Global foreign exchange market turnover

Foreign Exchange Transactions

A foreign exchange market transaction is composed of:

spot, outright forward and swaps. The global daily foreign exchange market turnover by

types of transaction as reported by Bank for International Settlement in 1989 through 2001 is depicted in exhibit 3.2. Average daily turnover for all currencies was $1.1369 trillion, of which 43 percent involving spot transactions, 9 percent over the counter forward transactions and 48 percent foreign exchange swaps as of April 1995.

Spot Transaction

A spot transaction involves the exchange of one currency, for example, the U.S. dollar with the Japanese yen at an agreed exchange rate to be settled in cash in two business days between two counter parties.

The spot transaction nearly accounts 40 percent of all transactions in the foreign currency exchange market. For example Kodak needs to pay £10 million to a British supplier in a spot transaction. The foreign exchange dealer in New York has quoted the pound as follows:

$1.5210-$1.5240 Kodak pays $15.24 million U.S. dollar in two business days to

settle the spot transaction at the ask rate of $1.5240. The foreign exchange dealer profit from the above spread in dollar term is $30,000.

Outright Forward

An over the counter transaction involving the exchange of one currency, for example, the British £ with the euro at the forward exchange rate determined today for the delivery to take place for cash settlement in more than two business days.

Example: Hedging with Forward Contract: Nissan manufacturing enters into a forward contract with the Bank of America today to sell 350 million yen at a forward price determined today and Nissan will deliver yen in 31 days to the Bank of America, the Bank has the following quote for 31days yen forward:

121.32-122.40 In 31 days Nissan delivers the yen and receives

$2.8595 million at the ask price of 122.40 Ų/$.

Exhibit 3.3: Forward Hedge and Unhedged Positions

2.65

2.7

2.75

2.8

2.85

2.9

2.95

120 122 124 126 128 130 132

Yen per Dollar

Do

llar

Receiv

ab

le

unhedged forw ard hedge

yen/$ unhedged forward hedge123 2.845528 2.859477124 2.822581 2.859477121 2.892562 2.859477127 2.755906 2.859477

122.4 2.859477 2.859477130 2.692308 2.859477

122.1 2.866503 2.859477115 3.043478 $2.86

Hedging with FRA The forward rate agreement FRA is an over the counter instrument to hedge

interest rate risk. Example: Assuming a manufacturing firm wishes to borrow $10 million in 60

days for only 30 days. To protect himself from rising interest rate, he buys an FRA at 7.125 percent. In 60 days the 30-days rate at the spot is 9.125%. The losing party, in this case the buyer of the FRA, will receive the present value of the difference in 60 days as follows:

Cash received by the losing party= 10M [( .02 ) (30/360)] / (1+09125x30/360) = $16,540.95

The buyer of FRA is indirectly guaranteed the rate at 7.125 percent in 60 days. However, if the actual rate exceeds the agreed rate say by 1.5 percent in 60 days the losing party, in this case the buyer of the FRA gets compensated by the present value of the difference in 60 days, since, the buyer of the FRA has to pay at the spot 1.5 percent more to acquire the capital needed.

If the rate in 60 days falls by 1.375 percent, the buyer of the FRA in 30 days will be borrowing at spot at 1.375 percent below the agreed rate and the present value of this amount has to be sent to the seller of the FRA in 60 days.

Foreign Exchange Swaps A contract involving two counterparties to exchange, for example

the U.S. dollar for the Singapore dollar in principal amount only in two business days at the prevailing spot exchange rate for cash settlement at the expiration of the contract (the short leg), and reversal of the exchange of the same two currencies at the forward rate agreed by the two parties and at a date in future say three business days known as (long leg) provided that the rate for the long leg is usually different from the rate prevailing at the conclusion of the short leg.

The above foreign exchange swap described is a spot / forward swap. When the short leg of the swaps is more than 2 business days, then the swap is the forward/forward swaps.

A FOREX Swap can also be described as the portfolio of long and short position entered simultaneously in two different dates prevailing in the future say 30 and 60 days and at the rate determined today for the respective, that is, 30 and 60 days forward rate.

Example: An importer needs £1,000,000 in 60-days for only 30 days to pay for an outstanding obligations entered with a British supplier. The importer has few alternatives:

Buy 30-days FRA in 60-days as of today, Wait and borrow in 60-days by paying the prevailing spot rate or Enter into foreign exchange swap agreement. Example: Suppose the importer sells £1,000,000 60-days forward

at $1.5210/£ and simultaneously buys £1,000,000 90-days forward at $1.5278/£. This swap transaction is borrowing in disguise for 30 days at fully collateralized basis at the U.S. rate of 5.36 percent per annum.

The implied 30-days forward repo-rate as the importer is selling pounds 60-days forward with the agreement to buy it back in 90-days as follows:

(1+ repo-rate)= $1.5278/£/$1.5210/£ The actual 30-days rate in 60 days could be higher or lower than

5.36 percent.

Foreign Exchange Market Functions

Three types of transactions take place in the foreign exchange market. Each transaction is intended to provide a particular function. For example,

A spot transaction is intended to transfer purchasing power from one party to another and vice versa.

The forward transaction is intended to transfer risk from one party to another, transferring risk is hedging that is intended to reduce the exposure to foreign exchange risk and finally

A swap transaction is essentially a financing at a fully collateralized basis.

Foreign Exchange Quotations

$/Yen Yen/$ Fri Thu Fri Thu Japan (yen) .007942 .007802 125.92 128.17 1- month forward .007954 .007814 125.72 127.97 3- months forward .007979 .007839 125.32 127.57 6- months forward .008025 .007883 124.61 126.85 Britain (pound ) 1.4582 1.4570 .6858 .6863 1- month forward 1.4556 1.4544 .6870 .6876 3-months forward 1.4501 1.4489 .6896 .6902 6-months forward 1.4421 1.4408 .6934 .6941 ------------------------------------------------------------------------------------------------------------ Source: Investors Business daily, May 17, 2002.

Spot and forward Quotations for Yen and British Pound in the Inter-Bank Market Offer $/ƒ Bid Bid ƒ/$ Offer Japan (yen) spot .007942 .0078666 125.92 127.12 1- month forward .007954 .0078833 125.72 126.85 3- months forward .007979 .0078989 125.32 126.60 6- months forward .008025 .0079403 124.61 125.94 Point’s quotations 1-month forward -20 to - 27 3-months forward -60 to - 52 6-months forward -131 to - 118 Bid Offer Bid Offer Britain (pound ) spot 1.4582 1.4599 .6849784 .685777 1- month forward 1.4556 1.4578 .6859652 .685777 3-months forward 1.4501 1.4545 .6875215 .6896076 6-months forward 1.4421 1.4471 .6910373 .6934332 Point’s quotations 1-month forward -26 to - 21 3-months forward -81 to - 54 6-months forward -161 to - 128

Foreign Exchange Market Major Players and Distribution of Their Shares

Foreign Exchange Market Shares

0.00 10.00 20.00 30.00 40.00 50.00

J.P. Morgan

Citigroup

Deutsche Bank

Goldman Sachs

C.S.F.B.

U.B.S. Warburg

State Street

Morgan Stanley

Bank of America

Barclays

Others

Maj

or

FO

RE

X D

eale

rs

Percent

Source: Euromoney: Bank for International Settlement

Triangular Arbitrage

It is possible that the foreign exchange rate spot or forward delivery in the Inter-bank market to be out of sink

temporarily and arbitragers try to align the currency by buying and selling the under-valued or over-valued currency.

Suppose the bid ask price for the pound/$, yen/$ and yen/£ is quoted as follows by banks in United kingdom, United States and Japan.

. Bid Offer pound/$ .69103 .69343 $ /yen .00794028 .00802503 yen/£ 182.85 183.92 The yen appears to be non-aligned as the cross-currency

implied exchange rate for the bid and offer price for yen/£ respectively has to be equal to 179.70-182.24.

Example

Start with $1 million

Sell Ų for $ at Bid Buy Ų with £ at bid Buy £ with $ at bid direct term European term European term

The above triangular arbitrage generates $3,293.91 profit provided that the arbitrager

started with $1million and follows the above process illustrated in the diagram.

Ų

$

£

Big Mac Index

J-Curve

Relative Version of PPP

Time 0 U.S Time 1 $1.50/£ $1.4318/£ U.K

$150 $157.50 5% Inflation

£100 10% Inflation

£110

Exchange rate pass-through

The exporter has three options as far as how much of the increase in import price due to its own currency appreciation is willing to absorb.

1. Absorb all of the increase in import price by cutting its profit margin and or cost, zero pass-through.

2. Absorb none of the increase in import price and passes all of the increase to the importer, 100% pass-through.

3. Absorb some of the increase and pass the remaining to the importer, partial pass-through, under 100%.

Exchange rate pass-through

Suppose Lexus is priced at 3.5 million yen, the current spot is 100Ų/$. Assuming yen appreciates to 90Ų/$, the dollar price of the Lexus will rise from $35,000 to $38,889 in a complete pass-through.

However, at this price Lexus might lose business to competing cars and therefore, the price in the U.S. may go up to $37,100. The price in the U.S. is only increased by 6 percent while the yen appreciated by 11.11 percent.

The pass-through is incomplete and the degree of pass through as the ratio of the change in U.S. price and the change in the exchange rate or .06/. 1111, is 54 percent.

Industry Code (SIC) Industry Pass-Through Coefficient

20 Food and kindred products 0.2485 22 Textile mill products 0.3124 23 Apparels 0.1068 24 Lumber and wood products 0.0812 25 Furniture and fixtures 0.3576 28 Chemicals and allied products 0.5312 30 Rubber and plastic products 0.5318 31 Leather products 0.3144 32 Stone, glass, concrete products 0.8843 33 Primary metal industries 0.2123 34 Fabricated metal products 0.3138 35 Machinery, except electrical 0.7559 36 Electrical and electronic machinery 0.3914 37 Transportation equipment 0.3583 38 Measurement instruments 0.7256 39 Miscellaneous manufacturing 0.2765

Average 0.4205

Exchange Rate Pass-through Coefficients for Selected U.S. Manufacturing

International Fisher Parity

Time 0 U.S Time 1 S0 = $1/euro S1= $.9905/euro France

$100 $104 4% Interest rate

100 Euro

5% Interest rate

105 Euro

IRP

S=$1000/Sf 5000

$1000

SF 5000

1070

SF 5250

7%

5%

F=$1070/SF 5000

The forward premium or discount (F– S0)/ S0 is in direct quote and in equilibrium has to be equal approximately to interest rates differential in the Equation 3.7 as follows:

(F– S0)/ S0 ( R$ – Rf)

Forward Interest Rate Parity

U.S.A $145.82 4.5% $152.38 S0 =$1.4582/£ F=$1.4376/£ £100 6% £106 U.K F= S0 (1+R$) / (1+Rf) 3.6

Where the parameters are as defined previously. The forward premium or discount (F– S0)/ S0 is in direct quote and in equilibrium has to

be equal approximately to interest rates differential in the Equation 3.7 as follows:

(F– S0)/ S0 ( R$ – Rf)

IRP Relationship (F– S0)/ S0 IRP Line X Y -1.5% ( R$ – Rf) -1.5 %

Example IRP

Suppose interests differential in dollars and Swiss francs is 4 percent per annum (U.S. and Swiss interest rates are 7 and 3 percent respectively) and SF is in 1.4 percent premium against dollar, with spot rate at $.633/SF and one year forward in SF is $.6419/SF.

There is deviation from parity and borrowing SF1,000,000. at 3 percent, That is SF1,030,000

and buying US $, $633,000, with SF1,000,000 investing dollar $633,000(1.07) = $677,310 and finally selling $677,310 dollar forward at $.6419/SF

will result in SF1,055164.35, for a risk-less arbitrage profit of SF25,164.35, that is

SF1,055164.35-SF1,030,000=SF25,164.35

Forward Premium (discount) and Interest Rates Differential

Yen Pound S/peseta 1-Month Forward 5.4 (5.7) -1.9 (-1.9) 1.2 (1.2) 3- Months Forward 4.8 (5.3) -1.9 (-1.8) 1.2 (1.2) 1- year Forward 4.5 (5) -1.8 (-1.6) 1.6 (1.5) Source: The figures are interest rate differential and forward premium (discount) in the parentheses versus US dollar September 10 1998, The Financial Times.

S0 = $1/euro S1= $.9903/euro F= $.9903/euro R$ = 4% Rf = 5% Π$ = 2.5%

Πf = 3.5%

Exhibit 3.21: International Parity Relationship

-1

-1 -1 -1

Percentage change exchange rate

Nominal Inflation differential

Forward premium or discount

Interest rate differential

Real Exchange Rate

The nominal exchange rate adjusted for the respective inflation rates in two different economies provides a measure of the economy’s real cost of producing goods for consumption and goods for export over the given period.

The real exchange rate Er is defined as the nominal exchange rate En adjusted for the inflation differentials in two economies as follows:

Er = En (Pf / P$)

Where Pf and P$ are price index in foreign currency and dollars respectively.

Real Exchange Rates for Major Currencies

COUNTRY NAME Canada France Germany Japan Singapore U.K U.S

1989 86.0 129.5 134.1 150.3 140.7 94.2 109.3 1990 85.9 111.4 116.3 157.4 129.9 85.6 104.7 1991 82.8 114.1 119.0 144.6 122.8 89.1 103.5 1992 89.6 106.7 107.0 136.4 115.7 89.9 101.2 1993 95.2 114.4 113.7 120.2 114.8 107.8 104.7 1994 102.4 112.3 113.1 110.7 107.2 103.3 103.4 1995 100.0 100.0 100.0 100.0 100.0 100.0 100.0 1996 100.6 103.5 106.5 118.9 100.8 102.1 104.3 1997 101.4 118.4 121.5 129.4 104.6 96.1 112.0 1998 108.6 119.3 123.8 140.4 119.8 93.5 120.0 1999 109.3 124.2 121.6 99.0 119.3 2000 109.4 119.2 123.5 105.2 125.2 2001 113.5 133.8 128.3 110.6 134.5

Source: Author’s own estimates, real exchange rate index set at 100 for 1995.

Korea Indonesia Malaysia Philippines Thailand China-Mainland

China-Hong Kong Singapore

1990 100 100 100 100 100 100 100 100 1991 101.27 99.83 100.62 83.72 98.54 104.72 93.16 94.40 1992 106.73 103.93 95.06 85.05 99.90 106.72 93.51 94.96 1993 110.84 104.18 99.43 95.29 100.58 99.83 94.95 93.13 1994 106.35 109.43 93.80 82.59 96.91 133.69 93.65 83.51 1995 106.39 114.07 93.49 89.08 96.79 140.18 93.40 81.90 1996 115.60 119.50 93.20 88.66 98.51 151.09 96.07 81.69 1997 231.84 234.55 143.62 137.93 181.05 157.90 96.13 96.87

Source: Author’s own estimates using end of the period exchange rates from IFS, real exchange rate index set at 100 for 1990.

Exhibit 3.25: Real Exchange Rates for East Asian Economies 1991-96.