So, what is the history of the foreign exchange market? Rather than start way back in history with the barter system and discuss when coins were first introduced, let's start with when the original method for exchange and payment of international debits and credits was to use gold. To do this, countries agreed not to restrict the cross-border flow of gold and to allow their gold coins to be melted down and recast by other countries. During this period, rate fluctuations and associated risks were small. The gold standard lasted until World War I. To finance the war, most countries printed large amounts of money—far in excess of their gold reserves—leading to the demise of the gold standard. Efforts to return to the gold standard failed after the war because most currencies were either over- or undervalued and were not easily matched to a gold standard. In addition, worldwide inflation at this time caused disparities among currencies, which led to currency devaluations and further inequalities among currencies. Needless to say, this was a very difficult time to exchange foreign currencies.

At the end of World War II, in an effort to avoid the difficulties encountered after World War I, the Americans proposed a system based on fixed exchange rates and the creation of the International Monetary Fund (IMF) at the Bretton Woods conference in 1944. The new system had three goals:

To do this, the Americans guaranteed that it would buy and sell gold at $35 per ounce, thereby establishing the dollar as a parity reference for all currencies and gold. In other words, the dollar replaced gold as the dominant reserve currency of the international monetary system. As a result, in addition to reserves of gold, countries held reserves of dollars, which earned interest and were easily converted into gold. The dollar became the major currency for settlement of international transactions.

This system worked well until the late 1960s when, in spite of attempts made to stabilize the markets, the widely different growth rates in individual countries caused difficulties in the fixed rate system. Some countries revalued their currencies, while others let them "float." Eventually, this led to the demise of the Bretton Woods system. In 1973, due to continued loss of confidence in the American dollar and massive American balance of payments deficits, the system of fixed exchange rates finally collapsed. Because fixed rates were not practical, most countries let their currencies float against other currencies. This was seen as a short-term solution, until a return to stable, fixed rates was possible. However, the IMF conference in 1976 formally adopted the flexible exchange rates with a "gentlemen's agreement." Member nations are required to abstain from rate manipulation and from creating unfair advantages over other member nations.

The foreign exchange market is not entirely a free market because some countries have rules regarding repatriation of funds and some currencies are fixed or semifixed to other currencies. An example of the latter is the old European Monetary System (EMS), which was an exchange rate mechanism including most European Community (EC) countries where currencies fluctuated within relatively narrow, mutually agreed upon bands.

Since currencies have been able to float, their values have fluctuated dramatically. Continuous adjustments in currencies' values have brought volatility to the foreign exchange market. As a result, any company or institution doing business which involves currencies other than its own is faced with exposure to changes in the values of those other currencies.

By way of explanation, foreign exchange exposure is the risk of financial impact due to changes in foreign exchange rates and, in general, there are three types of foreign exchange exposures:

There are actually five basic foreign exchange products:

The last four are referred to as foreign exchange derivative contracts.

The basic uses of foreign exchange products include the following:

In actual terms for spot transactions, client groups, such as corporations, investors, funds, and institutions, will use spot transactions as part of their foreign exchange management programs. Speculators will also use this market because it is an extremely active and liquid market with roughly two-thirds of all foreign exchange activity being traded. There can be plenty of movement (volatility) in any one day, which will enable a speculator to possibly benefit from such gyrations.

The foreign exchange market has some unique characteristics. As has already been mentioned, it is active 24 hours a day. Generally speaking, there is no centralized market place as there is with the stock market. Rather, deals are done in an "over-the-counter" style, with individual buyers and sellers dealing verbally, or acting through brokers; over the telephone or electronically over the Internet via various foreign exchange trading platforms.

This means that rates change from dealer to dealer rather than being controlled by a central market. For example, investors do not call around to get the best price on a specific stock because the price is quoted on the stock exchange, but they do call around to different dealers to get the best exchange rate on a specific currency. They may also refer to various widely available bank/broker screens (e.g., Bloomberg and Reuters) for indicative pricing only.

There are two exceptions to the lack of a physical marketplace. First, foreign currency futures are traded on a few regulated markets, of which the better known are the International Monetary Market (IMM) in Chicago, the SIMEX (Singapore International Monetary Exchange), and the LIFFE (London International Financial Futures Exchange) in London.

Second, in some countries there are daily "fixings" where major currency dealers meet to "fix" the exchange rate of their local currency against currencies of their major trading partners at a predetermined moment in the day. Immediately after the fixing, the rates continue to fluctuate and trade freely. The fixings happen less in this day and age and are only symbolic meetings and represent less than 0.5% of all worldwide daily trading.

Although there is no central marketplace, there are major dealing centers in three regions of the world where much of the world's FX transactions take place. There are also many smaller centers in different parts of the world.

The western European market is serviced by major dealing centers in London, Frankfurt, Paris, and Zurich. The North American market is serviced by the major dealing center in New York City, but there are also active dealing rooms in Chicago, San Francisco, Los Angeles, and a few other major cities in the States. The far eastern market is serviced by major dealing centers in Tokyo, Hong Kong, and Singapore. Around 84% of the world's foreign exchange business is executed in these major dealing centers.

To make a market means to be willing and ready to buy and sell currencies. Market makers are those market participants that both buy and sell currencies. According to market practice, a market maker, dealer, or trader will generally quote a two-way price to another market maker. (The terms dealer and trader are used interchangeably when referring to market makers.) For market makers, reciprocity is standard practice. They constantly make prices to one another, and market makers are primarily banks.

Price takers are those market participants seeking to either buy or sell currencies and are usually corporations, fund managers, or speculators. For price takers, there is no reciprocity inasmuch as they won't quote a price to other market participants.

The major participants in the market play a number of roles depending on their need for foreign exchange and the purpose of their activities:

Figure 64.1. Example of a Foreign Exchange Transaction

Speculators are growing in numbers by the day as access to the Internet becomes more freely available and with ease of access to various online trading platforms. It is said that 95% of the daily foreign exchange volume is made up of trading or speculation, while the remaining 5% of daily volume consists of governments and commercial activities.

Foreign exchange rates are a means of expressing the value and worth of one economy as expressed by its currency as compared to that of another. Normal market usage is to quote the exchange rate for spot value, that is, for delivery two business days from the trade date (except Canadian transactions against the dollar, where the spot date is only one day). The two business days are normally required in order to get the trade information between the counterparties involved agreed and to process the funds through the local clearing systems. The two payments are made on the same date, regardless of the time zone difference.

Figure 64.1 provides an example of a foreign exchange transaction.

A cross rate is the rate of exchange between two currencies that do not involve the domestic currency. In other words, within the international marketplace, cross rates have come to mean rates that do not involve the American dollar.

Most transactions are dealt as the American dollar against another currency. However, currencies are also dealt against each other, for example the Swiss franc against the Japanese yen (CHF/JPY). In these instances, it is necessary to calculate the cross rate. In order to calculate this cross rate, start with the two rates against the dollar. The objective is to obtain the number of Japanese yen per Swiss franc Consider:

Each quotation represents a bid and an offer for the currency against the dollar. The cross rate is achieved by taking opposite sides of the two prices. The rate for selling yen and buying francs is achieved by using the left-hand side of the dollar/yen (bid) rate and the right-hand side of the dollar/franc (offer) rate. The same logic is applied for buying yen and selling francs. Thus, the preceding quotations can be broken down as follows:

Hence, the spot cross rate for Swiss francs against the Japanese yen is 93.57/62. The number of places after the decimal point is determined by the convention of the quoted currency (the variable currency). In this example, this is the yen, since we are looking for the number of yen per franc. It is usual to quote cross currency exchange rates using the "heavier" currency as the base, for example, the number of yen per franc.

There is, of course, a variation to the rule. For currencies like the euro and sterling, it is market practice to multiply the respective currencies against each other. For example, consider the following;

Then the sterling against yen spot cross rate calculation will be:

Equation 64.1. 

Thus, it follows that one pound is equal to 215.67 or 215.79 yen. This is the only way it is expressed.

Exchange rates (or prices) in the foreign exchange market are driven by the laws of supply and demand. The supply and demand for specific currencies change given the amount of trade and investment being done in that currency. If there is a high demand for a currency its value increases. If there is a low demand, then its value decreases.

However, exchange rates are affected not only by supply and demand. The exchange rate will also be influenced by the economic, political, monetary, and social factors of the country involved and also by outside developments. Exchange rates can change quickly and significantly, reflecting the volatility in the market; and rates can also be moved by rumors and anticipated factors. Typically, currency rates can fluctuate from day to day due to small imbalances in supply and demand and to economic and political factors that affect the sentiment of market makers and investors.

Economic factors include economic policy, disseminated by government agencies and central banks, and economic conditions, generally revealed through economic reports. Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy, that is, the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates. Economic conditions include:

Internal, regional, and international political conditions and events can have a profound effect on the currency markets. For instance, political upheaval and instability can have a negative impact on a nation's economy. The rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive or negative interest in a neighboring country and, in the process, affect its currency.

Market psychology is perhaps the most difficult to define but it does influence the foreign exchange market in a variety of ways:

It must be remembered that there are risks with spot transactions. First, there is credit risk. Like the risk a bank incurs when making a loan, a foreign exchange contract poses the risk that the client will not perform according to the terms of the contract (that is, will not deliver the appropriate currency on time). In a foreign exchange transaction, the market maker and the client agree that each will deliver to the other a specified amount of a currency on a specific date, at an agreed rate. Trading the currencies of countries that are in different time zones compounds this risk.

Second, there is market/price risk. Trading in any currency has a degree of risk. Exchange rate risk is inevitable because currency values rise and fall constantly in response to market pressures. When engaging in a foreign exchange trade, the client's position is open until it is closed or covered. While that position is open, the client is exposed to the risk of changes in exchange rates. A few moments can transform a potentially profitable transaction into a loss.

Third, there is country risk. Some countries (and their currencies) are more risky than others. Country risk may be due to anything from governmental regulations and restrictions to political situations, or the amount of foreign currency reserves the country has. However, this risk is usually of less significance.

Figure 64.3. Spot Exchange Risk

The spot exchange risk is shown graphically in Figure 64.3.

Today, dealings in the foreign exchange market are usually done over the telephone or via the Internet. The Internet is a very quick and easy way to transact a foreign exchange transaction, with "click and deal" or "request for price" systems dominating. However, the majority of all trading is still transacted over the telephone. Using the telephone allows for prompt and timely execution but does leave room for errors in communication.

When asking for a quote, the following basic information needs to be conveyed to the market maker directly or to a corporate foreign exchange dealer: type of transaction, currency pair, and quantity. For example, a client would say: "I want to buy CHF 5 million value spot—what is your quote, please?"

Today, a market maker normally quotes a two-way price, where the trader stands ready to bid for, or offer up to, some standard amount. The difference between the two prices, as already mentioned, is the spread. Market convention, where trading is between market "professionals," is not to quote the big figures. Instead, a trader tends to quote only the last two figures of the price, the pips. For example, if the rate of dollars against Swiss francs were 1.2507/10, then the trader would quote only 07/10. That is, the trader bids for dollars at 1.2507 and offers dollars at 1.2510. If a client is checking prices with other market makers, then the client should inform the trader by saying that it is at his risk, that is, the quote can be changed by the trader. The client should then ask again when a new price is needed. If the client wishes to deal, then the trader's price would be hit, that is, where one side of the price or the other is accepted. Written confirmation, whether the deal is oral or electronic, will be exchanged and instructions taken as to whether this trade is to be settled or not and the currency amounts are transferred into the designated accounts on the value date.

As an example, suppose XYZ Corporation, based in Japan, needs to raise dollars to pay for a delivery of machine parts from America. The treasurer gets in contact with his bank dealer to arrange to buy the dollars in the spot market. The treasurer's screens display indicative prices contributed by certain major banks. This gives the treasurer a good idea of the current exchange rate. However, this is only an indicative rate and it is not a dealable price (that is, not a price to be dealt on). Therefore, the following steps are taken:

At this stage, the dealer fills in a deal ticket with the details of the trade including currencies, amount, which currency is bought and which one is sold, value date, exchange rate, counterparty, and settlement details if known.

The treasurer could also have said "at 09" or "mine."All three ways would be correct and within market practice. Also, the dealer knew that the treasurer was used to market conventions and, hence, did not quote the big figure of 117.

As another example, suppose that Mr. Jones is a high-net-worth individual who has a margin account with ABC International. He calls up and speaks to his favorite salesperson. After the customary pleasantries, Mr. Jones asks for a dealing price for sterling in "half a pound." The salesperson obtains the price from the trader and communicates it to Mr. Jones for consideration. It is likely that Mr. Jones has a general idea of where the price is from his computer screen. If Mr. Jones accepts the price, the salesperson immediately informs the trader, possibly via a hand signal. It is then up to the trader what happens with that position. The dealing conversation could be:

In the two preceding examples, the process happened in only one or two seconds, as the market can move very rapidly. The salesperson and the trader can always change the price as long as the client has not firmly accepted the last quote made. Before making a decision to actually trade, it is not unusual for a client to shop around for quotes from various market makers in order to obtain the best deal. Sometimes, clients will ask for quotes knowing that they are not ready to actually trade but just want to check where the market is.

It should be noted that the following information is needed when asking for a quote:

If possible, the trader will try to know what side of the price you are or, at best, guess. However, wherever possible, always ask for a two-way quote. But, in all cases, be extremely clear in the details of a trade or the instructions given, in order to avoid costly errors at a later stage. It is all too easy to mishear a quote "for a half" and think it is a quote in "four and a half."

In days gone by, banking institutions were the sole purveyor of the information vital to the transaction of business in the market. With no central organized market, bank dealers executed trades solely by telephone or telex, writing trade details on pieces of paper, keeping positions on blotters, and maintaining charts by hand. The resulting scarcity of information meant that price discovery was inefficient, bid-offer spreads were wide, margins were large, and major institutions played the largest role simply because they knew where activity and prices in the marketplace were occurring. As a result, foreign exchange trading was a profitable activity for these institutions. The risks of trading were somewhat controlled and isolated at the bank level, with a degree of volatility sufficient enough to warrant active participation by only the most sophisticated of market participants.

Today, most clients are pretty sophisticated when it comes to knowing where the market is and what bid-offer spreads to expect for the foreign exchange deals. Banks and brokers that are uncompetitive in their pricing don't even leave the starting blocks in the race to win foreign exchange business. What distinguishes the best from the rest is the provision of high-quality information, in the way of charting and flows of relevant market information. Also, clients are looking for systems that are Internet enabled, scalable across regions, reliable, and safeguarded against crashes. In addition, clients are looking for Internet platforms that offer real-time risk management systems, among other demands.

Today, access to price information is widely available. Both institutional investors and retail investors can now gain live access to multicontributor price feeds, which can be downloaded directly into spreadsheets, if necessary. In addition, up-to-the-minute political and economic developments are widely available through news sources such as MMS and CNBC. As a result of these developments, however, bid-offer spreads have collapsed, as have profit margins, and this in turn has hampered the growth of direct investor participation.

Also, any currency trader needs to develop a global perspective and a feel for intermarket relationships. Interest rate trends are the most important external information source. If the U.S. Federal Reserve cuts rates, the dollar should weaken. However, if the European Central Bank is expected to follow suit, interest rate trends will converge and the value of the currency may not change at all. A trader will need to follow not only the chairman of the Federal Reserve, but also his counterparts in the European Central Bank and the Bank of Japan as well.

Currencies tend to be trendier than either stocks or commodities, and it is important to understand the trend from both a fundamental and a technical point of view. Currencies cannot reverse trends very easily because economies do not reverse quickly relative to one another. However, a successful trader will recognize how fundamentals and technicals combine to indicate a trend reversal. Of course, finding the trend reversal before it happens is the "Holy Grail" of trading. No one can be expected to be successful 100 percent of the time.

Activity in the foreign exchange market still remains predominantly the domain of the large professional players. Foreign exchange is both a science and an art. Risk can be quantified and alternatives identified to reduce or eliminate it. But judgment and personal attitudes toward risk, as well as other personal and corporate orientations, are required for consistent position management. However, with liquidity and the advent of Internet trading, plus the availability of margin trading, this 24-hour market is accessible to any person with the relevant knowledge and experience. Nevertheless, a strong, disciplined approach to trading must be followed, as profit opportunities and potential loss are equal and opposite.

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