Trading the

Currency Interbank Market

This article is designed to instruct beginners on how to trade the foreign exchange interbank market (as opposed to the IMM currency futures market).

What is a Foreign Exchange Quote
Take a typical quote for the dollar/mark rate: USD/DEM 1.7263/68
What this indicates is the number of German marks that there are to one US dollar. Note that the rate name (USD/DEM) is made up of two parts, the primary currency (USD) and the secondary currency (DEM). The order that these are given in is important: DEM/USD is not that same as USD/DEM, in fact one is the reciprocal of the other.

The important thing to remember is that if the dollar strengthens then the rate will go up. In other words if the primary currency strengthens then the rate increases so that more marks are required per dollar as the dollar is stronger. This means that if you believe that the rate will increase you want to buy dollars or to sell marks. Similarly if you believe that the rate will go down then you want to sell dollars or to buy marks (more on this later).

The Bid/Ask Spread
Note that the quote above has two parts to it: 1.7263 and 1.7268 (typically shortened to 1.7263/68). What this means is that the bank offering the quote will buy dollars/sell marks from you at 1.7263 and sell dollars/buy marks at 1.7268. This means that you will be selling at the lower price and buying at the higher price. It is important that you get this correct as in a typical deal you do not bother to say whether you are buying or selling dollars you only indicate the price you want to deal at. For example if you are quoted 1.7263/68 and you want to buy dollars/sell marks you would say "at 68" or "68 done" whereas if you wanted to sell dollars/buy marks then you would say "at 63" or "63 done" etc..

Cross Rates
Most currencies are quoted with the dollar as the primary rate, with a few notable exceptions being: GBP/USD, AUS/USD. There are also markets quoted for the major "cross rates". That is markets that do not involve the dollars at all. For example:
GBP/DEM, DEM/JYP, DEM/CHF. Note in each case the first named currency is the primary rate so that the DEM/JPY rate goes up if the German mark strengthens agains the Japanese yen.

Trading
An interbank trade consists of the following:

• Whether you are buying or selling
• The rate at which it was done
• The date for the deal
• The amount for the deal

For example you might be buying dollars at 1.7268 for settlement in two business days time (a spot trade) for an amount of 1 million dollars. What this means is that in 2 days time you will take delivery of 1 million dollars, paying 1,726,800 marks in exchange. Now if you are merely speculating on the direction of the rate and do not actually want to receive 1 million dollars then you will need to offset this transaction with an opposite one. For example, later in the day the rate might move to 1.7318/23 and you sell 1 million dollars at 1.7318 again for delivery in two business days times. This trade means that you will be delivering 1 million dollars, receiving 1,731,800 marks in exchange. What you should notice is that the two dollar amounts cancel out so that you are no longer required to deliver or receive any dollars, your account is merely credited with the difference in the number of marks that was to be exchanged.

As you can see the net result is a profit of 5,000 marks. When the amount specified for the trade is given in the denomination of the primary currency then the profit is given in the secondary currency and the amount equals the difference between the buying and selling price multiplied by the size of the transaction:

Primary Currency Size: Profit = Size * ( Rate sold at - Rate bought at)

Alternatively one could have traded in amounts that were denominated in the secondary currency, marks in this instance. For example if one bought dollars/sold marks at 1.7268 for an amount of 1.5 million marks then in order to offset the trade one would need to sell dollars/buy marks at 1.7318 again for 1.5 million marks.

As you can see, if the size is specified in the secondary currency then the profit is given in the primary currency.

Secondary Currency Size: Profit = Size *( 1/(Rate bought at) - 1/(Rate sold at))

Forward Rates

Whilst most quotes are given for the spot market with settlement in two business days time one can agree on a settlement day further in the future. There is a simple relationship between the spot market and the forward rate which depends on the differences in the the interest rates between the primary and the secondary currencies for the specified times.

Forward Rate = Spot Rate * (1 + I secd ) / (1 + I prim)

where

I prim = the interest earned over the period in the primary currency

I secd = the interest earned over the period in the secondary currency.

In practice you merely ask the dealer to roll the deal forward to a given date and to give you the new price as the above calculations are pretty standard. Note that there is a bigger Bid/Ask spread for forward contracts as there is less liquidity.

Currency Codes

The main currency codes are as follows: