Foreign Exchange
Foreign Exchange (or FX) is the conversion of one currency into another. Each FX trade is quoted as a pair of currencies.
The base currency is quoted first: this is the currency that is being bought or sold. The quote currency comes second: this is the price of the base currency. For instance if EUR/USD is trading at 1.1251, this means that 1 Euro costs 1.1251 US Dollars. The most widely traded currency pairs incorporate the US Dollar, and it is typically the base currency, for example USD/JPY (Japanese Yen) or USD/CHF (Swiss Franc). Notable exceptions are the British Pound (GBP/USD) also known as Cable, Euro (EUR/USD), Australian Dollar (AUD/USD) and the New Zealand Dollar (NZD/USD) also known as the Kiwi. A cross currency pair is one that does not include the USD, for instance EUR/GBP or EUR/JPY.
The market for foreign exchange is one of the largest in the world. According to the Bank for International Settlements, average turnover is $5.1 trillion every day.* Recall that the entire capitalization of the NYSE is only $19.3 trillion. The simple reason is that every time a company in one country transacts with a foreign company an FX transaction must take place. Even if the trade is settled in USD (as most international transactions are), one or both parties must eventually repatriate that money into local currency for expenditure in the domestic economy.
The market for foreign exchange is one of the largest in the world. According to the Bank for International Settlements, average turnover is $5.1 trillion every day.* Recall that the entire capitalization of the NYSE is only $19.3 trillion. The simple reason is that every time a company in one country transacts with a foreign company an FX transaction must take place. Even if the trade is settled in USD (as most international transactions are), one or both parties must eventually repatriate that money into local currency for expenditure in the domestic economy.
Spot
The most common FX transactions are spot trades that settle in two days (T+2). Spot is essentially an immediate trade, where the time value of the contract is not taken into account. One major exception to T+2 settlement is the US Dollar vs Canadian Dollar (USD/CAD) which settles the next business day. When two banks do a spot trade, they are exchanging demand deposits in bank accounts.
For example, let’s say JP Morgan agrees to buy 1 million EUR/USD from Barclays at a price of 1.1248. Barclays is based in the UK, and therefore holds a nostro account (latin for "ours") at a bank in the Eurozone denominated in EUR, for example Deutsche Bank. Barclays instructs Deutsche to debit Barclays’ account for 1 million EUR and wire the money to JP Morgan. Barclays also holds a nostro account with an American bank in USD, for example BNY Mellon. JP Morgan wires 1,124,800 USD to BNY Mellon, with instructions to credit the account of Barclays. Two business days are allotted in order to give the four banks involved time to perform the required checks and wire transfers.
For example, let’s say JP Morgan agrees to buy 1 million EUR/USD from Barclays at a price of 1.1248. Barclays is based in the UK, and therefore holds a nostro account (latin for "ours") at a bank in the Eurozone denominated in EUR, for example Deutsche Bank. Barclays instructs Deutsche to debit Barclays’ account for 1 million EUR and wire the money to JP Morgan. Barclays also holds a nostro account with an American bank in USD, for example BNY Mellon. JP Morgan wires 1,124,800 USD to BNY Mellon, with instructions to credit the account of Barclays. Two business days are allotted in order to give the four banks involved time to perform the required checks and wire transfers.