Foreign Exchange Markets Outline

• The Organization of Markets

• Spot Markets

• Exchange Rate Arithmetic

• Forward Markets

Markets For Foreign Exchange Why do they exist?

• To buy and sell currencies, of course, buy why trade curriencies– To permit transactions of goods and services across borders

– To link savers and investors across borders

How would an Efficient FX market do that?

• Facilitate the real objectives without excessive “transactions costs” such as brokerage fees, taxes, red tape. (Operating efficiency)

• Channel capital to its most efficient use (Allocative efficiency)

• Allow prices to signal real value (Informational efficiency)

FX Spot Markets What it is?

• Market for FX settled within 2 working days.

• The spot market is an over the counter market. That is, there is no centralized exchange, but rather the participants are connected by an information network

Participants in FX Market

• The FX market is a two-tiered market:– Interbank Market (Wholesale)

• About 700 banks worldwide stand ready to make a market in foreign exchange.

• Nonbank dealers account for about 20% of the market.

• There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.

– Client Market (Retail)

• Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

Circadian Rhythms of the FX Market

Electronic Conversations per Hour

05000

1000015000200002500030000350004000045000

1:00 10 am inTokyo

3:00Lunchhour inTokyo

5:00 Europe

coming in

7:00 9:00 Asia

going out

11:00Lunchhour inLondon

1:00 Americascoming in

15:00 5:00Londongoing out

19:00 9:00 New

Zealandcoming in

11:00 6 pm in

NY

average peak

Exchange Rate Arithmetic Quoting FX (Hint: Just Think About It as Another Price)

• The most natural way to think about the price of anything is as the number of dollars you have to give up to get one unit of the good (or, equivalently, the number of dollars you would get if you sold one unit of the good). We call this a direct quote.

• For example if you asked how much gasoline cost this morning, you might find out that it cost $1.50. You’d know this means one gallon costs $1.50 (P$/gallon=$1.50).

• Of course this is just a convention. We could just as easily express values as the number of units of a good you could get for $1.00– That is $1.00 will purchase 1/1.5 gallons of gas. (Pgallons/$=.667)

Direct and Indirect Quotes

• Direct Quotes for a currency: Price of one unit of the currency being bought or sold (when quoted from view of American referred to as American Quote)– S$/£=1.50 means that it will cost $1.50 to purchase or sell 1 British

Pound.

• Indirect Quotes: The price of one unit of the domestic currency when quoted from view of non-American, referred to as European Quote– S£/$=1/1.50 is the indirect quote

• Notice the Direct Quote = 1/Indirect Quote• The easiest way to keep all of this straight is to think about FX

quotes as buying or selling the currency in the denominator

Spreads in FX Quotes

• When expressed as a Direct Quote, Bid<Ask– S$/£ bid =1.4000, S$/£ ask 1.4015 (sometimes written 1.400-.15)

• S£/$ bid =1/1.4000, S£/$ ask =1/1.4015 (Bid>Ask)

– The convention is to express spreads as a % of Ask

• Spread=(Ask-Bid)/Ask

The Bid-Ask Spread

• A dealer would likely quote these prices as 72-77.

• It is presumed that anyone trading $10m already knows the “big figure”.

Bid Ask

1.9072

.5242

S($/£)S(£/$)

1.9077

.5243

big figure

small figure

Cross Rates

• Suppose. S$/kr = .12 and S$/MXP=.10

• Imagine a Mexican exporter who has just been paid kr100,000 but finds there is no ready market to trade krona for pesos. What to do?– Sell krona for dollars:

• kr 100,000=S$/krx100,000 = .12x100,000=$12,000

– Buy pesos with dollars:

• MXP 120,000 = 12,000/S$/MXP = 12,000/.10

– It would appear as if Smxp/kr = 1.2

• In general. If there are three currencies X,Y, and Z.

• SY/Z=SX/Z/SX/Y

– Notice how the notation helps keep things straight. Using the usual rules of algebra, Y/Z=(X/Z)/(X/Y)

Example: Suppose an Australian importer has made a purchase from a Canadian and is obligated to pay

C$100,000. If S$/A$ = .5 and S$/C$=.75, how much is this going to cost in A$?

• To raise the necessary amount, the Australian needs to sell $75,000=.75x100,000.

• To buy the necessary dollars will require A$ 150,000=75,000/.5

• As we know, SA$/C$ = S$/C$/S$/A$ = .75/.5

• Cross Rate Table

Using foreign exchange markets for fun and profit

• Trading for profit – Arbitrageurs (who find opportunities to make risk free profits by

buying and selling almost at the same time)

– Speculators (who profit by accepting risk) hold inventories of currency for a period of time.

Bilateral Arbitrage

• $/euro quotes

–

– Money Pump

• Buy 1 euro in NY for .8620

• Sell 1 euro in London for $0.8625 (profit=$.0005)

• Repeat several billion times.

– Obvious conclusion: if the bid in one market is less than the ask in another market, buy low and sell high.

Cross Rates

• Suppose that S($/€) = 1.50– i.e. $1.50 = €1.00

• and that S(¥/€) = 50– i.e. €1.00 = ¥50

• What must the $/¥ cross rate be?

$1.50¥50=

$1.50 €1.00€1.00 ¥50×

$1.00 = ¥33.33

$0.0300 = ¥1

Triangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate any implied cross rate to see if an arbitrage exists. £1.00

¥80=

£1.50 $1.00

$1.00 ¥120×

Triangular Arbitrage

$

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

The implied S(¥/£) cross rate is

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.So, how can we make money?

¥ £

£1.00

¥80=

£1.50 $1.00

$1.00 ¥120×

Then trade yen for your preferred currency.

Buy the £ @ ¥80; sell @ ¥85.

Triangular Arbitrage

$

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

$

Triangular Arbitrage

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

Triangular Arbitrage

$

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Here we have to go “clockwise” to make money—but it doesn’t matter where we start.

¥ £1

2 3

$

If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient!

Money Pump

• Sell $1 for C$ 2

• Sell C$ 2 for Euro. 2x.6711 = € 1.342

• Sell €1.342 for US Dollar: 1.342x.75=$1.0067 (yielding a profit of $.0067)

• Repeat several billion times

In general, a cross rate arbitrage opportunity exists if SX/YSY/ZSZ/X 1

Foreign Exchange Forward Markets

• Forward Market: A market where traders enter into contracts that obligate one party to deliver a certain amount of a good at a certain price on a certain date and one party to accept delivery and pay for the good. Although a forward contract is actually a simple thing, the jargon can make it seem more complex than it really is. Here are some basic definitions and concepts– If you have agreed to sell anything in the future you are short.

– If you have agreed to buy anything in the future you are long

Sometimes (in fact most of the time) the forward rate will be different than the spot rate (we’ll talk later

about why)

• A “Forward Premium” is said to exist if Spot Rate < Forward Rate

• A “Forward Discount” is said to exist if Spot Rate > Forward Rate

Premiums and discounts are often expressed as annualized percentage rate

• Premium = [(F-S)/S]x360/(no of days future)

• Suppose: S$/euro=1.0 and 90 day F$/euro=1.05– Premium=20%= [(1.05-1.0)/1.0][360/90]