K.

Alec Chrystal

T HE economies of the free world are becoming

increasingly interdependent. US. exports now amount
be described. This will be followed by a discussion of
some of the more important acti~tiesof market partici-
to almost 10 percent of Gross National P,mduct. For pants. Finally, there will be an introduction to the
both Britain and Canada, the figun?currently exceeds analysis of a new feature of exchange markets - cur-
2s percent. Imports are about the :same size. Trade of rency options. The concern of this paper is with the
this magnitude would not be possible without the structure and mechanics of foreign exchange markets,
ability to buy and sell currencies. Currencies must be not with the determinants of exchange rates them-
bought and sold because the acceptable means of pay- selves.
ment in other countries is not the U.S. dollar. As a
result, importers, exporters, travel (agents,tourists and
many others with overseas business must change dol- THE BASICS OF FOREIGN EXCHANGE
lars into foreign currency and/or the reverse. MARKETS
The trading of currencies takes place in foreign ex- There is an almost bewildering variety of foreign
change markets whose major funsction is to facilitate exchange markets. Spot markets and forward markets
international trade and investment. Foreign exchange abound in a number of currencies. In addition, there
markets, however, are shrouded in mystery One are diverse prices quoted for these currencies. This
reason for this is that a considerablle amount of foreign section attempts to bring order to this seeming dis-
exchange market activity does not appear to be related array.
directly to the needs of international trade and invest-
ment. Spot, Forward, Bid,Ask
The purpose of this paper is to1 explain how these Virtually eve? major newspaper, such as the Wall
markets work.' The basics offoreign exchange will first Street Journal or the London Financial Times, prints a
daily list of exchange rates. These are expressed either
as the number of units of a particular currency that
exchange for one US. dollar or as the number of U.S.
K. Aiec Chrysfai, prolessor of economics-elect, University ol dollars that exchange for one unit of a particular cur-
Shefield, England, is a visiting scholar at the Federal Reserve Bank rency. Sometimes both are listed side by side !see
01 St. Louis. Leslie Bailis Koppel provided iresearch assistance. The
author wishes to thank Joseph Hempen, Centerre Bank, Sf.Louis, lor table 11.
his advice on this paper.
For major currencies, up to four different prices
'For further discussion 01 foreign exchange markets in the United
States. see Kubarych (1983). See also Dufeyand Giddy (1978)and typically will be quoted. One is the "spot" price. The
McKmnon (1979). others may be "30 days forward." "90 days forward."

307
Table 1
Foreign Exchange Rate Quotations
The Dollar SDot and Forward

.....
h m l U l0allUl ......
**,CMlmrrnllntr .....
.kSau 1111

#In.,"
....
R N n N I "e ......
-1 iCNltlrnl ........
IPOY"1 .....
B O W hmm
S O q hnam ..
1MOw hmm . .
CUOI ~Oollarl ....
YMaViDnM ...
SOqhmm . .
(omm
IWOW
all, .mu nte1 .....
PN IYWI ............
w m u IPUoI .......
0 . a i h l ......
M I'SUUl,
omw "8. ........ u.m 4.m
h o w nu ...... 91.61 91 m
AI& I M I N l l ........ 5.7m 5.7190
krp 1Fmc1 .......... 1.0750 8.0154
10.0- h M .... 1.0955 8.lDp
S O a V F a n m ..... 8.1695 8.t725
ImO h M .... 8 3103 8.3154

,n-!
W.YI
Ir,iODIu(1...........
h*,T"rnrn2,
k*
....
.......
93.
771
10.8
=.io
7
1020
W
u.ll ~Rumnl...... ss. m.
mu W n l l ......... W M53
M,*I ........... 17m n.m
Wr IL", ............. 1m. Ism50
0 lvnl .............. 26% 2456s
3D -
O r.rn d ..... 244 P 245.lS
wa~km..... 243 48 24.75
~moqh m m ...... 241.10 241.39
w .
lIpouml ...... 6.M 46s

-
U w a IRuqOrll ...... 2.uSo 2x3
m..1- IPUot
M
ng .......... wn 1nm
L HID .IGWidnl .... 1.W 1.mO
X" Ke
W
I 130Ulrl ... Xu07 l y l l
ImlMnl ......... 740 7.Iw3
i R y a l ......... 11.10 13.30
r m lspll ................ 1wm 1m.a
mIIuIl~+=m...... I I mi t m 7
mru ,E%%u........ ol 124.3 la.90

-
w w. IRrml .... 3.4 3.4
tvrrn l o o n v l ...... 2.1455 2.1w
w kmn lRMl ..... 1.12n 1.1%
s.6 Iru Wall ......
rra 1- ...........
n8.m m.m
1s2.m t31.w
f.M 11- .......... 7.9140 1W
lkvrl ...... 2.1% 2.11111
x4aV&a-.a-d ..... nsu 1.t65s
'1ooavFonM ..... 2.tu9 2.1170

-
1100 m 2.11n 2.1177
r n . L I ..... 1:: ' 40.17 4.17
h W laull ........ n.01 om
v.N t 4 8 a p o o l
filmma ................ s.n s.n
lMml
omul "Y ....:....... 4.10 rm
ROUW nu ............ 13.90 11.15
1. g l l :::::: 2.m
2.87Il
2.m
2.sm
0DO"wmPI ..... 2.WO 2 . W
lmOw&a-.a-d......
........................ l.Wl7
____
1.04Sl
2.6W L a 9

Wall Street Journal. September 8, 1983

308 Section Six Internntional Finance

 and "180 days fonvard."Thesemay be expressed either
in "European Terms" lsuch as number of $ per El or in Table 2
"American Terms" lsuch as number off. per Si. lSee the
glossary for further exp1anatio;n.l
Dollar Price of Deutschemarks and
Sterlina at Various Banks
The spot price is what you must pay to buy curren-
cies for immediate delivery (two working days in the
interbank market; over the counter, if you buy bank
notes or travelers checksl. The fonvard prices for each Rail
currency are what you will have to pay if you sign a Local (St. Louis) banks (avg.) .3572-.3844 112251.5025
~~ ~~~~~ ~~~~

contract today t o b u i i ~ t C E i i i i % E ~ o n ~ c f u t i i f rWholesale

e~

date 130 days h m now, etc.1.In this market.you pay for New York banks ,3681-3683 1.457C-1.4580
the currency when the contrasct matures. European banks (high) ,26944696 1.4573-1.-
Why would anyone buy and sell foreign currency European banks (low) ,36774678 1.4610-1.4qil
fonvard? There are some maim advantages fmm hav- Bankers INS1 ,3681 1.*588
ing such opportunities available. For example, an ex- Note: These prices were all quoted on November 2 8 , I-. ba
porter who has receipts of foreign currency due at tween2:00p.m.and2:45p.m.(CenValStandardiime).Ricesfor
some future date can sell those funds forward now, l o c a l banks were acquirsd by felephonrg for meir piw on a
S10.00(1transaction. The prices quoted were reference raterand
thereby avoiding all risks associated with subsequent no1me final pnce they would offer on a firmframadw. F q afor
r
adverse exchange rate changes. Similarly, an importer Bankers TNSt is that given in the Wall Streel Journal, NcMmbar
who will have to pay for a shipment ofgoods in foreign 2 9 , 1983, as priced at 2:W p.m. (Central Standard Tm) on
November 28. 1983. Other prices were taken from me T e W e
currency in, say. three months can buy the foreign informationsystem at 235 p.m. N e w York prices were me laled
exchange fonvard and. again, avoid having to bear the availaDle (Morgan and Citibank. respMsvely). European p n a S
exchange rate risk. were the l a prices quoted before dose of trading in Eurqm by
various banks. Deutschemark pnces were actually qwed in
American terms. The sell pncesabove have been r o u n d e d up. The
The exchange rates quoted i n the financial press Ifor differencebetween buy and sel prices for DM in me interbank
example, those in table 11 are not the ones individuals market aclually worked out a1 5o.ooOt5.
would get at a local bank. Unless othenvise specified,
the published prices refer to those quoted by banks to
other banks for currency deals in excess of $1million.
Even these prices will vary somewhat depending upon
whether the bank buys orsells. The difference between A n example of the range of spot exchange rates avail-
the buying and selling price is sometimes known as the able is presented in table 2,which shows prices for
"bid-ask spread." The spread partly reflects the banks' deutschemarks and sterling quoted within a one-hour
costs and pmfit margins in tra:nsactions;however, ma- period on November 28,1983.There are two important
jor banks make their profits more fmm capital gains points to notice. First, all except those in the first line
than fmm the spread.' are prices quoted in the interbank, or wholesale, mar-
ket fortransactions in excess o!Sl million.The sterling
The market for bank notes and travelers checks is prices have a bid-ask spread or only 0.1 cent lwhich is
quite separate h m the interbank foreign exchange
only about 0.07 percent of the price, or $7 on 510,0001.
market. For smaller currency exchanges, such as an
On DM. the spread per dollars worth works out to be
individual going on vacation (abroad might make, the
about half that on sterling 6 4 on .$1O.OOOl.3
spread is greater than in the interbank market. This
presumably reflects the larger average costs -includ- Second, the prices quoted by local banks for small. or
ing the exchange rate risks that banks face by holding retail, transactions, which sewe only as a guide and do
bank notes in denominations too small to be sold in the not necessarily represent prices on actual deals, in-
interbank market - associated with these smaller ex- volve a much larger bid-ask spread. These retail
changes. As a result, individuals generally pay a higher spreads vary fmm bank to bank, but are related to land
price for foreign exchange than those quoted in the larger thanl the interbank rates. In some cases, they
newspapers.

'In practice. the spread will vary during the day. depending upon
2Noticethe Wall Street Journal quotes only a bank selling prlce at a market conditions. For example, the sterling spread may be as linle
paRicular time. The Fmancial Times quotes the bid-ask spread and as 0.01 cents at times and on average is a b u t 0.05 cents Spreads
the range over the day. generally will be larger on less wldely traded currencles.

Article 32 A Guide to Foreign Exchange Markets 309

maybeoftheorderof4centsorlessonsterling,though channeled thmugh brokers.* If all interbank transac-
the prices quoted in St. Louis involved average spreads tions are included, the figure rises to 59 percent.
of 8 cents on sterling. The latter nepresents a spread of
Most small banks and local officesof major banks do
about 5% percent labout $550 perS10.000 transactionl.
not deal directly in the interbank foreign exchange
The equivalent spread for DM wats 7 percent 6700 per
market. Rather theytypicallywill have acredit line with
$10,000 transactionl.
a large bank or their head office. Transactions will thus
The spread on forward transactions will usually be involve an extra step lsee figure 1I.The customer deals
wider than on spot, especially for longer maturities. with a local bank, which in turn deals with a major
For interbank trade, the closing spread on one and bank or head office.The interbank foreign exchange
three months forward-~
~~~~ sterlinepnepternbed3&t market exists betyeen the major_bankseither.didE
was .15 cents, while the spot spre,ad was .10 cents. This or indirectly via a broker.
is shown in the top line of the Financial Times report in
table 1. Of coume, like !he spot spread, the forward FUTURES AND OPTION MARKETS
spread varies with time of day and market conditions.
At times it may be as low as .02 cents. No information is FOR FOREIGN EXCHANGE
available for the size of spread on the forward prices Until very recently, the interbank market was the
typical1.v offered on small transactions, since the retail
onlychannel thmugh which foreign exchange transac-
market on forward transactions is very small. tions took place. The past decade has produced major
innovations in foreign exchange trading. On May 16.
1972, the International Money Market IlMMl opened
HOW DOES "THE" FOREIGN under the auspices of the Chicago Mercantile Ex-
EXCHANGE MARKET OPERATE? change. One novel feature of the IMM is that it pmvides
a trading floor on which deals are struck by brokerj
It is generally not possible to go to a specific building face to face, rather than over telephone lines. The most
and "see" the market where prices of foreign exchange significant difference between the IMM and the inter-
are determined. With few exceptions, the vast bulk of bank market, however, is that trading on the IMM is in
foreign exchange business is done over the telephone futures contracts for foreign exchange, the typical busi-
between specialist divisions of major banks. Foreign ness being contracts for delivery on the third Wednes-
exchange dealers in each bank ally operate from day of March, June, Septemberor December.Acti\it?/at
one mrm; each dealer has several telephones and is the 1Mh.l has expanded greatly since its opening. For
sunuulided by video screens and news tapes. Typical- example, during 1972, 144,336 contracts were traded;
ly, each dealer specializes in one or a small number of the figure for 1981 was 6,121.932.
markets isuch as sterling'dollar osr deutschemarkudol-
There is an important distinction between "forward"
larl. Trades are conducted with other dealers who
transactions and "futures" contracts. The former are
represent banks around the world. These dealers typi-
individual agreements between two parties, say. a bank
cally deal regularly with one another and are thus able
and customer. The latter is a contract traded on an
to make firm commitments by word of mouth.
organized market of a standard size and settlement
date. which is resalable at the darker price up to the
Only the head or regional officos of the larger banks
close of trading in the contract. These organized mar-
actively deal in foreign exchange The largest of these
banks are known as "market maktars" since they stand kets are discussed more fully below.
ready to buy or sell any of the major currencies on a while the major banks conduct foreign exchange
more orless continuous basis. Unusually large transac- deals in large denominations, the IMM trading is done
tions, however. w i l l only be accommodated by market in contracts of standard size~whichare fairly small.
makers on more favorable terms. In such cases, foreign Examples of the standard contracts at present are
exchange bmkers may be used as middlemen to find a E25.000; DM125.000; Canadian $100.000. These are
taker or takers for the deal. Bmkem lofwhich there are actually smaller today than in the early days of the
four major firms and a handful of smaller ones) do not IMM.
trade on their own account, but specialize in setting up
large foreign exchange transactions in return for a Further, unlike prices on the interbank market, price
commission itypicallv 0.03 cents or less on the sterling
~~
movements in any single day a& subject to specific
I

spread,. In April 1983, 56 percent of spot transactions

by value involving banks in the United States were 'See Federal Reserve Bank 01 New York (1983)

310 Section Six International Finance

Figure 1
Structure of Foreign Exchange Markets

$ with DM

Stockbroker

/
/
/
0

DM with $

Article 32 A Guide to Foreign Exchange Mnrkets 311

limits at the IMM. For example, for sterling futures, ling. deutschemarks. Swiss Francs and veri in identical
prices are not allowed to vary more than $.0500away bundles to those sold on the 1". In its firstyear. the
from the previous day's settlement price; this limit is foreign exchange business of LIFFE did not take offin a
expanded if it is reached i n the same direction for two big way. The major provider of exchange rate risk cov-
successive days. The limit does not apply on the last erage for business continues to be the bank network.
day a contract is traded. Less than 5 percent of such cover is provided by mar-
kets such as IMM and LIFFE at present.
Unlike the interbank market, parties to a foreign ex-
changecontract at the 1" Wicallydo not know each An entirely new feature of foreign exchange markets
other. Default risk. however. is minor because con- that has arisen in the 1980s is-unce of option
tmcts a r e - g u a r a m * m h q e ltsetffa-'mfi~ markets." The Philadelphia Exchange was the first to
m k e the cost of this guarantee, the exchange insists introduce foreign exchange options. These ale in five
upon "margin requirements" to cover fluctuations in currencies (deutschemark, sterling, swiss franc. yen
thevdueofacontract.Thismeansthatanindividualor and Canadian dollar). Trades are conducted in stan-
firm buying a futures Contract would. in effect, place a dard bundles half the size of the IMM futures con-
deposit equal to about 4 Percent of the value of the tracts. The IMM introduced an options market in Ger-
contract? man marks on January 24, 1984: this market trades
options on futures contracts whereas the Philadelphia
Perhaps the major limitation of the IMM from the options are for spot currencies.
point ofview of importers orexpmers is that contracts
cover only eight cumncies -those of Britain, Canada, Futures and options prices for foreign exchange are
West Germany, Switzerland, Japan, Mexico, France published daily in the financial press. Table 3 shows
and the Netherlands -
and they are specified in stan- prices for February 14. 1984.as displayed in the Wall
dard sizes for particular dates. Only by chance will Street Journal on the following day. Futures prices on
these conform exactly to the needs of importers and the IMM are presented for five currencies (left-hand
exporters. Large firms and finarcial institutions w i
l column!. There are five contracts quoted fur each cur-
find the market useful, however, if they have a fairly rency: March, June. September, December and March
continuous stream of pa?rments and receipts in the 1985.For each contract, opening and last settlement
traded foreign currencies. Although contracts have a (settle1prices, the range over the day, the change from
specified standard date. they offer a fairly flexible the previous day, the range over the life of the contract
method of avoiding exchange rate risk because they at-+ and t h e number of contracts outstanding with the
marketable continuouslY. exchange topen interest1 are listed.
A major economic advantage of the IMM for non- Consider the March and June DM futures. March
bank customen is its low transaction cost. Though the futures opened at 16.3653 per mark and closed at S.3706
brokerage cost of a contract wil vav. a "round trip" per mark;June opened at 5.3698per mark and closed at
(that is, one buy and one Sell1 Costs as little as $15.This 5.3746 per mark. Turn now to the Chicago Mercantile
is only .04 percent ofthevalueofa sterlingcontract and Exchange UMMI futures options (center' columnl.
less for some of the larger Contracts. Of course, such These are options on the futuys contracts just dis-
costs are high compared with the interbank market, cussed lsee inset for explanation bf optionsl. Thus, the
where the brokerage Cost On DM 1 million would be line labeled "Futures" lists the settle prices of the
about $6.25 lthe equivalent-valuesd eight futures con- March and June futures as above.
tracts would cost $60 in brokerage. taking $7.50 per
single deall. They are low, however. compared with Let us look at the call options. These are rights to buy
those in the retail market. where the spread may in- DM futures at specified prices - the strike price. For
volve a cost of up to 2.5 percent or 3 percent per example, take the call option at strike price 35. This
transaction. means that one. can purchase an option to buy DM
125~000March futures up to the March settlement date
A market similar to the IMM. t.he London Interna- for S.3500per mark. This option will cost 2.05cents per
tional Financial Futures Exchange (LIFFEI, opened in mark, or $2,562.50, plus brokerage fees. The June OP-
September 1982.On LIFFE. futures are traded in ster- tion to buy June futures DM at $.3500permark d l Cost
2.46 cents per mark. or $3,075.00. plus brokerage fees.

'A bank may also insist upon ?me minilnum depsit to cover a
,
forward contract, though there IS no firm rule. 'For a discussion of options in commodities. see Eelongia (1983)

312 Section Six Intmtionnf Finance

 Table 3
Futures and Options Markets

The March call option at strike price a.3900 per mark on spot;options on futures. The channels through
costs only 0.01 cents per mark 01- $12.50.These price which these markets are formed are. however, fairly
differencesindicate that the mark.et expects the dollar straightfonvard lsee figure It. The main channel is the
price of the mark lo exceed S.3500. but not to rise intehank network, though for large interhank transac-
substantial1.v above $.3900. tions, foreign exchange brokers may be used as
middlemen.
Notice that when yov exercise a futures call option
you buy the relevant futures contract but only fulfill
that futures contract at maturity In contrast, the Phil- FOREIGN EXCHANGE MARKET
- adelphia foreign currency options lright columnl are
ACTI\’ITIES
options to buy foreign exchange lspott itself rather
than futures. So, when a call option is exercised. for- Much foreign exchange market trading does not
eign currency is obtained immediately. appear to be related to the simple basic purpose of
allowing businesses to buy or sell foreign currency in
The only difference in presentation of the currency
order, say, to sell or purchase goods overseas. It is
option prices as compared with the futures options is
of the large range of
that. in the folmer, the spot exch,ange rate is listed for
through the
comparison rather than the futun?sprice. Thus, on the
Philadelphia exchange. call options on March DM
62,500at-strike price $3500 per mark cost 1.99 cents per
mark or $1.243.75.plus brokerage. Brokerage fees here
would be of the same order as on the I M M , about $16
There are several other acti\ities. however. in foreign
per transaction round trip. per contract.
exchange markets that are less well unde~stoodand
We have seen that there are several different malkets whose ~nlevanceis less ob\ious lo people interested in
for foreign exchange - spot, forward. futures. options understanding what these markets accomplish

Article 32 A Guide to Foreign Exchange Markets 313

 Foreign Exchange Options
An option is a contract specifying the right to buy
or sell- in this case foreign exchange - within a
specific period (American optionl or at a specific
date IEuropean optionl. A call option wnfers the
right to buy. A put option canfern the tight to sell.
Since each of these options must have a buyer and a
seller, there are four possible ways of trading
-
a single
o m u y a c d , sen a call, buy a put, sell a put.
The buyer of an option has the right to undertake
the wntmct specified but ma:y choose not to d o so if
it turns out to be unprofitable. The seller of the
option must fulfill the contract if the buyer desires.
Cleariy, the buyer must pay the seller some pre-
mium lthe option price1 for this privilege.An option
that would be profitable to exercise at the current
exchange rate is said to be "in the money." The price
at which it is exercised is the "exercise" or "strike"
price.

Consideracalloptionon E1.OOO lalthough options

ofthis size are not presently available on organized
exchanges, it is used to present a simple illustration
ofthe principles involved).Suppose this costs $0.03
per pound or $30 and the exercise price is $1.50 per
pound. The option expires in three months. This
means that the buyer has pabd $30 for the right to
buy €1000 with dollars at a price of $150 per pound
any time in the next three months. If the current
spot price of sterling is, say, $1.45,the option is '*out
of the money" because sterling can be bought
cheaper on the spot market. However, if the spot
price were to rise to, say, $155,the option would be
in the money. If sold at that time, the option buyer
would get a $50 return I1000 x $0.051. which would
m o r e t h a n c o v e r t h e c o s t of t h e o p t i o n
IS50 - 530 = $20 profitl. In contrast, a put option at One simple relationship which is of interm may be called
the same terms would be in the money at the cur- "option price padty." This arises because m r a g e will ensure
that the differencebetween a c a l l option price (per unit) and a put
rent spot price of $1.45, but out of the money at option price ( p e r unit) at the same exercise price will be equal to
$155. the piesent value of the dfterem between me exercise price
and the forward exchange rate at maturity of me options (if me
Figure 2 presents a diagrammatic illustration of options are marketable, it will also hold for any date to maturity).
how the profitability of an option depends upon the The relationship may be expressed:
relationship between the exercise price and the cur- c - p = -F - E
rent spot price.' F
er
e Za illustrates thepmfit avail- I + I 3

wimn C and P are the call and put aphon prkas at exercise price
E. F is the forward exchange rate snd r is the interest rate p e r
'The pitang of opbons has been th+ sthim d a large lheorefical period of the mntracts. This arises because the simuitaneous
literature with a major mntribukm b e i n g made by Bl&k and buying of a call and selling d a put is equivalent to buying
Sch&s (1973). The Black-Wes fonula has been m o d i f i e d currency loyard at price E. The lornard mntract. however,
(or Weign exchange options by Garman and Kohlhagen (1983) would be paid forat me end of the period, whereas the options are
[see also Giddy (1983)].but the BIa&.Schoies formula is mm- transacted at the beginning. Hem. the forward contract has to
plex and beyond the scope of the present paper. be dimunfed back to the present.

314 Section Six Internntional Finance

 able frum buying a call optlion at exercise price A. At exercise price. This combination will show a profit
spot exchange rate A and ainphinglower, the option at exercise price A if the spot price goes either above
will not be exercised so the loss will equal the price b or below a. I t is known as a "straddle." The strad-
of the option. At a spot exchange rate above a, the dle is of special interest because it makes clear the
option is sufficiently in the money to more than role of options as a hedge against risk. The price of a
cover its cost. Between A and a, the option is in the straddle can be regarded as the market valuation of
money but not by enough to cover cost. The pmfit thevariability of the exchange rate.That is, the buyer
frum selling a call could be illustrated by reversing of the straddle will show a pmfit if the spot price
~~
the + and - signs in figure 2a. or b a i n g j h c-~me
~~
~
s s o m e c e m d x a h & k ~
frum
profit line about the horizontal axis. by more than plus or minus some known percent-
age. The seller of the straddle accepts that risk for a
Figure 2b illustrates the profit frum buying a put
lump sum. More complicated "multiple strategies"
option. At spot exchange rates below a. the option
are also possible?
with exercise price A will !;how a profit.
Figure 2c illustrates the profit from a simul-
taneous purchase of a put and caIl at the same %eeGddy(1983).

Two major classes of activitv hill be discussed. First. tice ofexpressing exchange rates in American terms in
the existence of a large number of foreign exchange the United States and in European terms elsewhere.
markets in many locations (creates opportunities to The adoption of standard practice has reduced the
profit h m "arbitrage." Second. there is implicitly a likelihood of inconsistencies.' Also. in recent years.
market in (foreign exchange1 risk bearing. Those who such opportunities for pmtit making have been greatly
%ish to avoid foreign exchange risk lat a price] may do reduced by high-speed, computerized information
so. Those who accept the risk in expectation of profits systems and the increased sophistication of the banks
are known as "speculators." operating in the market.
+itrage of a slightly different kind results from
price differeqces in different locations. This is "space"
Triangular Arbitrage arbitrage. Forexample. ifsterlingwere cheaperin Lon-
Triangular arbitrage is the pmcess that ensures that don than in New York. it would be profitable to buy in
all exchange rates are mutuall,y consistent. If, for exam- London and sell in New York. Similarly. if prices in the
ple, one U.S. dollar exchanges for one Canadian dollar, interbank market differed from those at the IMhl, it
and one Canadian dollar exchanges for one British would be profitable IO arbitrage between them. As a
pound, then the US. dollar-pound exchange rate result of this activity. prices in different locations will
should be one pound for on8 dollar. If it differs. then be brought broadly into line.
there is an opportunity for pmfit making. To see why lnieresi Arbitrage
this is so, suppose that you could purchase two US.
dollannith one British pouncl.Byfirst buyingCS1 with Interest arbitrage is slightly different in nature frum
U.S.%l,thenpurchasingElwilhC%l.andfinallybu.~ngtriangular orspace arbitrage; however, the basic motive
U.S.$Z with El. you could double your money im- of tinding and exploiting profitable opportunities still
mediately. Clearly this opportunity will not last for long applies. There is no reason why interest rates denomi-
since it involves making large profits with certainty. nated in differentcurrencies should be equal. Interest
The process of triangular artlitrage is exactly that of rates are the cost of borrowing or the return to lending
finding and exploiting pmfitable opportunities in such for a specific period of time. The relative price lex-
exchange rate inconsistencies. As a'result of triangular change ratel of money may change over time so that
arbitrage, such inconsistencies will be eliminated the comparison of,say. a U.S.and a British interest rate
rapidly. Cmss rates, however, w i l l only be roughly con- requires some allowance for expected exchange rate
si tent iven the bid-ask sprea.d associated with trans- changes. Thus, it w i l l be not at all unusual to find
7. g
action costs.
'AIL except U.K. and Irish exchange rates are expressed in American
In the past, the possibility of making profits from terms. Futures and optiis contracts are expressed in European
triangular ah-itrage was greater as a result of the prac- terms.

-.-Article 32 A Guide to Foreign Exchange Markets 315

 interest rates denominated in dollars and interest rates Speculation
denominated in. say, pound!$being somewhat differ-
ent. However, real returns on assets of similar quality Arbitrage in the foreign exchange markets involves
should be the same if the exchange rate risk is covered liltle or no risk since transactions can be completed
or hedged in the fonvard market. Were this not tme. it rapidly. An alternative source of pmfit is available horn
would be possible to b o m w i.n one tun-ncy and lend outguessing other market participants as to what fu-
in another at a pmfit ulth no exchange risk. ture exchange rates will be. This is called speculation.
Although any foreign exchange transaction that is not
Suppose we lend one dollar for a year in the United entirely hedged forward has a speculative element,
S t a t e s at a m i m l e r e s m f r , ~ ; : - T h r a m m m m u m ~ o r r t p d t n b ~ ~ aspecutatlofifir
re pmht is discussebhG.
lated at the end of the year per dollar lent will be 1 + r,,, Until recently, the main foreign exchange specula-
lcapital plus interest).If. instead ofmaking dollarloans, tom wem the foreign exchange departments of banks,
we convened them into pounds and lent them in the with a lessermle being played by portfolio managers of
United Kingdom at the rate ru,k. the amount of pounds other financial institutions and international corpora-
we would have for each original dollar at the end of the tions. The IMM. however, has made it much easier for
year would be SI1 +I-,,~), whew S is the spot exchange individuals and smaller businesses to speculate. A high
rate lin pounds per dollari at the beginning of the proportion of IMM transactions appears to be specula-
period.At the outset, it is not known if 1 fr,, dollars is tive in the sense that only about 5 percent of contracts
going to be worth more than St1 + rOkI pounds in a lead to ultimate delivery of foreign exchange. This
.war's time because the spot (exchange rate in a year's means that most ofthe acti\ity involves the buying and
time is unknown. This uncertainty can be avoided by selling of a contract at dlfferenr limes and possibly
selling the pounds forward into dollars. Then the rela- different prices prior to maturity. It is possible, how-
tive value of the two loans would n o longer depend on
ever, that buying and selling of contracts before matu-
what subsequently happens 113 the spot exchange rate. rity would arise out of a strategy to reduce risk. So it is
5
By doing this, we end up with (1+ rUkIdollars per
not possible to say that all such activity is speculative.
original dollar invested. This is known as the "cov-
ered," or hedged, return on pounds. Speculation is important for the efficient working of
foreign exchange markets. It is a form of arbitrage that
Since the covered return in our example is denomi- occurs acmss time rather than acmss space o r be-
nated in dollars, it can reasonably be compared with tween markets at the same time. Just as arbitrage in-
the U.S. interest rate. If these returns are very different, creases the efficiency of markets by keeping prices
investon will move funds where the return is highest consistent, so speculation increases the efficiency of
on a covered basis. This process is interest arbitrage. It forward, futures and options markets by keeping those
is assumed that the assets involved are equally safe markets liquid. Those who wish to avoid foreign ex-
and. because the returns are covered, all exchange risk change risk may thereby do so in a well-developed
is avoided. Of coune, if funds (domove in large volume market. Without speculators, risk avoidance in foreign
between assets or between financial centers, then in- exchange markets would be more difficult and, in
terest rates and the exchange rates (spot and forward) many cases, impo~sible.~
will change in predictable ways. Fundswill continue to
flow between countries until there is no extra pmfit to
be made horn interest arbitrage. This will occur when Risk Reduction
the returns on both dollar- and sterling-denominated
Speculation clearly involves a shifting of risk fmm
assets are equal, that is, when
one party to another. For example. if a bank buys for-
11) I1 +r,J = f 1 1 + r,,k~.

This result is known as covered interest parity. It holds ~ ~~

more or less exactly, subject only to a margin due to r,. we take, say,the three-month eurcdollar deposit rate In Parls and
, long as the appropriate dollar and
transaction C O S ~ S so forruwetakemethree-montheuroster(ingdeposilrateinPar~s,then
(1) wil hold lust about exactly. Indeed if we took the interest rate and
sterling interest rates are compared."
exchange rate quotes all from the same bank. it would be remarkable
if (1) did not hold. Olherwiw the bank would be offering to pay you lo
borrow fromit and lend straight back!That is. the prlce of borrowing
would be less than the covered retum on lending.A margin between
'Since there are many dinerent interest rates, itobviously cannot hold borrowing and lending rates. of course.will make this even less likely
for all of them. Where (1 1 does hold is if the Interest rales chosen are so that in reality you would lose.
eurwurrency deposlt rates of the sam'eduration. In other words, iffor This is not to say that all speculative activity is necessarily beneficial.

316 Section Six lntmtional Fimnce

 - I

Covered Interest Parity: An Example

The following interest rate and exchange rate bid-ask spread on the forward rate would be
quotations are taken from the London Financial 1.4927-1.4942.
Times of September 8, 1983 Italble 11.
Now let us see ifwe would do better to invest in a
~c,osing~~ ~~ ~ ~ ~~ ~ ~~~~ ~ ~~ ~~

~ e - m o n t ~ e u m s t e r n g ~ d e p ~ o ~ ~ e - m o i
Exchange Rate: spot 3-Month Forward eumdollar deposit where the dollars to be received
dollars per 1.4910-1.4920 .17-22 discount were sold forward into sterling.The return per El00
pound invested in eumsterling is E2.369 (annual interest
Interest Rates: Eumsterling rate of g1%61. whereas the return on a covered eum-
Eurodollar
3-Month Offer 9'% 10%
dollar deposit is
Rate 1.4910
E2251 = I100 X - 1.02471 - 100.
The interest rate on the threemonth eumdollar 1.4942
deposit is a little higher 1.7 percent1 than that on an
eumsterling deposit. If the exchange rate remains Thus, we could not make a pmfit out of covered
unchanged, it would be better lo hold dollars; if the interest arbitrage. Despite the fact that dollar in-
exchange rate falls, the eumsterling deposit would terest rates are higher, the discount on forward dol-
be preferable. Suppose you decide to cover the ex- lars in the forward market means they buy fewer
change risk by selling the dollars forward into forward pounds. As a result, there is no benefit to
pounds. Let us compare the return to holding a the operation. Transaction costs for most indi-
sterling deposit with the return to holding a dollar viduals would be even greater than those above as
deposit sold forward into sterling (assuming that they would face a larger bid-ask spread than that
you start with sterling]. quoted on the interbank market.

TWO imponant points need to be clarified about Consequently, there is no benefit for the typical
the above data. First, the intenst rates are annual- investor h m making a covered or hedged eumcur-
ized so they are not what woul'dactually be earned rency deposit. The return will be at least as high on a
over a three-month period. For example, the three- deposit in the currency in which you stan and wish
month rate equivalent to an annual rate of 10% to end up. That i s , if you have dollars and wish to
percent is 2.47percent. end up with dollars, make a eumdollar deposit. If
you have sterling and wish to end up with sterling.
Second, the forward exchange rates need some make a eumsterling deposit. Ifyou have sterling and
explanation. The dollar is at a discount against ster- wish to end up in dollars, there is likely to be little or
ling. This means the forward dollar buys less ster- no difference between holding a eumsterling de-
ling. So we have to add the discount onto the spot posit sold forward into dollars or buying dollars
price to get the forward price (because the price is spot and holding a eumdollar deposit. Ofcourse. if
the number of dollars per pound, not the reverse]. you hold an "uncovered" deposit and exchange
Notice also that the discount lis measured in frac- mtes subsequently change, the result will be v e y
tions of a cent, not fractions of a dollar! So the different.

ward foreign exchange horn a customer, it increases its minimize the risk of losses due to unexpected ex-
exposure to risk while the custom'er reduces his. How- change rate changes. One simple way to do this is to
ever, there is not a fixed amount o f risk that has to be ensure that assets and liabilities denominated in each
"shared out ." Some strategies may involve a net reduc- operating currency are equal. This is known as "match-
tion of risk all around. ing." For example, a bank that sells sterling foward to a
customer may simultaneously buy sterling foward. In
As a general rule. financial institutions (or other this event, the bank is exposed to zem exchange rate
firmsl, operating in a variety of currencies, will t!y to risk.

Article 32 A Guide to Foreign Exchange Markets 317

 - I

Why Is the Dollar the "Money" of Foreign

ExGhange Markets?
One interesting aspect of the organization of the ery country is in payments balance vis a vis the rest
foreign exchange markets is that the "money" used of the world, it will not necessarily be in bilateral
in these markets is generally the US.dollar. This is balance with each other country. Because some cur-
generally true for spot makets and universally true rency has to be used to cover this residual finance.it
for forward markets. "Cross-markets" between is natural to choose the currency that has the lowest
...
many currencies ~m~vi??rthin; arrr+fotaecmss~ fmsactie-~hFy&&Lsb~wE-ha%aceeG!3-
~~ ~
~~ ~

markets are virtually nonexistent. For example, the nomic reasons why cross-markets between many
bulk of foreign exchange trading between Es and currencies do not exist2 It typically will be easier
cruzeiro w li involve dollar-6 and dollar-cruzeiro and cheaper to set u p a deal in two steps via the
transactions instead of direct .€-cruzeiro trading. dollar than in a single step Icruzeiro-dollar. dollar-
The only exception to this is the transactions involv- drachma rather than cruzeiro-drachmal. This is be-
ing the major Organization for Economic Coopera- cause these cross-markets, if they existed. would be
tion and Development 1OE:CDI currencies. especid- fairly thin and hence relatively costly for such trans-
Iy within Europe. Of the ,$7025 billion turnover in actions. The two markets with the dollar, on the
foreign exchange reported by US. banks in April other hand, are well developed.
1983,only $1.5 billion did not involve US. dollars.
There are two explanations for this special mle of These analyses refer to the rule of the dollar in the
the dollar in foreign exchange markets. Both rely interbank market. In the development ofthe trading
upon the fact that transaction costs are likely to be places such as the IMM in Chicago and LlFFE in
lower if the dollar is used as a medium. Krugman London to date, it is also true that all currency
shows that the clearing of foreign exchange markets futures are traded against the dollar.
requires some "intermediary" currency.' Even ifev-

'See Krugman (1980). '

Se
eChryslal(1982)

Banks often use "swaps" to close gaps in the matu- months. Once the swap is set up. the bank's net profits
rity structure of their assets and liabilities in a cur- are protected against subsequent changes in spot ex-
rency. This involves the simultaneous purchase and change rates during the next six months.
sale of a currency for different maturity dates. In April
1983,33 percent of U.S. banks' foreign exchange turn- Within the limits imposed by the nature of the con-
over involved swaps as compared with 63 percent spot tracts, a similar effect can be achieved by an appmpri-
contracts a n d only 4 percent outright forward ate portfolio of futures contr+cts on the I M M Thus. a
contracts.'U bank would buy and sell f;tures contracts so as to
match closely its forward commitments to customen.
Suppose a bank has sold DM to a customer three In reality, banks will use a combination of methods to
months forward and bought the same amount of DM reduce foreign exchange risk.
from a different customer six months forward. There
are two ways in which the bank could achieve zem Markets that permit banks, firms and individuals to
foreign exchange risk exposure. It could either under- hedge foreign exchange risk are essential in times of
take two separate offsetting forward transactions, or it fluctuating exchange rates. This is especially impor-
could set up a single swap with another bank that has tant for banks if they are to be able to pro\ide efficient
the opposite mismatch of dollar-DM flows whereby it foreign exchange services for their customers. In the
receives DM in exchange for dollars in three months absence of markets that permit foreign exchange risk
and receives back dollars in exchange for DM in Six hedging, the cost and uncertainty of international
transactions would be greatly increased. and interna-
tional specialization and trade would be greatly re-
'Osee Federal Reserve Bank of New York (1983) duced.

318 Section Six International Finance

CONCLUSION b e able t o reduce exchange rate risk whenever oossi-
ble. Some risk r e d u c t i o n i s achieved by i n t e k a n k
The exchange are complexand* for swaps, b u t some i s also taken up by speculation. Mi-
the outsider,hard to The Primary Iilnc- trage and speculation b o t h increase t h e efficiency of
tionofthesemarkets isstraightforward. l t i s t o facilitate
foreign exchange markets and have
spot and fOnvad
international transactions related t o trade. travel or exchange markets to
enabled foreign a high
investment. F0 exchange markets can now

transactions.
7
a large range Of and
level ofefficiency. Without t h e successful operation of
these markets, t h e obstacles t o international trade a n d
investment would be substantial a n d t h e world would

Glossary -
foreign exchange speculation the act of taking a net posi-
& in a foreqncurrency with the intentm of making a profit from
* m r l u n w o n - an optan that can be exercisad any t h e
ex- rate changes.
up to maturity. toward oxchange rate -the price of foreign currency for
* m r l u n tema -an exchange rate expressed as number of delivery at a Mure date agreed to by a Contra* today.
currency units per dollar.
ubitmga -the simunaneous purchase and saie of curremy in Mums mark& -a market in w h i mntraas are traded to buy
separate markets lor a profit arising from a price disaepancy or sel a standard amount of currency in the future at a particular
price.
between the markets.
M d u k spread -the difference between the buyq
i (M)and w i n g -or covering exchange risk, means that foreign cur-
selling (ask)poce. rency is sold forward into local currency so that its value S not
affected by subsaquant exchaw rate changes.Say an exporter
c o m d interest .rMtng.- t q i i g a couimy's currency
spot, investing for a period. and selling the pmieeds toward in
order to make a net protit due to the hgher interest rate in that
knom he will be w d ftO.Oo0 in two months. He can wait until he
gets the m a y and m e r i it into dollars at whatever the spot rate
countrf. This act involves "hedging" because il guarantees a turns out Io be. This o u t m e is umrtain as the spot rate may
covered return without risk. The opporlunitles to prom in this way change. Alternatively. he can sell CtO.Oo0 two months forward at
today's two-month forward price. Suppose this is $1.5per f . In two
seldom arise because covered imerest dflerentiak are normally
dose to zero. momhs. he will receive f10.000.fulfil his forward contract and
receivetl5.Oo0.Thisexportcwltracthasbeenhedgedormvered
mwnd intmat p M -
y the gap between interest rates in
fmeign and domestic currencies will be matched by the forward
in Uw faward market.

exchange rate differential, such that the "mvered" interest rate matching - equating assets and liabilities denominated in
differential wil be close to zero. each currency so that tosses due to foreign exchange rate
changes are minimized.
.urodo(lar deposna - bank deposits. generally bearing in-
terest and made for a specific time period. that are denominatedin
dollars but are in banks outside the United !States. Similarly. euro. -
options markel a market in which Contracts are traded that
sterling deposits would be denominated in :sterling bu( wtside tha gives a purchaser the nght but no obligation to buy (call)or to sell
United Kingdom. (put) a currency in the Mure at a given price.

Europmn option -an option that can be exercised only on a .pot archinge rate -the price paid to exchange currencies
for immediate delivery (twobusiness days in the interbank market,
specified date.
European M a - an exchange rate elpressad as number of
or over the Counter in the retail and travelers check market).
dollars per currency unit.
Swap - the simultaneous purchase and sale of a currency for
floating exchange rate - an exchange rate that is allowed to different maturity dates mat closes the gaps in the maturily struc-
adjust freely to the supply of and demand for foreign exchange. lure of w t s and liabilities in a currency.

Article 32 A Guide to Foreign Exchange Markets 329

 REFERENCES Federal Reserve Bank of New York. "Summary of Results of U.S.
Foreign Exchange Market Turnover Survey Conduned in April
Belongia. Michael T. "Commodity Options: A New Risk Manage- 1983" (September 8. 1983).
ment Tool for Agricultural Markets." this Review (JuneIJuly 1983). Garman. Mark 8.. and Steven W. Kohlhagen. "Foreign Currency
pp. 5-15. Option Values," Journal 01 lnrernarlonal Money and Finance (De-
cember 1983). pp. 231-37.
Black, Fisher. and Myron Scholes. "The Pricing of Options and
Corporate Liabilities." Journal 01 Political Economy (MaylJune Giddy. Ian H. "Foreign Exchange Options." Journalof Furures Mar-
1973). pp. 637-54 kers (Summer 1983). pp. 142-64
Chrystal. K. Alec "On the Theoly 081International Money" (paper Krugman, Paul. "Vehicle Currencies and the Structure of Inierna-
tional Exchange," Journal of Money, Credil and Banking (August
7
present to U K International Eumomics Study Group Confer-
mce. Se !ember ' .1982. Sussex, En_glandlforthc_omingj&LB!a&
and G. S.Donance.eds.. Problems:oflnternational Finance (Lon-
1980). pp. 513-26.
~~..
Kubarych. Roger M. Foreign Exchange Markers in the Unired
~~~~

don:.Macmillan, 1984). Stares. (Federal Reserve Bank 01 New York. 1983).

Dufey. Gunler. and Ian H. Giddy. The lnrernational Money Marker McKinnon. Ronald I. Money in lnrernarional Exchange: The Con-
(Prentice-Hall. 1978). vertible Currency Sysrern (Oxford University Press, 1979).

320 Section Six IntemationaI Finance