int. finance- fx market
TRANSCRIPT
INTERNATIONALFINANACE
Function and Structure of the FX MarketFunction and Structure of the FX Market The Spot MarketThe Spot Market The Forward MarketThe Forward Market
Function and Structure of the FX MarketFunction and Structure of the FX Market FX Market ParticipantsFX Market Participants Correspondent Banking RelationshipsCorrespondent Banking Relationships
The Spot MarketThe Spot Market The Forward MarketThe Forward Market
Function and Structure of the FX MarketFunction and Structure of the FX Market The Spot MarketThe Spot Market
Spot Rate QuotationsSpot Rate Quotations The Bid-Ask SpreadThe Bid-Ask Spread Spot FX TradingSpot FX Trading Cross Exchange Rate QuotationsCross Exchange Rate Quotations Triangular ArbitrageTriangular Arbitrage Spot Foreign Exchange Market MicrostructureSpot Foreign Exchange Market Microstructure
The Forward MarketThe Forward Market
Function and Structure of the FX MarketFunction and Structure of the FX Market The Spot MarketThe Spot Market The Forward MarketThe Forward Market
Forward Rate QuotationsForward Rate Quotations Long and Short Forward PositionsLong and Short Forward Positions Forward Cross-Exchange RatesForward Cross-Exchange Rates Swap TransactionsSwap Transactions Forward PremiumForward Premium
Function and Structure of the FX MarketFunction and Structure of the FX Market The Spot MarketThe Spot Market The Forward MarketThe Forward Market
Chapter OutlineChapter Outline
The Function and Structure of The Function and Structure of the FX Marketthe FX Market
FX Market ParticipantsFX Market Participants Correspondent Banking RelationshipsCorrespondent Banking Relationships
FX Market ParticipantsFX Market Participants The FX market is a two-tiered market:The FX market is a two-tiered market:
1.1. Interbank Market (Wholesale)Interbank Market (Wholesale)• About 700 banks worldwide stand ready to make a About 700 banks worldwide stand ready to make a
market in foreign exchange.market in foreign exchange.• Nonbank dealers account for about 20% of the Nonbank dealers account for about 20% of the
market.market.• There are FX brokers who match buy and sell orders There are FX brokers who match buy and sell orders
but do not carry inventory and FX specialists.but do not carry inventory and FX specialists.
2.2. Client Market (Retail)Client Market (Retail) Market participants include international Market participants include international
banks, their customers, nonbank dealers, FX banks, their customers, nonbank dealers, FX brokers, and central banks.brokers, and central banks.
International Banks-around 100to 200 banks International Banks-around 100to 200 banks worldwide ‘make a market’ i.e. they stand worldwide ‘make a market’ i.e. they stand willing to buy or sell foreign currency for their willing to buy or sell foreign currency for their own account.own account.
Customers broadly include MNCs, Money Customers broadly include MNCs, Money managers and private speculators. managers and private speculators.
Circadian Rhythms of the FX Circadian Rhythms of the FX MarketMarket
Electronic Conversations per Hour
05000
1000015000200002500030000350004000045000
1:00 10 am inTokyo
3:00Lunchhour inTokyo
5:00 Europe
coming in
7:00 9:00 Asia
going out
11:00Lunchhour inLondon
1:00 Americascoming in
15:00 5:00London
going out
19:00 9:00 New
Zealandcoming in
11:00 6 pm in
NY
average peak
Correspondent Banking Correspondent Banking RelationshipsRelationships
Large commercial banks maintain demand Large commercial banks maintain demand deposit accounts with one another which deposit accounts with one another which facilitates the efficient functioning of the facilitates the efficient functioning of the FX market.FX market.
Correspondent Banking RelationshipsCorrespondent Banking Relationships Bank A is in London, Bank B is in New York.Bank A is in London, Bank B is in New York. The current exchange rate is £1.00 = $2.00. The current exchange rate is £1.00 = $2.00. A currency trader employed at Bank A buys A currency trader employed at Bank A buys
£100m from a currency trader at Bank B for £100m from a currency trader at Bank B for $200m settled using its correspondent $200m settled using its correspondent relationship.relationship.
Bank A
London
Bank B
NYC
$200
£100
Correspondent Banking Correspondent Banking RelationshipsRelationships
Assets Liabilities
£ deposit at B £300m
Other Assets £600m
B’s Deposit$1,000m
Other L&E £600m
Total Assets £1,300m Total L&E £1,300m
Assets Liabilities
$ deposit at A$1000m
Other Assets $800m
A’s Deposit £300m
Other L&E $800m
Total Assets $2,200m Total L&E$2,200m
£400m $1,200m $1200m £400m
$600mB’s Deposit £200m
$600m
£ deposit at A £200m
£100m
A’s Deposit $800m
Bank A
London
Bank B
NYC
$200
£100
$ deposit at B $800m
£100m
Correspondent Banking RelationshipsCorrespondent Banking Relationships
International commercial banks International commercial banks communicate with one another with:communicate with one another with: SWIFT: The SWIFT: The SSociety for ociety for WWorldwide orldwide IInterbank nterbank FFinancial inancial TTelecommunications.elecommunications.
CHIPS: CHIPS: CClearing learing HHouse ouse IInterbank nterbank PPayments ayments SSystem ystem
ECHO ECHO EExchange xchange CClearing learing HHouse ouse LLimited, the imited, the first global clearinghouse for settling interbank first global clearinghouse for settling interbank FX transactions.FX transactions.
The Spot MarketThe Spot Market
Spot Rate QuotationsSpot Rate Quotations The Bid-Ask SpreadThe Bid-Ask Spread Spot FX tradingSpot FX trading Cross RatesCross Rates
Spot Rate QuotationsSpot Rate Quotations Direct quotationDirect quotation
A foreign exchange rate quoted as the domestic A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other currency per unit of the foreign currency. In other words, it involves quoting in fixed units of foreign words, it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency against variable amounts of the domestic currency. currency.
e.g.e.g. Rs 50 = $1 Rs 50 = $1
Indirect QuotationIndirect Quotation
A foreign exchange rate quoted as the foreign currency A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. In an indirect quote, per unit of the domestic currency. In an indirect quote, the foreign currency is a variable amount and the the foreign currency is a variable amount and the domestic currency is fixed at one unit.domestic currency is fixed at one unit.- e.g. $2 = Rs. 100- e.g. $2 = Rs. 100
American and European QuoteAmerican and European Quote A quote can be classified as European or A quote can be classified as European or
American only if one of the currencies is the American only if one of the currencies is the dollardollar
American Quote- number of dollars expressed American Quote- number of dollars expressed per unit of any other currency e.g.$2=1pound per unit of any other currency e.g.$2=1pound or $ 2.5=Rs.100or $ 2.5=Rs.100
European Quote- no. of units of any other European Quote- no. of units of any other currency expressed per dollar e.g. Rs.45= $1currency expressed per dollar e.g. Rs.45= $1
Spot Rate Quotations
CountryCountryUSD equiv USD equiv FridayFriday
USD equiv USD equiv ThursdayThursday
Currency per USD Currency per USD FridayFriday
Currency per Currency per USD ThursdayUSD Thursday
Argentina (Peso)Argentina (Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377
Australia (Dollar)Australia (Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762
Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774 2.63782.6378
Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242 0.52260.5226
1 Month Forward1 Month Forward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235
3 Months Forward3 Months Forward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253
6 Months Forward6 Months Forward 1.89041.8904 1.89591.8959 0.52900.5290 0.52750.5275
Canada (Dollar)Canada (Dollar) 0.80370.8037 0.80680.8068 1.24421.2442 1.23951.2395
1 Month Forward1 Month Forward 0.80370.8037 0.80690.8069 1.24421.2442 1.23931.2393
3 Months Forward3 Months Forward 0.80430.8043 0.80740.8074 1.24331.2433 1.23851.2385
6 Months Forward6 Months Forward 0.80570.8057 0.80880.8088 1.24121.2412 1.23641.2364
Spot Rate Quotations
The direct quote for British pound is:
£1 = $1.9077
CountryCountryUSD equiv USD equiv FridayFriday
USD equiv USD equiv ThursdayThursday
Currency per Currency per USD FridayUSD Friday
Currency per Currency per USD ThursdayUSD Thursday
Argentina (Peso)Argentina (Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377
Australia (Dollar)Australia (Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762
Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774 2.63782.6378
Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242 0.52260.5226
1 Month Forward1 Month Forward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235
3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253
6 Months 6 Months ForwardForward 1.89041.8904 1.89591.8959 0.52900.5290 0.52750.5275
Spot Rate Quotations
The indirect quote for British pound is:
£.5242 = $1
CountryCountry
USD USD equiv equiv FridayFriday
USD equiv USD equiv ThursdayThursday
Currency per Currency per USD FridayUSD Friday
Currency per Currency per USD ThursdayUSD Thursday
Argentina Argentina (Peso)(Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377
Australia Australia (Dollar)(Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762
Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774 2.63782.6378
Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242 0.52260.5226
1 Month 1 Month ForwardForward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235
3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253
6 Months 6 Months ForwardForward 1.89041.8904 1.89591.8959 0.52900.5290 0.52750.5275
Spot Rate Quotations
Note that the direct quote is the reciprocal of the indirect quote:
5242.
11.9077
CountryCountry
USD USD equiv equiv FridayFriday
USD equiv USD equiv ThursdayThursday
Currency per Currency per USD FridayUSD Friday
Currency per Currency per USD ThursdayUSD Thursday
Argentina Argentina (Peso)(Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377
Australia Australia (Dollar)(Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762
Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774 2.63782.6378
Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242 0.52260.5226
1 Month 1 Month ForwardForward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235
3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253
6 Months 6 Months ForwardForward 1.89041.8904 1.89591.8959 0.52900.5290 0.52750.5275
The Bid-Ask SpreadThe Bid-Ask Spread
The bid (buying) price is the price a dealer The bid (buying) price is the price a dealer is willing to pay you for something.is willing to pay you for something.
The ask (selling) price is the amount the The ask (selling) price is the amount the dealer wants you to pay for the thing.dealer wants you to pay for the thing.
The bid-ask spread is the difference The bid-ask spread is the difference between the bid and ask prices.between the bid and ask prices.
The Bid-Ask SpreadThe Bid-Ask Spread A Bank could offer A Bank could offer
bid price of $1.25/€bid price of $1.25/€ ask price of $1.26/€ask price of $1.26/€ While there are a variety of ways to quote While there are a variety of ways to quote
that,that,
$/€: 1.25/1.26 or Rs./$: 45.45/45.50 or 45.45/50$/€: 1.25/1.26 or Rs./$: 45.45/45.50 or 45.45/50
The bid-ask spread represents the The bid-ask spread represents the dealer’s expected profit.dealer’s expected profit.
Interbank Quote vs Merchant QuoteInterbank Quote vs Merchant Quote
Merchant quote is the quote given by a Merchant quote is the quote given by a bank to its retail customersbank to its retail customers
The Bid-Ask SpreadThe Bid-Ask Spread
A dealer would likely quote these prices as 72-77.A dealer would likely quote these prices as 72-77. It is presumed that anyone trading $10m already It is presumed that anyone trading $10m already
knows the “big figure”.knows the “big figure”.
Bid Ask
1.9072
.5242
S($/£)
S(£/$)
1.9077
.5243
big figure
small figure
Spot FX tradingSpot FX trading
In the interbank market, the standard size In the interbank market, the standard size trade is about U.S. $10 million.trade is about U.S. $10 million.
A bank trading room is a noisy, active A bank trading room is a noisy, active place.place.
The stakes are high.The stakes are high. The “long term” is about 10 minutes.The “long term” is about 10 minutes.
Cross RatesCross Rates Suppose that Suppose that SS($/€) = 1.50($/€) = 1.50
i.ei.e. $1.50 = €1.00 . $1.50 = €1.00 and that and that SS(¥/€) = 50(¥/€) = 50
i.ei.e. €1.00 = ¥50. €1.00 = ¥50 What must the $/¥ cross rate be?What must the $/¥ cross rate be?
$1.50
¥50=
$1.50 €1.00
€1.00 ¥50×
$1.00 = ¥33.33
$0.0300 = ¥1
Triangular ArbitrageTriangular Arbitrage
$
£¥
Credit Lyonnais
S(£/$)=1.50Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
Suppose we observe these banks posting these exchange rates.
First calculate any implied cross rate to see if an arbitrage exists. £1.00
¥80=
£1.50 $1.00
$1.00 ¥120×
Triangular ArbitrageTriangular Arbitrage
$
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
The implied S(¥/£) cross rate is
Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.So, how can we make money?
¥ £
£1.00
¥80=
£1.50 $1.00
$1.00 ¥120×
Then trade yen for your preferred currency.
Buy the £ @ ¥80; sell @ ¥85.
Triangular ArbitrageTriangular Arbitrage
$
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
As easy as 1 – 2 – 3:
1. Sell our $ for £,
2. Sell our £ for ¥,
3. Sell those ¥ for $.¥ £
1
2
3
$
Triangular ArbitrageTriangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥12,750,000 for $ at S(¥/$) = 120receive $106,250
profit per round trip = $106,250 – $100,000 = $6,250
Triangular ArbitrageTriangular Arbitrage
$
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
Here we have to go “clockwise” to make money—but it doesn’t matter where we start.
¥ £1
2 3
$
If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient!
Spot Foreign Exchange Spot Foreign Exchange MicrostructureMicrostructure
Market Microstructure refers to the Market Microstructure refers to the mechanics of how a marketplace mechanics of how a marketplace operates.operates.
Bid-Ask spreads in the spot FX market:Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and increase with FX exchange rate volatility and decrease with dealer competition.decrease with dealer competition.
Private information is an important Private information is an important determinant of spot exchange rates.determinant of spot exchange rates.
The Forward MarketThe Forward Market
Forward Rate QuotationsForward Rate Quotations Long and Short Forward PositionsLong and Short Forward Positions Forward Cross Exchange RatesForward Cross Exchange Rates Swap TransactionsSwap Transactions Forward PremiumForward Premium
The Forward MarketThe Forward Market
A forward contract is an agreement to buy A forward contract is an agreement to buy or sell an asset in the future at prices or sell an asset in the future at prices agreed upon today.agreed upon today.
If you have ever had to order an out-of-If you have ever had to order an out-of-stock textbook, then you have entered into stock textbook, then you have entered into a forward contract.a forward contract.
Forward Rate QuotationsForward Rate Quotations
The forward market for FX involves The forward market for FX involves agreements to buy and sell foreign agreements to buy and sell foreign currencies in the future at prices agreed currencies in the future at prices agreed upon today.upon today.
Bank quotes for 1, 3, 6, 9, and 12 month Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward maturities are readily available for forward contracts.contracts.
Longer-term swaps are available.Longer-term swaps are available.
Forward Rate QuotationsForward Rate Quotations
Consider the example from above:Consider the example from above:
for British pounds, the spot rate is for British pounds, the spot rate is
$1.9077$1.9077 = = ££1.001.00
While the 180-day forward rate is While the 180-day forward rate is
$1.8904$1.8904 = = ££1.001.00 What’s up with that?What’s up with that?
Spot Rate Quotations
Clearly the market participants expect that the pound will be worth less in dollars in six months.
CountryCountry
USD USD equiv equiv FridayFriday
USD equiv USD equiv ThursdayThursday
Currency per Currency per USD FridayUSD Friday
Currency per Currency per USD ThursdayUSD Thursday
Argentina Argentina (Peso)(Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377
Australia Australia (Dollar)(Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762
Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774 2.63782.6378
Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242 0.52260.5226
1 Month 1 Month ForwardForward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235
3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253
6 Months 6 Months ForwardForward 1.89041.8904 1.89591.8959 0.52900.5290 0.52750.5275
Canada Canada (Dollar)(Dollar) 0.80370.8037 0.80680.8068 1.24421.2442 1.23951.2395
1 Month 1 Month ForwardForward 0.80370.8037 0.80690.8069 1.24421.2442 1.23931.2393
3 Months 3 Months ForwardForward 0.80430.8043 0.80740.8074 1.24331.2433 1.23851.2385
6 Months 6 Months ForwardForward 0.80570.8057 0.80880.8088 1.24121.2412 1.23641.2364
Forward Rate QuotationsForward Rate Quotations
Consider the (dollar) holding period return Consider the (dollar) holding period return of a dollar-based investor who buys of a dollar-based investor who buys ££1 1 million at the spot and sells them forward:million at the spot and sells them forward:
$HPR=gainpain
$1,890,400 – $1,907,700$1,907,700=
–$17,300$1,907,700=
$HPR = –0.0091
Annualized dollar HPR = –1.81% = –0.91% × 2
Forward PremiumForward Premium
The interest rate differential implied by The interest rate differential implied by forward premium or discount.forward premium or discount.
For example, suppose the € is appreciating For example, suppose the € is appreciating from from SS($/€) = 1.25 to ($/€) = 1.25 to FF180180($/€) = 1.30($/€) = 1.30
The 180-day forward premium is given by:The 180-day forward premium is given by:
= 0.08 1.30 – 1.25
1.25 × 2=f180,€v$
F180($/€) – S($/€) S($/€)= ×
360180
Long and Short Forward PositionsLong and Short Forward Positions
If you have agreed to If you have agreed to ssell anything (spot or ell anything (spot or forward), you are “forward), you are “sshort”.hort”.
If you have agreed to buy anything (forward If you have agreed to buy anything (forward or spot), you are “long”.or spot), you are “long”.
If you have agreed to If you have agreed to ssell FX forward, you ell FX forward, you are are sshort.hort.
If you have agreed to buy FX forward, you If you have agreed to buy FX forward, you are long.are long.
Payoff ProfilesPayoff Profiles
0 S180($/¥)
F180($/¥) = .009524
Short positionloss
profitIf you agree to sell anything in the future at a set price and the spot price later falls then you gain.
If you agree to sell anything in the future at a set price and the spot price later rises then you lose.
Payoff ProfilesPayoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
profit
Whether the payoff profile slopes up or
down
depends upon whether you use the
direct or indirect quote:
F180(¥/$) = 105 or F180($/¥) = .009524.
short position
Payoff ProfilesPayoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105
profitshort position
Payoff ProfilesPayoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
120
If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105.
15¥
profitshort position
Payoff ProfilesPayoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
Long position-F180(¥/$)
F180(¥/$) short positionprofit
Since this is a zero-sum game, the long position payoff is the
opposite of the short.
Payoff ProfilesPayoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
Long position
-F180(¥/$)profit
The long in this forward contract agreed to BUY ¥ in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will lose by having to buy ¥ at S180(¥/$) = 120
and delivering ¥ at F180(¥/$) = 105.
120
–15¥
Forward Cross Exchange RatesForward Cross Exchange Rates
It’s just an “delayed” example of the spot It’s just an “delayed” example of the spot cross rate discussed above.cross rate discussed above.
In generic termsIn generic terms
)/($
)/($)/(
and
)/($
)/($)/(
kF
jFjkF
jF
kFkjF
N
NN
N
NN
Notice that the “$”s cancel.
CountryCountry
USD USD equiv equiv FridayFriday
USD equiv USD equiv ThursdayThursday
Currency per Currency per USD FridayUSD Friday
Argentina Argentina (Peso)(Peso) 0.33090.3309 0.32920.3292 3.02213.0221
Australia Australia (Dollar)(Dollar) 0.78300.7830 0.78360.7836 1.27711.2771
Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774
Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242
1 Month 1 Month ForwardForward 1.90441.9044 1.91011.9101 0.52510.5251
3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268
6 Months 6 Months ForwardForward 1.89041.8904 1.89591.8959 0.52900.5290
Canada (Dollar)Canada (Dollar) 0.80370.8037 0.80680.8068 1.24421.2442
1 Month 1 Month ForwardForward 0.80370.8037 0.80690.8069 1.24421.2442
3 Months 3 Months ForwardForward 0.80430.8043 0.80740.8074 1.24331.2433
6 Months 6 Months ForwardForward 0.80570.8057 0.80880.8088 1.24121.2412
Forward Cross Exchange Rates
GBP1.00
CAD2.3464=
GBP1.00 USD1.00
USD1.8904 CAD1.2412×
pound-Canadian dollar cross rate
The forward
Currency SymbolsCurrency Symbols
In addition to the familiar currency symbols In addition to the familiar currency symbols ((e.g.e.g. £, ¥, €, £, ¥, €, $) there are three-letter codes $) there are three-letter codes for all currencies.for all currencies.It is a long list, but selected codes include:It is a long list, but selected codes include:
CHFCHF Swiss francsSwiss francsGBPGBP British poundBritish poundZARZAR South African randSouth African randCADCAD Canadian dollarCanadian dollarJPYJPY Japanese yenJapanese yen
SWAPSSWAPS A swap is an agreement to provide a A swap is an agreement to provide a
counterparty with something he wants in counterparty with something he wants in exchange for something that you want. exchange for something that you want. Often on a recurring basis—e.g. every six Often on a recurring basis—e.g. every six
months for five years.months for five years. Swap transactions account for Swap transactions account for
approximately 56 percent of interbank FX approximately 56 percent of interbank FX trading, whereas outright trades are 11 trading, whereas outright trades are 11 percent.percent.
Swaps are covered fully in chapter 14.Swaps are covered fully in chapter 14.
SummarySummary
Spot rate quotationsSpot rate quotations Direct and indirect quotesDirect and indirect quotes Bid and ask pricesBid and ask prices
Cross RatesCross Rates Triangular arbitrageTriangular arbitrage
Forward Rate QuotationsForward Rate Quotations Forward premium (discount)Forward premium (discount) Forward pointsForward points
Practice ProblemPractice Problem The current spot exchange rate is $1.55/£ and The current spot exchange rate is $1.55/£ and
the three-month forward rate is $1.50/£. Based the three-month forward rate is $1.50/£. Based on your analysis of the exchange rate, you are on your analysis of the exchange rate, you are confident that the spot exchange rate will be confident that the spot exchange rate will be $1.52/£ in three months. Assume that you would $1.52/£ in three months. Assume that you would like to buy or sell £1,000,000.like to buy or sell £1,000,000.
a. What actions do you need to take to speculate a. What actions do you need to take to speculate in the forward market? What is the expected in the forward market? What is the expected dollar profit from speculation?dollar profit from speculation?
b. What would be your speculative profit in dollar b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out terms if the spot exchange rate actually turns out to be $1.46/£?to be $1.46/£?
c. Graph your results.c. Graph your results.
SolutionSolution
a.a. If you believe the spot exchange rate will be If you believe the spot exchange rate will be $1.52/£ in three months, you should buy $1.52/£ in three months, you should buy £1,000,000 forward for $1.50/£. Your expected £1,000,000 forward for $1.50/£. Your expected profit will be: profit will be:
$20,000 = £1,000,000 × ($1.52 – $1.50)$20,000 = £1,000,000 × ($1.52 – $1.50)
b.b. If the spot exchange rate actually turns out to be If the spot exchange rate actually turns out to be $1.46/£ in three months, your loss from the long $1.46/£ in three months, your loss from the long position will be: position will be:
––$40,000 = £1,000,000 × ($1.46 – $1.50)$40,000 = £1,000,000 × ($1.46 – $1.50)
SolutionSolution
loss
0 S180(£/$)
F180(£/$) = 1.50
–$40k
1.52
$20k
profit
1.46
End Chapter FiveEnd Chapter Five
International Financial Management
P G Apte
CURRENCY MARKETSCURRENCY MARKETS•The foreign exchange market is the market in which currencies are bought and sold against each other.
•The interbank foreign exchange market is an over-the-counter (OTC) market. Daily turnover about $1.5 trillion. Average transaction is about USD 4 million
•The participants in the wholesale market are commercial banks, investment institutions, corporations and central banks. Currency brokers act as middlemen between dealers
•A small number of currencies account for bulk of turnover: USD, GBP, EUR, CHF, CAD, JPY, DEM, AUD
CURRENCY MARKETSCURRENCY MARKETS
•Among the participants, primary price makers or professional dealers make a two-way market to each other and to their clients
•Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks
•Corporations usually are price takers. However, some non-bank, non-financial companies do act as market makers.
•Large money centre banks deal in a large number of currencies. Smaller banks have a restricted range.
CURRENCY MARKETSGeographically, the markets span all the time zones from New Zealand to the West coast of the United States. When it is 3.00 p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00 p.m. in Hong Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in Singapore it is 12.00 noon in Bahrain. When it is 3.00 p.m. in Bahrain it is noon in Frankfurt and Zurich and 11.00 a.m. in London. 3.00 p.m. in London is 10.00 a.m. in New York. By the time New York is starting to wind down at 3.00 p.m., it is noon in Los Angeles. By the time it is 3.00 p.m. in Los Angeles it is 9.00 a.m. of the next day in Sydney. The gap between New York closing and Tokyo opening is about 21/2 hours. Thus the market functions 24 hours. Of all these centres, London, Tokyo and New York are the big ones accounting for about 50% volume.
Foreign Exchange Interbank (I/B) Desk of Foreign Exchange Interbank (I/B) Desk of Bank ABank A
Corporate Desk of Bank A or I/B Desk of Bank B
I/B
Desk
of
Bank A
I/B Desk
of Bank C
Corporate Foreign Exchange (CorpFx) Corporate Foreign Exchange (CorpFx) Desk of Bank ADesk of Bank A
Corporate Client
of Bank A
CorpFx
Desk
of
Bank A
I/B Desk
of Bank A
Dealings of Corporate Foreign Exchange Dealings of Corporate Foreign Exchange (CorpFx) Desk of Bank A(CorpFx) Desk of Bank A
Client of Bank A
CorpFx Desk of Bank A
Export / Import Desk of Bank A
Outward / Inward Remittance Desk of Bank A
CURRENCY MARKETSCURRENCY MARKETS
• Spot Markets : Value date 2 business days from transaction date. If bank holiday in either settlement centre, push to next business day.
•Outright Forwards : Value date 3 days and beyond.
•Standard forward dates : 1,2,3,6,9,12 months. Spot value date plus required calendar months.
•Swaps : A spot plus a forward or two forwards. Buy USD spot vs. EUR, sell USD 3 month forward vs.EUR. Sell USD 1 month forward, buy USD 3 month forward vs. GBP.
CURRENCY MARKETSCURRENCY MARKETS• A spot GBP/USD deal on Friday Dec 8 : Value date Tuesday Dec 11
•If Dec 11 holiday in NY/London, value date 12 Dec.
•A 2-month forward deal USD/CHF on Monday Dec 11: Value date Feb 13 2001. If holiday in NY/Zurich, Feb 14.
•A 2-month forward USD/JPY on Dec 26. Value date Feb 28. If holiday Tokyo/NY, push forward? NO. Pushing forward must not carry to next calendar month. Push back to Feb 27.
• Spot deals in some currency pairs such as US dollar-Canadian dollar settled in one business day
CURRENCY MARKETSCURRENCY MARKETS
ACI QUOTATION CONVENTIONS
SPOT RATE QUOTATIONS:• Base Currency/Quoted Currency Bid Rate/Offer Rate•USD/CHF : USD base, CHF quoted•GBP/USD : GBP base, USD quoted
•Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD
•Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate.
•Bid rate applies to market maker buying base currency. Offer rate applies to market maker selling base currency.
CURRENCY MARKETS• Currency Codes : All currencies have a 3-letter code used by SWIFT for all interbank transactions. DEM : Deutsche Mark CHF : Swiss Franc NLG : Dutch Guilder BEF : Belgian Franc FRF : French Franc DKK : Danish Kroner ESP : Spanish Peseta ITL : Italian Lira USD : US Dollar AUD : Australian Dollar CAD : Canadian Dollar JPY : Japanese Yen GBP : British Pound IEP : Irish Pound (punt) INR : Indian Rupee SAR : Saudi Riyal EUR : Euro
CURRENCY MARKETSCURRENCY MARKETSSPOT QUOTES : EXAMPLES
USD/CHF SPOT: 1.4575/1.4580
Bid Offer
Bank will buy 1 USD and give CHF 1.4575
Bank will sell 1 USD and want to be paid CHF 1.4580.
Shortened to 1.4575/80 or even 75/80 between dealers. “1.45” is the “big figure”
CURRENCY MARKETSCURRENCY MARKETS
SPOT QUOTES : EXAMPLES
Interpret these quotes :
GBP/USD : 1.5665/70 USD/DEM : 1.9995/05
GBP/EUR : 1.2545/50 USD/INR : 46.7585/46.7685
USD/JPY : 110.25/35
•Most currencies quoted up to six significant figures. Last two figures known as “points” or “pips”. GBP/USD the bid-offer spread is 10 pips. Smaller currencies quoted to 2 decimals.
CURRENCY MARKETS• Quotations in European Terms: Units of a currency per US dollar. Example : USD/INR : 46.7560/7675
• Quotations in American Terms : US dollars per unit of a currency. Example : GBP/USD : 1.5060/65
• Direct Quotations: Units of “home” currency per unit of “foreign” currency. Example : USD/INR above, a direct quote in India.
• Reciprocal or Indirect Quotations: Units of “foreign” currency per unit of “home currency”. Example:
USD/GBP : 0.6638/0.6640, an indirect quote in UK.
CURRENCY MARKETS
Interbank Arbitrage : Suppose banks A and B are quoting : A BGBP/USD : 1.4550/1.4560 1.4538/1.4548
--------- Bank A bid ask ---------- Bank B bid askBuy GBP from bank B, sell to bank A. Prices will move. A BGBP/USD : 1.4550/1.4560 1.4548/1.4558 --------- Bank A ---------- Bank B
No arbitrage. Quotes must “overlap”.
INVERSE QUOTES AND 2-POINT ARBITRAGE
USD/CHF : 1.4955/1.4962 A bank in Zurich
CHF/USD : 0.6695/0.6699 A bank in NY
Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich sell in New York.
$(1,000,000/1.4955) i.e. $6,68,700 needed to acquire the Swiss francs.
$(0.6695 1000000) i.e. $6,69,500, obtained on selling, a riskless profit of $800. Zurich USD/CHF quotes imply certain CHF/USD quotes:
Implied (CHF/USD)bid = 1/(USD/CHF)ask
Implied (CHF/USD)ask = 1/(USD/CHF)bid
INVERSE QUOTES AND 2-POINT ARBITRAGE
To prevent arbitrage, the New York bank's (CHF/USD) quotes must overlap the (CHF/USD) quotes implied by the Swiss bank's quotes. The latter work out to 0.6684/0.6687. A quote such as 0.6686/0.6689 will not lead to arbitrage though it may lead to a one-way market for the banks. The rates actually found in the markets will obey the above relations to a very close approximation.
GBP/USD: 1.5465/70 USD/GBP ?USD/INR: 46.7550/46.7650 (100)INR/USD ?GBP/EUR: 1.3035/45 EUR/GBP?
Cross-Rates and Three-Point ArbitrageA New York bank is currently offering these quotes :
USD/JPY : 110.25/111.10 USD/AUD : 1.6520/1.6530
At the same time, a bank in Sydney is quoting : AUD/JPY : 68.30/69.00
Is there an arbitrage opportunity?
Consider this sequence of transactions: Sell yen against US dollars and the US dollars against Australian dollars both in New York and finally sell the AUD for yen in Sydney. This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C; Finally sell C buy A.
Cross-Rates and Three-Point ArbitrageThe calculations are :(N: NY S: Sydney)
1 JPY in NY gets USD [1/(USD/JPY)ask(N)] = USD (1/111.10)
Sell USD [1/(USD/JPY)ask(N)] in NY to get AUD
{[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520)
Sell AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } in Sydney to get
JPY{[1/(USD/JPY)ask(N)](USD/AUD)bid(N)(AUD/JPY bid(S) }
= JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156
EUR Locking RatesEUR Locking RatesEUR Locking RatesEUR/ATS= 13.760300EUR/BEF= 40.339900EUR/DEM= 1.955830EUR/ESP= 166.386000EUR/FIM= 5.945730EUR/FRF= 6.559570EUR/IEP= 0.787564EUR/ITL= 1936.270000EUR/LUF= 40.339900EUR/NLG= 2.203710EUR/PTE= 200.482000
INTERBANK SPOT DEALINGINTERBANK SPOT DEALING
•Monday September 21 10.45 amBANK A: "Bank A calling. DLR-FRF 25 please.•BANK B: "Forty -Fiftytwo” (Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 4.1540/4.1552.)
•BANK A: “Mine”
(Bank A dealer finds bank B’s price acceptable and wishes to buy USD 25 million. She conveys this by saying “mine”)
SPOT DEALING (Contd.)SPOT DEALING (Contd.)
•BANK B: OK. I sell you USD 25 million against FRF at 4.1552 value 23 September. BNP Paris for my FRF.•BANK A: CITIBANK NYK for my dollars. Thanks & Bye.
• Deal is consummated. Back office staff will retrieve details, exchange confirmatory faxes/telexes and arrange settlement.
•Spot deals account for about 60 % of total turnover.
•Dealers work within limits assigned by management
•Counterparty must be acceptable credit.
FORWARD AND SWAP QUOTESFORWARD AND SWAP QUOTES
• Forward outrights can be given like spot quotes.
• USD/CHF 3-months 1.5655/65 bid/ask
•More commonly given as a spot quote plus a pair of swap points
USD/CHF Spot : 1.6525/35
1 month : 15/10 2 months : 25/18 3 months : 35/25
GBP/USD Spot : 1.4925/35
1 month : 12/15 2 months : 20/25 3 months : 28/35
FORWARD AND SWAP QUOTESFORWARD AND SWAP QUOTES
• To find outrights : Spot quote ± Swap Points
• Each swap point is 0.0001 ( or 0.01)
•When to add, when to subtract?
•Take USD/CHF Spot : 1.6525/35 1 month : 15/10
•If you add : 1 month outright : 1.6540/45
• If you subtract 1 month outrights : 1.6510/1.6525
•Which is correct?
•Two “rules” : 1 Ask > Bid 2 Bid-Ask spread must widen as you go farther into future
FORWARD AND SWAP QUOTESFORWARD AND SWAP QUOTES
• Using rule 2, 1.6540/1.6545 is wrong. 1.6510/25 is correct.
• Now take GBP/USD Spot 1.4925/35 2 months : 20/25
• If add, 2 month outrights 1.4945/1.4960, if subtract
1.4905/1.4910. The latter is correct.
•Mechanical rule : If swap points are Big/Small, subtract, base currency at forward discount, quoted currency at premium. If swap points Small/Big, add. Quoted currency at discount, base currency at premium.
FORWARD AND SWAP QUOTESFORWARD AND SWAP QUOTES
• A quote like : USD/SEK Spot 8.4565/70 3 month : 10/20
•Bank will do either swap:
(1) Buy USD spot, sell USD 3 months forward agnst SEK. The forward rate would be 20 points above the spot rate.
(2) Sell USD spot, buy 3 months forward, forward rate 10 points above spot.
In a swap, amount of one currency - usually the base currency- kept same in the spot and the forward leg. Buy USD 1m spot, sell USD 1m forward. Amount of SEK will be different.
INTERBANK FORWARD DEALINGINTERBANK FORWARD DEALING
DEC 4 2000BANK A : "Bank A calling. Three-month yen-dollar please.”
BANK B : "Thirty two; twenty five."
BANK A : "Fifteen dollars yours at thirty two".
BANK B : "OK. Let's use a spot of 120.50 which is for value December 6; I buy at 120.18 for value March 6."
OPTION FORWARDSOPTION FORWARDS•Delivery date to be chosen by the contract buyer within a specified interval.
•A 3 month forward with delivery option over 3rd month
•A 6 month forward with delivery option over last three months.
•Banks extract maximum premium or give least discount
•GBP/USD spot : 1.4565/70 2 Mth. 15/10 3 Mth 22/17
•Customer wants to buy USD, 3 mths forward, option over
3rd month. USD at premium at 2 mths, greater premium at 3 mths. Bank will charge 3 mths premium.
OPTION FORWARDS•If customer wanted to sell USD, bank would give only 2 months premium.
•USD/CHF Spot 1.6570/75 3 Mths 15/20
(1) Customer wants to buy USD 3 mths forward option period from spot to 3 months. Rates?
(2) Customer wants to buy CHF. Rates?
•In the Indian market, length of option period cannot exceed one month.
FORWARD QUOTESINR1F=
Bid AskINR= 46.4425 46.4625 INRON= 0.25 0.50 INRTN= 0.75 1.00 INRDECM= 5.00 6.00 INRJANM= 20.75 21.75 INRFEBM= 34.50 35.50 INRMARM= 51.00 52.00 INRAPRM= 67.25 68.25 INRMAYM= 83.50 84.50 INRJUNM= 98.50 99.50 INRJULM= 116.50 117.50 INRAUGM= 133.50 134.50 INRSEPM= 150.50 152.00 INROCTM= 167.50 169.00 INRNOVM= 184.00 185.50
BROKEN DATESBROKEN DATES• Standard forward are whole months. Banks will do any number of days forward - 63 days, 135 days etc. These are “broken date” or “odd date” forwards.
•Interpolate between two whole month dates. OK if the gap between the two dates is not too long and no special technical factors are at work.
•USD/INR spot 46.95/96 1 month 10/12 2 mths 20/27
•Customer wants to buy USD 43 days forward.
•15 paise premium from 1 mth to 2 mths. Suppose 30 days in 2nd month. 0.5 paisa per day, 6 paise for 12 days. Rate would be 46.96+0.12+0.06 = 47.14
SHORT DATESSHORT DATES
• Delivery same day- cash
•Delivery next day - Tomorrow or “Tom”.
•Markets quote overnight O/N, tomorrow/next T/N and Spot/Next S/N swaps. These are used to compute rates for short date transactions.
•Reverse swap points and follow add/subtract rule.
•USD/DEM Spot 1.9545/50 T/N : 5/3 3/5
•Outright for tom : 1.9548/50
FOREX AND MONEY MARKETSFOREX AND MONEY MARKETS• Annualised %Premium/Discount, T-year forward
= [(Forward-Spot)/(Spot)] × (1/T) × 100
•Use mid rates for quick calculations.
•Annualised forward margin = Interest rate differential
True for fully convertible currencies with no capital controls.
• Currency with higher interest rate will be at discount.
•3-month Euro LIBOR : 8% p.a. 3-month USD LIBOR : 6%
•USD will be at a 3-month forward premium of 2% p.a.
FOREX AND MONEY MARKETS
This relation between interest rate differential and spot-forward margin is known as Covered Interest Parity.
It holds for freely convertible currencies with no capital controls.
It is a result of investors arbitraging between money markets in different currencies in search of highest return.
Holds with Euromarket interest rates.
It is not a causal relation but an equilibrium relationship.
It will be analysed in detail in the next chapter
FORWARD-FORWARDS AND FORWARD-FORWARDS AND RELATED PRODUCTSRELATED PRODUCTS
• Buy USD 1 month sell 3 months vs.GBP. A 1-3 swap.
•Related products are FSAs, ERAs and FXAs
•Third currency forwards in the Indian market.
•Forward contracts can be cancelled. Settlement payments
depend upon current forward rates.
•Forward contracts tie up credit limits and attract capital adequacy norms. FSAs, ERAs and FXAs are innovations to get around these problems. Analysed in next chapter