Foreign Exchange Market Fundamentals
Market structure and participants
The foreign exchange market is a decentralised over-the-counter (OTC) market where participants trade bilaterally or through electronic venues. The exam tests how quotes, participants, sessions and conventions fit together.
- OTC and bilateral: FX is not a single exchange; prices are negotiated or streamed by liquidity providers. Interbank platforms, ECNs and single-bank platforms differ in transparency and access.
- Participants: commercial and central banks, corporates, asset managers, hedge funds, retail brokers and central banks. Central banks may intervene or set policy rates.
- Sessions: liquidity is highest when London and New York overlap; Tokyo and London overlap earlier. Session timing affects spreads and volatility.
- Quotation convention: the base currency is quoted first; EUR/USD 1.0850 means 1 EUR buys 1.0850 USD. A pip is 0.0001 for most pairs and 0.01 for JPY pairs.
- Settlement: spot generally settles T+2, with exceptions such as USD/CAD T+1.
Worked example
A client buys EUR 1,000,000 against USD at a dealer quote of EUR/USD 1.0850/1.0855. The client pays the ask, so USD cost = 1,000,000 × 1.0855 = USD 1,085,500. The spread is 5 pips, or 0.0005. Versus the mid of 1.08525, the spread cost is 1,000,000 × 0.00025 = USD 250. Reasoning: EUR is the base currency; buying the base currency uses the dealer's ask.
Traps
- Reversing base and quote currencies, which inverts the economic exposure.
- Assuming every pair has four decimal places; JPY pairs quote to two.
- Treating FX as exchange-traded and ignoring counterparty and settlement risk.
- Ignoring value dates and currency holiday calendars.