All Trading in Currencies is Done in the Foreign Exchange (FOREX) Market

All trading in currencies is done in the foreign exchange (FOREX) market. However, it is an over-the-market in that there is no physical location for the FOREX market. Trades of currencies between foreign exchange dealers are done via telephone or computer link.

There are two parts to the FOREX market:
1) Spot Market
2) Forward Market

The major participants in the market are: large exporters/importers, central banks, foreign currency brokers and the commercial banks. Almost all trades in foreign exchange go through foreign exchange dealers employed by the large commercial banks. Foreign exchange dealers constantly buy and sell large amounts of currency throughout the day and are always ready to buy or sell more (although at a price they set). This means that the FOREX market is very liquid, you will always be able to find someone to buy your currency from you or sell you the currency you need (although maybe not at a price you like). Anyone wanting to trade currencies will do so by buying or selling the currency from one of these dealers.
Foreign exchange brokers are intermediaries who will carry out orders to buy or sell currency. Smaller firms and individuals generally do not have access to trading directly with the currency dealers employed by the banks because they deal with large sums of money. Therefore, if a small firm wishes to engage in currency transactions, it will probably have to be done through a currency broker. In aggregating the orders of many clients, a currency broker has the clout necessary to deal directly with the currency dealers. Currency brokers also possess the expertise and knowledge of the market necessary to trade directly in currencies. Of course, brokers charge clients a commission to perform this service for them. It should be noted that there is really a fine line between brokers and traders, as almost all major banks have both. They will have a trading floor where then actual dealers employed by the bank operate and trades in the FOREX market are carried out, and there will be a currency broker service offered on the retail side.

As one might guess by this point, the commercial banks are the most important players in the FOREX market. Approximately 85% of trades in the FOREX market are done between banks (i.e. FOREX dealers trading with each other).
Spot Market

The spot market is the market for the immediate exchange of currency. It is here that the current exchange rates are set (the spot rate). When someone sells a currency to someone else (in exchange for another currency), they are required to deliver that currency two working days later. Actual delivery of a currency is done through a transfer of bank accounts.
Example: A London bank sells DM to a New York bank for $US. Two working days later, the London bank transfers ownership of a DM deposit (held in a German bank) to the New York bank and gets ownership of a $US deposit in the U.S.

These types of transactions are often carried out through SWIFT (Society for Worldwide Interbank Telecommunications) which is a communications and computer system designed to keep track of and execute these types of trades.

The people that actually set the exchange rates are the banks’ dealers. Dealers set prices at which they are willing to buy and sell each currency (individual dealers will specialize in certain currencies). The dealers guarantee that they are willing to buy or sell the currency at the prices they set. Of course these prices are constantly changing and are only guaranteed up to a maximum trade size. The guaranteed trade size is the depth of the quote. For instance, a dealer may quote a price for £’s in terms of $US, but only guarantee the price on trades up to a value of $5 million US (which is a typical quoted depth). The price for trade of a larger size will have to be negotiated.
The existence of traders quoting prices at all times is an important feature of the FOREX market because of the liquidity it provides. There is virtually no chance that you will not be able to find someone to buy from or sell to.

FOREX dealers make much of their profit on the Bid-Ask Spread. A dealer will quote two prices for a currency:
Bid Price - the price at which the dealer is willing to buy the currency
Ask Price - the price at which the dealer is willing to sell the currency

Ask Price > Bid Price

The difference between the two prices is the Bid-Ask Spread.

Each dealer sets his or her own Bid-Ask prices and attempts to do two things:
1) Match the number of buyers and sellers he/she has at those prices.
2) Keep the volume of trades he/she is making high.

Example: The quoted price for Australian dollars as of September 29,1997 was 1.3878/88 $Aus/$US.
1.3878 $Aus/$US is the bid price.
1.3888 $Aus/$US is the ask price.
If the dealer buys $500,000 Aus. and sells $500,000 Aus. without any change in the exchange rate, what is his profit?
Because of the way the rates are quoted (units of $Aus per $US), they are really the bid and ask prices for the $US. Therefore, you must convert these to prices for $Aus.

Bid for $Aus = 1/Ask for $US

That is, take the inverse to convert $Aus/$US into $US/$Aus and note that the price the dealer will sell $US at is the same as the price at which he will buy $Aus.

Ask for $Aus = 1/1.3878 = 0.7206 $US/$Aus

Bid for $Aus = 1/1.3888 = 0.7200 $US/$Aus

The dealers profit is:
($500,000 Aus.)([0.7206-0.7200]$US/$Aus)
= $300 US

Dealers try to set their bid and ask prices to make the number of buyers coming to them equal to the number of sellers. If the bid price is too high, then people will want to sell to the dealer. The dealer will begin to develop an inventory of the currency that he cannot sell. This means that the dealer becomes exposed to exchange rate risk. If the currency depreciates before the inventory can be sold, the dealer will suffer a loss. Conversely, if the dealer sets the ask price too low, too many people will want to buy at that price. The trader develops a short position in the currency (he needs to deliver currency that he does not have yet). If the currency appreciates, the dealer suffers a loss. (Note: having the currency is a long position, owing the currency is a short position.)
Generally, dealers want to avoid exchange rate risk and so adjust the bid-ask prices to match the number of buyers and sellers that they have coming to them.

The bid-ask spread is set by competition among dealers. Dealers earn profits on each unit of currency bought and sold through them. If their spread is larger than other dealers, then customers will go to those other dealers. Thus, the spread tends to be similar for all dealers.

Occasionally, dealers will speculate on exchange rates by allowing themselves to build up short or long positions. However, these positions are only taken for a short time.

In the end then, it is the expectations of currency dealers that determine the day-to-day changes in exchange rates. Of course, the rates that dealers set are in response to the supply and demand for that currency, and that, in turn, is determined by the various factors we have discussed.

Currency Arbitrage

Currencies are traded in many centres around the world, by many different currency dealers. Arbitrage will tend to make these quotes consistent with one another. An arbitrage opportunity occurs if you are able to make large profits without risk.

You have $1,000,000 US to invest and observe the following quotes:
London: 104.58/68 ¥/$US
New York: 1.5173/83 $US/£
Hong Kong: 158.5158/68 ¥/£

You phone London and buy $1,000,000 US worth of ¥.
Gives you ($1,000,000 US)(104.58 ¥/$US) = ¥104,580,000
Phone Hong Kong and sell the ¥ for £’s.

Gives you (¥104,580,000)(1/158.5168) = £659,740.80

Phone New York and sell £ for $US.
Gives you (£659,740.80)(1.5173 $US/£) = $1,001,024.71 US

You have just earned an instant profit of $1024.71 US with no risk. This is an arbitrage opportunity. It is sometimes referred to as triangular arbitrage because it involves three currencies.
Triangular arbitrage takes advantage of inconsistencies in cross-rates (two non-US currencies quoted against each other, e.g. ¥/£.). Generally, arbitrage opportunities like this should not exist, or at least not exist for longer than a couple of minutes. Everyone involved in the FOREX market will observe this opportunity and try to take advantage of it. Millions (or billions) of dollars will be invested and this will drive up ¥ in London, drive down ¥ in Hong Kong and drive down £ in New York until the arbitrage opportunity disappears. Thus, market forces will guarantee that rates across different markets and different currencies are consistent.