Foreign Exchange Introduction



Foreign exchange (FX) market is a huge market with trillion of dollars worth of transactions taking place on daily basis. These are transacted amongst others by hedgers arising from import and export businesses as well as speculators trying to generate profit from the movement of exchange rates.

Foreign exchanges are transacted as value spot i.e. two working days from deal date. Deliveries for dates other than spot dates are considered forward except for value today and value the next business day.

Exchange rates are quoted either directly or indirectly. Direct quotation is defined as the number of unit of local currency per unit of foreign currency. For instance, when USD/MYR is quoted as 4.0000 it means that MYR4.00 is worth USD1.00. An indirect quotation on the other hand is defined as the number of unit of foreign currency per unit of local currency. For instance, when AUD/USD is quoted as 0.7200, it means that USD0.72 is worth AUD1.00.

The usage of the term direct and indirect can be confusing due to the use of the term ‘foreign’ and ‘local’ currency. When someone in China is looking at USD/MYR rate, both USD and MYR are foreign currencies and the terms direct and indirect quotations are misleading. Alternatively, the term base currency or commodity currency can be used to describe USD in the case of USD/MYR and AUD in the case of AUD/USD.

FX Contracts

There are three basic fx contracts in the market namely;

  1. Spot FX Contract
  2. Forward FX Contract
  3. FX Swap Contracts
For now we will include derivative fx contracts such as options, futures and cross currency swaps.

Spot FX Contract

The FX market is trading for delivery two business days from the deal date and often referred to as the spot FX market and has a very active interbank market. There is no physical location for the market and transactions are done via various medium such as Reuters Dealing Screen and Bloomberg. These two mediums are generally only available to banks. Phone lines are used by corporations to book the spot FX rate to convert their foreign currency cash flows. With the advance of technology, the trend is changing with some corporation already having direct access to bank quotations via secured and/or subscribed internet page.

Example 3-1

A Malaysian exporter is expected to receive payment of USD2,000,000 two business days from today and wishes to convert the receipt to MYR. The exporter approaches one of the local banks and agreed to sell the USD at USD/MYR exchange rate of 4.2000. On spot date, the exporter will receive MYR8,400,000 credited into the account.

Diagram 3-1 illustrates the timing of the cash flows from the bank’s perspective.

Diagram 3-1

Forward FX Contract

Payments for import and export transaction are not immediate. Generally importers are given credits terms of up to six months and payments for purchases worth billion of dollars are normally staggered and scheduled over a few years unless financed by debts issuance.

Credit terms on import allow importers to make foreign currency payments at a future date instead of on delivery date of the import. In other words, exporters will receive the payments on a forward date. If the payments are not in the currencies of the exporters’ country, the exporters are exposed to the fluctuation in FX rate.

A FX forward transaction is a FX contract which is dealt today for deliveries at a future date i.e. a date after the spot date.

Example 3-2

Payment date in for the Malaysian exporter is delayed to one month after spot date as depicted in the following diagram.

Diagram 3-2

The exporter has two options:

  1. Sell the USD proceed for MYR two business days prior to the receipts of the export proceed at the prevailing USD/MYR rate. If the prevailing USD/MYR rate is at 4.4000, the MYR proceed will be MYR8,800,000. On the other hand, a stronger MYR of 4.0000 will reduce the MYR proceed to MYR8,000,000; or
  2. Sell the USD2 million for MYR for value forward date to a bank at an agreed forward rate. Assuming the agreed forward rate is 4.2075, the MYR proceed will be MYR8,415,000. Regardless of the movement in USD/MYR exchange rate, the MYR proceed remains and will be received on the agreed delivery date.
Lets assume that the exporter prefers to book the forward FX rate with the bank. How does the bank derive the pricing for the contract? This is discussed in detail in the next section.