and direct quotes are obtainable from market making banks. A cross rate can also be calculated from the two currencies involved as expressed against the USD (DEM/JPY = (USD/JPY)/(USD/DEM)).

The day on which a forex transaction is due to be settled (the date a participant's currency account is actually credited or debited) is called the value Date. The majority of forex trades are done for "spot value." Spot value is the settlement date in the interbank market that takes place two business days from the trade date. All currency contracts for value beyond the spot date are referred to as "forward value" transactions. Forward value dates are conventionally quoted in multiples of one-month periods, which begin one month from the spot value date and range out 12 months ahead. Forward contracts may be made for any valid business value date. 

Interbank Spot Market

The spot market is the one in existence at the moment the spot market maker's quote is supplied. Settlement for the trade done is made within the following two business days. The quote (using the above example of USD/DEM = 1.7500 - 1.7507), as in the case of any bid-offer spread, consists of the prices at which the quoting market maker (the interbank currency dealer) will buy and sell one currency in exchange for the other. The first number in the quote, the bid side (or market maker's purchase price), is the quantity of DEM that the market maker will exchange (sell) for each USD he buys. In other words, the bid price represents the price at which the market maker will 'buy' USD, expressed in DEM and the price at which other market participants can sell USD. Conversely, the second number in the price quotation, the offer (or asking side or market maker's selling price), is the quantity of DEM that the market maker will exchange (buy) for each USD he sells. In other words, the offer price represents the price at which the market maker will sell USD, expressed in DEM, and the price at which other market participants can buy USD.

A market maker's price quote, be it over the phone or on a computer screen will remain unchanged for as long as the dealer feels comfortable with it. Sometimes in a quick market environment this period may only be a few seconds before being changed to a new price quote. The bid-offer quotes stated by market makers are constantly reviewed and updated as those market makers continually reassess their own currency positions and determine whether they wish to be 'better' buyers or sellers of a particular currency that they have the responsibility of quoting. A market maker is considered a "better" buyer of a currency when his bid for that currency is higher than the general market bid rate, and a "better" seller of a currency when his offer is lower than the general market offer rate. The resulting quote reflects the market maker's own attitude toward the market price's current and expected future performance.

The point difference between a bid and an offer is called the price spread and is a measure of the quote's quality. It is also an indication of the depth of the market liquidity for a currency. The narrower the spread, the better the quality and the greater the depth of the market for that currency. A wider spread indicates either greater uncertainty over market conditions or a lack of price liquidity. Wider spreads occur with unexpected news releases or prevail toward the end of market trading hours in a particular geographic area. The spread is analogous to the risk premium for quoting during both normal and volatile market conditions. 

Interbank Forward Market

The forward market within the interbank market enables participants to establish at the time of the currency deal, a rate for the exchange of the currencies at some future business value date past the spot date (three business days and beyond). A forward rate is calculated by either adding or subtracting the forward "swap rate" to or from the spot rate for the two currencies being exchanged. Forward swap rates are based on the difference between the Euromarket interest rates for a particular future maturity date of the two currencies involved in the forward transaction. Forward swap rates are typically expressed in points, with one point usually equal to the price unit the currency is traded in (USD/DEM's trade unit is the fourth decimal point - 0.0001). For example, a forward swap rate of 0.0075 would be referred to as 75 points and may represent the interest rate differential between the USD and the DEM for a one-month maturity.

The forward swap points are either added to or subtracted from the spot rate when determining the forward price for the future date desired. To determine whether the forward swap rate is added or subtracted, it is first necessary to decide if one currency is trading at a premium or discount relative to the other in the forward market. This is arrived at by comparing the Euromarket interest rates of the two currencies being exchanged. If the one month Eurorate of one currency (e.g. DEM's Euromark rate) is lower than the Eurorate of the other (e.g. USD's Eurodollar rate) then the USD will be regarded as trading at a discount to the DEM given the European terms quotation method, and the resulting swap points will be subtracted from the USD/DEM spot rate to obtain the forward one month USD/DEM rate. If the one month Euromark rate is higher than the one month Eurodollar rate then the dollar will be trading at a premium and the subsequent swap points will be added to the USD/DEM spot rate to obtain the forward market one month USD/DEM currency dealing rate. 

T. W. John Hunter is an account executive for E-Forex Company. E-Forex is a software company that specializes in foreign exchange trading systems. Questions regarding this article or other foreign exchange market matters can directed to E-Forex Company at 1-800-562-5585 or to Email address: info@eforex.com.