Foreign Exchange Market

  1. Characteristics of the Foreign Exchange Market
 Barter Exchange

King Hiram of Tyre exchanged cedarwood of Lebanon for an annual shipment of 20,000 kors of grain ans 20 of oil (1 Kings 5).

Phoenicians started silent barter trade, but their alphabet was soon adopted to facilitate grade. Their alphabet facilitated the spread of science and ideas.

e.g., crucifixion was Phoenician custom to kill condemned criminals, and was soon adopted by the Romans.

 Barter exchange requires Double coincidence of wants : In the foreign exchange market, for anybody wanting to sell dollars to get British pound, there must be someone else wanting to sell the pound for the dollar at the same exchange rate (like in barter exchange).

 Role of FX market

 The FX market performs an international clearing function by bringing two parties wishing to trade currencies at agreeable exchange rates.

The FX market takes place between dealers and brokers in financial centers around the world. During the hours of business common to different time zones, they rapidly exchange shorthand messages expressing their bids for different currencies.

To make a profit on FX maneuvers, a trader has to make quick decisions correctly. Foreign exchange traders lead an exciting and hectic life, and the pressure often shortens many careers.

The fastest possible communications are used. Before the trans-Atlantic cable was laid in 1865 by Cyrus West Field (after many failed attempts), somebody wanting to exchange dollars for pounds often had to wait three months (average: 45 days one way) for a roundtrip voyage to clear up the transaction. Modern telephone links have reduced the transaction costs on foreign exchange to near zero for large transactions.

   Currencies of the world

  2. Origin of Money

Inside the lid, there is a Chinese character copied below. Cowries were used as money during the Shang dynasty (1600 - 1046 BC)
Chinese money, British Museum

cowry cowry


Cretan oxhide ingot (flat)

Dollar is derived from German taler or Joachimstaler in 1530s, a silver coin minted from a mine near Joachimstal, which lies within the Czech Republic.


  3. Recent Development in the Foreign Exchange Market

 The daily transactions volume in the FX markets in 1998 was estimated to be over $2.5 trillion dollars. In 2014, the daily volume was over $5 trillion. In April 2019, FX trading averaged $6.6 trillion per day.

UK (41%), US (19%), Singapore (5.7%), Japan (5.6%), Hong Kong (4.1%), 2014.

Composition: USD accounts for 88%, Euro 31%, Yen 22%, Pound Sterling 13% (in 2016), CNY 2%. CNY is not traded in Forex market.)

This is likely to decline once BRICS adopt their reserve currency.

(Daily volume on New York Stock Exchanges is about $169 billion in 2013. It is about 3% of the global FX market.

The Foreign Exchange market expanded considerably since President Nixon closed the gold window and currencies were left afloat vis-á-vis other currencies and speculators could profit from their transactions.


Until recently, this market was used mostly by banks, who fully appreciated the excellent opportunities to increase their profits.

Today, it is accessible to any investor who wants to diversify his portfolio.


$2 trillion in spot transactions

$1 trillion in forward transactions

$3 trillion in foreign exchange swaps (e.g., buying a foreign currency in the spot and selling it in the forward market to be delivered during the same week) Also reverse transactions at the end of contract period.

Up to 90% are speculative transactions .

traded Currencies

(i) USD is still the dominant currency (88%).

(ii) The emergence of Yen as a major currency (17%), and

(iii) new Euro, in addition to the Dollar (32%, EU maintains a large trade surplus with the US: about $150 billion a year.)

(iv) yuan: Chinese Renminbi is convertible on current account, but not on capital account (4.3%). When it becomes fully convertible, which is not likely to occur until 2020 or later, it will fundamentally affect the foreign exchange market due to its sheer volume.

(v) Russian ruble: 1.1% (no chance for Ruble-RMB takeover)

(vi) Passive role of the IMF. IMF can discipline only the countries with large trade deficits.

 When The foreign exchange market operates 24 hours a day permitting intervention in the major international foreign exchange markets at any point in time.
European Banking

(Why Swiss Franc played an important role in the FX market? Philip IV owed much money to the Knights Templar (c. 1119-1312, flag = red Maltese cross). At the behest of Philip IV of France, the Knights were disbanded by Pope Clement V in 1312. They were a military order that had been founded in 1119 AD to protect Christian pilgrims from Europe to Jerusalem, but gradually had since evolved to become a multinational banker. Pilgrims deposited money with the Templars in France and were able to withdrew the fund in Jerusalem and elsewhere. Some of the surviving Knights reportedly fled to Switzerland. Swiss Franc has become a major currency in the Forex market. These Knights were stationed at the Temple of Solomon (#1) below, now located at Al Aqsa mosque in Jerusalem.)

map of Jerusalem, 1640 AD

Crusaders dug a moat around Caesarea, Israel

a worn-out Templar flag ©

The introduction of the euro in 2002 dramatically changed the composition of these foreign currencies as most of the European currencies were replaced by the euro.

Knights Hospitaller (1099 - ) (provided care for injured pilgrims at first, but turned into a military order. Its flag is similar to Swiss flag).


  4. Some FE Customs
 traded currencies  Although there is an exchange rate between the domestic currency and every other currency, most FE transactions involve only a small number of international currencies.
Euro and European banking

Before the single currency euro was launched in 2002, the composition of foreign currency transactions in the New York market in 1985 was as follows: Mark 32%, Pound 23%, Canada $ 12%, Yen 10%, Swiss Franc 10%, others 13%.

 Selling price

The exchange rate is the domestic price of a foreign currency. The FE quotations list selling price in dollars or foreign currency per dollar.

The selling price refers to the price at which a large customer could have bought the currency from the dealers. The buying price at which one could have sold foreign currency to the dealers is normally 0.1% below the selling price, which represents the commission of FE dealers or banks. This is called interbank trading as it occurs usually between foreign exchange dealers in different banks in major financial centers. Obviously, the "retail" rates for corporate customers are less favorable than the "wholesale" rates. (> $1 million)

 Spread This spread can be higher in foreign exchange markets other than New York/London, and also in an exchange crisis, and in rarely traded currencies. Because the market participants know this customary spread, usually only the selling prices are published.  
 Spot rates (i) For most currencies, only a spot rate is quoted. Spot exchange is foreign exchange for immediate delivery that is used for international payments (for imports and investment). The daily quotations are for bank (cable) transfers. While transactions between these banks are instantaneous, these funds become available for use by customers 1-2 working days after the purchase.

(ii) Transactions agreed on Monday will result in payments on Wednesday. Those agreed on Thursday will be available on Monday. Canadian/US dollar business is cleared in one day (because Toronto and New York are in the same time zone).

(iii) Some New York banks maintain 2 shifts (one arriving at office at 3 am when London and Frankfurt are open). Large New York banks also have branches in Tokyo, Frankfurt, and London. Thus, they are in contact with all financial centers 24 hours.

(iv) When a FE dealer or broker quotes a price on the telephone, he can be held to it for only a few seconds (It used to be up to 1 minute). Dealers may quote different prices to different customers. Prices change throughout the day. Bluffing/counterbluffing for a large sum of FE. For average customers, it does not pay to get more than one quote.

 Bank notes


 Buying and selling rates for bank notes may be listed. Prices do not change throughout the day. Selling price for BN may be higher/lower than the selling price for Cable transfers. The spread is much larger than 0.1% for cable transfers, and may go up to 5-10%.

Forward rates

forward rates are for currency to be delivered 30, 90 or 180 days later at the known price on a given day. Forward rates are available for major international currencies.

Currency futures

Currency futures markets were established by Chicago Mercantille exchange in 1972. Futures prices are for contracts applicable to a specific calendar dates (Third Wednesday of June, September, December and March).  

  5. Participants of the Foreign Exchange markets
 Retail customers

They are importers/exporters of goods, services and financial assets (stocks/bonds).

They are most numerous.

They buy and sell FE for transaction purposes.

These do not usually trade currencies one another because it is difficult to match double coincidence of wants. Instead they go to a commercial bank for the transactions.

Electronic trading: 10% of spot market. $150 billion per day.

 Foreign Exchange dealers (speculators)

(i) FE Dealers are large commercial banks, which buy and sell FE. They assume an open position, and are exposed to exchange risks. Specifically, they are the international departments of large commercial banks in the financial centers of the world: London, New York, Tokyo, Zurich, Frankfurt, Paris, Singapore, Hong Kong, Toronto. Their speculative transactions account for 90% of daily trade volume. One speculative episode may last a few minutes.

(ii) Forex scandal. Dealers (e.g., The Cartel, One Team One Dream, The Mafia, etc. share confidential information about clients' intention through electronic chatroom. Dealers were front-running large client orders (buying before filling buy orders and selling before filling sell orders of the clients. Buying a large amount of a currency soon raises the price.

Front running: Buy a large amount of a currency using the bank's own fund and other dealers (as shown in the videotape: legal) This move raises the market price. The bank sells it to the client after the price rises: legal)

However, they violate client confidentiality . Five banks agreed to pay fines totalling more than $5.7 billion in 2015. (Citibank, HSBC, JPMorgan, RBS and UBS. Profits from front running = roughly 1/10 of 1%, + fee = 1/10 of 1%.) How traders use front-running to profit from client orders, NY Times).

In New York City, there are about 100 such banks.

(iii) Large banks outside the center also participate through their affiliates.

(iv) Small regional banks do not directly participate in the FE market. But to meet their customers' FE need, they deal with correspondant banks. Almost 14,000 commercial banks maintain corresponent relationship with FE dealers.

(iv) FE dealers typically maintain a trading room equipped with telephones and telex machines. They ususally communicate directly with the trading rooms of banks in other centers. They go through a broker when dealing with other banks in the same center. They are exposed to FE risks.

Major dealers: Deutsche Bank, Citi, Barclays, UBS (Switzerland), HSBC (HK/Shanghai   → UK), JP Morgan, Royal Bank of Scotland, Credit Suisse, Morgan Stanley, Bank of America.

Salary = up to $2 million.

 FE brokers

These are brokers for retail customers , and work for a commission. There are 8 brokers in New York, and more than 100 in the U.S. (e.g., TD Ameritrade, Leverage must be less than 50:1. They usually specialize in a few currencies, and earn commission = 1/10 of 1% - 1/8 of 1%.

 Central Banks

(i) Central banks participate (a) to facilitate Treasury's transactions, and (b) to prevent or effect a change in the value of their currency.

(ii) in the US, Federal Reserve Bank of NY acts as agent for the entire Federal Reserve System and the Treasury Department.

(iii) it usually tries to conceal its intervention. It may requres an obscure bank in Midwest to place an order in the New York market.

(iv) Sometimes it publicizes its buying intent.

China buys Gold, Challenges US Dollar

(v) Saudi Arabia will accept yuan payments (petroyuan)

(vi) Russia will accept yuan payments

(vii) Brazil will accept yuan payments

(viii) BRICS proposes a new currency backed by gold.

China gold holdings: 1948 tons, $3.3 trillion

US: 8000 metric tons, Germany:3,300 tons, China, 1948 tonss.

China keeps buying gold. China bans gold exports.

 Other speculators numerous, but they participate through FE dealers. 


  5. Three Traders (Speculation in FX Markets)
 Videotape (June 4, 1985)

World Poker Championship: Cards are shown only to the viewers. Apparently, viewers cannot convey any message to the players. The winner's prize is over $2 million.

Casino Royale: Bond wins $115 million (Casino Royale).

With sharp minds, the players can incorporate all the information on the displayed cards and calculate the probability of a desired card. In the case of poker, there are only 52 possible cards. Accordingly, bright individuals can compute the probabilities of winning of his own and competing players. These probabilities of winning are almost instantaneously computed for TV viewers.

Since so many things can possibly affect the probability that a currency will rise against another, computer programs or formulas for the price of a given stock or currency to rise cannot be devised. Some investment companies will claim they have developed a certain formula or program to buy and sell currencies (or stocks), but they are doomed. If a particular method brings profits to the investor, more people will invest money into that formula, thereby driving the prices of currencies/stocks downward and raising the prices of those they are selling, eventually eliminating profits.

Instead of relying on a fixed formula, currency dealers can incorporate all the available information about the currency markets and other news on world events which affect currency values.

  BBC Billion Dollars 1985 (three traders)

 Ronnie Schlaefer

(day trader)

A Swiss, living in New York
A day trader (he may hold foreign currencies even overnight)
has a bunch of medical doctors who invests a minimum of $0.5 million.

13 rich investors, around the world 50% profit rate in 1984.

management fee = fixed.
performance fee = 20- 25% once a year.
made many mistakes of missing the moment to sell mark, but breaks even at the end of the day

 Richard Hill
31 years old, works for London Barclay. gets No commission.
The majority of FX traders are 20 - 35 years old.
Chris Pablo: boss. A sterling dealer, old. Traders must concentrate when working. People get nervous. Traders earn fixed salary. No commission, but pushed aside when a big mistake is made.

Hill finds out that Russians (Moscow) are buying £ with mark, jumps on the bandwagon by buying £, thereby raising the price a little and then selling it later.

Hill bought and sold 750 million £ and profited π = $160,000 (£91,400) that day. (one day's interest at 1% is £20547). The rate of return is about 8% per year.

U: = you, pls = please

Barclay: 8 dealers, made $150 million profit, 1984
($.5 million a day) Today, their profits from foreign exchange transactions would be over $1 million a day.

 William Wong
(works for Chemical bank, Hong Kong) sold £20 million, made ($20,000 morning) pounds he bought worth $30,000 less (from Richard Hill).

Salary = $40,000 + 3% commission.

When selling a large amount of FE, people notice it and price falls. To avoid it, William Wong requests the assistance of other dealers and sell £ simultaneously.

At the end of the day, he bought and sold 120 million £, with profit = $30,000 (£17,142), which is equivalent to one day's interest on the principal at 5.2 % per year.

 Swing Trader  hold their positions for a few days (less than a week) , takes overnight risks, must be up-to-date with the latest changes in fundamentals. Tries to profit from price changes or swings within a week. Difficult to decide when to enter and when to exit (Ronnie Schlafer). Rule-based strategy. There is no perfect rule for all.
 Position trader
(George Soros)
hold their positions for weeks. (7 Winning Strategies for Trading Forex, Grace Cheng) ⇒ "buy and hold" usually turns into "buy and forget"!

  6. Exchange Arbitrage

Any foreign exchange delaer can engage in exchange arbitrage.

Exchange arbitrage involes the simultaneous purchase and sale of a currency in different foreign exchange markets. Thus, arbitragers take a closed position. (No risk)


Arbitrage becomes profitable whenever the price of a currency in one market differs from that in another market.

Suppose the pound quoted in NY is $1.75, but pound quoted in London is $1.78. Then an arbitrager in NY and his partner in London can take the following steps:

(a) buy 10 M pounds in NY: cost = $17.5 M

(b) sell 10 M pounds in London: revenue = $17.8 M

(c) profit = $300,000 less the cost of telephone, cable transfer. The supply of pound shrinks in NY, increases in London.

 Effect of arbitrage  FX arbitrage wipes out the spread in exchange rates between FE markets.


  7. Currency Speculation
 Speculation is risky

Speculators assume an open position, i.e., take risk in the FE markets. Their intention is to make windfall gains from the fluctuations in the FE markets.

expectations change in response to information about the markets. Speculators pay attention to news that affect the world markets.


 When to buy?

 When speculators expect a rise in the exchange rate in the future, they go long (buy that currency), i.e., buy FE if ESt+1 > St.


when to sell?

 They go short by selling FE if they expect a fall in the exchange rate,

sell FE if St > ESt+1.

 Forward market  in the forward market for pound,

if F90 > ES90 (when they expect a fall in the spot rate), then sell forward pound,

if F90 < ES90 (when they expect a rise in the spot rate), then buy forward pound.

 speculation is destabilizing Speculation under the fixed exchange rate system is destabilizing. If the dollar is weak, the speculators correctly expect that the dollar will depreciate soon and sell the dollar. This makes it harder for government to defend its exchange rate.
 Perils of supporting a weak pound  
Currency instability Under flexible exchange rates, speculation is stabilizing. Speculators sell high and buy low, earning profits. They sell after the upper turning point, thereby expediting the process to reach the equilibrium exchange rate. Likewise, they buy after the lower turning point.
What Nixon did

President Nixon once tried to punish these specualtors by dumping gold, effectively raising the official price of gold, but eventually he gave up. On August 15, 1971, President Nixon announced:

"In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation's currency is based on the strength of that nation's economy-and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators.

"I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.

How George Soros (position trader) made over $1 billion

"the Man who broke the Bank of England"

Suppose the pound is weak at $2.00 per pound, and that the equilibrium rate is $1.50.

Borrow 1 billion pounds (the weak currency) for a month at the annual interest rate of 4% per year.

Convert 1 billion pounds into USD (the strong currency) = £1 billion × 2.00 = $2 billion. Buy US securities at the same rate. If there is no change in interest rate (when interest rates are equal), then don't bother with the interest rates.

Since pound is weak, sooner or later the pound will be devalued and falls to its equilibrium level, $1.50.

Pay off the loan in a weak currency after the collapse. When the pound falls to $1.50, buy back the pound to pay off the loan.

Revenue is $2 billion/$1.50 = £1.333 billion. Cost = £1 billion.

Profit from the speculation is £333,333,333 (or (1/3) × 1.5 = $.5 billion dollars, or 1/3 of £1 billion)

  Collateral damage: local firms routinely borrowing money (to pay wages, for instance) from the banks for their operation file bankrupcy.

Forward Exchange Rates