a guide to foreign exchange markets

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A Guide to Foreign Exchange

Markets

K. Alec Chrystal

HE economies of the free world are becoming

increasingly interdependent. U.S. exports now amount

to almost 10 percent of Gross National Product. For

both Britain and Canada, the figure currently exceeds

25 percent. Imports are about the same size. Trade of this magnitude would not be possible without the

ability to buy and sell currencies. Currencies must be

bought and sold because the acceptable means of pay-

ment in other countries is not the U.S. dollar. As a

result, importers, exporters, travel agents, tourists andmany others with overseas business must change dol-

lars into foreign currency and/or the reverse.

The trading of currencies takes place in foreign ex-

change markets whose major function is to facilitate

international trade and investment. Foreign exchange

markets, however, are shrouded in mystery. One

reason for this is that a considerable amount of foreign

exchange market activity does not appear to be related

directly to the needs of international trade and invest-

ment.

The purpose of this paper is to explain how these

markets work.1

The basics of foreign exchange will first

K. Alec Chrystal, professor of economics-elect, University of Sheffield, England, is a visiting scholar at the Federal Reserve Bank of St. Louis. Leslie Bailis Koppel provided research assistance. The author wishes to thank Joseph Hernpen, Centerre Bank, St. Louis, for his advice on this paper.1

For further discussion of foreign exchange markets in the United

States, see Kubarych (1983). See also Dutey and Giddy (1978) andMcKinnon (1979).

be described. This will be followed by a discussion of

some of the more important activities of market partici-

pants. Finally, there will be an introduction to the

analysis of a new feature of exchange markets — cur-

rency options. The concern of this paper is with the

structure and mechanics of foreign exchange markets,

not with the detemiinants of exchange rates them-

selves.

THE BASICS OF FOREIGN EXCHANGE

MARKETSThere is an almost bewildering variety of foreign

exchange markets. Spot markets and forward markets

abound in a number of currencies. tn addition, there

are diverse prices quoted for these currencies. This

section attempts to bring order to this seeming dis-

array.

Spot) Forward, Bid, Ask

Virtually every major newspaper, such as the Wall

Street Journal or the London Financial Times, prints a

daily list of exchange rates. These are expressed either

as the number of units of a particular currency thatexchange for one U.S. dollar or as the number of U.S.

dollars that exchange for one unit of a particular cur-

rency. Sometimes both are listed side by side see

table Il.

For major currencies, up to four different prices

typically will be quoted. One is the “spot” price. Theothers may be ‘30 days forward,” 90 days forward,”

5



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and “180 days forward.” These may be expressed either

in “European Terms” (such as number of $ per LI or in

“American Terms” (such as number oIL per $1. (See the

glossary for further explanation .1

The spot price is what you must pay to buy curren-

cies for immediate delivery (two working days in the

interbank market; over the counter, if you buy bank

notes or travelers checks). The forward prices for each

currency are what you will have to pay if you sign a

contract today to buy that currency on a specific futuredate (30 days from now, etc.). In this market, you pay for

the currency when the contract matures.

Why would anyone buy and sell foreign currency

forward? There are some major advantages from hav-

ing such opportunities available. For example, an ex-

porter who has receipts of foreign currency due at

some future date can sell those funds forward now,

thereby avoiding all risks associated with subsequent

adverse exchange rate changes. Similarly, an importer

who will have to pay for a shipment of goods in foreigncurrency in, say, three months can buy the foreign

exchange forward and, again, avoid having to bear the

exchange rate risk.

The exchange rates quoted in the financial press (for

example, those in table 1) are not the ones individuals

would get at a local bank. Unless otherwise specified,

the published prices refer to those quoted by banks to

other banks for currency deals in excess of $1 million.

Even these prices will vary somewhat depending upon

whether the bank buys or sells. The difference between

the buying and selling price is sometimes known as the

bid-ask spread.” The spread partly reflects the banks’costs and profit margins in transactions; however, ma-

jor banks make their profits more from capital gains

than from the spread.2

‘rhe market for bank notes arid travelers checks is

quite separate from the interbank foreign exchange

market. For smaller currency exchanges, such as an

individual going on vacation abroad might make, the

spread is greater than in the interbank market. ‘Ibis

presumably reflects the larger average costs — includ-

ing the exchange rate risks that banks face by holding

banknotes in denominations too small to be sold in the

interbank market — associated with these smaller ex-changes. As a result, individuals generally paya higher

price for foreign exchange than those quoted in the

newspapers.

tNotice the Wall Street Journal quotes only a bank selling price at aparticular time. The Financial Times quotes the bid-ask spread andthe range over the day.

\ii ix~ttiipIrtil tlit’ iirigr ol 51)01 V\rllZIilizi’ rates a%ail

able is presented ui table Z. which .sIiow% prires or

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h)OiiitS 1(1 t’iijti(i’. I ii’,! all c’’~ec’pltlici,,c’ iii tin’ lirsi lie

‘‘I’ I~ir’s qtiott’cI iii the interhank 1)1 ~vhioles~iIi’.iii~ii

Let tor li-ansac—tion,. in ewess ol S L niihlioit. I he .‘,ti’rling

prices have a hid-ask spread ol cinI~0 I ccitt ~vhiich i’.

oiiI~ahlotil 0.07 percent cit the price or 57 on S 10.000

On Ifli. the ~pic’~id per dollar-s norih ~~oiks out 1cr hi’

abont hall that on sterling ‘54 on .410.000

Sc.’c’oi)(l. tIt’ ~Ilces c1

iiciti’d I,,’ local hank,. lorsriiall. n’

ct’tzul. ti-arisat-ticins which ‘,er~eonly as a uuiclr and doriot rierev,arl\ nrpiesciit prices on actual clc’als. iii—

‘. oItc’ a iiiiic1 I.ii-ger- h,icl—~tsL spi’t’.ttl I hic’se rtails

1,rvzccls ,.ar; tc-c,r)) Ii;,iik Ic, bank. but are i elated to ‘and

larger than the inlethztnk iate’,. Iii sonic cases. thin

In practice, the spread w I va~during Inc day depending uponmarket corrditiops Fnr example the slorl,np spreadmay he as litheas 001 cents at ti~iesana or averages about 0.05 cents Spreadsqenert-;yw,’i h~arger on ‘ess wioeiy traded cijrrcnc es

7




may be of the order of 4 cents orless on sterling, though

the prices quoted in St. Louis involved average spreads

of 8 cents on sterling. The latter represents a spread of

about 5½percent (about $530 per $10,000 transaction).

‘rhe equivalent spread for DM was 7 percent ($700 per

$10,000 transaction).

The spread on forward transactions will usually be

wider than on spot, especially for longer maturities.For interbank trade, the closing spread on one and

three months forward sterling on September 8, 1983,

was .15 cents, while the spot spread was .10 cents. This

is shown in the top line of the Financial Times report in

table 1. Of course, like the spot spread, the forward

spread varies with time of day and market conditions.

At times it may be as low as .02 cents. No information is

available for the size of spread on the forward prices

typically offered on small transactions, since the retail

market on forward transactions is very small.

HOW DOES “THE” FOREIGN

EXCHANGE MARKET OPERATE?

It is generally not possible to go to a specific building

and “see” the market where prices of foreign exchange

are determined. With few exceptions, the vast bulk of

foreign exchange business is done over the telephone

between specialist divisions of major banks. Foreign

exchange dealers in each bank usually operate from

one room; each dealer has several telephones and is

surrounded by video screens and news tapes. Typical-

ly, each dealer specializes in one ot’ a small number of

markets (such as sterling/dollar or deutschemark/dol-lar). Trades are conducted with other dealers who

represent banks around the world. These dealers tvpi-

cally deal regularly with one another and are thus able

to make firm commitments by word of mouth.

Only the head or regional offices of the larger banks

actively deal in foreign exchange. The largest of these

banks are known as “market makers” since they stand

ready to buy or sell any of the major currencies on a

more orless continuous basis.Unusuallylarge transac-

tions, however, will only be accommodated by market

maket’s on more favorable terms. In such cases, foreign

exchange brokers may be used as middlemen to find ataker or takers for the deal. Brokers (of which there are

four major firms and a handful of smaller ones) do not

trade on their own account, but specialize in setting up

large foreign exchange transactions in return for acommission (typically 0.03 cents or less on the sterling

spread). In April 1983, 56 percent of spot transactions

by value involving banks in the United States were

channeled through brokers.4

If all interbank transac

tions at-c included, the figure rises to 59 percent.

Most small banks and local offices of major banks d

not deal directly in the interbank foreign exchang

market. Rather they typically will have a credit line wit

a large bank or their head office. Transactions will thu

involve an extra step (see figure IL The customer deal

with a local bank, which in turn deals with a majobank or head office. The interbank foreign exchang

market exists between the major banks either directl

or indirectly via a broker.

FUTURES AND OPTION MARKETS

FOR FOREIGN EXCHANGE

Until very recently, the interbank market was th

only channel through which foreign exchange transac

tions took place. The past decade has produced majo

innovations in foreign exchange trading. On May 1

1972, the International Money Market (1MM) opene

under the auspices of the Chicago Mercantile Echange. One novel feature of the 1MM is that it provide

a trading floor on which deals are struck by broker

face to face, rather than over telephone lines. The mos

significant difference between the 1MM and the inter

bank market, however, is that trading on the 1MM is i

futures contracts forforeign exchange, the wpical bus

ness being contracts for delivery on the third Wedne

day of March, June, September or December. Activity a

the 1MM has expanded greatly since its opening. Fo

example, during 1972, 144,336 contracts were traded

the figure for 1981 was 6,121,932.

There is an important distinction between “forwardtransactions and “futures” contracts. The former ar

individual agreements between two parties, say, a ban

and customer’. The latter’ is a contract traded on a

organized market of a standard size and settlemen

date, which is resalable at the market price up to th

close of trading in the contract. These organized makets are discussed more fully below.

While the major banks conduct foreign exchang

deals in large denominations, the 1MM trading is don

in contracts of standard size which are fairly smal

Examples of the standard contracts at present ar

L25,000; DM125,000; Canadian $100,000. These aractually smaller today than in the early days of th

1MM.

Further, unlike prices on the interbank market, pric

movements in any single day are subject to specifi

4See Federal Reserve Bank of New York (1983).

8




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limits at the 1MM. For- example, for sterling futures,

prices are not allowed to vary more than $0500 away

from the previous day’s settlement price; this limit is

expanded if it is reached in the same direction for two

successive days. The limit does not apply on the last

day a contract is traded.

Unlike the interbank market, parties to a foreign ex-

change contract at the 1MM typically do not know eachother. Default risk, however, is minor because con-

tracts are guaranteed by the exchange itself. To mini-

mize the cost of this guarantee, the exchange insists

upon “margin requirements” to cover fluctuations in

the value of a contract. This means that an individual or

firm buying a futures contract would, in effect, place a

deposit equal to about 4 percent of the value of the

contract.5

Perhaps the major limitation of the 1MM from the

point of view of importers or exporters is that contracts

cover only eight currencies—those of Britain, Canada,

West Germany, Switzerland, Japan, Mexico, Franceand the Netherlands — and they are specified in stan-

dard sizes for particular dates. Only by chance will

these conform exactly to the needs of importers and

exporters. Large firms and financial institutions will

find the market useful, however, if they have a fairly

continuous stream of payments and receipts in the

traded foreign currencies. Although contracts have a

specified standard date, they offer a fairly flexible

method of avoiding exchange rate risk because they are

marketable continuously.

A major economic advantage of the 1MM for non-

bank customers is its low transaction cost. Though thebrokerage cost of a contract will vary, a ‘round trip”

(that is, one buy and one sell) costs as little as $15. This

is only .04 percent of the value of a sterling contract and

less for some of the lat-ger contracts. Of course, such

costs are high compared with the interbank market,

where the brokerage cost on DM 1 million would be

about $6.25 (the equivalent-valued eight futures con-

tracts would cost $60 in brokerage, taking $7.50 per

single dealt. They are low, however, compared with

those in the retail market, where the spread may in-

volve a cost of up to 2.5 percent or 3 percent per

transaction.

A market similat to the 1MM, the London Interna-

tional Financial Futures Exchange (LIFFE(, opened in

September 1982. On LIFFE, futures are traded in ster-

5A bank may also insist upon some minimum deposit to cover aforward contract, though there is no firm rule.

ling, deutschemarks, Swiss francs and yen in identic

bundles to those sold on the 1MM. In its first year, t

foreign exchange business of L1FFE did not take off in

big way. The majot provider of exchange rate risk co

erage for business continues to be the bank networ

Less than 5 percent of such cover is provided by m

kets such as 1MM and LIFFE at present.

An entirely new feature of foreign exchange markethat has arisen in the 1980s is the existence of optio

markets.” The Philadelphia Exchange was the first

introduce foreign exchange options. ‘Fhese are in f

currencies (deutschemark, sterling, Swiss franc, y

and Canadian dollar). Trades are conducted in sta

dard bundles half the size of the 1MM futures co

tracts. The 1MM introduced an options market in G

man marks on January 24, 1984; this market trad

options on futures conti-acts whereas the Philadelph

options are for spot currencies.

Futures and options prices for foreign exchange a

published daily in the financial press. Table 3 showprices for February 14, 1984, as displayed in the W

Street Journal on the following day. Futures prices

the 1MM are presented for five currencies (left-han

column(. There are five contracts quoted for each cu

rency: March, June, September, December and Mar

1985. For each contr’act, opening and last settleme

(settle( prices, the range over the day, the change fro

the previous day, the range over the life of the contra

and the number of contracts outstanding with th

exchange (open interest( are listed.

Consider the March and June DM futures. Mar

futures opened at $3653 per mark and closed at $370per’ mark; June opened at $3698 per mark and closed

$3746 pet’ mark. Turn now to the Chicago Mercanti

Exchange (1MM) futures options (center column

These are options on the futur-es contracts just d

cussed (see inset for explanation of options). Thus, th

line labeled “Futures” lists the settle prices of th

March and June futures as above.

Let us look at the call options. These are rights to bu

DM futures at specified prices — the strike price. F

example, take the call option at strike price 35. Th

means that one can purchase an option to buy D

125,000 March futures up to the March settlement da

for 5.3500 per mark. This option will cost 2.05 cents p

mark, or $2,562.50, plus brokerage fees. The June otion to buy June futures DM at 5.3500 per’ mark will co

2.46 cents pet- mat-k, or $3,075.00, plus brokerage fee

“For a discussion of options in commodities, see Belongia (1983).

10




‘l’he March call option at strike price 5.3900 per mark

costs only 0.01 cents per mark or $12.50. These pr’ice

differences indicate that the market expects the dollar’

price of the mark to exceed 5.3500, but not to rise

substantially above 5.3900.

Notice that when you exercise a futures call option

you buy the relevant futures contract but onE’ fulfill

that futures contract at maturity. In contrast, the Phil-

adelphia foreign currency options (right column( are

options to buy foreign exchange (spot) itself iather

than futures. So, when a call option is exercised, for-

eign curr’eticy is obtained immediately.

The only difference in presentation of the currency

option prices as compared with the futures options is

that. in the lormei-, the spot exchange r-ate is listed for

comparison rather than the futures price. ‘I’hus, on thePhiladelphia exchange, call options on March DM

62,500 at strike price 5.3500 per mar-k cost 1.99 cents per

rnar’k or $1,243.75, plus brokerage. Brokerage fees here

would be ofthe same or-der as on thc 1MM, about $16

PeA- transaction round trip, per contr’act.

We have seen that there are sevei-al different maikets

for foreign exchange — spot, fijrward, futures, options

on spot, options on futures. The channels through

which these markets are formed are, however, fairly

straightforward (see figur-e IL The main channel is the

inter1jank network, though for lar-ge interbank transac-

tions, foreign exchange brokers may be used as

middlemen.

FOREIGN EXCHANGE MARKETACTIVITIES

Much foreign exchange market trading does not

appear to be related to the simple basic purpose of

allowing businesses to buy or sell foreign cuxrency in

order, say, to sell or- purchase goods overseas. It is

certainly easy to see the usefulness ofthe large range of

foreign exchange transacrions available through the

interhank and organized markets (spot. forward, in-tures, options) to facilitate trade between nations. It is

also clearthat there is a useful role forforeign exchange

broker’s in helping to “make” the interbank rnar’ket.

‘l’here are several other activities, however, iii foreign

exchange markets that are less well understood and

whose relevance is less obvious to people interested in

understanding what these mat-kets accomplish.

11




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Two major classes of activity will be discussed. First,

the existence of a large number of foreign exchange

markets in many locations creates opportunities to

profit from ‘arbitrage.’ Second, there is implicitly a

market in (foreign exchange) risk bearing. Those who

wish to avoid foreign exchange risk (at a price) may do

so. Those who accept ;he risk in expectation of profits

are known as speculators.”

Triangular Arbitrage

Triangular arbitrage is the process that ensures that

all exchange rates are mutually consistent. IL for exam-ple, one U.S. dollar exchanges for one Canadian dollar,

and one Canadian dollar- exchanges for one British

pound, then the U.S. dollar-pound exchange rate

should be one pound for one dollar. If it differs, thenthere is an opportunity for profit making. To see why

this is so, suppose that you could purchase two U.S.

dollars with one British pound. By first buying C$1 with

U.5.51, then purchasing £1 with C$1, and finally buying

US$2 with £1, you could double your money im-

mediately. Clearly this opportunity will not last for- long

since it involves making large profits with certainty.

The process of triangular arbitrage is exactly that of

finding and exploiting ptofitable opportunities in suchexchange rate inconsistencies. As a result of triangular

arbitrage, such inconsistencies will be eliminated

rapidly. Cross rates, however, will only be roughly con-

sistent given the bid-ask spread associated with trans-

action costs.

In the past. the possibility of making profits from

triangular arbitrage was greater as a result of the prac-

tice of expressing exchange rates in American terms in

the United States and in European terms elsewhere.

The adoption of standard practice has reduced the

likelihood of inconsistencies.’ Also, in recent years,

such opportunities for profit making have been greatly

reduced by high-speed, computerized infonnation

systems and the increased sophistication of the banks

operating in the market.

Arbitrage of a slightly different kind results from

price differences in different locations. This is ‘space”

arbitrage. For example, if sterling were cheaper in Lon-

don than in New York, it would be profitable to buy in

London and sell in New York. Similarly, if prices in the

interbank market differed from those at the 1MM, it

would be profitable to arbitrage between them. As a

result of this activity, prices in different locations will

be brought broadly into line.

Interest Arbitrage

Interest arbitrage is slightly different in nature from

triangular or space arbitrage; however, the basic motive

of finding and exploiting profitable opportunities still

applies. There is no reason why interest r-ates denomi-

nated in different currencies should be equal. Interest

rates are the cost of borrowing or the return to lending

fot a specific period of time. The relative price (ex-change rate of money may change over time so that

the comparison of, say, a U.S. and a British interest rate

requires some allowance for expected exchange rate

changes. Thus, it will be not at all unusual to find

‘All except U.K. and Irish exchange rates are expressed in Americanterms. Futures and options contracts are expressed in Europeanterms.

13




interest rates denominated in dollars and interest rates

denominated in, say, pounds being somewhat differ-

ent. However, real returns on assets of similar quality

should be the same if the exchange rate r-isk is covered

or’ hedged in the forward market. Wet’e this not true, it

would be possible to borrow in one cur-i-ency and lend

in another at a profit with no exchange risk.

Suppose we lend one dollar for a year in the United

States at an interest rate of r,,~.The amount accumu-

lated at the end of the year per dollar lent will be I + r~,8

(capital plus interest) - If, instead of making dollar loans,

we converted them into pounds and lent them in the

United Kingdom at the rate r~4

k,the amount of pounds

we would have for each original dollar at the end of the

year would be Sf1 + r~k(,where S is the spot exchange

rate (in pounds per dollar( at the beginning of the

period. At the outset, it is not known if 1 + r~,5dollars is

going to be worth more than 5(1 + r~k(pounds in ayear’s time because the spot exchange rate in a year’s

time is unknown. This uncertainty can be avoided byselling the pounds forward into dollar’s. ‘[hen the rela-

tive value of the two loans would no longer depend on

what subsequently happens to the spot exchange rate.

By doing this, we end up with (1 + r~,k(dollars per

original dollar invested. This is known as the ‘cov-

ered,’ or hedged, return on pounds.

Since the covered return in our example is denomi-

nated in dollars, it can reasonably be compared with

the U.S. interest rate. If these returns are very different,

investors will move funds where the retur-n is highest

on a covered basis. This process is interest arbitrage. It

is assumed that the assets involved are equally safeand, because the returns are covered, all exchange risk

is avoided. Of course, if funds do move in large volume

between assets or between financial centers, then in-

terest rates and the exchange rates (spot and forwardi

will change in predictable ways. Funds will continue to

flow between countries until there is no extra profit to

be made from interest arbitr-age. This will occur when

the returns on both dollar-- and sterling-denominated

assets are equal, that is, when

If (1+r~8

) = n+r~kL

Speculation

Arbitrage in the foreign exchange markets involve

little or- no risk since transactions can be complete

rapidly. An alternative source of profit is available from

ourguessing other market participants as to what f

ture exchange rates will be. This is called speculation

Although any foreign exchange transaction that is no

entirely hedged forward has a speculative elemen

only deliberate speculation for’ profit is discussed here

Until recently, the main foreign exchange specul

tors were the foreign exchange departments of bank

with a lesser role being played by portfolio managers

other financial institutions and international corpora

tions. The 1MM, however, has made it much easier’ fo

individuals and smaller businesses to speculate. A hig

proportion of 1MM transactions appears to be specul

tive in the sense that only about 5 percent of contract

lead to ultimate delivery of foreign exchange. Th

means that most of the activity involves the buying an

selling of a contract at d~ffcrent times and possibldifferent prices prior to maturity. It is possible, how

ever, that buying and selling of contracts before matu

rity would arise out of a str-ate~’to reduce risk. So it

not possible to say that all such activity is speculative

Speculation is important for the efficient working

foreign exchange markets. It is a form of arbitrage tha

occurs across time rather than across space or btween markets at the same time. Just as arbitrage in

creases the efficiency of markets by keeping price

consistent, so speculation increases the efficiency

forward, futures and options markets by keeping thos

markets liquid. Those who wish to avoid foreign echange risk may thereby do so in a well-develope

market. Without speculators~,r’iskavoidance in foreig

exchange markets would be more difficult and, imany cases, impossible.”

Risk Reduction

Speculation clearly involves a shifting of risk from

one party to another. For example, if a bank buys fo

This result is known as covered interest parity. It holds

more or less exactly, subject only to a margin due totransaction costs, so long as the appropriate dollar’ and

sterling interest rates are compared.8

8Since there are many different interest rates, it obviously cannot holdfor allot them. Where (1) does hold is if the interest rates chosenareeurocurrencydeposit rates of the same duration. In otherwords, itfor

r~,we take, say, the three-month eurodollar deposit rate in Paris afor rUkwe take the three-montheurosterling deposit rate in Paris, th(1) will hold lust about exactly. Indeed, if we took the interest rate aexchange rate quotes all from the same bank, it would be remarkabif (I) did not hold. Otherwise the bank would be offering to pay youborrow from it and lend straight backl That is, the price of borrowiwould be less than the covered return on lending. A margin betweborrowing and lending rates, of course, will make thiseven less likso that in reality you would lose.

9This is not to say that all speculative activity is necessarilybeneficia

14



FEGE~ALRESERVE BANK OF ST. ~OU~S MAROH 1984

Covered Interest Parity: An Example

11w lotion rig iflti-nst ate anti n_change -alt- hid- ask spii’ad tin tin’ loin aid tate ~\otilII lii—

iIliiltatinns ale laken rum the London 1-iciniujal 1-1927 1 41)42.

I lOWS ol Si’pti9TthlT 8,1

9M3 litHe 1-. - \o~~let us see it nf’ nouilrl do hettei- to irv,.vst in a

( losing three—month eiiilister ing deposit iw a three—mouth

i,~change Hate Sj_n 3\tp~lil_ L12.1~%.~.1:iJ c-iir-tirlollai’ tte})t)sit t~lien! the (lOhlairs to he iTht9~’i’d

ili,llai-s pt-c- I-PUll- I 11)20 IT-- 22 discount war-i sold Ion~aitIinto stl’i log I hi’ ii’ttun F~~~-t100

potlIlCi iirtestitt ill (or SteIIiIl!4 is 2 369 annual iilti’i’r’st

iatt (II !P ti,.’ \\Iil,iiZls the iettii’n oil a eo~’eu’e.dcoin—inti’wst Rates. ltiix;stui ici~ I lilOdt)ilai -

—-—-— —- clolIztide1

iosit is

1 -\liiiilll ( )ilei- 9’’i,.

Rati’ i.-49t02.25I - tOO ‘~ - -- 1 i12 17 — mu

1 hi, uitei-est i-aU’ on the tIli’I!t’-illIJntii i’uiIltlollzii I I11~I2(lepllsit is a lii tie hcghei- 7 pecrent than that on an

- - liii is wi- could 1101 niakt’ a piulit out ol i:ovei’erleurusteruig dV

1)OsIt II hit’ c—.u’harige rule rt-malns . . -

- - Hltt’ti’st .trInii’age l)i~spite tile tail that dollar jji -

unchanged. it nould hi’ Imliet- to hold dollais, it the -

- tni’t’st rates art’ higher- till! iliscotirit till ton~ai-ddot—c!\tliatIgl’ i-ate tails, the t’oi’o-.teruig deposit would -

lw’s ill the lr,i’n art o1,Eiikeh 111(51115 they buy teweihi- pr-Ierahle SIi~}lose von decide to cm ti the e~ - . . _ -

- - . Iornanl jiouncis Asaiesolt. till-il! us no bent-lit to‘-hange rsk in sellicig the dollars tornarl into . - . . -

the opi~iation I i-an-,aclion costs toi’ iiinst 111111—piJililds. let its I lltliifltl’e liii’ i-ettii-ii to IIIJI(IIIlg Li

- - . - viduals ~~otitd hi, i~\ cii greater 111811 those ahtj~e ar~sic-i-hog deposit vt Itil the return ti) holiling a cloliw - -

- . thi’\. noi,ild hire a lie-get- hId ask spli-ati 111,11) thattIi’posil sold lornard into step mg !asstiiliit’ig that

i1

tiotid (ill ihi’ nitt’ihank market‘ on stat I xvii h sterling-.

- - cotist-i~tientI~- hi-ti’ is 10 ht’i’ielit lot tht~tvpi’aII ‘Vu unpor;int points i iced to lit, tlai lied atjr,tit - - - -

- en t-stoi- from nlakmg a i-ut eI’NI ui hedged etirlirLir-—till ahote data I- i-st 11111 interest iati~sart- arinrial— - . -

- ltlll\ deposit. tile rvttiiii ~tilt lit’ at least as high On aI/eli SI) the~alt, not t~hdinould actually In- eai-iit-d . -

- iit’I)Osit iii tht’ t’iiiii’iit’v inn 111th tOil starl and n-ishour a three-month pei-u;d liii- ri;implc. the tiuli!— - .. - -

III (‘11(1 u~i that is. ii oil ilat-li dollars aunt wish toinhiilth i-ate equivalent to au ajintiat -alt- ul 1W - - -

- - —

(‘11(1 ti}i ‘‘ ith dollars. niakt’ a enu-ollollar deposil-

Iipt~ier1t t~2-Is pei-~i-nt. - - -

ton hate stei’luig am! ttisii to (lId IiJ) t-t-nh stel-Ictlg.~‘econd, till’ Ii itt aid exehiangi’ rates need 501111 naki- a etiiister ing deposit ttvt;ti han, sti-ili ig arId

n_pianauioul I lit- dollLo- is at a discount against stir— ttisl) to thu till ill thillai’s lilt-i-i’ IS likely to lie 19th’ or

1mg Ibis ineatm the lijinac (I ilcihlin hovs 1155 stei— miii ditiereni-v hetnei-n holding a eiuiiisit-rhing up—

hug. So tte han- to mid the tlisroiiiit onto the spot

posil sold toi-nai-d into dtihliii’s In liuivirig diillais

pi~-~- to r41’t the torn-aid pun- heraose till- pu-ire is spoi nOd lioldi ig a t-tirodohlar deposit. ( )l clitilse iithe iltilllIfl’l ut doilztis per

1iotind. not the -eu’i st’ you hold ad tilIl’rrtl!rtl (leplJSit 81111 i-tc-haiigt’

\otuce also tint the llisl-IJtlrlt is tiit-asur’d iii tiiu-— i-aU’s sohisequemlv change, tin- irstilt will lie ten’

lions ol a ll’ilt 1101 ti-actions ol a (1()llai~So the dilli-it-ut

nar d lot eign i’srhange horn a i-usurullcr it 1111 cases its muumive tlu risk ul losses tile to une’tpertcll I’’

t’\pOsl.lI-c lii risk tthili till- rtcstomer reduces his I ton— rhunge I ate i-han~es ( )ne si uple wat to ito this is to

ncr lhc-c-e is 111)1 .1 ti\r-d amount ot risk that ills to hi’ eflsnr-e that assets and liatiitrties dcnurni sited in each

‘shai-ed (lilt Some siraleLies niat molt i-a net ‘cdiii’ operating riurrcnrt are equal. this is kulo\t las 11181111

tool lit risk all around iui,~. loi sample 1 hank that sells sterling lounard liii

1-ristorner- ni_n sonuitanrotrslv tim sterin~ Iou’nard In

general rote liriauicial inslituterns -or other this i-u-nt. the tlank is n_posed to I_eu-u e’¼1-hangi-rate

liinis:. ir1

Ierati ig n—i tar-il-It cii rio-rent es. ttill Ii to risk.




<*hfltlIsflofl* // N

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/

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N tN/N: / ~ / N /‘tNN /7 / NNNN / N/Nil / / //~,

Banks often use ‘swaps to close gaps in the matu-

rity structure of their assets and liabilities in a cur-r’ency. This involves the simultaneous purchase and

sale of a currency for ditferent maturity dates. In April

1983, 33 percent of U.S. banks’ foreign exchange turn-

over involved swaps as compared with 63 percent spot

contracts and only 4 percent outright forward

contracts.1

°

Suppose a bank has sold DM to a customer three

months forward and bought the same amount of DM

from a different customer six months forward. There

are two ways in which the bank could achieve zero

foreign exchange risk exposure. It could either under-

take two separate offsetting forward transactions, or itcould set up a single swap with another bank that has

the opposite mismatch of dollar-DM flows whereby it

teceives DM in exchange for dollars in three months

and receives back dollars in exchange for DM in six

‘°SeeFederal Reserve Bank of New York (1983).

months. Once the swap is set up, the bank’s net profits

are protected against subsequent changes in spot exchange rates during the next six months.

Within the limits imposed by the nature of the con

tracts, a similar effect can be achieved by an appropri-

ate portfolio of futuies contracts on the 1MM. Thus, abank would buy and sell futures contracts so as to

match closely its forward commitments to customers.

In reality, banks will use a combination of methods toreduce foreign exchange risk.

Markets that permit banks, firms and individuals to

hedge foreign exchange risk are essential in times of

fluctuating exchange rates. This is especially impor-tant for banks if they are to be able to provide efficient

foreign exchange services for their customers. In the

absence of markets that permit foreign exchange risk

hedging, the cost and uncertainty of international

transactions would be greatly increased, and interna-

tional specialization and trade would be greatly re

duced.

16



FEDERAL RESERVE BANK OF ST LOUIS MARCH 1984

CONCLUStON

The foreign exchange markets are complex and, for

the outsider, hard to comprehend. The primacy func-

tion of these markets is straightforward. It is to facilitate

international transactions related to trade, travel or

investment. Foreign exchange markets can now

accommodate a large range of current and forward

transactions -

Given the variability of exchange rates, it is important

forbanks and firms operating in foreign currencies to

be able to reduce exchange rate risk whenever possi-

ble, Some risk reduction is achieved by interbank

swaps, but some is also taken up by speculation Arbi-

trage and speculation both increase the efficiency of spot and forward foreign exchange markets and have

enabled foreign exchange markets to achieve a high

level of efficiency. Without the successful operation of

these markets, the obstacles to international trade and

investment would be substantial and the world would

be a poorer place

17




REFERENCES Federal Reserve Bank of New York. “Summary of Results of USForeign Exchange Market Turnover Survey Conducted in Apr

Belongia, Michael T. “Commodity Options: A New Risk Manage- 1983” (September 8, 1983).ment Toot for Agricultural Markets,” this Review (June/July 1983), Garman, Mark B., and Steven W. Kohlhagen. “Foreign Currencpp. 5—15. Option Values,” Journal of International Money and Finance (D

cember 1983), pp. 231—37.Black, Fisher, and Myron Scholes. “The Pricing of Options andCorporate Liabilities,” Journal of Political Economy (May/June Giddy, tan H. “Foreign Exchange Options,” Journal of Futures Ma1973), pp. 637—54. kets (Summer 1983), pp. 143—66,

Chrystal, K. Alec. “On the Theory of International Money” (paper Krugman, Paul, “Vehicle Currencies and the Structure of Intemnpresented to UK. International Economics Study Group Confer- tional Exchange,”Journal of Money, Credit and Banking (Augusence, September1982, Sussex, England). Forthcoming in J. Black 1980), pp. 513-26.and C, S. Dorrance, eds., Problems of International Finance (Lon- Kubarych, Roger M. Foreign Exchange Markets in the Unitedon: Macmillan, 1984). States. (Federal Reserve Bank of New York, 1983).

Dufey, Gunter, and Ian H. Giddy. The International Money Market McKinnon, Ronald I, Money in International Exchange: The Con(Prentice-Hall, 1978). vertible Currency System (Oxford University Press, 1979),

18

a guide to foreign exchange markets

Documents