Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

CHAPTER 8

Foreign Exchange

Introduction

The market for the sale and purchase of currencies is an over-the-counter market: there is no organized exchange on which currencies are traded. The largest players in the market are commercial banks. These banks typically provide two-way quotes for a number of currencies. They will quote a bid rate for buying a particular currency as well as an ask rate for selling the currency. The difference between the two rates, which is termed the spread, is a source of profit for the dealer. In the major money centers of the world, some nonbank dealers as well as large multinational corporations may also don the mantle of dealers. The market in which these entities operate is referred to as the interbank market. The transactions sizes are typically very large, usually of the magnitude of several million U.S. dollars. The retail market for foreign exchange, in which tourists typically transact in the form of currency notes and travelers checks, is characterized by transactions of much smaller magnitudes, and the corresponding bid–ask spreads are also larger.

An exchange rate is the price of one country's currency in terms of the currency of another country. In any bilateral trade, there has to be a buyer and a seller. In the foreign-exchange market, the words buy, sell, purchase, and sale are always used from the dealer's perspective. When a dealer buys a foreign currency from a client, she will pay the equivalent in terms of the domestic currency. ...