Introduction

• The foreign exchange market (also referred to as the Forex, FX, or currency market) is the market where participants exchange one currency for another. Spot trades are trades where there is an agreement for the immediate or almost immediate exchange of currencies and forward trades are trades where there is an agreement to exchange currencies at a future time. The Forex market attracts both hedgers and speculators.
• The foreign exchange market is the largest market in the world in terms of notional trading volume. It was shown that trading in foreign exchange markets averaged USD 5.09 trillion per day in April 2016. This Figure shows that the volume of trading has grown quite rapidly since 1998. In 2016, 88% of the trading was between the U.S. dollar (USD) and another currency.

• The seven most popular currency pairs (listed by their global Forex market shares) were
  • USD and the euro (23.0%)
  • USD and the Japanese yen (17.7%)
  • USD and the British pound (9.2%)
  • USD and the Australian dollar (5.2%)
  • USD and the Canadian dollar (4.3%)
  • USD and the Chinese yuan (3.8%)
  • USD and the Swiss franc (3.5%)
• Exchange rates can have a large effect on reported profits for firms that operate in multiple countries. Specifically, these firms are subject to foreign exchange gains and losses from both operating cash flows in foreign currencies as well as from the translation of asset and liability values in those currencies.

Quotes

• When an exchange rate is quoted, there is a base currency and a quote currency. Currency pairs are typically indicated as XXXYYY or XXX/YYY (with XXX as the base currency and YYY as the quote currency). The exchange rate shows how much of the quote currency is needed to buy one unit of the base currency. For example, a EURUSD quote of 1.2345 indicates that 1.2345 U.S. dollars are needed to buy one euro. A USDSEK quote of 8.7654 would indicate that 8.7654 Swedish kronor are needed to buy one U.S. dollar. The three-letter abbreviations for some traded currencies are shown in this table.

Country/Currency	Abbreviation
Argentina Peso	ARS
Australian Dollar	AUD
Brazil Real	BRL
Britain Pound	GBP
Canadian Dollar	CAD
China Yuan/Renminbi	CNY
Columbia Peso	COP
Czech Koruna	CZK
Denmark Krone	DKK

Country/Currency	Abbreviation
Egypt Pound	EGP
Euro	EUR
Hong Kong Dollar	HKD
Iceland Krona	ISK
India Rupee	INR
Iran Rial	IRR
Iraq Dinar	IQD
Israel New Shekel	ILS
Japan Yen	JPY
Malaysia Ringgit	MYR
Mexico Peso	MXN
New Zealand Dollar	NZD
Norway Krona	NOK

• The most common exchange rate quotes are between USD and another currency. Other quotes (e.g., between GBP and EUR) are known as cross-currency quotes. Currency traders have conventions about which currency is the base currency when exchange rates are quoted. In the case of the exchange rate between the U.S. dollar and the British pound, for example, the U.S. dollar is the quote currency. This is also the case when the U.S. dollar is quoted with the euro, the Australian dollar, and the New Zealand dollar. In most other cases, however, the U.S. dollar is the base currency and the other currency is the quote currency. The quote for the Canadian dollar, for example, is USDCAD, and it indicates the number of Canadian dollars that are equivalent to one U.S. dollar.
• Spot exchange rates are typically quoted with four decimal places. The bid-ask spread faced by corporations when they trade large amounts of a currency is quite small. On July 6, 2018, for example, EURUSD was quoted as bid 1.1744 and ask 1.1746. (For the small currency exchanges necessary when traveling, however, bid-ask spreads are much larger.)
• Forward exchange rates are quoted with the same base currency as spot exchange rates. They are usually shown as points that are multiplied by 1/10,000 and then added to (or subtracted from) the spot quote. This table shows the points quoted for EURUSD on July 6, 2018.

Maturity	Bid	Ask
1 Week	5.74	5.90
2 Weeks	11.67	11.75
3 Weeks	17.55	17.65
1 Month	26.10	27.20
2 Months	52.87	53.87
3 Months	80.87	82.07
4 Months	112.58	113.98
5 Months	138.06	139.46
6 Months	172.70	174.70

Maturity	Bid	Ask
7 Months	203.89	206.39
8 Months	231.79	234.29
9 Months	263.36	265.86
10 Months	294.45	296.95
11 Months	326.60	329.10
1 Year	359.5	362.0
15 Months	460.01	461.77
21 Months	662.53	665.83
2 Years	754.50	759.45

• As an example, consider the EURUSD three-month forward quote with bid 80.87 and ask = 82.07. Because the spot rate was bid 1.1744 and ask 1.1746, this means that the three month forward bid quote is

1.1744 + 0.008087 = 1.182487

Meanwhile, the three-month forward ask quote is

1.1746 + 0.008207 = 1.182807

The bid-ask spread for the points is 1.20. This increases the bid-ask spread for the three month forwards by 0.00012 relative to the bid-ask spread for spot trades and makes it so that the bid-ask spread for the forward quote is 0.00032(= 0.0002 + 0.00012).

Maturity	Bid	Ask
3 Years	1,119.70	1,135.70
4 Years	1,452.40	1,472.40
5 Years	1,754.80	1,778.80
6 Years	2,031.00	2,063.00
7 Years	2,284.00	2,324.00
8 Years	2,516.00	2,556.00
9 Years	2,729.00	2,768.00
10 Years	2,929.00	2,969.00
12 Years	2,731.00	2,806.00
15 Years	3,139.00	3,239.00
20 Years	3,834.00	3,984.00
30 Years	5,259.00	5,277.40

• The bid-ask spread increases as the maturity of the forward contract increases. For example, the 20-year forward rate is bid:

1.1744+0.3834=1.5578

And ask

1.1746+0.3984=1.5730

for a bid-ask spread of 0.0152.

• The quotes indicate that EUR, when purchased with USD, is more expensive in the forward market than in the spot market. The reason for this will be discussed later.

• The points can also be negative so that the forward exchange rate is less than the spot exchange rate. For example, this table shows USDCAD forward rates on July 6, 2018. The spot exchange rate is bid 1.3082, ask 1.3083.

Maturity	Bid	Ask
1 Week	-2.21	-1.81
2 Weeks	-3.98	-3.48
3 Weeks	-5.85	-5.25
1 Month	-8.29	-7.67
2 Months	-15.20	-14.29
3 Months	-22.10	-20.91
4 Months	-28.91	-27.42
5 Months	-35.90	-33.95
6 Months	-43.60	-41.08

Maturity	Bid	Ask
7 Months	-53.84	-49.84
8 Months	-57.88	-55.08
9 Months	-63.00	-60.00
10 Months	-71.27	-68.07
11 Months	-76.00	-72.40
1 Year	-82.15	-78.15
15 Months	-104.00	-94.00
21 Months	-146.06	-131.38
2 Years	-162.70	-142.70

• Note that the magnitude of negative ask points is always less than the magnitude of negative bid points. This is consistent with the bid-ask spread for forward quotes being greater than the bid-ask spread for spot quotes. The ten-year forward bid quote is

1.3082 – 0.0521 = 1.2561

Meanwhile, the ten-year forward ask quote is

1.3083-0.0241=1.2842

The bid-ask spread is therefore 0.0281. However, note that the bid-ask spread for ten-year forwards on EURUSD from this table is a much lower 0.0042. One reason for the difference is that long-dated forward contracts on EURUSD are more actively traded than those on USDCAD.

Maturity	Bid	Ask
3 Years	-214.00	-183.00
4 Years	-285.70	-205.70
5 Years	-290.10	-270.10
6 Years	-385.00	-265.00
7 Years	-441.00	-241.00
8 Years	-498.00	-218.00
9 Years	-521.00	-241.00
10 Years	-521.00	-241.00

Quotes – Outrights And Swaps

• A forward foreign exchange transaction, where two parties agree on an exchange at some future date, is termed an outright transaction or a forward outright transaction. It can be contrasted with an FX swap transaction, where currency is exchanged on two different dates. Typically, an FX swap involves a foreign currency being bought (sold) in the spot market and then sold (bought) in the forward market. An FX swap is a way of funding an asset denominated in a foreign currency by paying interest in the domestic currency.

• This table shows a breakdown of this trading between spot trades, forward trades, FX swaps, currency swaps, and other products. While an FX swap involves the exchange of currency on two different dates (as has been described), a currency swap (also known as a cross-currency swap) involves the exchange of principal and a stream of interest payments in one currency for principal and a stream of interest payments in another currency. Currency swaps will be discussed in detail later.

Type of Transaction	Daily Volume (Billions of USD)
Spot	1,654
Outright Forward	700
FX Swaps	2,383
Currency Swaps	96
Other Products (Incl. Option)	254
Total	5,087

Quotes – Futures Quotes

• Forex futures trade actively on exchanges throughout the world. The CME Group in the United States trades many different futures contracts on exchange rates between the U.S. dollar and other currencies. These are always quoted with USD as the base currency. This is because (from the perspective of the exchange) a foreign currency is treated like any other asset and is valued in U.S. dollars. For example, a six-month forward quote for the USDCAD of 1.3000 corresponds to a six-month futures quote of 0.7692 (=1/1.3000) USD per CAD.

Popular contracts traded by the CME Group are on

• • 100,000 AUD
  • 62,500 GBP
  • 100,000 CAD
  • 125,0000 EUR
  • 12,500,000 JPY
  • 125,000 CHF

The maturity months available on a given date include the following three months along with March, June, September, and December for the next 20 months.

Estimating Risk

• Firms need to quantify their exposures to exchange rates at different times in the future. Once this is done, they must then decide whether their exposures are acceptable or whether some hedging is necessary.
• There are three categories of risk which need to be examined:
  1. Transaction risk,
  2. Translation risk, and
  3. Economic risk

Estimating Risk – Transaction Risk

• Transaction risk is the risk related to receivables and payables.
• Translation risk arises from assets and liabilities denominated in a foreign currency. These must be valued in a firm’s domestic currency when financial statements are produced. This can lead to foreign exchange gains or losses.
• Translation risk is fundamentally different from transaction risk. Whereas transaction risk directly affects a company’s cash flows, translation risk does not. However, it can have a big effect on its reported earnings. It is sometimes recommended that translation risk be netted against transaction risk, but this is not appropriate.

Estimating Risk – Transaction And Translation Risk

• Forward contracts are very useful for hedging transaction risk. Transaction risk exposures should be estimated month by month, and each month’s exposure can be hedged separately. But it only makes sense to hedge translation exposure on one future date. For example, it would be over-hedging to hedge the FX exposure to the value of the assets in one and in two years because the price change over the first year is then considered twice.
• Hedging translation risk with forward contracts on a reporting date makes accounting profits less volatile on that reporting date. However, it is questionable whether this is a good idea unless there is a plan to sell foreign currency assets or retire foreign currency liabilities at a particular time in the future. This is because hedging replaces accounting risk with cash flow risk (because forward contracts do affect future cash flows). While translation risk is reduced, the transaction risk relating to the cash flows from the forward contracts is increased. A better way of avoiding translation risk is to finance the assets in a country with borrowings in that country. In that case, gains (losses) on assets are offset by losses (gains) on liabilities. For example, consider again the U.S. company with a GBP 10 million manufacturing facility in the U.K. If the translation risk is considered unacceptable, the facility can be financed by GBP 10 million of borrowings. There will then be no net translation gain or loss.

Estimating Risk – Economic Risk

• Economic risk is the risk that a company’s future cash flows will be affected by exchange rate movements. For example, a U.S. firm that sells software in Brazil and denominates the price of the software in USD has no transaction risk. However, the firm does have economic risk. If the real (BRL) declines in value relative to the USD, the company’s customers in Brazil will find its software more expensive. As a result, either the demand for the software will decrease or the firm will find it necessary to reduce the USD price of the software when it is sold in Brazil.
• Sometimes exchange rate movements can affect a firm’s competitive position in its domestic market. Consider a U.K. firm with no production or sales overseas. Exchange rate movements might make it more profitable for a foreign competitor to increase its activities in the U.K. in a way that adversely affects the firm.
• Economic risk is more difficult to quantify than transaction or translation risk, but possible exchange rate movements should be considered when key strategic decisions are being made. For example, foreign exchange considerations might play a role in a decision to move production overseas.

Multi-Currency Hedging Using Options

• Multinational companies have exposures to many different currencies. These exposures can lower FX risk due to diversification effects because exchange rate movements across different currencies are not perfectly correlated. Thus, volatility arising from exposures to many different currencies is usually less than that arising from an exposure to a single currency.
• Treasurers often prefer options to forward contracts when hedging due to obvious reasons. One FX hedging strategy is to buy options on individual currencies to cover each possible adverse exchange rate movement. A less expensive alternative, however, is for a firm to identify the portfolio of currencies to which it is exposed and buy an option on that portfolio in the over-the-counter market. For example, a corporation could buy an option on a portfolio consisting of:
  • A long position in 100,000 units of currency A,
  • A long position in 200,000 units of currency B, and
  • A short position in 75,000 units of currency C.

This type of option is known as a basket option. Multinational firms usually have exposures to an exchange rate in every month of the year. One way to limit this exposure is to trade options with monthly maturities. A less expensive alternative is to trade options on the average exchange rate during the year. These options are known as Asian options.

Determination Of Exchange Rates

• Exchange rates are determined by many interrelated factors. Future exchange rates cannot be predicted with any precision. Exchange rates (like the prices of all financial assets) are ultimately determined by supply and demand, which are in turn influenced by many factors. Some of the most important economic variables that influence exchange rates are :
  • Balance of Payments and Trade Flows
  • Inflation
  • Monetary Policy

Determination Of Exchange Rates – Balance Of Payments And Trade Flows

• The balance of payments between two countries measures the difference between the value of exports and the value of imports. For example, suppose exports from country A to country B increase. When exporters exchange their foreign currency-denominated revenues for their domestic currency, it will increase the demand for country A’s currency and strengthen it relative to country B’s currency. If imports from country A to country B increase, however, country A’s currency will weaken relative to that of country B (because importers would have to buy country B’s currency to pay for the goods they are importing).
• There are some equilibrating forces at work here. As country A increases its exports to country B, its currency strengthens. This causes its exports to become more expensive for customers in country B. As a result, there is lower demand for those exported goods in Country B. Similarly, country A imports increase as its currency weakens. As a result, goods imported from Country B become more expensive, and this in turn reduces the demand for goods imported from Country B. For Example- The value of the Canadian dollar is influenced by the price of oil, because Canada is an oil exporting nation. The Canadian dollar was worth more than the U.S. dollar from 2011-2014, when the price of crude oil was high. When the price of oil declined, so did the Canadian dollar.

Determination Of Exchange Rates – Monetary Policy

• The value of a country’s currency is also influenced by the monetary policy of its central bank. If country A increases its money supply by 25% while country B keeps its money supply unchanged, the value of country A’s currency will tend to decline by 25% relative to country B’s currency (with all else being equal). This is because 25% more of country A’s currency is being used to purchase the same amount of goods.

Real Versus Nominal Interest Rates

• Analysts distinguish between nominal interest rates and real interest rates. Nominal interest rates are usually quoted in the market and indicate the return that will be earned on a currency. An interest rate of 4% per year for a currency of a country indicates that 100 of that currency will grow to 104 in one year.
• Real interest rates are adjusted for inflation.

• In general:

where

is the real interest rate,

is the nominal interest rate, and

is the rate of inflation.

This is often approximated as:

• The real interest rate (and sometimes even the nominal interest rate) can be negative. For example, the nominal interest rates in the Swedish krone, Japanese yen, Danish krone, euro, and Swiss franc were negative in period following the 2007-2008 financial crisis. Additionally, it was estimated by Fitch Ratings that about USD 8 trillion of government bonds worldwide offered yields below zero in 2018. It is sometimes argued that interest rates cannot become negative because it is always possible to hold cash (which has an interest rate of zero). However, storage costs for large amounts of cash are not trivial, and thus negative rates do not necessarily present arbitrage opportunities.

Covered Interest Parity

• Purchasing power parity provides results that are at best approximately true in the long-term. Over short periods of time, there can be significant deviations from purchasing power parity. A more precise result can be derived based on arbitrage arguments relating to forward exchange rates, spot exchange rates, and interest rates.

• There is no uncertainty about the amount of USD that will be obtained at time T for either scenario. In the absence of arbitrage opportunities, they must therefore give the same result:

So that

• In general, for an exchange rate XXXYYY,

If the risk-free rate for currency XXX is higher than that for currency YYY, XXX is weaker in the forward market than in the spot market (i.e., it takes less units of YYY to buy one unit of XXX in the forward market than it does in the spot market). If the risk-free rate for currency XXX is lower than that for currency YYY, XXX is stronger in the forward market than in the spot market (i.e., it takes more units of YYY to buy one unit of XXX in the forward market than it does in the spot market).

Covered Interest Parity – Interpretation Of Points

• It is approximately true that when T<1

This can be written as

or

so that

or approximately

• This provides an interpretation of the forward rate points. The term F – S is the points divided by 10,000 and (when expressed as a percentage of the spot rate) is approximately equal to the interest rate differential applied to time T.

Example –

Suppose that interest rates in currencies XXX and YYY are 3% and 5% per annum (respectively) and that the XXXYYY spot rate is 1.2500. The six month XXXYYY forward rate will be

In this case, the forward rate would be quoted as 121 points (= (1.2621 – 1.25) × 10,000) and:

This corresponds to 0.97%, which is approximately equal to the 2% per year interest rate differential applied to six months.

Uncovered Interest Parity

• Covered interest parity concerns forward exchange rates and can be expected to hold well because it depends on arbitrage arguments. Uncovered interest parity is an argument concerned with exchange rates themselves and is just one of the many interacting factors that determine how exchange rates move. It argues that investors should earn the same interest rate in all currencies when expected exchange rate movements are considered. For Example – Consider currencies X and Y with risk-free rates of 2% and 6% (respectively). In equilibrium, the two currencies should be equally attractive. According to uncovered interest rate parity, this means that the investor should expect the value of currency Y to weaken by about 4% relative to the value of currency X.
• There are many potential violations of uncovered interest parity. In 2018, the interest rate in USD was much higher than the interest rate in EUR. However, the U.S. economy was generally considered to be much stronger than many European economies. Many market participants did not consider the interest rate differential to be indicative of a stronger euro in the future.
• If both covered and uncovered interest rate parity held, the forward exchange rate would equal the expected future spot exchange rate.