Principles of foreign

Overview
To be able to explain how foreign exchange dealing
actually happens in practice using a number of examples,
it is important to understand some of the principles
underlying the money market transactions
involved. In addition to exchange rate quotation, this
chapter also explains how dealers manage positions,
and describes the most fundamental operation of all,
the spot transaction.
In the introduction to this booklet, the exchange rate
was defined as the price of a foreign currency in
domestic currency units. This definition of an exchange
rate is also termed a “direct quotation,” and
is used by most countries. The price of (as a rule) one
hundred units of foreign currency, but only the price
of one unit in the case of the dollar and sterling, is
quoted in the domestic currency. In Switzerland,
therefore, foreign currencies are quoted in CHF, but
there are exceptions to this rule. Since the decimal
system was not used in Britain in the early years, the
equivalent of sterling was quoted in the foreign currency.
This method is known as “indirect quotation.”
Even today, sterling is still quoted indirectly.
To ensure that the market functions smoothly, it
needs other conventions. In professional foreign
exchange dealing between banks, dealers normally
quote dollar rates. This means that the values of the
various local currencies are expressed by indicating
the price of one USD in the local currency. For
instance, in response to an inquiry from Zurich at a
Norwegian bank about its NOK rates, the Norwegian
dealer will not quote the rate for the CHF against
the NOK, but of the USD against the NOK.
This method of quoting currencies in dollar rates,
standard practice since the 1950s, has had a serious
impact on the meaning of arbitrage in foreign
currency operations.

Between the two world wars, foreign currencies were
still quoted against the country’s own currency. For
example, a Swiss dealer enquiring about the DEM
rate at a bank in Stockholm would have received a
reply in SEK. If this resulted in a deal, the Swiss dealer
would then have tried to sell the DEM in another
country, covered by a purchase of SEK somewhere
else. This resulted in a whole range of true arbitrage
operations. Originally, “arbitrage” meant taking
quick advantage of price differences prevailing in different
markets, a process which eventually tended to
make these differences disappear quickly. Arbitrage
in the earlier sense of the term is more or less impossible.
Nowadays, arbitrage means exchange gains
from professional interbank business, as against
customer-related business.
In foreign exchange operations, customers are offered
two rates for each currency pair. For example if the
USD is quoted against the EUR at EUR/USD 1.1521/
1.1536, the first of these rates is the buying rate
offered by the bank for the EUR, while the second
rate is the selling rate for the EUR. Professionals refer
to this first rate as the bid rate. The second rate is the
selling rate for the EUR, or the buying rate of the USD.
It is also known as the ask rate. The middle rate is the
mid-point between the buying and selling rates.
USD closing rates on 27 January 1999

Buying rate (bid) Selling rate (ask)
for USD for USD
USD/CHF 1.3932 1.3942
EUR/USD 1.1521 1.1536
USD/JPY 113.75 113.85
GBP/USD 1.6554 1.6564
USD/DKK 6.4513 6.4553
USD/SEK 7.7199 7.7249
USD/NOK 7.4565 7.4665
USD/CAD 1.5200 1.5210
The table shows the buying and selling rates for
interbank foreign exchange operations. In the case of
transactions involving smaller amounts, the margins
between the bid and ask rates are rather larger.
In recent years, trading in “cross currencies” has
increased considerably. Customers and smaller banks
want to do business against currencies other than the
dollar, for instance EUR against CHF or GBP against
CHF. In such cases, “cross rates” have to be calculated.
Example 1:
EUR/GBP cross rates
What is the middle rate for EUR against GBP, based
on the middle rates for EUR against USD and GBP
against USD? The result is obtained by establishing a
chain equation:
GBP ? = EUR 1, if EUR 1 = USD 1.1530
and, USD 1.6560 = GBP 1

Answer:
1.1530
1.6560
Example 2:
EUR/CHF cross rates
What is the middle rate for EUR against CHF, based
on the middle rates for EUR against USD and USD
against CHF?
CHF ? = EUR 1, where EUR 1 = USD 1.1530
and USD 1 = CHF 1.3940
Answer:
EUR 1 = 1.1530 x 1.3940 = CHF 1.6073
What is interesting in the latter case is how the
formula is influenced by the indirect quotation for
EUR.
“Cross rates”
EUR 1 = = GBP 0.69630

An international bank must always maintain sufficient
foreign exchange holdings in all major currencies to
be able to execute international payment orders. As a
rule, current or checking accounts maintained with
foreign correspondent banks cannot be overdrawn.
The balances in these accounts are known as “working
balances.” However, a credit balance also means
that if the exchange rate climbs, the bank’s assets –
expressed in the domestic currency – also rise. This is
referred to as a “long position.” Holdings of foreign
currencies have been bought against holdings of
other currencies or against the bank’s own currency.
This automatically results in a “short position” in the
bank’s own currency.
For a number of reasons, the bank’s foreign exchange
position is only rarely identical to its “working balances.”
Firstly, Swiss banks are not interested in
having to maintain large working balances in all major
trading currencies, due to the inherent exchange risk.
They try to eliminate this risk, and swap transactions
offer an opportunity to do this (this process will be
described at a later stage).
Money market operations can also result in long and
short positions which differ from the working balances.
Let’s assume that a bank maintains an EUR
account with a Paris bank with a balance of EUR
1 million. A customer now deposits EUR 10 million for
three months. For a number of reasons, the bank
decides to convert this amount into USD and deposit
these dollars for three months. The EUR exchange
position will therefore be “short” to the tune of
EUR 9 million. In addition to the original balance of
EUR 1 million, a liability of EUR 10 million has arisen,
although the working balance is still EUR 1 million.
Of course, the bank’s foreign exchange operations
constantly change its foreign exchange position. If it
starts the day with a long position of USD 10 million,
later sells USD 2 million to a client and then USD
3 million to a bank, the long position is reduced to
Long and short positions
Dealer position
USD 5 million. The bank’s foreign exchange department
has to keep constant track of the positions in
various currencies. IT programes support and simplify
these monitoring activities.
The foreign exchange position reflects the bank’s
total exposure in various currencies, regardless of
maturities. It records not only direct foreign exchange
transactions, but also the currency exposures resulting
from money market operations.
However, a bank may have certain foreign currency
assets which it does not want to be included in daily
dealing operations. Whenever currency risks are left
unhedged, such items are excluded from the dealer
position, which may therefore differ from the bank’s
total position.
A long position in a particular foreign currency always
implies a corresponding short position in another currency.
If there are long and short positions in several
foreign currencies, we need a common denominator
to measure the total exposure.
The domestic currency is actually this common denominator.
Since all currencies in foreign exchange
operations are quoted in USD, it is convenient to
keep the dealer position on a dollar basis, even if the
bank’s domestic currency is not the dollar.
Example:
Dealer position in USD
If the dollar is the common denominator for measuring
the total currency exposure, the dealer position
will look as follows:
53
Dealer position
versus bank position
Long position Short position In USD
GBP 2 000 000 –3 312 800
CHF 4 000 000 +2 871 088
EUR 500 000 –581 800
JPY 300 000 000 +2 637 363
USD total +1 613 851
54
A bank which plays a major role on the foreign exchange
markets will not normally be content merely
to carry out orders from its customers, but will also
wish to trade for its own account. It will constantly
try to buy currency at the lowest possible rates and
sell it on at a profit. A conservative bank will place
more emphasis on arbitrage transactions than on the
hope of making money with its own foreign exchange
position. The bank’s dealing operations bring more
depth to the market.
If it only conducted customer business, trading patterns
would tend to be patchy and exchange rate
fluctuations more erratic, which in the long run, would
be to the detriment of its commercial customers. In
an actively traded market, rates adjust much more
quickly on an international scale. The market is therefore
sufficiently liquid to handle large customer transactions
without any major distortions in exchange rates.
How do foreign exchange dealers prepare for their
working day? Foreign exchange dealing in Europe is
officially opened at 8 a.m., but the dealer’s work
starts at least one hour earlier. Every morning, the
chief dealers give their staff guidelines for their
dealing activities. They will reassess their strategy on
the basis of their estimation of the market over the
next few months. They will also decide their tactics
for the day, based on the following factors:
– Trading activities in the past few hours in New
York and the Far East. Because of the time difference,
banks in New York will have continued
trading for several hours longer than the banks in
Europe, while in the Far East the working day is
already closing when the European day begins.
– New economic and political developments. As was
demonstrated in the theoretical discussion of how
exchange rates are set, changes in interest rates,
economic indicators and monetary aggregates are
the fundamental factors influencing exchange
Preparing for
the day’s business
rates. Political events such as military conflicts,
social unrest, the fall of a government, etc.,
can also influence, and sometimes even dominate,
the market scene.
– The bank’s own foreign exchange position.
Early in the morning, market makers use electronic
information systems to catch up on any events of
the past night which might impact exchange rates.
Charts (graphic presentations of rate movements)
and screen-based rate boards allow dealers to study
the latest developments in foreign exchange rates
in New York and the Far East. As soon as this preparatory
work is completed, the dealers will be ready
for international trades (between 8 am and 5 pm).
The day starts with a series of telephone calls between
the key market players, the aim being to
sound out what intentions are. Until recently, brokers
also acted as intermediaries in foreign exchange and
money market operations. Nowadays, however, the
Electronic Broking System (EBS) has largely replaced
the activities of the brokers themselves. The original
brokers used to work with minimum amounts of e.g.
USD 5 million, whereas the EBS allows flexible trading
from e.g. USD 1 to 999 million. EBS does not only
deal in USD, however. Currencies such as EUR/CHF,
EUR/JPY and EUR/GBP are also traded. This means
that the continuity of rate determination is substantially
higher, as a larger number of smaller amounts,
previously negotiated privately between banks, now
play a role in setting rates. Another advantage of this
cost-effective system is that the rates are always
available on-screen