Fundamentals of Financial Instruments, 2nd Edition

CHAPTER 8Foreign Exchange

INTRODUCTION

The market for the sale and purchase of currencies is an OTC market. That is, 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; that is, they will quote a bid rate for buying a particular currency and an ask rate for selling the currency. The difference between the two rates, which is called the spread, is a source of profit for the dealer. In the major money centers of the world, some nonbank dealers and 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 US 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 that of another. In any bilateral trade there has to be a buyer and a seller. In the foreign exchange market, the words buy/sell, or purchase/sale, are always used from the dealers' perspective. When dealers buy a foreign currency from a client, they will pay out the equivalent in terms of the domestic currency. On the other hand, when ...