forex euro currency markets
TRANSCRIPT
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The Foreign Exchange and Eurocurrency Markets
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Symbols and acronymsSymbols and acronyms
Upper Case Symbols = Prices
lower case symbols = changes in a price levelPt
d (orPtf) = price of an asset at time t in currency d (or f)
ptd (orpt
f) = inflation in currency d (or f) during period t
Std/f= spot exchange rate at time t between d and f
std/f= change in the spot exchange rate during period t
Fd/f= forward exchange rate between currencies d and f
ftd/f= change in the forward rate during period t
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Foreign exchange (Foreign exchange (fxfx) markets) markets
Markets
Spot market
trade in cash today with delivery in two business days Forward market
trade at a pre-specified price and on a pre-specified future date
Volume volume in April 2003 averaged $2.0 trillion per day
about 75% in the interbank market
Operational eINRiciency small retail transactions can be expensive
large interbank transactions have very low costs
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Major foreign exchange trading centersMajor foreign exchange trading centers
(Average daily volume during April of 1989, 1992, 1995, and 1998(Average daily volume during April of 1989, 1992, 1995, and 1998))
Source:Bank for International Settlements triennial survey of central banks.
0
London New York Tokyo
1989 1992 1995 1998
100
200
300
400
500
600
700
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Rule #1Rule #1
Keep track of your units.Keep track of your units.
An example: S$/INR= $.0250/INR SINR/$ = 1/ S$/INR=INR 40/$
Dollar value of a bottle of Champagne:Buy 1 bottle of wine PINR= INR400/btl
Spot exchange rate SINR/$ = INR40/$
How much is this in dollars?
P$ = PINR/SINR/$= (INR400/btl)/(INR4.00/$) = $10/btl
= PINRS$/INR= (INR400/btl)($.025/INR) = $10/btl
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Rule #2:Rule #2:
Always buy or sell the currency in theAlways buy or sell the currency in thedenominatordenominatorof a foreign exchange quote.of a foreign exchange quote.
Example of buying low and selling high:Buy wine at INR400/btl and sell at INR500/btl INR100/btl Profit
Buy INRs at $.020/INR
Sell $s at INR50/$Sell INRs at $.025/INR Buy $s at INR40/$
$.005/INR Profit INR10/$ Profit
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Forward premiums or discountsForward premiums or discounts
Percentage forward premium or discount
= (F1d/f
S0d/f
) / S0d/f
Forward premium
nominal value in the forward exchange market is
higher than in the spot exchange market
Forward discount
nominal value in the forward exchange market islower than in the spot exchange market
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An example ofAn example of
forward premiums and discountsforward premiums and discounts
Suppose S0
$/INR= $0.020/INR and F1
$/INR= $0.025/INR
Rupee forward premium
= ($.025/INR$.020/INR)/($.020/INR) = +25%
so the Rupee is selling at a 25% forward premium.
Alternatively, S0
INR/$ = INR50.00/$ S0$/INR= $0.020/INR
F1
INR/$ = INR40.00/$ F1$/INR= $0.025/INR
Dollar forward premium
= (INR40/$INR50/$)/(INR50/$) = 20%
so the dollar is selling at a 20% forward discount.
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Percentage changes in foreign exchange ratesPercentage changes in foreign exchange rates
Percentage change in the value of a foreign currency
= (S1d/f S0d/f) / S0d/fAn example: S
0INR/$ = INR50/$ S
0$/INR= $0.020/INR
S1INR/$ = INR40/$ S1$/INR= $0.025/INR
Percentage change in the franc = (S1$/INRS
0$/INR) / S
0$/INR
= ($0.025/INR$0.020/INR)/($0.020/INR) = +25%
Percentage change in the dollar = (S1INR/$S
0INR/$ ) / S
0INR/$
= (INR40/$INR50/$)/(INR50/$) = 20%
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The interbank Eurocurrency marketThe interbank Eurocurrency market
Eurocurrencies are bank deposits or loans residing
outside of the country issuing the currency
Few regulationsNo reserve requirements, interest rate regulations or caps,withholding taxes, deposit insurance requirements, or credit
allocation regulations; less stringent disclosure requirements
Low risk Relatively short maturities: Maturities of less than 5 years
Low interest rate risk: Interest rates tied to a variable rate
base such as the London Interbank Offer Rate (LIBOR)
Low default risk: Traded between large commercial banks,investment banks and multinational corporations
Highly competitive
Daily volume of several hundred billion dollars ensures
competitive bid and offer prices
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Spreads in domestic and EurocurrencySpreads in domestic and Eurocurrency
credit marketscredit markets
LIBOR
Eurocurrency
deposit rate in
the interbank
market
LIBID
Domestic loan rate for
commercial accounts
1/8%
Eurocurrency
loan rate in the
interbank
market
1/8%1/2%2%
Domestic deposit rate forcommercial accounts
Eurocurrency loan
rate for commercial
accounts
Eurocurrency deposit
rate for commercial
accounts
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Linkages between credit & currency marketsLinkages between credit & currency markets
$
Eurocurrencies
U.S.
internal
credit market
U.K.
internal
credit market
Japanese
internal
credit market
external credit markets
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Exposure to foreign exchange riskExposure to foreign exchange risk(contract price INR400,000)(contract price INR400,000)
Expected receipt in Rupees
at E[S1$/INR] = $.025/INR
Actual exchange
S1$/INR= $.020/INR
Net loss from
original position
Risk (or payoff) profile
of underlying exposure
V
$/INR
S$/INR
$.05/IN
R
$.05/INR
+ slope
+INR400,000 +$10,000 at$.025/INR
+INR400,000 +$8,000 at$.020/INR
$2,000
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Currency hedging with forwardsCurrency hedging with forwards(contract price INR400,000)(contract price INR400,000)
Buy $10,000 forward +$10,000
at F1$/INR= $.025/INR
Sell INR400,000 forward INR400,000
Market exchange of INR +$8,000
for $ at S1
$/INR= $.020/INR
INR400,000
Net gain on forward +$2,000
Risk profile
of a forward
contract
V
$/INR
S$/INR-$0.05/INR
+$0.05/IN
R
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Net currency exposureNet currency exposure
Underlying position
(long INR)
Sell INR forward(short INR and long dollars)
Net position
Net exposure V$/INR
long francs
S$/INR
short francs
+INR400,000
+$10,000
INR40,0000
+$10,000
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Example of foreign exchange tradingExample of foreign exchange trading
Market Participants
Dealers: make a market in foreign currency (quote bid & offer prices)
Traders: trade for their own acct
Rules of the Game - Buy ringgits low and sell ringgits high One contract Rg1,000,000,000 (Malaysian ringgits)
Trades can be for up to 10 contracts
Record transactions as either a ringgit purchase or saleDealer quotes are good for two minutes
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Arbitrage profit in the MalaysianArbitrage profit in the Malaysian ringgitringgit marketmarket
Bank A: $0.26602/Rg BID and $0.26612/Rg OFFER
Bank B: $0.26617/Rg BID and $0.26627/Rg OFFER
Bank A Bank B$0.26627/Rg Offer
$0.26617/Rg Bid Sell to B
$0.26612/Rg Offer Buy from A
$0.26602/Rg Bid
1. Buy Rg1 billion from Bank A at $0.26612/Rg offer price
2. Sells Rg1 billion to Bank B at its $0.26617/Rg bid price
Arbitrage Profit = ($0.00005/Rg)(Rg1 billion) = $50,000
with NO NET INVESTMENT and NO RISK.
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Sample foreign exchange ledgerSample foreign exchange ledger
NAME Bank of Cash, Credit, and Industry DATE October 19, 2003
Counterparty Contracts Price Total $/Rg Cumulative Rg balance
1. Penn Square BUY 1 0.22004 $0.22004 +1
2. Citicorp BUY 3 0.22010 $0.66030 +4
3. Bk of Tokyo SELL 2 0.22016 +$0.44032 +2
4. Bk of Tokyo SELL 4 0.22020 +$0.88080 2
5. . . .
FINAL CLOSING RATES: $.22018/Rg BID and $0.22023/Rg OFFER
Closing trade BUY 2 0.22023 $0.44046 0
Sum of dollar transactions: +$0.00032/Rg
Times contract size x Rg1,000,000,000
Profit (loss) +$320,000
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Opening prices:Opening prices:
$0. 21945/Rg BID & $0.21950/Rg OFFER$0. 21945/Rg BID & $0.21950/Rg OFFER
News announcements: The member nations of the G7 have announced that they
are buying dollars in an effort to stabilize the dollar.
The U.S. Federal Reserve announces that in an effort tostimulate economic activity it is lowering the discount
rate on overnight loans to commercial banks.
The U.S. government reports that the U.S. money supplyM1 increased by $1 billion more than expected in the
most recent quarter.
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The Impact of News EventsThe Impact of News Events
The member nations of the G7 have announced that they are
buying dollars in an effort to stabilize the dollar.
Value of the U.S. dollar
Value of the Malaysian ringgit
The Malaysian ringgit depreciates
and the spot rate S$/Rg falls
P$P$
S$
D$
D$
Q$
QRg
DRg
DRg
SRg
PRg
PRg
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The Impact of News EventsThe Impact of News EventsThe U.S. Federal Reserve announces that in an effort to
stimulate economic activity it is lowering the discount rate on
overnight loans to commercial banks.
This makes it easier for U.S. businesses to borrow and increases economic
activity. If this also increases U.S. inflation, then the value of the U.S.
dollar should fall. This will result in an appreciation of the ringgit against
the dollar.
Increases in the domestic discount rate usually, but not always, lead to
increases in the value of the domestic currency.
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The Impact of News EventsThe Impact of News EventsThe government reports that U.S. money supply M1 increased by
$1 billion more than expected in the most recent quarter.
While this would seem to result in a larger supply of dollars and hence alower value for the dollar, the increase in the money supply has already
occurred and hence should be reflected in the market price of the dollar.
On the other hand, if the U.S. Federal Reserve is likely to react to this
announcement by increasing the discount rate to slow down the economy,then the dollar may rise in anticipation of Fed policy.
If the dollar rises against the ringgit, then the ringgit will fall against the
dollar.