What is the process of converting currency called?

Stock Markets, Derivatives Markets, and Foreign Exchange Markets

Rajesh Kumar, in Strategies of Banks and Other Financial Institutions, 2014

5.3.5 Foreign Exchange Market and Instruments

The foreign exchange market or forex market is the market where currencies are traded. The forex market is the world’s largest financial market where trillions are traded daily. It is the most liquid among all the markets in the financial world. Moreover, there is no central marketplace for the exchange of currency in the forex market. It is an OTC market. The currency market is open 24 hours a day, five days a week, with all major currencies traded in all major financial centers. Trading of currency in the forex market involves the simultaneous purchase and sale of two currencies. In this process the value of one currency (base currency) is determined by its comparison to another currency (counter currency). The price at which one currency can be exchanged for another currency is called the foreign exchange rate. The major currency pairs that are traded include the EUR/USD, USD/JPY, GBP/USD, and USD/CHF.6 The most popular forex market is the euro to US dollar exchange rate (EUR to USD), which trades the value of euros in US dollars.

Foreign exchange markets can be considered as a linkage of banks, nonbank dealers, and forex dealers and brokers who all are connected via a network of telephones, computer terminals, and automated dealing systems. Electronic Broking Services and Reuters are the largest vendors of quote screen monitors used in trading currencies.

The forex market consists of three major segments: Australasia, Europe, and North America. Australasia includes the major trading centers of Bahrain, Sydney, Tokyo, Hong Kong, and Singapore. Europe includes Zürich, Frankfurt, Paris, Brussels, London, and Amsterdam. The North America region includes New York, Montreal, Toronto, Chicago, San Francisco, and Los Angeles.

5.3.5.1 Exchange rate quotation

The two basic quotations are direct and indirect quotes. In direct quotation, the cost of one unit of foreign currency is given in units of local or home currency. In indirect quotations the cost of one unit of local or home currency is given in units of foreign currency.

For example, consider EUR as the local currency. Then

Direct Quote: 1 USD = 0.773407 EUR

Indirect Quote: 1 EUR = 1.29303 USD

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The Foreign Exchange Market

Michael Melvin, Stefan Norrbin, in International Money and Finance (Ninth Edition), 2017

Abstract

Foreign exchange trading refers to trading one country’s money for that of another country. The kind of money specifically traded takes the form of bank deposits or bank transfers of deposits denominated in foreign currency. The foreign exchange market typically refers to large commercial banks in financial centers, such as New York or London, that trade foreign-currency-denominated deposits with each other. This chapter provides a big picture of foreign exchange trading and particularly covers the details of the “spot market,” which is the buying and selling of foreign exchange to be delivered on the spot as opposed to paying at some future date. Major issues discussed are trading volume, geographic trading patterns, spot exchange rates, currency arbitrage, and short- and long-term foreign exchange rate movements. Specific examples illustrate the discussions of broad concepts. Two appendices further elaborate on exchange rate indexes and the top foreign exchange dealers.

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The Foreign Exchange Market

Michael Melvin, Stefan C. Norrbin, in International Money and Finance (Eighth Edition), 2013

Appendix 1B The Top Foreign Exchange Dealers

Foreign exchange trading is dominated by large commercial banks with worldwide operations. The market is very competitive, since each bank tries to maintain its share of the corporate business. Euromoney magazine provides some interesting insights into this market by publishing periodic surveys of information supplied by the treasurers of the major multinational firms.

When asked to rank the factors that determined who got their foreign exchange business, the treasurers responded that the following factors were the most important: The speed with which a bank makes foreign exchange quotes was ranked third. A second-place ranking was given to competitiveness of quotes. The most important factor was the firm’s relationship with the bank. A bank that handles the other banking needs of a firm is also likely to receive its foreign exchange business.

The significance of competitive quotes is indicated by the fact that treasurers often contact more than one bank to get several quotes before placing a deal. Another implication is that the market will be dominated by the big banks, because only the giants have the global activity to allow competitive quotes on a large number of currencies. Table 1B.1 gives the rankings of the Euromoney survey. According to the rankings, Deutsche Bank receives more business than any other bank. Note also that the big three—Deutsche Bank, UBS and Barclays Capital—dominate the foreign exchange market

Table 1B.1. The Top 15 Foreign Exchange Dealers with Market Share

1.

Deutsche Bank (18.1%)

2.

UBS (11.3%)

3.

Barclays Capital (11.1%)

4.

Citi (7.7%)

5.

Royal Bank of Scotland (6.5%)

6.

JPMorgan (6.4%)

7.

HSBC (4.6%)

8.

Credit Suisse (4.4%)

9.

Goldman Sachs (4.3%)

10.

Morgan Stanley (2.9%)

11.

BNP Paribas (2.9%)

12.

Bank of America Merrill Lynch (2.3%)

13.

Societe Generale (2.1%)

14.

Commerzbank (1.5%)

15.

Standard Chartered (1.2%)

Rankings as reported in Euromoney, May 2010.

What makes Deutsche Bank the world’s best foreign exchange dealer? Many factors have kept them on top of the heap. An important factor is simply sheer size. Deutsche Bank holds the bank accounts for many corporations, giving it a natural advantage in foreign exchange trading. Foreign exchange trading has emerged as an important center for bank profitability. Since each trade generates revenue for the bank, the volatile foreign exchange markets of recent years have often led to frenetic activity in the market with a commensurate revenue increase for the banks.

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Foreign Exchange Markets and Triggers for Bank Risk in Developing Economies

Leonard Onyiriuba, in Bank Risk Management in Developing Economies, 2016

Foreign currency markets and risk management

The dynamics of foreign currency markets and deals are quite intriguing. To start with, the markets are volatile and risky. Yet, they also present interesting risk-return paradoxes. Ironically, dealers in the markets seem to embrace these features. Let me first examine the main features and dynamics of the two types of foreign exchange markets in developing economies (The FX dealers trade on behalf of their banks in foreign currency markets. It follows that “banks” can be substituted for “dealers” in this and other discussions in this chapter without change of meaning. For example, “quoting bank” substitutes for “quoting dealer” and implies the dealer who quotes rates to the “calling bank”—meaning the “calling dealer.”).

Forms of Foreign Currency Markets

Foreign exchange market is a network for the trading of foreign currencies, including interactions of the traders and regulations of how, where and when they close deals. It is an arrangement for the buying, selling, and redeeming of obligations in foreign currency trading. There are two main foreign exchange markets—interbank and autonomous—in developing economies.

Central Bank (Interbank) Market

The interbank FX market refers to formal and organized structures put in place by the monetary authority, such as the Central Bank, for conducting trading, transactions, and deals in foreign currencies. This market is referred to as either interbank foreign exchange market (IFEM), as in Nigeria, or official foreign exchange market. The Central Bank controls, monitors, and supervises this markets conduct of trading, transactions, and deals in most countries.

Thus, the rate of exchange in this market is referred to as the official exchange rate—ostensibly to distinguish it from that of the autonomous FX market. The official rate itself is the cost of one currency (say, dollar) relative to another (say, euro), as determined in an open market by demand and supply for them. It is the amount of one currency that an FX dealer pays or spends to get one unit of another currency in formal trading of the two currencies.

In some countries, like Nigeria, the conduct of FX transactions in this market is guided by the wholesale Dutch auction system. Under this system, the authorized dealers bid for FX under the auspices of the Central Bank every week. The Central Bank sells FX to only the banks with the winning bids at their bid rates. The losers would be the banks whose bids are unsuccessful. In this way, the determination of the FX rate is to a large extent left to the market forces. However, the Central Bank indirectly influences the exchange rate. It does this by fixing an amount of the FX it would supply to the market and for which the authorized dealers bid. In most cases, rates movements follow speculation on the quantity of the FX that Central Bank would likely want to offer for sale sell in market.

As authorized dealers, banks gain from FX transactions. For example, the Dutch Auction System of FX bidding provides a window through which the participating banks could boost their liquidity position on regular, largely, weekly basis. One way through which this is achieved is when, on weekly basis, huge float domestic currency funds accumulate in the customers’ current accounts as deposits for the FX bidding. The banks would retain and continue to utilize the funds until and pending when the amounts equivalent to the customers’ bid have been debited from their accounts with the Central bank.

Autonomous Market

The autonomous foreign exchange market—also variously known as “parallel FX market,” “FX black market,” or “underground FX market”—is a major cause for concern to the monetary authorities in developing economies. The continued existence of this FX market despite their proscription is especially disturbing to the banking regulatory authorities. In some countries, the black market fallout of exchange rates management has assumed a troubling dimension. In most cases, there is a wide disparity between the official (IFEM) and autonomous FX rates.

The parallel market is a network of illegal trading in foreign currencies, including the interactions between the traders with respect to how they conduct and consummate deals. The rate of FX exchange in this market is called “black market rate,” “autonomous rate,” or “parallel market rate.” The rate is the cost of one currency (say, dollar) in terms of another currency (say, euro) as determined and applicable in an underground market for foreign exchange trading. It is, in essence, the rate at which a unit of one currency exchanges for one unit of another currency in an underground FX trading.

The FX traded in the black market is referred to as “free funds”—compared with “official funds” that depicts FX traded in the interbank market. Many commercial banking customers—especially the traders—do most of their import transactions with free funds. This implies that they obtain FX from autonomous sources. In reference here is FX procured outside sales by the Central Bank in countries that have administered foreign exchange policies. The risk management implication is that banks should adhere strictly to FX regulations and endeavor to operate within regulatory requirements and guidelines at all times. Critical issues often border on documentation, disclosure, and reporting requirements for FX sources and transactions.

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Foreign Exchange Market and Interest Rates

Morton Glantz, Robert Kissell, in Multi-Asset Risk Modeling, 2014

Introduction

The foreign exchange market (FX market) is where participants come to buy and sell foreign currencies (e.g., foreign exchange rates, currencies, etc.). Foreign exchange trading occurs around the clock and throughout all global markets. It is the only truly continuous and nonstop trading market in the world, with participants trading day and night, weekday and weekend, and on holidays. It has also been described as the intersection of Wall Street and Main Street.

Participants trading on the foreign exchange include corporations, governments, central banks, investment banks, commercial banks, hedge funds, retail brokers, investors, and vacationers. One of the biggest differences between the FX markets and other financial markets is the overall activity from corporations to facilitate day-to-day business practices as well as to hedge longer-term risk. Corporations will engage in FX trading to facilitate necessary business transactions, to hedge against market risk, and, to a lesser extent, to facilitate longer-term investment needs.

Foreign exchange trading volumes from many of these global companies are dramatically larger than even the largest financial institutions, hedge funds, and some governments. Other financial markets (such as the markets) simply do not receive the same amount of interest from Main Street corporations because they do not meet their business needs of buying and selling goods in foreign countries.

The FX market is an over-the-counter market (OTC) in which prices are quoted by FX brokers (broker-dealers) and transactions are negotiated directly with the buyers and sellers (participants). The FX market is not a single exchange like the old New York Stock Exchange (NYSE). It is a global network of markets connected by computer systems (and even still by a phone network!) that more closely resembles the NASDAQ market structure. There are FX markets in all countries. The major FX markets are London, New York, Paris, Zurich, Frankfurt, Singapore, Hong Kong, and Tokyo. London is the largest.

In this chapter we provide an overview of the FX market and the important terms that need to be understood for proper risk-management practices. Readers interested in further background and a more detailed investigation into the foreign exchange market and interest rates are referred to endnotes [1–3]. We build on the framework and modeling methodology introduced in these sources throughout the chapters. Readers are encouraged to visit these sites for continuously updated references and modeling methodologies.

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Corporate Finance

Hans R. Stoll, in Handbook of the Economics of Finance, 2003

9.2 Currency market

The currency market is a dealer market made largely by the same dealers active in the bond market. Currency dealers display indicative quotes, but quotes at which trades may occur are usually made bilaterally. Like the bond market, the currency market has an interdealer market in which dealers can trade anonymously with each other. Lyons (1995) analyses the behavior of a major currency dealer and concludes that inventory considerations are important determinants of dealer behavior in two senses. First, there is a direct effect from the dealer’s desire to have a zero position at day-end. Second, there is an indirect effect from information about other dealers’ inventories that influences the dealer’s behavior. Other articles examining the microstructure of currency markets include Bessembinder (1994), Bollerslev and Melvin (1994) and Huang and Masulis (1999).

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Introduction to Finance and Financial Markets

Piotr Staszkiewicz, Lucia Staszkiewicz, in Finance, 2015

1.5.2 Forex and the Interbank Market

The interbank market is a market where banks and other financial institutions trade currencies. Individual retail investors cannot trade their currencies on the interbank market. Most of the transactions are performed at the banks’ own risk.

The forex market is a market for currencies. It is the largest, most liquid market in the world in terms of the total cash value traded, and any entity or country may participate in this market. There is no central marketplace for currency exchange. Trade is conducted OTC. The forex market is open 24 h a day, 7 days a week and currencies are traded worldwide among the major financial centers. In the past, forex trading in the currency market had largely been the domain of large financial institutions. The advancement of the internet has altered this picture and now it is possible for less-experienced investors to buy and sell currencies through the foreign exchange platforms. The following table mentions different classifications of the financial markets.

Instance of TransactionLevel of SupervisionType of QuotationType of Scale
Primary Supervised Continuous Wholesale
Secondary Non-supervised Periodic Details
OTC Mixed

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The Currency Exchange Market in East Asia

Shaomin Li, in East Asian Business in the New World, 2016

7.1 The Foreign Exchange Market

The foreign exchange market is the global market for exchanging currencies of different countries. It is decentralized in a sense that no one single authority, such as an international agency or government, controls it. The major players in the market are governments (usually through their central banks) and commercial banks. Firms such as manufacturers, exporters and importers, and individuals such as international travelers also participate in the market. There are a few key concepts we need to understand the market. Foreign exchange is the action of converting one currency into another. The rate that is agreed upon by the two parties in the exchange is called exchange rate, which may fluctuate widely, creating the foreign exchange risk. As will be seen in the case of Japan Airlines (JAL) below, the risk can be high.

There are two types of exchange rates that are commonly used in the foreign exchange market. The spot exchange rate is the exchange rate used on a direct exchange between two currencies “on the spot,” with the shortest time frame such as on a particular day. For example, a traveler exchanges some Japanese yen using US dollars upon arriving at the Tokyo airport. The forward exchange rate is a rate agreed by two parties to exchange currencies for a future date, such as 6 months or 1 year from now. A main purpose of using the forward exchange rate is to manage the foreign exchange risk, as shown in the case below.

The main functions of the market are to (1) facilitate currency conversion, (2) provide instruments to manage foreign exchange risk (such as forward exchange), and (3) allow investors to speculate in the market for profit.

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Financial Markets, Trading Processes, and Instruments

John L. Teall, in Financial Trading and Investing, 2013

Interdealer Brokers and Electronic Broking

The interbank forex markets comprise transactions directly between banks and through electronic brokering platforms. Interdealer brokers facilitate many of these transactions, as well as for those of other institutions. The largest, the UK-based ICAP Plc, is very active in both voice and electronic markets, averaging over $1.5 trillion daily in all of its brokering services.

FX dealers and certain other financial institutions are permitted to participate in the major electronic broking services. These services provide quotes, permit entry of quotes, and trade execution services. The largest of these with respect to forex trading is Electronic Broking Services (EBS), which was created as a joint venture of several of the world’s major foreign exchange market–making banks, and then acquired by ICAP in 2006. It handles close to $200 billion daily in spot FX transactions as well as contracts for several commodities. Its chief competitor is Reuters Dealing 3000 Xtra, which is particularly active in sterling and Australian dollars. These services permit straight-through processing, improving speed of transactions and reduced errors.

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Microstructure of Currency Markets

M.D.D. Evans, in Handbook of Safeguarding Global Financial Stability, 2013

Introduction

Models of foreign exchange market microstructure examine the determination and behavior of spot exchange rates in an environment that replicates the key features of trading in the foreign exchange (FX) market. Traditional macro exchange rate models pay little attention to how trading in the FX market actually takes place. The implicit assumption is that the details of trading (i.e., who quotes currency prices and how trade takes place) are unimportant for the behavior of exchange rates over months, quarters or longer. Micro-based models, by contrast, examine how information relevant to the pricing of foreign currency becomes reflected in the spot exchange rate via the trading process. According to this view, trading is not an ancillary market activity that can be ignored when considering exchange rate behavior. Rather, trading is an integral part of the process through which spot rates are determined and evolve.

The past decade has witnessed a rapid growth in micro-based exchange rate research. Originally, the focus was on partial equilibrium models that captured the key features of FX trading. These models provided a new and rich array of empirical predictions that are strongly supported by the data and provide a new perspective on the proximate drivers of exchange rates over short horizons, ranging from a few minutes to a few weeks. Recent micro-based research moves away from the traditional partial equilibrium domain of microstructure models to focus on the link between currency trading and macroeconomic conditions. This research aims to provide the microfoundations of the exchange rate dynamics that have been missing in general equilibrium macro models.

This discussion on micro-based exchange rate research is structured as follows: The section ‘Currency Trading Models’ first lays out the key features of the FX market and describes how they are incorporated into a canonical model of currency trading. The empirical implications of the model are then discussed. The section ‘From Micro to Macro’ examines research that links spot rate dynamics to macroeconomic conditions via currency trading. The section ‘Micro Perspectives on Exchange Rate Puzzles’ discusses how this research sheds light on some long-standing puzzles concerning the behavior of exchange rates. The section ‘Conclusion’ winds up with some thoughts on the direction of future micro-based exchange rate research.

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