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CHAPTER 7CHAPTER 7

THE FOREIGN THE FOREIGN EXCHANGE EXCHANGE

MARKETMARKET

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. INTRODUCTIONINTRODUCTION

II.II. ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

III.III. THE SPOT MARKETTHE SPOT MARKET

IV.IV. THE FORWARD MARKETTHE FORWARD MARKET

V.V. INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY

PART I. INTRODUCTIONPART I. INTRODUCTION


A.A. The Currency Market:The Currency Market:

where money where money denominated in one denominated in one currency currency is bought and is bought and sold with sold with money money denominated denominated in another in another currency.currency.

INTRODUCTIONINTRODUCTION

B. International Trade and B. International Trade and Capital Transactions:Capital Transactions:

- facilitated with the ability- facilitated with the ability

to transfer purchasing powerto transfer purchasing power

between countriesbetween countries

INTRODUCTIONINTRODUCTION

C.C. LocationLocation

1.1. OTC-type: no specific OTC-type: no specific locationlocation

2.2. Most trades by phone, Most trades by phone,

telex, or SWIFTtelex, or SWIFT

SWIFT: SWIFT: Society for Worldwide Society for Worldwide Interbank Financial Interbank Financial TelecommunicationsTelecommunications

PART II.PART II.ORGANIZATION OF THE FOREIGN ORGANIZATION OF THE FOREIGN EXCHANGE MARKETEXCHANGE MARKET

II .. PARTICIPANTS IN THE PARTICIPANTS IN THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET

A.A. Participants at 2 LevelsParticipants at 2 Levels

1.1. Wholesale Level (95%)Wholesale Level (95%)

- major banks- major banks

2.2. Retail LevelRetail Level- business - business customers.customers.

ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET

B.B. Two Types of Currency Two Types of Currency MarketsMarkets

1.1. Spot Market:Spot Market:

- immediate transaction- immediate transaction

- recorded by 2nd - recorded by 2nd business daybusiness day


2.2. Forward Market:Forward Market:

- transactions take place at - transactions take place at a a specified future specified future datedate


C.C. Participants by MarketParticipants by Market

1. 1. Spot MarketSpot Market

a.a. commercial bankscommercial banks

b.b. brokersbrokers

c.c. customers of customers of commercial commercial and central and central banksbanks


2.2. Forward MarketForward Market

a.a. arbitrageursarbitrageurs

b.b. traderstraders

c.c. hedgershedgers

d.d. speculatorsspeculators


II.II. CLEARING SYSTEMSCLEARING SYSTEMS

A. Clearing House Interbank A. Clearing House Interbank Payments System Payments System

(CHIPS) (CHIPS)

- used in U.S. for electronic- used in U.S. for electronic

fund transfers.fund transfers.


B.B. FedWireFedWire

- operated by the Fed- operated by the Fed

- used for domestic - used for domestic

transferstransfers


III.III. ELECTRONIC TRADINGELECTRONIC TRADING

A.A. Automated TradingAutomated Trading

- genuine screen-based - genuine screen-based marketmarket


B.B. Results:Results:

1.1. Reduces cost of tradingReduces cost of trading

2.2. Threatens traders’ Threatens traders’

oligopoly of oligopoly of

information information

3.3. Provides liquidityProvides liquidity


IV.IV. SIZE OF THE MARKETSIZE OF THE MARKET

A.A. Largest in the worldLargest in the world

1995: $1.2 trillion daily1995: $1.2 trillion daily


B.B. Market Centers (1995): Market Centers (1995):

London =London = $464 billion $464 billion dailydaily

New York= $244 billion New York= $244 billion dailydaily

Tokyo = $161 billion Tokyo = $161 billion dailydaily

PART III.PART III.THE SPOT MARKETTHE SPOT MARKET

I.I. SPOT QUOTATIONSSPOT QUOTATIONS

A.A. Sources Sources

1.1. All major newspapersAll major newspapers

2.2. Major currencies have Major currencies have four different quotes:four different quotes:

a.a. spot pricespot priceb.b. 30-day30-dayc.c. 90-day90-dayd.d. 180-day180-day

THE SPOT MARKETTHE SPOT MARKET

B.B. Method of QuotationMethod of Quotation

1.1. For interbank dollar For interbank dollar trades:trades:

a.a. American termsAmerican terms

example: $.5838/dmexample: $.5838/dm

b.b. European termsEuropean terms

example: dm1.713/$example: dm1.713/$


2.2. For nonbank customers:For nonbank customers:

Direct quoteDirect quote

gives the home currency gives the home currency

price of one unit of foreign price of one unit of foreign

currency.currency.

EXAMPLE:EXAMPLE: dm0.25/FFdm0.25/FF


C.C. Transactions CostsTransactions Costs

1. 1. Bid-Ask SpreadBid-Ask Spreadused to calculate the feeused to calculate the feecharged by the bankcharged by the bank

Bid = the price at which Bid = the price at which the bank is willing to buythe bank is willing to buy

Ask = the price it will sellAsk = the price it will sellthe currencythe currency


4.4. Percent Spread Formula Percent Spread Formula (PS):(PS):

100xAsk

BidAskPS


D.D. Cross RatesCross Rates

1.1. The exchange rate The exchange rate

between 2 non - between 2 non -

US$ US$ currencies.currencies.


2.2. Calculating Cross RatesCalculating Cross RatesWhen you want to know When you want to know what the dm/what the dm/ cross rate cross rate is, and you know is, and you know dm2/US$ and dm2/US$ and .55/US$.55/US$

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

= dm3.636/ = dm3.636/


E.E. Currency ArbitrageCurrency Arbitrage

1.1. If cross rates differ fromIf cross rates differ from

one financial center to one financial center to another, and profit another, and profit

opportunities exist.opportunities exist.


2.2. Buy cheap in one int’l Buy cheap in one int’l market,market,

sell at a higher price in sell at a higher price in anotheranother

3.3. Role of Available Role of Available InformationInformation


F.F. Settlement Date Value Date:Settlement Date Value Date:

1.1. Date monies are dueDate monies are due

2.2. 2nd Working day after date 2nd Working day after date of of original transaction.original transaction.


G.G. Exchange RiskExchange Risk

1.1. Bankers = middlemenBankers = middlemen

a.a. Incurring risk of adverseIncurring risk of adverse

exchange rate moves.exchange rate moves.

b.b. Increased uncertainty Increased uncertainty about future exchange about future exchange rate requiresrate requires


1.) 1.) Demand for higher riskDemand for higher risk

premiumpremium

2.)2.) Bankers widen bid-ask Bankers widen bid-ask spreadspread

PART II.PART II.MECHANICS OF SPOT MECHANICS OF SPOT TRANSACTIONSTRANSACTIONS

SPOT TRANSACTIONS: An SPOT TRANSACTIONS: An ExampleExample

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

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

(exporter)(exporter)

MECHANICS OF SPOT MECHANICS OF SPOT TRANSACTIONSTRANSACTIONS

Step 2.Step 2. Bank sends importerBank sends importer

contract note including:contract note including:

- amount of foreign- amount of foreign

currencycurrency

- agreed exchange rate- agreed exchange rate

- confirmation of Step 1.- confirmation of Step 1.

MECHANICS OF SPOT MECHANICS OF SPOT TRANSACTIONSTRANSACTIONS

Step 3.Step 3. SettlementSettlement

Correspondent bank in HongCorrespondent bank in HongKong transfers HK$ fromKong transfers HK$ fromnostro account to exporter’s.nostro account to exporter’s.

Value Date.Value Date.

U.S. bank debits importer’sU.S. bank debits importer’saccount.account.

PART III.PART III.THE FORWARD MARKETTHE FORWARD MARKET


A. Definition of a Forward A. Definition of a Forward ContractContract

an agreement between a bank and an agreement between a bank and a customer to deliver a specified a customer to deliver a specified amount of currency against amount of currency against another currency at a specified another currency at a specified future date and at a fixed future date and at a fixed

exchange exchange rate.rate.

THE FORWARD MARKETTHE FORWARD MARKET

2. Purpose of a Forward:2. Purpose of a Forward:

HedgingHedging

the act of reducing the act of reducing

exchangeexchange

rate risk.rate risk.


B.B. Forward Rate QuotationsForward Rate Quotations

1. 1. Two Methods:Two Methods:

a.a. Outright Rate: Outright Rate: quoted to quoted to commercial customers.commercial customers.

b.b. Swap Rate: Swap Rate: quoted in thequoted in the

interbank market as a interbank market as a discount or premium.discount or premium.

THE FORWARD MARKET THE FORWARD MARKET

CALCULATING THE FORWARDCALCULATING THE FORWARDPREMIUM OR DISCOUNTPREMIUM OR DISCOUNT

= = F-SF-S x x 1212 x 100 x 100 SS n n

where F = the forward rate of exchangewhere F = the forward rate of exchange

S = the spot rate of exchangeS = the spot rate of exchange

n = the number of months in then = the number of months in the

forward contractforward contract


C.C. Forward Contract MaturitiesForward Contract Maturities

1. 1. Contract TermsContract Terms

a.a. 30-day30-day

b.b. 90-day90-day

c.c. 180-day180-day

d.d. 360-day360-day

2.2. Longer-term Longer-term ContractsContracts

PART IV.PART IV.INTEREST RATE PARITY THEORYINTEREST RATE PARITY THEORY


A. The Theory states:A. The Theory states:

the forward rate (F) differs the forward rate (F) differs from the spot rate (S) at from the spot rate (S) at equilibrium by an amount equilibrium by an amount equal to the interest equal to the interest differential (rdifferential (rhh - r - rff) between ) between

two countries.two countries.

INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY

2. 2. The forward premium orThe forward premium or

discount equals the interestdiscount equals the interest

rate differential.rate differential.

(F - S)/S = (r(F - S)/S = (rhh - r - rff) )

where where rrh h = the home rate = the home rate

rrff = the foreign rate = the foreign rate


3.3. In equilibrium, returns onIn equilibrium, returns on

currencies will be the samecurrencies will be the same

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

(1 + r(1 + rhh)) = = FF

(1 + r(1 + rff) S) S


B.B. Covered Interest ArbitrageCovered Interest Arbitrage

1. Conditions required:1. Conditions required:

interest rate differential doesinterest rate differential does

not equal the forward not equal the forward

premium or discount.premium or discount.

2.2. Funds will move to a countryFunds will move to a country

with a more attractive rate.with a more attractive rate.


3. 3. Market pressures develop:Market pressures develop:

a.a. As one currency is moreAs one currency is more

demanded spot and solddemanded spot and sold

forward.forward.

b. Inflow of fund depressesb. Inflow of fund depresses

interest rates.interest rates.

c.c. Parity eventually Parity eventually

reached.reached.


C.C. Summary:Summary:

Interest Rate Parity states:Interest Rate Parity states:

1.1. Higher interest rates on a Higher interest rates on a

currency offset by currency offset by forwardforward discounts.discounts.

2.2. Lower interest rates are Lower interest rates are offset by forward offset by forward premiums.premiums.

forex marketss

Business

market centers

spot marketspot market

spot marketthe spot

forward marketforward

spot quotationsspot

spot pricespot price

major banks major banks

business customers