The Foreign The Foreign Exchange MarketExchange MarketChapter 6Chapter 6

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The Foreign Exchange The Foreign Exchange MarketsMarkets

I.I. INTRODUCTIONINTRODUCTIONA.A. The Market:The Market:the anyplace where money the anyplace where money denominated in one currency is denominated in one currency is bought and sold with money bought and sold with money denominated in another denominated 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 abilityto transfer purchasing to transfer purchasing power power between countriesbetween countries

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INTRODUCTIONINTRODUCTION

C.C. LocationLocation1.1. OTC-type: no specific OTC-type: no specific locationlocation2.2. Most trades by phone or Most trades by phone or SWIFT*SWIFT*

**SWIFT: Society for Worldwide Interbank SWIFT: Society for Worldwide Interbank Financial TelecommunicationsFinancial 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 FOREIGN

EXCHANGE MARKETEXCHANGE MARKETA.A. Participants at 2 LevelsParticipants at 2 Levels1.1. Wholesale Level (95%)Wholesale Level (95%)- - major commercial major commercial banksbanks2.2. Retail LevelRetail Level- banks dealing for - banks dealing for business business customers.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 MarketsMarkets1.1. 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 a specified future datespecified future date

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ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

C.C. Participants by MarketParticipants by Market1. 1. Spot MarketSpot Marketa.a. commercial bankscommercial banksb.b. brokersbrokersc.c. customers of commercial customers of commercial banksbanksd.d. central bankscentral banks

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ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

2.2. Forward MarketForward Marketa.a. arbitrageursarbitrageurs

(hold (hold currency)currency)

b.b. speculatorsspeculatorsc. 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 world2005: $1.9 trillion daily2005: $1.9 trillion dailyB.B. Market Centers (1998): Market Centers (1998): London =London = $637 billion daily $637 billion dailyNew York= $351 billion dailyNew York= $351 billion dailyTokyo = $149 billion dailyTokyo = $149 billion dailyC. C. Benchmark: 1999 USGDP = $9.1 Benchmark: 1999 USGDP = $9.1 trilliontrillion

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PART III.PART III.THE SPOT MARKETTHE SPOT MARKETI.I. SPOT QUOTATIONSSPOT QUOTATIONS

A.A. Sources Sources 1.1. All major newspapersAll major newspapers2.2. Major currencies have Major currencies have four four different quotes: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 price of one unit 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 MARKETC.C. Transactions CostsTransactions Costs

1. 1. Bid-Ask SpreadBid-Ask Spreadused 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 ProblemSuppose 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 $.1395/kr Krona and the Swiss franc are $.1395/kr

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

$.1133$.1133SFSF = = _SF_ _SF_ = = 8.8268.826 x x US$US$ = =8.8268.826kr 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

2020

THE SPOT MARKETTHE SPOT MARKETE.E. Currency ArbitrageCurrency Arbitrage1.1. When cross rates differ fromWhen cross rates differ fromone 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 Contractan agreement between a an agreement between a bankbank and and a a customer to buy or sellcustomer to buy or sell1. a specified amount of currency 1. a specified amount of currency against another currencyagainst another currency2. 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:HedgingHedgingthe process of reducing the process of reducing

or or mitigating exchangemitigating exchangerate risk.rate risk.

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Hedging ToolsHedging Tools

TypeType ContractContract FeaturesFeatures

ForwardForward 1.1. Fixed currency Fixed currency amountamountFutureFuture 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 Require performance by 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 nAlternate= Alternate= F-SF-S x x 360360 x 100 x 100 SS n nwherewhereF = 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? 12 100

1.4511 1.4487 12 1001.4487 3

.66%

F S x xS 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 360 1001.4487 30

.91%

F S x xS n

x x