Most of the time cross border commercial transactions necesitate a conversion of currencies by one of the parties. A commercial transaction can be an exporter selling goods to another country, or an importer buying goods from another country, or a company, individual or country investing in another country.

All the buying and selling of foreign currencies takes place in the 24 hour foreign exchange market. This market is a network of foreign exchange traders across the globe who are connected by telephone lines and computers. These traders mostly work for financial institutions such as banks or financial boutiques, some work in the treasury departments of large companies, and a few trade as individuals conducting online foreign exchange trading.

The foreign exchange market does not have a central point but there are three major centres of trading, the United Kingdom, the United States and Japan. These centres handle as much as 60% of all foreign exchange transactions conducted daily, with London handling 33% of the daily worlwide volume of $1,200 billion.

Their are four major participants in the foreign exchange market.

• The banks and financial institutions are the biggest participants in forex markets and mostly buy and sell foreign exchange between themselves to make a profit. In fact two thirds of all foreign exchange trading transactions are banks dealing directly with each other.
• Brokers act as intermediaries between a customer and a bank and generally charge a commission on the transactions they arrange.
• Customers are mainly large companies who need foreign currency to buy and sell goods or invest in other countries. They could also be high net worth individuals who are investing in other countries.
• Central Banks enter the foreign exchange market to influence the value of their currencies.

With such high trading volumes in the foreign exchange market the price of a currency pair is changing throughout the trading day and this activity can have a positive (currency strengthens) or negative (currency weakens) effect on currencies.

The participants in the foreign exchange market are in the market to buy the foreign currency they require to purchase goods and services from other countries. To protect (hedge) themselves against a change in an exchange rate. Or, to earn a short term profit from changes in the exchange rates.

Exchange rates move in response to several factors both economic and speculative. In the end however, the foriegn exchange traders are responding to supply and demand factors which are at the heart of this complex market and every other free market. If the demand for a currency is greater than it's supply the currency will strengthen. If the supply of a currency is greater than the demand the currency will weaken. Some factors which can effect the supply and demand of a particular currency are:

• economic news
• political events
• international investment
• economic cycles
• government policies
• new tax laws
• economic statistics

In general money flows towards where the highest rate of return is and of course the least risk. That is why in times of political turmoil money flows tend to head to safe havens such as the U.S. dollar and the Pound stirling.

A foreign exchange rate is quoted in two prices.The buying price and the selling price. Let's say for example you are Bank B and you call Bank A and ask them what their sterling/dollar rate is. Bank A may quote a rate 1,5100 - 1,5110.This means that Bank A sells 1,5100 dollars for every one sterling it buys and buys 1,5100 dollars for every one sterling it sells.The buy foreign exchange rate is called the 'bid rate' and the sell rate is called the 'offer rate'.

You will note that a Sterling/Dollar foreign exchange rate is1 Sterling = 1,4900 dollars

The Euro/Dollar foreign exchange rate is 1 Euro = 1,4300 dollars

The Dollar/Yen exchange rate is 1 dollar = 89,00 yen

The prime currency is always the currency which is bought or sold by the person quoting the rate.

An exchange rate is made up of several components which foreign exchange traders use in their jargon when they are making a transaction. The numbers after the point (1.4900) are called the pips. The number before the point (1.4900) is called the big figure. Sometimes if the rate as in this case is around 4900 and could move below 4900 the big figure is quoted as 49. Currency delivery days in the foreign exchange market are on the spot date which is two business from the transaction date. For example for a transaction agreed to on a Monday, the currencies would be delivered on the Wednesday. However if it is a forward or a swap transaction the currencies are delivered on a forward date sometime in the future. Forward and Swap transactions which have delivery dates sometime in the future will be explained in the next article. Now Lets look at a typical foreign exchange transaction between two traders.

Bank A Trader: What's your sterling/dollar spot please.

Bank B Trader: Sterling/dollar is 20 - 30 big figure 49

Bank A Trader: I buy 10 at 30 sterling my London

Bank B Trader: Ok done. Dollars my New York.

So what has happened? Bank A asked Bank B for their sterling/dollar spot rate. Bank B quoted 1,4920 - 1,4930. Bank A bought 10 million sterling at 1,4930. Bank A want their sterling delivered to their London office and Bank B want 14,930,000 dollars delivered to their New York office. Both currencies will be delivered in two business days from now.

Now Bank A has a long sterling position of 10 million at a price of 1,4930. So in order to make a profit they will have to sell the sterling at a rate of at least 1,4931. They check around the foreign exchange traders at other banks and are quoted the following rates.

Bank B 1,4923-33

Bank C 1,4924-32

Bank D 1,4924-31

The best foreign exchange rate for Bank A would be Bank C and Bank D at 1,4924 but they would still lose 6 pips per sterling. Now what if another bank called Bank A and asked them for their sterling/dollar spot rate. Bank A could quote a rate similar to Bank B. A good quote would be 1,4922-33. At that rate another bank buying sterling would buy at 1,4933 giving Bank A 3 pips per sterling profit ($3,000 profit - 10million x 0.0003). It would be highly unlikely that any bank would sell sterling at 1,4922 because the sterling seems to strengthening against the dollar. Even if another bank sold them sterling at 1,4922 Bank A could immediately sell the sterling to either Banks B,C or D at a profit of 2 or 3 pips. So the foreign exchange traders in Bank A are in a good position to make some money on the sterling/dollar.

Look for the next article on trading foreign exchange where we will look at trading currency forwards and currency swaps.

Capital Structure

Stock Options Trading

Share Categories

Trade Clearing and Trade Settlement

Risk Management