324_foreign exchange market-forex
TRANSCRIPT
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Copyright 2009 Pearson Prentice Hall. All rights reserved.
Chapter 5
The Foreign
Exchange
Market
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1. Definition and Organization of the Foreign Exchange Markets
2. Foreign Exchange Market Functions
3. Foreign Exchange Market Participants
4. Size and Structure of Foreign Exchange Market Transactions5. Types of Foreign Exchange Market Transactions
6. Quotations of Currencies on Foreign Exchange Markets
CONTENTS AND PURPOSE
Purpose: Enhance theoretical knowledge from the first two chapters with practicalissues of foreign exchange markets functioning
Principles for the analysis of the international business finance problems
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5-4
Foreign Exchange Markets
The FOREX market provides the physical andinstitutional structure through which The money of one country is exchanged for that of another
country The rate of exchangebetween currencies is determined
Foreign exchange transactions are physically completed
A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount of onecurrency will be delivered for some other currency at aspecified rate
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Definition and Organization of the Foreign
Exchange Markets
Foreign Exchange Markets are markets on whichindividuals, fi rms and banks buy and sell foreign
currencies: foreign exchange trading occurs with the help of the
telecommunication net between buyers and sellers offoreign exchange that are located all over the world
can actually talk about a singleinternational foreign
exchange market for every single currency
foreign exchange trading takes place at least in some ofthe world financial centers in every moment
interbank-markets client markets
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Clearing of currencies:
service of exchanging one currency for another
Provision of Credit:
trader that bought a certain good from themanufacturer, needs time to sell this good to thefinal customer and to pay the manufacturer with themoney he received from the customer
Foreign Exchange Market Functions
Clearing of Currencies and Provision of Credit
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Foreign Exchange Markets
There are six main character istics of the FOREX
markets which will be discussed
The geographic extent
The three main functions
The markets participants
Its daily transaction volume
Types of transactionsincluding spot, forward and swaps Methods of stating exchange rates, quotations, and changes
in exchange rates
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Geographic Extent of the Market
Geographically, the FOREX market spans theglobe with prices moving and currencies tradingevery hour of every business day
Major world trading starts each morning inSydney and Tokyo
Then moveswest to Hong Kong and Singapore
Continuingto Europe and finishing on the WestCoast of the U.S.
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Exhibit 5.1 Measuring Foreign
Exchange Market Activity: Average
Electronic Conversions per Hour
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Foreign Exchange Market and Insurance Against
Foreign Exchange Risk
hedging:activities with which the foreign exchange market
participants avoid exchange rate risk or activities withwhich they are closing their open foreign exchange
positionclosed foreign exchange position: size of the assets in a certain currency is equal to the size of the
liabilities in the same currency full insurance against exchange rate risk with respect to this
currency
open foreign exchange position: long: net assets in a certain currency short: net liabilities in a certain currency
in the spot or forward foreign exchange marketstandardized forward contracts and options
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Market Participants
The FOREX market consists of two tiers, the interbank or
wholesalemarket, and the client or retail market.
Five broad categories of participants operate within these two
tiers Bank and non bank foreign exchange dealers
Individuals and firms conducting commercial or investment transactions
Speculators and arbitragers
Central banks and treasuries Foreign exchange brokers
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Foreign Exchange Market Participants
Economic Agents and Types of Activities on
Foreign Exchange MarketsClient buys $
with
Local bank
Main banks
interbank market
Local bank
Client buys with $
Purchases and sales
of big multinational
companiesBrokers
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Economic Agents and Types of
Activities on Foreign Exchange Markets
Brokers:
agents that connects dealers interested in buyingand selling foreign exchange, but does not become
an active client in the transactionthey provide their client, the bank, with the
information about the exchange rates at whichbanks are willing to buy or sell a particular currency
Central banks: foreign exchange market interventions are meant to influence the exchange rate of the domestic
currency in a way that is beneficial for the domestic economy and, consequently, for the country
it does not necessarily have a profit, it can also have a loss
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Economic Agents and Motivation for the
Foreign Exchange Market Participation
Arbitragers:
they want to earn a profit without taking any kind ofrisk (usually commercial banks):
try to profit from simultaneous exchange rate differences indifferent markets
making use of the interest rate differences that exist innational financial markets of two countries along withtransactions on spot and forward foreign exchange marketat the same time (covered interest parity)
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Economic Agents and Motivation for the
Foreign Exchange Market Participation
Hedgers and Speculators:
Hedgers do not want to take risk while participating in the market, they want toinsure themselves against the exchange rate changes
Speculators think they know what the future exchange rate of a particularcurrency will be, and they are willing to accept exchange rate risk with the goal ofmaking profit
Every foreign exchange market participant can behave either as a hedger or as aspeculator in the context of a particular transaction
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Bank and Non-bank Dealers
These participants profit from buying currencies at a bid price
and then reselling them at an off er or askprice
Competition among dealers narrows the spread between the bidand offer rate contributing to the marketsefficiency
Dealers on behalf of large international banks often act as
market makers, often willing to stand in and buy or sell thesecurrencies without having a counterpart with which to unload the
inventory
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Bank and Non-bank Dealers
They trade amongst other banks and dealers in order to
keep their inventory levels at manageable levels
Currency trading is profitable and often contributesbetween 10% - 20% of abanksaverage net income
Small- to medium-sized banks rarely act as marketmakers yet still participate in the interbank market
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Individuals and Firms Conducting
Commercial/Investment Transactions
Importers, exporters, portfolio investors, MNEs,
tourists and others use the FOREX market to
facilitate execution of commercial or investment
transactions
Some of these participants use the market to
hedge foreign exchange rate risk
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Speculators and Arbitragers
Speculators and arbitragers seek to profit from trading in the
market itself
They operate for their own interest, without need or obligation to
serve clients or ensure a continuous market
Speculatorsseek all their profit from exchange rate changes
Arbitragerstry to profit from simultaneous differences in
exchange rates in different markets
A large proportion of speculation and arbitrage is conducted onbehalf of major banks by traders employed by those banks
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Central Banks and Treasuries
Central banks and treasuries use the market to acquireor spend their countryscur rency reserves as well as toinfluence the price at which their own currency trades
They may act to support the value of their cur rencybecause of their governmentspolicies or obligations orbecause of commitments entered through joint floatagreements such as the European Monetary System(EMS)
Consequently their motive is not to profi t but ratherinf luence the foreign exchange value of their currencyin a manner that will benefit their interests
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Continuous Linked Settlement
Continuous Linked Settlement (CLS) system (since
2002) eliminates losses if either party unable to settle
CLS links with Real-Time Gross Settlement (RTGS)
systems in seven major currencies
Eventually we expect same-day settlement instead of
the current lag of two days
The U.S. Commodity Futures Trading Commission(CFTC) regulates foreign exchange trading
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Transactions in the Interbank Market
Transactions within this market can be executed
on a spot, forward, or swapbasis
A spottransaction requires almost immediatedelivery of foreign exchange
Aforwardtransaction requires delivery of foreign
exchange at some future date
Aswaptransaction is the simultaneous exchange of
one foreign currency for another
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Spot Transactions
A spot transaction in the interbank market is thepurchase of foreign exchange, with delivery andpayment between banks to take place, normally,
on the second following business dayThe settlement date is often referred to as the value
date
This is the date when most dollar transactions aresettled through the computerized Clearing HouseInterbank Payment Systems (CHIPS) in New York
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Outright Forward Transactions
This transaction requires delivery at a future value dateof a specified amount of one currency for another
The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of
one, two, three, six, nine and twelve months Terminology typically used is buying or selling forward
A contract to deliver dollars for euros in six months is bothbuying euros forward for dollarsandselling dollars forward
for euros
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Types of Foreign Exchange Market Transactions
Spot Foreign Exchange Transactions
almost immediate delivery of foreign exchange
buyer and seller establish the exchange rate at the time ofthe agreement, payment and delivery are not required untilmaturity
forward exchange rates: 1, 3, 6, 9 months, one year
Outright Forward Transactions
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Swap Transactions
A swap transaction in the interbank market is thesimultaneous purchase and sale of a given amount offoreign exchange for two different value dates
Both purchase and sale are conducted with the samecounterpart
A common type of swap is aspot against forward The dealer buys a currency in the spot market and
simultaneously sells the same amount back to the same bankin the forward market
Since this transaction occurs at the same time and with thesame counterpart, the dealer incurs no exchange rate exposure
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Swap Transactions
simultaneous purchase and sale of a given
amount of foreign exchange for two
different value dates:
spot against forward swaps: dc
ba *
aannual swap rate (%),
bpremium/discount during the time of the currency swap,
cspot exchange rate, and
d- 1/part of the year, for which the currency swap is agreed upon
(if the contract is valid for a three-month period, then this is one
quarter of a year)
forward-forward swaps
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Swap Transactions
Forward-forward swapsA dealer sells 20,000
forward for dollars for delivery in two months at
$1.8420/ and simultaneously buys 20,000 forward
for delivery in three months at $1.8400/ The difference between the buying and selling price is
equivalent to the interest rate differential
Thus a swap can be viewed as a technique for borrowing
another currency on a fully collateralized basis
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Swap Transactions
Non-deliverable forwards (NDFs)NDFs possess the
same characteristics as traditional forward contracts
except that they are settled only in US dollars and the
foreign currency being sold or bought forward is notdelivered
The dollar-settlement feature reflects the fact that NDFs are
contracted offshore and are beyond the reach and regulatory
frameworks of the home country governments
Pricing of NDFs reflects basic interest rate differentials
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Futures
basic characteristics of futures:
the amount of the currency that is being traded
type of currency quotation
contract expiration
last day of trading with the contract settlement day
margin requirements
information about futures trading
futures usage:
arbitrage between outright forward contract and futures
rarely used as an insurance instrument (rigidity!)
Similarities and differences between outright forward contract and
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Similarities and differences between outright forward contract and
futures:
both need to be executed unconditionally
they are usually established for at most one year
Characteristic Futures Outright Forward Contract
Size of the contracts standardized for a given currency depends on the individual needs of the
clientLocation and trade
activity
at the stock exchange or at a given
location; actively traded in an
organized market
with the provision of agents, connected
among each other with the help of
telecommunications; not traded in anorganized market
Duration of the
contract
standardized, but at most a year depends on the individual needs of the
client , but not more than a yearContr act has to be
executed
yes yes
I nsurance and
Securi ty of doi ng
Business wi th the
Instrument
insurance explicitly required (marg inrequirements); high security of doing
business with the ins trument
insurance not required explicitly(implicit insurance are affiliat ions oftwo partners up till now); lower
security than futuresTrade regulati on regulated with the stock exchange
rules
regulation not exp licitly determined
Characteristic Futures Outright Forward Contract
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Characteristic Futures Outright Forward Contract
Contract partners not in direct contact in direct contact
Pri ce determination based on supply and demand based on quotationsDetermination of the
dayof the sett lement
standardized depends on the individual needs of theclient
Accesibi li ty of thecontract for non-
bank agents
accessible to anyone in practice accessible to big clientswith good ratings
Li quidity of the
instrument and the
contract amounts
high liqu idity; small contract amountsand small size of transactions
low liquidity; high contract amountsand large size of transactions compared
to the size of futuresCosts of the
instrument
based on costs that the broker zaraunafor the purchase of the instrument andits sale later on
higher than for futures; based on thedifference in offer and bid price of thecurrency that the bank offers the client
Currency quotati on number of units of $ for one unit of aforeign currency (American quotation)
number of domestic currency units forone unit of a foreign currency
(European quotation)Riskiness of the
instrument
very limited; stock exchange enters thecontract, explicitly required insurance
higher than for futures; for this reason,business is done only with crediblepartners
Profi t yield/loss
payment
daily once; at contract execution or when the
contract expires
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Options
basic characteristics of options: financial instrument that gives the buyer the right, but not the obligation, to
buy or sell a standardized amount of a foreign currency, that is traded, at a
fixed price at a particular time, or until a particular time in the future
call option and put option
American and European options
three different prices:
exercise/strike price
cost, price or value of the option underlying or actual spot exchange rate
at-the-money
in-the-money
out-of-money
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Options
types of options trading:
in organized markets:
standardized contracts with given strike prices, standardized
durations (1, 3, 6, 9, 12 months) and expirations
only certain currencies, contract amounts are standardized over-the-counter trading:
expiration date, strike price and contract amount depend on the
individual needs of the client
counterparty risk!
retail and interbank market
informationabout options trading
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Usage of options:
when the economic agent expects that the
exchange rate trend of a particular currency
could change drasticallywhen the economic agent does not know for
sure that a certain foreign exchange flow will
occur in the future
advantages:
fixed option costs
options do not need to be executed
Options
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Profit/
loss
Limited
loss
Unlimited
profit
A. Buyer of a calloption
Profit/
loss
Limited
loss
Unlimited
profit
C. Buyer of a putoption
Profit/
loss
Limited
profit
Unlimited
loss
B. Seller of a calloption
Profit/
loss
Unlimitedloss
Limitedprofit
D. Seller of a putoption
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Size of the FOREX Market
The Bank for International Settlements (BIS)
estimates that daily global net turnover in
traditional FOREX market activity to be US$3.2trillion in April 2007
Spot transactions at $1,005 billion/day
Outright forward transactions at $363 billion/day
Swap transactions at $1,714 billion/day
Exhibit 5 2 Global Foreign Exchange
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Exhibit 5.2 Global Foreign Exchange
Market Turnover, 1989-2007 (daily
averages in April, billions of U.S. dollars)
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Size of the FOREX Market
The United Kingdom (London) and the United States
(New York) make up roughly 50% of the foreign
exchange market
The London trade alone makes up 34.1% of daily
transactions in the foreign exchange market
Switzerland has grown in recent years and is now the
third largest market with 6.1% of world trading
Exhibit 5 3 Top 10 Geographic Trading Centers
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Exhibit 5.3 Top 10 Geographic Trading Centers
in the Foreign Exchange Market, 1992-2007
(daily averages in April, billions of U.S. dollars)
Exhibit 5.4 Foreign Exchange Market
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Exhibit 5.4 Foreign Exchange Market
Turnover by Currency Pair (Daily
averages in April)
F i E h R t &
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Foreign Exchange Rates &
Quotations
A foreign exchange quote is a statement of willingnessto buy or sell at an announced rate
In the retail market (newspapers and exchange booths), quotesare often given as the home currency price of the foreign
currency Interbank quotesprofessional dealers or brokers may
state quotes in one of two ways The foreign currency price of one dollar
Sfr1.6000/$, read as 1.600 Swiss francs per dollar
The dollar price of a unit of foreign currency $0.6250/Sfr, read as 0.625 dollars per Swiss franc
F i E h R t &
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Foreign Exchange Rates &
Quotations
The former quote is considered to be inEuropean termsand the latter is considered tobe American terms
European Terms: express the rate as the foreigncurrency price of one U.S, dollar
SF 1.6000/$ (1.6000 SF per dollar)
Almost all European currencies, except two, are quoted the European way
The Pound Ster ling and the Euro are the exceptions
Additionally, Australian and New Zealand dollars are also quoted inAmerican terms
Foreign Exchange Rates &
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Foreign Exchange Rates &
Quotations
Direct and Indirect Quotes
A direct quote is a home currency price of a unit of aforeign currency
Sfr1.6000/$ is a direct quote in Switzerland Sfr1.6000/$ is a indirect quote when used in the US
Anindirectquote is a foreign currency price in a
unit of the home currency Sfr1.600/$ is an indirect quote in the US,
$0.6250/Sfr is a direct quote in the US and an indirectquote in Switzerland
Foreign Exchange Rates &
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Foreign Exchange Rates &
Quotations
Interbank quotes are given as a bidand ask
The bidis the price at which a dealer will buy
another currency
The askor offeris the price at which a dealer will
sell another currency Example: 118.27 - 118.37/$ is the bid/ask for Japanese yen
The bank will buy yen at 118.27 per dollar and sell yen at118.37 per dollar making profit on the spread
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Quotations of Currencies on Foreign
Exchange Markets
quotation of a currency tells us at what price
is a financial mediator willing to buy or sell
a certain currency
Currency Quotations in Spot Foreign Exchange
Markets
European and American quotation
direct and indirect quotation (which currency is regardedas a domestic/basis currency)
100*0
0
s
sss
t
100*0
t
t
s
sss
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Exhibit 5.5 Spot and Forward Quotations
for the Euro and Japanese Yen
Currency Quotations in Spot Foreign
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Currency Quotations in Spot Foreign
Exchange Markets
American quotation European quotation
Definition:
number of units of $ needed to buy a unit of a
foreign currency
Definition:
number of units of a foreign currency needed to buy
$1
Di rect quotation in the USA:
number of units of a domestic currency ($) needed
to buy a unit of foreign currency
Di rect quotation outside the USA:
number of units of a domestic currency needed to
buy a unit of a foreign currency ($)
I ndir ect quotation outside the USA:
number of units of a foreign currency ($) needed to
buy a unit of a domestic currency
I ndir ect quotation in the USA :
number of units of a foreign currency needed to buy
a unit of a domestic currency ($)
Currency Quotations in Spot Foreign
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Currency Quotations in Spot Foreign
Exchange Markets
bid price and offer/sell price quotation:
bid price is the exchange rate at which a bank is
willing to buy another currency
offer/sell price is the exchange rate at which the
same bank is willing to sell the currency in question
transaction costs:
banks usually do not charge provision
difference between the bid and offer/sell price
represents the banks profit and is called a margin or
spread
priceoffer/sell
pricebid-priceoffer/sellmargin
Currency Quotations in Spot Foreign
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Currency Quotations in Spot Foreign
Exchange Markets
cross exchange rate:
can be calculated with the help of the relationship of
two currencies with a third currency
tr iangular cur rency arbitrage:
it enables profit earning because of inconsistency
between currency quotations in different financial
centersbuying a particular currency in one financial center
and selling it in another financial center
Currency Quotations in Forward
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Currency Quotations in Forward
Foreign Exchange Markets
outright quotation
tokovna quotation, forward premium/discount:
forward discount:
when a currency is worth less (is cheaper relative to another currency) in theforward foreign exchange market than in the spot foreign exchange market
forward premium:
when a currency is worth more (is more expensive relative to another
currency) in the forward foreign exchange rate market than in the spot foreign
exchange market
annual forward premium and discount
100*360
*ns
sffUSD
100*360
*nf
fsfUSD
Publishing the Currency Quotations
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Financial Times
Wall Street Journal
g y Qin the Leading World Financial
Newspapers
Foreign Exchange Rates &
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Foreign Exchange Rates &
Quotations
Expressing Forward Quotations on a Points Basis
The previously mentioned rates for yen were considered
outright quotes
Forward quotes are different and typically quoted in terms ofpoints
Apointis the last digit of a quotation, with convention
dictating the number of digits to the right of the decimal
Hence a point is equal to 0.0001 of most currencies
Foreign Exchange Rates &
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Bid Ask
Outright spot: 118.27 118.37
Outright forward: 116.84 116.97
Plus points (3 months) -1.43 -1.40
Foreign Exchange Rates &
Quotations
Expressing Forward Quotations on a Points Basis
The yen is quoted only to two decimal points
A forward quotation is not a foreign exchange rate, rather the
differencebetween the spot and forward rates Example:
Foreign Exchange Rates &
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100xdays
360x
Foward
Foward-SpotfFC
Foreign Exchange Rates &
Quotations
Forward Quotations in Percentage Terms Forward quotations may also be expressed as the percent-per-
annum deviation from the spot rate This is similar to the forward discount or premium calculated earlier
The important thing to remember is which currency is beingused as the home or base currency
For indi rect quotes (i.e. quote expressed in foreign currency terms),the formula is
Foreign Exchange Rates &
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100xdays
360x
Spot
Spot-ForwardfH
Foreign Exchange Rates &
Quotations
Forward Quotations in Percentage Terms
For direct quotes (i.e. quote expressed in home
currency terms), the formula is
Foreign Exchange Rates &
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p.a.2.32%100x90
360x105.04
105.04-105.65f
p.a.2.32%100x90
360x
50.00946521
50.00946521-30.00952018f$
Foreign Exchange Rates &
Quotations
Forward Quotations in Percentage Terms
Example: I ndirect quote
Example: Direct quote
Exhibit 5.6 Foreign Exchange Rate
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Quotations on the U.S. Dollar/British Pound in
the Financial Press
Foreign Exchange Rates &
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Japanese yen 110.73/$
Mexican peso MXP 11.4456/$
Foreign Exchange Rates &
Quotations
Cross Rates
Many currencies pairs are inactively traded, so their exchange
rate is determined through their relationship to a widely
traded third currency Example: A Mexican importer needs Japanese yen to pay for
purchases in Tokyo. Both the Mexican peso (MXP) and
Japanese yen () are quoted in US dollars
Assume the following quotes:
Foreign Exchange Rates &
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9.6745/MXP
MXP11.4456/$
110.73/$
dollarpesos/USMexican
dollaryen/USJapanese
Foreign Exchange Rates &
Quotations
Cross Rates
The Mexican importer can buy one US dollar for
11.4456 Mexican pesos and with that dollar buy
110.73; the cross rate would be
Foreign Exchange Rates &
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Citibank $1.2223/
Barclays Bank $1.8410/
Dresdner Bank 1.5100/
Foreign Exchange Rates &
Quotations
I ntermarket Arbitrage
Cross rates can be used to check on opportunities for
intermarket arbitrage
Example: Assume the following exchange rates are
quoted
Foreign Exchange Rates &
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1.5062/
$1.2223/
$1.8410/
Foreign Exchange Rates &
Quotations
Intermarket Arbitrage The cross rate between Citibank and Barclays is
This cross rate is not the same as Dresdners rate quote of
1.5100/ Therefore, an opportunity exists for risk-less profit or
arbitrage
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Exhibit 5.8A Triangular Arbitrage
8
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Exhibit 5.8B Triangular Arbitrage
S f L i Obj ti
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Summary of Learning Objectives
The three functions of the foreign exchange market(FOREX) are to transfer purchasing power, providecredit, and minimize foreign exchange rate risk
The FOREX is composed of two tiers: the interbankmarket and the client market. Participants within thesetiers include bank and nonbank foreign exchangedealers, individuals and firms conducting commercial
and investment functions, speculators and arbitragers,central banks and treasuries and foreign exchangebrokers
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Summary of Learning Objectives
Geographically, the FOREX market spans the globe, with prices
moving and currencies traded every hour of every business day
A foreign exchange rateis the price of one currency expressed in
terms of another currency A foreign exchange quotation is a statement of willingness to
buy or sell currency at an announced price
Transactions within the FOREX market are executed either on a
spot basis requiring delivery two days after the transaction or ona forward basis requiring settlement at some designated future
date
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Summary of Learning Objectives
European terms quotations are the foreign currency
price of one US dollar. American termsare the dollar
price of a foreign currency
Quotations can also be direct or indirect. A directquote is the home currency price of a unit of foreign
currency, while an indirect quote is the foreign
currency price of a unit of the home currency
Direct and indirect are not synonymous for American
and European terms, because the home currency will
change for calculation purposes
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Summary of Learning Objectives
A cross rate is an exchange rate between two
currencies, calculated from their common
relationships with a third currency
When cross rates differ from the direct rates
between two currencies, intermarket arbitrage is
possible
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S l ti A ti i t d E h R t
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Exchange at $0.52/NZ$
4. Holds $20,912,320
2. Holds NZ$40 million
Exchange at $0.50/NZ$
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of$0.50 to $0.52 in 30 days.
1. Borrows $20 million
Borrows at 7.20% for 30 days
Lends at 6.48% for 30 days
3. Receives NZ$40,216,000
Returns $20,120,000Profit of $792,320
Speculating on Anticipated Exchange Rates
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Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.
Exchange at $0.48/NZ$
4. Holds NZ$41,900,000
2. Holds $20 million
Exchange at $0.50/NZ$
1. Borrows NZ$40 million
Borrows at 6.96% for 30 days
Lends at 6.72% for 30 days
3. Receives $20,112,000
Returns NZ$40,232,000Profit of NZ$1,668,000
or $800,640