the market for foreign exchange

© 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved

PowerPoint® Presentation Prepared ByCharles Schell

The Market for Foreign Exchange

Chapter 4

2 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved

Chapter Four Outline

The structure and function of foreign exchange markets;

Understanding the spot market (transaction now to trade currencies now) Quotations: direct versus indirect Trading Arbitrage opportunities.

Forward market (transaction now to trade currencies later)


4.1 The FOREX (also FX) Market


4.2 Spot Rate Quotations: Perspective of a US investor

Direct quotation: $/JY; / means per the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny”

Indirect quotation: JY/$ the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”


Spot Rate Quotations: US investor’s perspective

The direct quote for British pound is:

£1=$1.5627

Country

USD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852

Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.566 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward 1.5535 1.5568 0.6437 0.6423

6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975


Spot Rate Quotations

Country

USD equiv Friday

USD equiv Thursday



Argentina (Peso) 0.3309 0.3292 3.0221 3.0377


Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.566 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward 1.5535 1.5568 0.6437 0.6423

6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

The indirect quote for British pound is:

£.6399 = $1



Country

USD equiv Friday

USD equiv Thursday



Argentina (Peso) 0.3309 0.3292 3.0221 3.0377


Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.566 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward 1.5535 1.5568 0.6437 0.6423

6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

Note that the direct quote is the reciprocal of the indirect quote:

6399.

15627.1


The Bid-Ask Spread

You versus the dealer (or bank). The bid price is the price a dealer is willing to pay

you for something. You receive this lower price. The ask price is the amount the dealer wants you

to pay for the thing. You pay this higher price. E.g. Bid = RMB 6.10/$; Ask = RMB 6.30/$ The bid-ask spread is the difference between the

bid and ask prices.


Spot FX trading

In the interbank market, the standard size trade is about U.S. $10 million.

A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes.


Cross Rates


Cross Rates

3 currencies, 2 exchange rates: what is the 3rd exchange rate?

Suppose that S($/€) = .50 i.e. $1 = 2 €

and that S(¥/$) = 100 i.e. ¥1 = $0.01

What must the ¥/ € cross rate be?

50 )€¥/(€

05¥

$

100¥

€

5$. S


Triangular Arbitrage

£

$

€

Credit Lyonnais S

(€/$)=0.7720

BNP Paribas

S (€/£)=1.5100

BarclaysS ($/£)=1.9589

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.



The implied S(€/£) cross rate is S(€/£) = 1.5123

Paribas has posted a quote of Sa(€/£)=1.5100 so there is an arbitrage opportunity.

So, how can we make money?

Buy the £ @ €1.5100; sell @ €1.5123

£

$

€

Credit Lyonnais S

(€/$)=0.7720

BNP Paribas

S (€/£)=1.5100




As easy as 1 – 2 – 3:

1. Sell our $ for €,

2. Sell our € for £,

3. Sell those £ for $.1

2

3

£

$

€

Credit Lyonnais S

(€/$)=0.7720

BNP Paribas

S (€/£)=1.5100



Triangular arbitrage: traverse the 3 currencies

Only 2 paths: clockwise, counter-clockwise Path must be feasible: product of the 3 assembled

FX rates must be dimensionless E .G. feasible path (clockwise): ($/₤)(€/$)(₤/€) =

(1.9589)(0.772)(1/1.51)=1.0015 >1 Arbitrage! E.G. feasible path (counter-clockwise):

(€/₤)($/€)(₤/$)=(1.51)(1/0.772)(1/1.9589)= 0.998<1 Loss!

E.G. infeasible path: ($/₤)(€/$)(€/₤) is nonsense!



Sell $5,000,000 for € at S(€/$) = 0.7720

receive €3,860,000

Sell our €3,860,000 for £ at S(€/£) = 1.5100

receive £2,556,291

Sell £2,556,291 for $ at S($/£) = 1.9589receive $5,007,519

profit per round trip = $7,519


Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics of how a marketplace operates.

Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and decrease with dealer competition.

Private information is an important determinant of spot exchange rates.


4.3 The Forward Market

Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium


The Forward Market

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

The forward exchange rate, F, is quoted now. Buy forward: sign a contract with bank now to

buy the FX later at contractual rate F. Sell forward: sign a contract with bank now to sell

the FX later at contractual rate F.


Forward Rate Quotations

The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.

Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

1-month F different from 3-month F, etc.


Forward Rate Quotations

Consider the example from above: for British pound, the spot rate is

$1.5627 = £1.00

While the 180-day forward rate is $1.5445 = £1.00

What’s up with that?



Clearly the market participants expect that the pound will be worth less in dollars in six months.

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday

USD equiv FridayCountry


Long and Short Forward Positions

If you have agreed to sell anything (spot or forward) you are “short”.

If you have agreed to buy anything (forward or spot) you are “long”.

If you have agreed to sell forex forward, you are short.

If you have agreed to buy forex forward, you are long.


Payoff Profile: Sell Forward

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 Profile: Buy Forward

loss

0 S180($/¥)

F180($/¥) =.009524

profit The long in this forward contract agreed to BUY ¥ in 180 days at F180($/¥) = .009524

Long position


Anticipatory Hedging Rule

Hedge means protection. Situation of transactions (or contractual) exposure.

Whatever you will do in the future spot market you should do now in the forward mark.

Hedge a future spot sale of JPYs by selling JPYs forward. You, exporter to Japan, will receive JPY in future and want to protect yourself.

Hedge a future spot purchase of JPYs by buying JPYs forward. You, importer from Japan, will pay JPY in future and want to protect yourself.


Forward Cross Exchange Rates

It’s just an “delayed” example of the spot cross rate discussed above.

In generic terms

)/($

)/($)/(

and

)/($

)/($)/(

kF

jFjkF

jF

kFkjF

N

NN

N

NN


SWAPS

A swap is a compound transaction comprised of a spot transaction combined with a reversing forward transaction. E.g., Buy greenback (USD) spot and sell greenback forward.

Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.


Jargon: Forward Premium or Discount

Forward Premium: F > S0 .

For example, S($/€) = .5235 to F360($/€) = .5307. The euro exhibits a forward premium. The market

expects the euro to appreciate over the next year. Forward Discount: F < S0 .

For example, S(€/$) = 1.91 to F360 (€/$) = 1.884. The $ exhibits a forward discount. The market

expects the $ to depreciate over the year.


Summary

Foreign exchange markets: Allow the conversion of purchasing power from one

currency to another; Enables banking and credit across currencies, foreign

trade financing and trading in foreign currency futures and options;

Trading in the spot market involves immediate purchase and sale of currencies;

In the forward market, buyers and sellers can enter into agreements to buy or sell currencies at a future date and a forward price quoted now.

the market for foreign exchange

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