foreign exchange market - my liuc

FOREIGN EXCHANGE

MARKET

Luigi Vena

05/08/2015

Liuc – Carlo Cattaneo

International Financial Markets – 05/08/2015

TABLE OF CONTENTS

The FX market

Exchange rates

Exchange rates regimes

Financial balances

Coopeland – ch. 1, 2 and 8

International Financial Markets – Lecture IV: Forex 05/08/2015

The FX market

As every markets, the market for foreign currency can be

viewed as the place where supply and demand of foreign

currency meet.

International Financial Markets – Lecture IV: Forex 05/08/2015

The FX market

The foreign exchange market, or simply Forex or FX, is a

global decentralize.

The FX market is the place where people exchange

currencies.

The FX market operates on several levels:

The Interbank FX market;

The Corporate and retail FX market.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX market structure

Traders as well as market makers are geographically

dispersed.

They are linked by:

Voice brokers;

Direct dealing through telephone conversations.

Quotations are distributed over proprietary systems and

typically for indications.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX market structure

General Motors Microsoft

Chase Bank

Dealer

Deutsche Bank

Dealer

Broker

Barclay’s Bank Credit Suisse Bank of Tokyo

Bank of

America

Motorola

International Financial Markets – Lecture IV: Forex 05/08/2015

FX market structure

It is geographically dispersed

It is a dealer market

Open 24 hours a day

There is price dispersion

Highly customized products

International Financial Markets – Lecture IV: Forex 05/08/2015

FX market size

590 820

1190 1490

1200

1880

3300

3980

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1989 1992 1995 1998 2001 2004 2007 2010

Daily

ave

rag

e in

bill

ion

US$

International Financial Markets – Lecture IV: Forex 05/08/2015

Daily volumes by location

UK 37%

US 18%

Japan 06%

Singapore 05%

Switzerland 05%

Hong Kong 05%

Australia 04%

France 03%

Denmark 02%

Germany 02% Others 13%

International Financial Markets – Lecture IV: Forex 05/08/2015

Daily volumes by location

1854

904

312 266 263 238 192 152 120 109

646

0

200

400

600

800

1000

1200

1400

1600

1800

2000

International Financial Markets – Lecture IV: Forex 05/08/2015

Daily volumes by currency

84.9

39.1

19 12.9

7.6 6.4 5.3 2.4 2.2

20.2

0

10

20

30

40

50

60

70

80

90

100

200420072010

Perc

enta

ge s

hare

s of

ave

rage d

aily

turn

ove

r

International Financial Markets – Lecture IV: Forex 05/08/2015

Turnover by currency pair

14.3%

9.0%

6.3% 4.2% 4.6%

18.8%

27.7%

2.8% 2.7% 1.8% 4.1% 3.7%

0

200

400

600

800

1000

1200$ pairs

84.9%

€ pairs

39.1%

International Financial Markets – Lecture IV: Forex 05/08/2015

Main roles of the FX market

Medium of exchange

The foreign exchange market facilitates trades in goods and

services;

Medium of exchange

It facilitates purchase and sale of securities.

Medium of risk management

It helps to redenominate and manage currency risk in asset

stock or liability positions.

International Financial Markets – Lecture IV: Forex 05/08/2015

Main roles of the FX market

Who are the suppliers or demanders of the foreign

currency?

1. Exporters: they are paid with the foreign currency and

therefore the need to convert it.

2. Foreign investors: British investors exchange pounds for

dollars so as to buy shares in Apple.

3. Speculators: they operate in the FX markets aiming to

obtain profit from the trading activity.

International Financial Markets – Lecture IV: Forex 05/08/2015

What is an exchange rate?

The first thing to understand about an exchange rate is

that it is simply a price.

While it is normal to talk of the price of books rather than

the price of money, there is no normal way to express an

exchange rate.

Indeed, the same exchange rate can be expressed in the

following way:

EUR/USD=1.0758, that is 1EUR=1.0758USD

USD/EUR=0.9295, that is 1USD=0.9295EUR

International Financial Markets – Lecture IV: Forex 05/08/2015

What is an exchange rate?

The bilateral exchange rate is defined as the price of the

foreign currency in units of the domestic currency.

In other words, the exchange rates defines the number of

foreign currency units purchasable with one domestic

currency unit.

The bilateral exchange rate between, say, the UK and the

USA, is the price of dollars in terms of pounds.

International Financial Markets – Lecture IV: Forex 05/08/2015

What is an exchange rate?

Suppose that the EUR/USD=1.0758

How many dollars can you buy with 100 euros?

How many euros can you buy with 100 dollars?

What if the exchange rate rises to 1.11?

What if the exchange rate decline to 1?

International Financial Markets – Lecture IV: Forex 05/08/2015

What is an exchange rate?

The cross exchange rate is an exchange rate between the

two currencies A and B, computed through the currency C.

It can be computed as the ratio of the exchange rate of A

to C, divided by the exchange rate of B to C.

A

B=A/C

B/C

International Financial Markets – Lecture IV: Forex 05/08/2015

What is an exchange rate?

Suppose that:

€/$=1.0796, that is 1€=1.0796$

£/$=1.5044, that is 1£=1.5044$

The exchange rate €/£ equals…

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Floating rates:

A completely flexible (or floating rates) is the one whose

level is solely determined by the market demand and

supply. Therefore, there is not any outside intervention.

Example.

As the import grows, the demand (supply) of foreign

(domestic) currency increases too.

All else equal the greater the demand the greater will be

the clearing market exchange rate.

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Floating rates – The EUR/USD example

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Fixed rates

The excessive volatility of the exchange rate may be

hurtful.

For this reason sometimes governments want the exchange

rates not to vary.

They can do this imposing restrictions on dealing, or

intervening directly on the market

Fixing the interest rate implies surrendering control of the

domestic money stock.

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Fixed rates – The USD/CNY example

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Managed exchange rates

Between the two boundaries represented by the freely

and the fixed rate, there is the compromise of the

managed floating exchange rates.

This time the authorities sometimes intervene on the

market, fixing the exchange rate, sometimes decide to

remain on the sideline.

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Managed rates – example

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

In general the regimes can be classified on the basis of the

foreign currency reserves.

Under a pure float regimes, reserves are constant.

Under a managed regimes, reserves vary on a constant

basis but remain constantly around a broad level.

Under a fixed regimes, reserves must carry the burden of

the exchange rate fluctuations. Therefore, the reserves

probably exhibit swings up or down.

International Financial Markets – Lecture IV: Forex 05/08/2015

Types of exchange rates

Fixed exchange rate and foreign currency reserves.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX vocabulary

Appreciation vs Depreciation

Because every exchange rate involves two currencies

Appreciation of currency A against B

Depreciation of currency B against A

International Financial Markets – Lecture IV: Forex 05/08/2015

FX vocaabulary

Appreciation vs Depreciation – Example

Change from €/$=1.30 to €/$=1.00

(alternatively expressed as change from 0.7692€=1$ to

1€=1$)

Appreciation of dollar against euro or, alternatively,

depreciation of euro against dollar.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX vocabulary

Appreciation vs Depreciation

Exact percentage measures depend on the base rate.

x% depreciation of the Mexican peso means x% more

pesos to buy 1$

y% appreciation of the US$ means y% fewer dollars to

buy 1 peso.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX vocabulary

Sometimes exchange rates are indicated as follow:

4𝑀𝑃/$ , that is 1dollar for 4 Mexican pesos.

Therefore change from 4MP/$ to 8 MP/$ means an

appreciation (depreciation) of dollar (Mexican peso)

against Mexican peso (dollar).

From 4MP/$ to 8 MP/$ means a 100% depreciation of

the Mexican peso, that is a 50% appreciation the US

dollar.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX contracts

Spot exchange rates

It is an exchange of two currencies for immediate

delivery.

They involve the delivery of currency immediately after

the bargain is struck.

In other words, it is the rate figuring in agreements to

exchange one currency for another more or less

immediately.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX contracts

Forward exchange rates

It is the exchange rate agreed today for obligatory

delivery at a specified time in the future.

No exchange of funds on agreement day, or at any time

until the settlement date.

Quoting conventions:

Outright

% premium or discount relative to spot

International Financial Markets – Lecture IV: Forex 05/08/2015

FX contracts

Forward exchange rate – example

On 05/08/15 buy £1,000,000 1-month forward at

$1.60/£.

On 06/08/15 (settlement date) when spot pound is

$1.55:

Take delivery of £1,000,000, pay out $1,600,000;

“Cash settle”, pay $50,000 to cancel the obligation

International Financial Markets – Lecture IV: Forex 05/08/2015

Covered interest rate parity

Spot and forward exchange rates are linked by a “no-

arbitrage” relation.

The forward exchange rate depends on three known

variables:

The spot exchange rate (S);

The domestic interest rate (r);

The foreign interest rate (r*);

International Financial Markets – Lecture IV: Forex 05/08/2015

Covered interest rate parity

In order to avoid risk-free arbitrage opportunity the

following relation must hold:

1 + 𝑟 =𝐹

𝑆(1 + 𝑟∗)

The following allows for no-arbitrage opportunities since

the return in domestic deposits equals the return in foreign

deposits.

International Financial Markets – Lecture IV: Forex 05/08/2015

Covered interest rate parity

… 1 + 𝑟 =𝐹

𝑆(1 + 𝑟∗).

Reorganizing…

1 + 𝑟 = 1 + 𝑓 ∗ (1 + 𝑟∗)

Where 1 + 𝑓 =𝐹

𝑆 is known as the “forward premium

(discount)” that is the proportion by which a country’s

forward exchange rate exceeds its spot rate.

International Financial Markets – Lecture IV: Forex 05/08/2015

FX vocabulary

Direct quotations: the exchange rate expresses the

number of domestic currency units purchasable with a

foreign currency unit.

(In US the direct quote for Euro is $1.0796=€1)

Indirect quotations: the exchange rate expresses the

number of foreign currency units purchasable with a

domestic currency unit.

(In US the indirect quote for Euro is $1=€0.9263)

International Financial Markets – Lecture IV: Forex 05/08/2015

Exercise

Fill in the blank based on the following quotes:

Currency US $

Equivalent Currency per $

Equivalent of

$4,000

$Equivalent of

6,000 units of

foreign currency

Yen 85.2350

Euro (€) 1.3517

Canadian $ 1.0129

GB pounds (£) $9,633,91

Swiss Franc 1.0324

Chinese Yuan 6.61594

Indian Rupee 181,405.90

International Financial Markets – Lecture IV: Forex 05/08/2015

Exercise

Based on the quotes around a one year interval, determine

the extent to which USD and the foreign currency

appreciated or depreciated during the period

Currency 5/8/201X 5/8/20X+1

% appreciation/

depreciation of

USD

% appreciation/

depreciation of

foreign currency

USD/JPY 90.00 85.2350

EUR/USD 1.3329 1.3517

USD/CNY 6.8348 6.1659

AUD/USD 0.89087 1.0047

International Financial Markets – Lecture IV: Forex 05/08/2015

FX dealers behavior

Quoting behavior

There is little evidence of “quote shading” as a tool for

inventory control in interbank trades;

Quote shading: raising quotes when dealer is below the

desired inventory level and lowering quotes when above;

Dealer does not want to give away information about his

position to other interbank dealers.

Inventory controls

Dealers regains desired inventory level quickly (5/6

minutes) by actively initiating trades at other dealers quotes.

International Financial Markets – Lecture IV: Forex 05/08/2015

Exchange rate - focus

Since the FX market is a dealer market we have:

Bid rate (Price). It is the price of currency A in terms of

currency B at which dealers buy currency A (or sell the

currency B).

Ask rate (Price). It is the price of currency A in terms of

currency B at which dealers sell currency A (or buy

currency B).

The difference between the bid and ask rate is the so

called bid-ask spread.

International Financial Markets – Lecture IV: Forex 05/08/2015

Exchange rate - focus

The bid-ask spread measures the cost of liquidity services

The bid-ask spread can varies on a constant basis

The bid-ask spread increases when the volatility in the

spot rate increases too, and decreases when more dealers

are in the market.

The bid ask spread increases at the start of the trading

day (due to the investors “feelings”)

The bid-ask spread increases at the end of the trading

day (due to the inventory adjustment)

International Financial Markets – Lecture IV: Forex 05/08/2015

Exchange rate - focus

Since one can buy one currency by simultaneously selling

one another, the ask price of currency A in terms of

currency B is the reciprocal of the bid price of currency B

in terms of currency A and vice versa.

In formula:

𝑺𝒂 𝑨 𝑩 = 𝟏 𝑺𝒃 (𝑩 𝑨 )

where:

S(A/B) the price of B in terms of A

Sa and Sb, respectively, the ask and bid rates

International Financial Markets – Lecture IV: Forex 05/08/2015

Exercise

Given the following bid and ask (direct) quotations,

please compute the respective indirect quotes.

Bid Ask Bid Ask

EUR (Euro) 1.35135 1.35227

JPY (Yen) 0.119914 0.119954