Principles of foreign exchange dealing

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.