FOREX Market Participants The FOREX market is a two-tiered market: The FOREX market is a two-tiered...

FOREX Market ParticipantsFOREX Market Participants

The FOREX market is a two-tiered market:The FOREX market is a two-tiered market:• 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.

• Client Market (Retail)Client Market (Retail) Market participants include international Market participants include international

banks, their customers, nonbank dealers, banks, their customers, nonbank dealers, FOREX brokers, and central banks.FOREX brokers, and central banks.

London is Most Active FX MarketLondon is Most Active FX Market

Daily Trading Volumes by HourDaily Trading Volumes by Hour

Correspondent Banking Correspondent Banking RelationshipsRelationships

Large commercial banks maintain demand deposit Large commercial banks maintain demand deposit accounts with one another which facilitates the accounts with one another which facilitates the efficient functioning of the forex market.efficient functioning of the forex market.

International commercial banks communicate with International commercial banks communicate with one another 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 first global imited, the first global

clearinghouse for settling interbank FOREX transactions.clearinghouse for settling interbank FOREX transactions.

Correspondent BankingCorrespondent Banking

FX TurnoverFX Turnover

Spot Rate QuotationsSpot Rate Quotations

Direct quotationDirect quotation• the U.S. dollar equivalentthe U.S. dollar equivalent• e.g.e.g. “a Japanese Yen is worth about a “a Japanese Yen is worth about a

penny”penny” Indirect QuotationIndirect Quotation

• the price of a U.S. dollar in the foreign the price of a U.S. dollar in the foreign currencycurrency

• e.g.e.g. “you get 100 yen to the dollar” “you get 100 yen to the dollar”

Spot Rate Quotations

The direct quote for British pound is:

£1 = $1.5627

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 (Peso)Argentina (Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377

Australia (Dollar)Australia (Dollar) 0.59060.5906 0.59340.5934 1.69321.6932 1.68521.6852

Brazil (Real)Brazil (Real) 0.29390.2939 0.28790.2879 3.40253.4025 3.47343.4734

Britain (Pound)Britain (Pound) 1.56271.5627 1.5661.566 0.63990.6399 0.63860.6386

1 Month Forward1 Month Forward 1.55961.5596 1.56291.5629 0.64120.6412 0.63980.6398

3 Months 3 Months ForwardForward

1.55351.5535 1.55681.5568 0.64370.6437 0.64230.6423


1.54451.5445 1.54771.5477 0.64750.6475 0.64610.6461

Canada (Dollar)Canada (Dollar) 0.66920.6692 0.67510.6751 1.49431.4943 1.48131.4813

1 Month Forward1 Month Forward 0.66810.6681 0.67410.6741 1.49681.4968 1.48351.4835


0.66580.6658 0.67170.6717 1.5021.502 1.48881.4888


0.6620.662 0.66780.6678 1.51061.5106 1.49751.4975


The indirect quote for British pound is:

£.6399 = $1

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)

Currency per USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv FridayCountry


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

11.5627

.63991.49751.51060.66780.6626 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)


3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday


The Bid-Ask SpreadThe Bid-Ask Spread

The bid price is the price a dealer is The bid price is the price a dealer is willing to pay you for something.willing to pay you for something.

The ask price is the amount the The ask price is the amount the dealer wants you to pay for the dealer wants you to pay for the thing.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.

Spot FX tradingSpot FX trading

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

A bank trading room is a noisy, A bank trading room is a noisy, active place.active 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($/€) = .50($/€) = .50• i.ei.e. $1 = 2 € . $1 = 2 €

and that and that SS(¥/€) = 50(¥/€) = 50• i.ei.e. €1 = ¥50. €1 = ¥50

What must the $/¥ cross rate be?What must the $/¥ cross rate be?$ $ €

since ,¥ € ¥

$1 €1 $1($ / ¥) .01 or $1 ¥100

€2 ¥50 ¥100S

Triangular ArbitrageTriangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

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


$Credit

Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

80¥

1£

120¥

1$

1$

50.1£

The implied S(¥/£) cross rate is S(¥/£) = 80

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

So, how can we make money?

Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.

¥ £


$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

$


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

Spot Foreign Exchange Spot Foreign Exchange MicrostructureMicrostructure

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

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

If you have ever had to order an out-If you have ever had to order an out-of-stock textbook, then you have of-stock textbook, then you have entered into a forward contract.entered into a forward contract.

Forward Rate QuotationsForward Rate Quotations

The forward market for FOREX involves The forward market for FOREX 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 pound, the spot rate is for British pound, the spot rate is

$1.5627$1.5627 = = ££1.001.00

While the 180-day forward rate is While the 180-day forward rate is

$1.5445$1.5445 = = ££1.001.00 What’s up with that?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)


3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday


Long and Short Forward Long and Short Forward PositionsPositions

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

If you have agreed to If you have agreed to ssell forex forward, ell forex forward, you are you are sshort.hort.

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


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


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


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


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.


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¥

SWAPSSWAPS

A swap is an agreement to provide a A swap is an agreement to provide a counterparty with something he counterparty with something he wants in exchange for something wants in exchange for something that you want.that you want.

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

Forward PremiumForward Premium

It’s just the interest rate differential It’s just the interest rate differential implied by forward premium or discount.implied by forward premium or discount.

For example, suppose the € is appreciating For example, suppose the € is appreciating from from SS($/€) = .5235 to ($/€) = .5235 to FF180180($/€) = .5307($/€) = .5307

The forward premium is given by:The forward premium is given by:

180180,€ $

($ / €) ($ / €) 360 .5307 .5235.01375

($ / €) 180 .5235v

F Sf

S

FOREX Market Participants The FOREX market is a two-tiered market: The FOREX market is a two-tiered...

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