The Foreign The Foreign Exchange MarketExchange Market

Chapter 6Chapter 6

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The Foreign Exchange The Foreign Exchange MarketsMarkets

I.I. INTRODUCTIONINTRODUCTION

A.A. The Market:The Market:

the anyplace where money the anyplace where money denominated in one denominated in one

currency is currency is bought and sold bought and sold with money with money denominated denominated in another in another currency.currency.

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INTRODUCTIONINTRODUCTION

B. International Trade and B. International Trade and Capital Transactions:Capital Transactions:

facilitated with the abilityfacilitated with the ability

to transfer purchasing to transfer purchasing power between countriespower between countries

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INTRODUCTIONINTRODUCTION

C.C. LocationLocation

1.1. OTC-type: no specific OTC-type: no specific locationlocation

2.2. Most trades by phone or Most trades by phone or SWIFT*SWIFT*

**SWIFT: Society for Worldwide Interbank SWIFT: Society for Worldwide Interbank Financial Telecommunications Financial Telecommunications

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PART II.PART II.ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKETII .. PARTICIPANTS IN THE PARTICIPANTS IN THE

FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET

A.A. Participants at 2 LevelsParticipants at 2 Levels

1.1. Wholesale Level (95%)Wholesale Level (95%)

- - major commercial major commercial banksbanks

2.2. Retail LevelRetail Level- banks dealing for - banks dealing for business customers. business customers.

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Monday’s Direct Quote

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ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

B.B. Two Sub markets of Currency Two Sub markets of Currency MarketsMarkets

1.1. Spot Market:Spot Market:- immediate transaction- immediate transaction- recorded by 2nd business - recorded by 2nd business

dayday2.2. Forward Market:Forward Market:

- transactions take place at - transactions take place at a specified future datea specified future date

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ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

C.C. Participants by MarketParticipants by Market

1. 1. Spot MarketSpot Market

a.a. commercial bankscommercial banks

b.b. brokersbrokers

c.c. customers of customers of commercial commercial banksbanks

d.d. central bankscentral banks

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ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

2.2. Forward MarketForward Market

a.a. arbitrageursarbitrageurs

(hold (hold currency)currency)

b.b. speculatorsspeculators

c. c. hedgershedgers

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ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKETII.II.SIZE OF THE CURRENCY MARKETSIZE OF THE CURRENCY MARKET

A.A. Largest in the worldLargest in the world

2005: $1.9 trillion daily2005: $1.9 trillion daily

B.B. Market Centers (1998): Market Centers (1998):

London =London = $637 billion daily $637 billion daily

New York= $351 billion dailyNew York= $351 billion daily

Tokyo = $149 billion dailyTokyo = $149 billion daily

C. C. Benchmark: 1999 USGDP = Benchmark: 1999 USGDP = $9.1 $9.1 trilliontrillion

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PART III.PART III.THE SPOT MARKETTHE SPOT MARKET

I.I. SPOT QUOTATIONSSPOT QUOTATIONS

A.A. Sources Sources

1.1. All major newspapersAll major newspapers

2.2. Major currencies have Major currencies have four different quotes:four different quotes:a.a. spot pricespot priceb.b. 30-day30-dayc.c. 90-day90-dayd.d. 180-day180-day

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THE SPOT MARKETTHE SPOT MARKET

B.B. For nonbank customers:For nonbank customers:Direct quoteDirect quotegives the home currency gives the home currency price of one unit of price of one unit of foreign currency.foreign currency.

EXAMPLE in France :EXAMPLE in France :€.80/US$€.80/US$Indirect quoteIndirect quote is the reciprocal is the reciprocal of the direct quoteof the direct quote

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THE SPOT MARKETTHE SPOT MARKET

C.C. Transactions CostsTransactions Costs1. 1. Bid-Ask SpreadBid-Ask Spread

used to calculate the feeused to calculate the feecharged by the brokercharged by the broker

2.2. Bid = the price at which Bid = the price at which the broker is the broker is

willing to buy willing to buy 3.3. Ask = the price the broker Ask = the price the broker

will sellwill sell the currencythe currency

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THE SPOT MARKETTHE SPOT MARKET

Sample bid-ask quote:Sample bid-ask quote:

€€.7353-75/$ or €.7375/$.7353-75/$ or €.7375/$

If you are selling dollars for euros, this is the rate at which the broker will buy them from you

If you want to buy dollars wit euros, this is the rate at which the broker will sell them to you

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THE SPOT MARKETTHE SPOT MARKET

4.4. Percent Spread Percent Spread Formula:Formula:

Percent Spread = {(Ask-Bid)/Ask} x Percent Spread = {(Ask-Bid)/Ask} x 100100

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Sample ProblemSample Problem

Suppose the spot quote for the Swedish Suppose the spot quote for the Swedish krona is $.1395-99, what is the percent krona is $.1395-99, what is the percent spread? spread?

PS = PS = Ask –BidAsk –Bid x 100 x 100 Ask Ask

= = .1399 - .1395.1399 - .1395 x 100 x 100.1399.1399 = .29% or 29 basis = .29% or 29 basis pointspoints

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THE SPOT MARKETTHE SPOT MARKET

D.D. Cross RatesCross Rates

1.1. The exchange rate The exchange rate between 2 non-US$ between 2 non-US$ currencies.currencies.

2. 2. Purpose: to identify Purpose: to identify arbitrage opportunitiesarbitrage opportunities

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Sample ProblemSample Problem Suppose the spot quote for the SwedishSuppose the spot quote for the Swedish Krona and the Swiss franc are Krona and the Swiss franc are

$.1395/kr and $.1133/SF, what is the $.1395/kr and $.1133/SF, what is the quote for the krona in Geneva?quote for the krona in Geneva?

$.1133$.1133

SFSF = = _SF_ _SF_ = = 8.8268.826 x x US$US$ = =8.8268.826

kr kr $.1395$.1395 US$ US$ 7.168 7.1687.168 7.168

krkr

= SF1.23/kr= SF1.23/kr

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The Impact of The Impact of ArbitrageArbitrage

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THE SPOT MARKETTHE SPOT MARKETE.E. Currency ArbitrageCurrency Arbitrage

1.1. When cross rates differ fromWhen cross rates differ from

one financial center to another,one financial center to another,

arbitrage profit opportunities arbitrage profit opportunities exist.exist.

2.2. Strategy: Buy cheap in one Strategy: Buy cheap in one int’l market,int’l market,

Sell at a higher price in Sell at a higher price in anotheranother

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CURRENCY ARBITRAGECURRENCY ARBITRAGE

What is The Critical Role of What is The Critical Role of Arbitrage in the Global Financial Arbitrage in the Global Financial Markets?Markets?

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PART III.PART III.THE FORWARD THE FORWARD MARKETMARKETI.I. INTRODUCTIONINTRODUCTION

A. Definition of a Forward ContractA. Definition of a Forward Contract

an agreement between a an agreement between a bankbank and and a customer to buy or sella customer to buy or sell

1. a specified amount of currency 1. a specified amount of currency against another currencyagainst another currency

2. at a specified future date and 2. at a specified future date and

3. at a fixed exchange rate.3. at a fixed exchange rate.

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THE FORWARD THE FORWARD MARKETMARKET

2. Purpose of a Forward:2. Purpose of a Forward:

HedgingHedging

the process of reducing the process of reducing or or mitigating exchangemitigating exchange

rate risk.rate risk.

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Hedging ToolsHedging Tools

TypeType ContractContract FeaturesFeatures

ForwardForward 1.1. Fixed currency Fixed currency amountamount

FutureFuture 2.2. Fixed exchange rateFixed exchange rate

OptionOption 3.3. Fixed expiration Fixed expiration datedate

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THE FORWARD THE FORWARD MARKETMARKET

C.C. Forward Contracts Forward Contracts Require performance by Require performance by both partiesboth parties

1. 1. Contract Terms may beContract Terms may bea.a. 30-day30-dayb.b. 90-day90-dayc.c. 180-day180-dayd.d. 360-day360-day2.2. Longer-term Contracts possibleLonger-term Contracts possible

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CALCULATING THE FORWARD CALCULATING THE FORWARD PREMIUM OR DISCOUNTPREMIUM OR DISCOUNT

P or DP or D = = F-SF-S x x 1212 x 100 x 100 SS n n

Alternate= Alternate= F-SF-S x x 360360 x 100 x 100 SS n n

wherewhere

F = the forward rate of exchangeF = the forward rate of exchange

S = the spot rate of exchangeS = the spot rate of exchange

n = the number of months or n = the number of months or days in the forward contractdays in the forward contract

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Sample ProblemSample Problem

What is the forward discount or What is the forward discount or premium if the 3 month forward premium if the 3 month forward rate is $1.4511/£ and the spot is rate is $1.4511/£ and the spot is $1.4487?$1.4487?

12100

1.4511 1.4487 12100

1.4487 3.66%

F Sx x

S n

x x

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Sample ProblemSample Problem

What is the forward discount or What is the forward discount or premium if the 30 day forward rate premium if the 30 day forward rate is $1.4498/£ and the spot is is $1.4498/£ and the spot is $1.4487/£ ?$1.4487/£ ?360

100

1.4498 1.4487 360100

1.4487 30.91%

F Sx x

S n

x x