Ifm Forex Market

7/29/2019 Ifm Forex Market

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MODULE 2

THE FOREIGN

EXCHANGEMARKET


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CHAPTER OVERVIEW

I. INTRODUCTION

II. ORGANIZATION OF THE

FOREIGN EXCHANGEMARKET

III. THE SPOT MARKET

IV. THE FORWARD MARKET

V. INTEREST RATE PARITY

THEORY


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PART I. INTRODUCTION

I. INTRODUCTION

A. The Currency Market:

where moneydenominated in onecurrency is bought and

sold with moneydenominated in anothercurrency.


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INTRODUCTION

B. International Trade andCapital Transactions:

- facilitated with the abilityto transfer purchasing power

between countries


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INTRODUCTION

C. Location

1. OTC-type: no specific

location2. Most trades by phone,

telex, or SWIFT

SWIFT: Society for WorldwideInterbank Financial

Telecommunications


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PART II.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

I . PARTICIPANTS IN THEFOREIGN EXCHANGE

MARKETA. Participants at 2 Levels

1. Wholesale Level (95%)

- major banks

2. Retail Level- businesscustomers.


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ORGANIZATION OF THE

FOREIGN EXCHANGE MARKET

B. Two Types of CurrencyMarkets

1. Spot Market:- immediate transaction

- recorded by 2nd

business day


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ORGANIZATION OF THE


2. Forward Market:

- transactions take place at a

specified future date


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ORGANIZATION OF THE


C. Participants by Market

1. Spot Market

a. commercial banksb. brokers

c. customers of commercialand central banks

O GA A O O


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ORGANIZATION OF THE


2. Forward Market

a. arbitrageurs

b. tradersc. hedgers

d. speculators

ORGANIZATION OF THE


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ORGANIZATION OF THE


II. CLEARING SYSTEMS

A. Clearing House Interbank

Payments System(CHIPS)

- used in U.S. for electronic

fund transfers.

ORGANIZATION OF THE


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ORGANIZATION OF THE


B. FedWire

- operated by the Fed

- used for domestic transfers

ORGANIZATION OF THE


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ORGANIZATION OF THE


III. ELECTRONIC TRADING

A. Automated Trading

- genuine screen-basedmarket

ORGANIZATION OF THE


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ORGANIZATION OF THE


B. Results:

1. Reduces cost of trading

2. Threatens traders

oligopoly of information

3. Provides liquidity

ORGANIZATION OF THE


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ORGANIZATION OF THE


IV. SIZE OF THE MARKET

A. Largest in the world

1995: $1.2 trillion daily

ORGANIZATION OF THE


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ORGANIZATION OF THE


B. Market Centers (1995):

London = $464 billion

dailyNew York= $244 billion

daily

Tokyo = $161 billiondaily

PART III


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PART III.

THE SPOT MARKET

I. SPOT QUOTATIONS

A. Sources

1. All major newspapers2. Major currencies have

four different quotes:a. spot priceb. 30-dayc. 90-dayd. 180-day


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THE SPOT MARKET

B. Method of Quotation

1. For interbank dollar

trades:a. American terms

example: $0.5838/dm

b. European terms

example: dm1.713/$


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THE SPOT MARKET

2. For nonbank customers:

Direct quote

gives the home currency

price of one unit of foreign

currency.

EXAMPLE: INR 0.5/JPY


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THE SPOT MARKET

C. Transactions Costs

1. Bid-Ask Spread

used to calculate the feecharged by the bank

Bid = the price at which

the bank is willing to buy Ask = the price it will sell

the currency


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THE SPOT MARKET

4. Percent Spread Formula (PS):

100x

Ask

BidAskPS


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THE SPOT MARKET

D. Cross Rates

1. The exchange rate

between 2 non - US$

currencies.


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THE SPOT MARKET

2. Calculating Cross RatesWhen you want to knowwhat the dm/JPY cross

rate is, and you knowdm2/US$ and

JPY0.55/US$

then dm/ = dm2/US$ JPY.55/US$

= dm3.636/ JPY


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THE SPOT MARKET

E. Currency Arbitrage

1. If cross rates differ from

one financial center toanother, and profitopportunities exist.


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THE SPOT MARKET

F. Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of

original transaction. Following

Preceding

Modified Following


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THE SPOT MARKET

G. Exchange Risk

1. Bankers = middlemen

a. Incurring risk of adverseexchange rate moves.

b. Increased uncertaintyabout future exchangerate requires spread.


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THE SPOT MARKET

1.) Demand for higher risk

premium

2.) Bankers widen bid-askspread

ME H NI F P T


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ME H NI F P T

TRANSACTIONS

SPOT TRANSACTIONS: AnExample

Step 1. Currency transaction:verbal agreement, U.S.importer specifies:

a. Account to debit (his acct)b. Account to credit

(exporter)

MECHANICS OF SPOT


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MECHANICS OF SPOT

TRANSACTIONS

Step 2. Bank sends importer

contract note including:

- amount of foreigncurrency

- agreed exchange rate- confirmation of Step 1.

MECHANICS OF SPOT


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MECHANICS OF SPOT

TRANSACTIONS

Step 3. Settlement

Correspondent bank in Hong

Kong transfers HK$ fromnostro account to exporters.

Value Date.

U.S. bank debits importersaccount.

P RT III


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P RT III.

THE FORWARD MARKET

I. INTRODUCTION

A. Definition of a Forward

Contractan agreement between a bank anda customer to deliver a specified

amount of currency againstanother currency at a specifiedfuture date and at a fixed exchange

rate.


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THE FORWARD MARKET

2. Purpose of a Forward:

Hedging

the act of reducing exchange

rate risk.


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THE FORWARD MARKET

B. Forward Rate Quotations

1. Two Methods:

a. Outright Rate: quoted tocommercial customers.

b. Swap Rate: quoted in the

interbank market as adiscount or premium.


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THE FORWARD MARKET

CALCULATING THE FORWARDPREMIUM OR DISCOUNT

= F-S x 12 x 100S n

where F = the forward rate of exchangeS = the spot rate of exchange

n = the number of months in the

forward contract


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THE FORWARD MARKET

C. Forward Contract Maturities

1. Contract Terms

a. 30-dayb. 90-day

c. 180-day

d. 360-day

2. Longer-term Contracts

PART IV


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PART IV.

INTEREST RATE PARITY THEORY

I. INTRODUCTION

A. The Theory states:

the forward rate (F) differsfrom the spot rate (S) atequilibrium by an amount

equal to the interestdifferential (rh - rf) betweentwo countries.

INTERE T R TE P RITY


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THEORY

2. The forward premium or

discount equals the interest

rate differential.(F - S)/S = (rh - rf)

where rh = the home rate

rf = the foreign rate



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THEORY

3. In equilibrium, returns on

currencies will be the same

i. e. No profit will be realizedand interest parity existswhich can be written

(1 + rh) = F(1 + rf) S



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THEORY

B. Covered Interest Arbitrage

1. Conditions required:

interest rate differential does

not equal the forward

premium or discount.2. Funds will move to a country

with a more attractive rate.

INTEREST RATE PARITY


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THEORY

3. Market pressures develop:

a. As one currency is more

demanded spot and sold

forward.

b. Inflow of fund depresses

interest rates.



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THEORY

C. Summary:

Interest Rate Parity states:

1. Higher interest rates on acurrency offset by

forward discounts.

2. Lower interest rates are

offset by forward

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