8.1 The nature of forex markets

Box 8.1

The expression of exchange rates

Indirect quotation

The standard British way of expressing the value of sterling is to quote the amount of

foreign currency that exchanges for £1 (the indirect quotation of the exchange rate):

£1 US$1.7343 1.7353;	£1 A1.4321 1.4333;	£1 ¥204.069 204.273
dollars	euros	yen

The rst of the two gures in each case is the bid rate – the rate at which market-makers

are prepared to buy the home currency (sterling). The second gure is the offer rate – the

rate at which they are prepared to sell the home currency. Thus, we have:

bid rates:	£1 US$1.7343	£1 A1.4321	£1 ¥204.069
offer rates:	£1 US$1.7353	£1 A1.4333	£1 ¥204.273

The difference between the two (the bid–offer or bid–ask spread) covers the market-

makers’ costs and provides their prots. Thus, the size of the bid–offer spread reects

the degree of risk involved in holding the foreign currency in question. For example, there

are many transactions every day between sterling and US dollars (the £/$ market is very

deep) and so there is little chance of sudden, large movements in the exchange rate.

Consequently, the bid–offer spread represents only a tiny percentage of the value of the

currency. For currencies less commonly traded (for example, the New Zealand dollar), we

would expect a larger bid–offer spread to reect the greater risk market-makers face

in holding them.

To obtain a single gure for an exchange rate, the mid-point between the bid and offer

rates is taken: £1 $1.7348; £1 A1.4321; £1 ¥204.171.

Direct quotation

Given an indirect quotation, the direct quotation can be calculated as its reciprocal.

Thus, if we take the reciprocal of the indirect rates above, we obtain the following direct

quotations of sterling (the rates at which market-makers are prepared to buy and sell the

foreign currency):

£0.5766 £0.5763 $1;£0.6983 £0.6977 A1;Y100 £0.4900 £0.4895

Because the unit value of the Japanese currency is so small, it would be inconvenient

to express the sterling equivalent of a single yen in direct form (one would need too many

decimal places to show the small differences between bid and offer rates). Therefore,

it is conventional to express the rate in terms of units of ¥100. Note that, with direct

quotation, the rst gure is the higher of the two – the market-maker demands more

domestic currency in return for a unit of foreign currency than he will offer for a unit of

the foreign currency.

Note: On the Currencies & Money page of the Financial Times, you are given only the closing

mid-point (the mid-point between the bid and offer rates at the close of the market for the day).

Separate bid and offer rates are not provided.

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Chapter 8

• Foreign exchange markets Market participants can be split into ve groups:

l	the end-users of foreign exchange: rms, individuals and governments who need foreign currency in order to acquire goods and services from abroad;

l	the market-makers: large international banks which hold stocks of currencies to allow the market to operate and which make their prots through the spread between buying (bid) and selling (offer) rates of exchange;

l	speculators: banks, rms and individuals who attempt to prot from outguessing the market;

l	arbitrageurs: banks that make prots from buying in one market at the same time as selling in another, taking advantage of small inconsistencies that develop between markets;

l	central banks, which enter the market to attempt to inuence the international value of their currency – perhaps to protect a xed rate of exchange or to inuence an allegedly market-determined rate.

Exercise 8.1You are given the following information about exchange rates:

Closing mid-points

£1 SFr2.2782 (indirect quotation of sterling)

$1 ¥112.625 (indirect quotation of the US$)

A1 ¥143.265 (indirect quotation of the euro)

£1 A1.4583 (indirect quotation of sterling)

(a)	Calculate each of these rates in direct terms.

(b)	Look in the Financial Times and compare the exchange rates reported on the day you read this chapter with the above rates, which were exchange rates at the close of trading on 26 May 2006.

(c)	Work out which of the two currencies has weakened and which has strengthened in each case since 26 May 2006.

It is clear from the above list that it is possible for someone to play multiple roles

in the market. For instance, international banks may act in up to four capacities,

while central banks may be end-users on some occasions, speculators on others.

It appears, then, that the basis of the market must derive from the demand for and

supply of currencies originating from end-users. The notion that rational economic

motives underpin the behaviour of end-users leads to the view that exchange rates

should be determined by the market fundamentals– economic factors thought to

inuence the demand for and supply of currency such as the balance of payments,

relative rates of ination and interest rate differentials across countries. Changes in

these basic inuences on demand and supply will cause exchange rate adjustments.

However, according to holders of this view, exchange rates will always move towards

the new equilibrium position, dened as the set of exchange rates that will produce

balance in the balance of payments. In the 1950s and 1960s, exchange rate theories

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