pp chap 5 fx markets

8/9/2019 PP Chap 5 FX Markets

1/59

NTERNAT ONAL F NANC AL MANAG

EMENT

UNIVERSITY OF MASSACHUSETTSDARTMOUTH

Instructor: Professor Trib Puri

1


2/59

The Market for Foreign ExchangeObjectives of Study:

To understand why FX Market exist.

Continuous Trading so that xchange rates are readi!y known.

To understand the Function " Structure of FX Market #artici$ants

Seg%ents Market activities &'rbitrage( )edging( and S$ecu!ation*

To understand how exchange rates are deter%ined


3/59

FX Trading

Continuous TradingDaily volume approximately !"# Trillion

!


4/59

Function and Structure of

the FX Market + #artici$ants

The FX %arket is a two+tiered %arket:a. Tier ,: -nterbank Market &ho!esa!e*

• 'bout /00 banks wor!dwide stand ready to %ak e a %arket in foreign exchange.

• 1onbank dea!ers account for about 203 of the%arket.

• There are FX brokers who %atch buy and se!! or ders but do not carry inventory and FX s$ecia!ists.

• Centra! banks

b. Tier /: C!ient Market &4etai!* "


5/59

Mu!tinationa! 5anks of the -nterbank Market

.xa%$!es:

6o!d%an Sachs

5arc!ays Ca$ita!

7eutsche 5ank

85SCredit 9yonnais

Credit 'grico!e &France*

Industrial and Commer$ial %an& o' C(inaCredit )uisse Group

*)%C *oldings +,-.

#


6/59


the FX Market: Segments)pot Mar&et

For/ard mar&et

Futures and Options mar&et

)/ap Mar&et

Ex$(ange Traded Funds +ETFs.

$


7/59

Market Seg%ents + The S$ot Market

S$ot FX Trading

S$ot 4ate uotations

Two+way $ricing( 5id and 'sk. The 5id+ask s$read.

Market %icrostructure

Cross 4ates

%


8/59

S$ot Market + S$ot FX tradingA spot transa$tion o' a $urren$y is a trade t(at settles i

n 0 days or less in t(e inter 1an& mar&et"

On t(e settlement date +t(e date o' settlement is

re'erred to as value date.2 most dollar transa$tion

s in t(e /orld are settled t(roug( t(e $omputeri3

ed Cleaning *ouse Inter 1an& 4ayments )ystem +C*I4

). in Ne/ 5or&2 /(i$( $al$ulates t(e net 1alan$eso/ned 1y any one 1an& to anot(er and 'or payme

nt 1y 6788 4M t(at same day in FED2 Ne/ 5or& 'un

ds"

&


9/59

S$ot Market + S$ot 4ate uotations7irect ;uotation&'%erican Ter%s*

• #rice of a foreign currency in 8S7 ter%s.

• Example: $1.4425/£ -ndirect uotation &uro$ean Ter%s*

• #rice of 8S7 in ter%s of foreign currency

• Example: £0.6932/$

1ote that the direct and indirect ;uotes are a!ways reci$r

oca! of each other.

'


10/59

Two+way #ricing( 5-7"'S


11/59

0.0339% = x100

$1.4744 –

$1.4739$1.4744

The 5id+'sk S$read' dea!er ;uotes 8S7+84 rate as ,.2=>?+22

• bid $rice of @ in A : A,.2=>? $er @ &a!ways !ower than ask*

• ask $rice of @ in A : A,.2=22 $er @

The bid+ask s$read re$resents the dea!erBs ex$ected $rofit.

11

#ercent S$read D ,00'sk #rice E 5id #rice

'sk #rice


12/59

5-7+'S


13/59

Currency Conversion with 5id+'sk S$reads

' trader in 1ew ork wants to take a !ong $osition in $ound

s in exchange for A,0(000.

hat is the siGe of !ong $osition in 5#H The ;uotes are:

1!

,.?=,I E /0

.I0=, E =/

S &AJK*

S &KJA*

5id 'sk

T5e tr67er c6n 6ssu8e 6 3on9 osition in ; ,)u2 ; 6t)ID of 1'%1#0 4 4 ;#(%&

T5e tr67er c6n t6


14/59

'n xa%$!e

' business%an has just co%$!eted transactions in -ta!y and

ng!and. )e is now ho!ding @/I0(000 and KI00(000 and wantsto convert to 8.S. do!!ars.

)is currency dea!er $rovides this ;uotation:• G%49,)D 8"#80# : ;6

• ,)D9E,R


15/59

So!ution%id pri$e o' ?


16/59

S$ot Foreign xchange Microstructure

Market Microstructure refers to the %echanics of how a

%arket$!ace o$erates.

5id+'sk s$reads in the s$ot FX %arket: increase with FX exchange rate vo!ati!ity and decrease with dea!er co%$etition.

#rivate infor%ation is an i%$ortant deter%inant of s$ot ex

change rates.

1$


17/59

Cross 4ates' Cross rate is the exchange rate between a $air of currencies( which is i%$!ie

d by a $air of exchange rates between these currencies and a co%%on currenc

y( usua!!y do!!ar.Su$$ose a trader ;uotes the fo!!owing: L,>2./ JA( and A,.2,,JK

hat is the i%$!ied $rice of K in L.

Cross Rate 9 @¥ £

@ @ "!#9¥ £

1%

¥ $

$ £

x

¥134.2 $1.411

$ £ x


18/59

Cross RatesB Example 0Su$$ose the fo!!owing ;uotes are observed:

7< .II?Juro and 1N ,.?IIJuro

The i%$!ied exchange rate or the no+arbitrage exchange r ate between 7< and 1N &1NJ7


19/59

Cross rates with 5id and 'sk hen currency ;uotes are $resented without bid and ask &or

if the bid Eask s$read is Gero*( we have seen that the i%$!ied

cross rate is given by:

S&@JK* S&AJK* x S&@JA*

hen bid+ask ;uotes are $resented( then it is a bit %ore cu% berso%e to ca!cu!ate cross+ 5id and cross+ 'sk.

1'


20/59

xa%$!eSu$$ose a currency trader at 6o!d%an Sachs ;uotes the fo!!

owing ;uotes:

84O+8S7 &AJ@* ,./?=+?I

65#+8S7 &AJK* ,.II20+I/

Ca!cu!ate the i%$!ied uro+65# &@JK* with bid and ask.

(


21/59

4ewrite the direct and indirect rates given above with their r

es$ective reci$roca!s. ou wi!! need these for further ca!cu!a

tions.

1


22/59

The $rocess %ay be re$resented as:

Se!! @ + 5uy A

&5id of A in @*

Se!! A + 5uy K

&5id of K in A*

&@JK*5id H

The detai!s are:

,.Se!! @0.=?I to buy A, &5id $rice of A in @ @0.=?IJA*

/.Se!! A, to buy K0.2>I &5id of K in A A,.II20JK*

1ote that

@0.=?I A, K0.2>I

or( @0.=?I K0.2>I

or( ,K @,.,?I &5id $rice of K in @*


23/59

-f you have understood the above %echanis%( you can readi

!y su%%ariGe the bid cross rate as fo!!ows:

S&@JK*bid S&@JA*bid x S&AJK*bid

&@0.=?IJA* x &A,.II20JK* @,.,?IJK

!


24/59

The $rocess %ay be re$resented as:

"

Se!! A+ 5uy @

&'sk of A in @*

Se!! K+ 5uy A

&'sk of K in A*

&@JK*'sk H

To su%%ariGe:

,K A,.III/ @,.,?=I

,K @,.,?=I &'sk $rice of K in @*-f you have understood the above %echanis%( you can readi!y su%%ariGe the

ask cross rate as fo!!ows:

S&@JK*ask S&@JA*ask x S&AJK*ask &@0.==00JA* x &A,.III/JK* @,.,?=IJK


25/59

#


26/59

Market Seg%ents+ The Forward MarketForward 4ate uotations

9ong and Short Forward #ositions

Forward #re%iu%

$


27/59

The Forward MarketIn t(e 'or/ard F mar&et2 $urren$ies are traded 'or'uture deliveries at $rices agreed u$on today"

)tandard 'uture deliveries are !8 days2 >8 days2


28/59

Forward 4ate uotationsThe forward %arket for FX invo!ves agree%ents to buy a

nd se!! foreign currencies in the future at $rices agreed u$

on today.

5ank ;uotes for ,( >( ( ?( and ,/ %onth %aturities are re

adi!y avai!ab!e for forward contracts.

&


29/59

Forward 4ate uotations

'

Country/currency in US$ per US$

British Pound ,.?=,= .I0=/

,+%os forward ,.?=00 .I0=

>+%ost forward ,.?> .I0

+%os forward ,.?I?> .I,02

hy the $ound is worth less in do!!arsin %onthsH


30/59

)pot Di''erential)pot di''erential measures $(ange in spot rate over

a $ertain period o' time +Appre$iation or depre$iation o' a $urren$y against anot(er $urren$y over a pe

riod o' time." For spot ex$(ange rates expressed as)F92 it is de'ined as7

'$$reciation of A against SF

!(


31/59

Example7

So SF 0.2I0JA S, SF 0.?I/IJA

Appre$iation o' against )F

@ @

@ 0.,/=/ or ,/.=/ 3

!1


32/59

Depre$iation o' )F against dollar

@

@

@ +0.,,/? or +,,./?3

!


33/59

Example2:

SP ;uotes are as fo!!ows:

Pan ,2: S$ot rate for 5raGi!ian 4ea! A0.=I=J4A

Pan /?: S$ot rate for 5raGi!ian 4ea! A0.2I2J4A

Ca!cu!ate the a$$reciation or de$reciation( as the case %ay b

e( of 5raGi!ian 4ea! against the 8S A fro% Pan ,2 to Pan /?.

!!


34/59

!"

9et S0 be exchange rate on Panuary ,2 and St be the exchange rat

e on Panuary /?.

@ + 0.>I?> or E >I.?>3

#ercentage a$$reciation of do!!ar against 4ea!


35/59

Forward 7ifferentia!

re%iu% or 7iscount*Forward differentia! %easures the va!ue of a currency ver

sus another currency in the forward %arket with res$ect t

o current s$ot %arket.

The 'nnua!iGed Forward 4ate 7ifferentia! is defined as:

'nnua!iGed Forward 7ifferentia!

here n is the nu%ber of days to %aturity of the forward co

ntract. The forward differentia! %ay be a $re%iu% or a disco

unt de$ending u$on whether FQ S0( or FR S0. !#


36/59

xa%$!e: The fo!!owing ;uotes are $ub!ished in SP:

S$ot A0.=0/,JSF SF ,.2/2>JA>0 days 0.=02, ,.2/0/

?0 days 0.=0 ,.2,0

,0 days 0.=,I ,.>?=?

Find out the forward $re%iu% or discount on SF against A in

the ,0+days forward %arket.

!$


37/59

'nnua!iGed forward $re%iu% on SF against A

>.23 $.a.

'nnua!iGed forward discount on A against SF in ,0+days

+>.=03 $.a.

!%


38/59

9ong and Short Forward #ositions-f you have agreed to se!! anything &s$ot or forward*( you

are short.

-f you have agreed to buy anything &forward or s$ot*( you

are !ong.

-f you have agreed to se!! FX forward( you are short.

-f you have agreed to buy FX forward( you are !ong.

!&


39/59


the FX Market + Curren$y Futures and OptionsCurren$y Futures

Li&e 'or/ard $ontra$ts2 'utures $ontra$ts are also maturity $ontra$ts"

A 'utures $ontra$t represents a pure 1et on t(e dire$tion

o' pri$e o' t(e underlying asset +in our $ase 'oreign $urren$y is t(e underlying asset and t(e pri$e is t(e ex$(ange rate.

Futures $ontra$ts are mar&edBtoBmar&et on a daily 1asis andt(e (older o' t(e 'utures $ontra$t re$eives or pays daily $as( 'lo/s depending upon t(e dire$tion o' movement o' 'utures pri$e"

!'


40/59

C,RRENC5 O4T ON)

A unilateral $ontra$t giving t(e (older t(e rig(t2

1ut not t(e o1ligation to 1uy +$all option. or sel

l +put option. t(e underlying $urren$y at any ti

me until +at. expiration"

"(


41/59


the FX Market + )/apsCurren$y )/aps

A s/ap transa$tion in t(e inter1an& mar&et is t

(e sale +pur$(ase. o' a $urren$y /it( a simultan

eous agreement to repur$(ase +sell. it at a 'utur

e date" T(us s/ap is t(e ex$(ange o' one $urre

n$y 'or anot(er on one day2 mat$(ed 1y a rever

se ex$(ange on a later day"

"1


42/59


The FX Market + TFsCurrencies are now recogniGed as a distinct asset c!ass( !ike stocks an

d bonds. Currency TFs faci!itate investing in these currencies'n TF where each share re$resents a fixed nu%ber of FC units &e.g

. ,00 uros*.-ndividua! shares are deno%inated in the 8.S. do!!ar and trade on the 1ew ork Stock xchange.The $rice of one share at any $oint in ti%e wi!! ref!ect the s$ot do!!ar

va!ue of ,00 uros $!us accu%u!ated interest %inus ex$enses.

Examples o' Curren$y ETFs7 Australia +FA.2 %ra3il +%F.2 %ritain +F%2G%%.2 Canada +FC.2 C(ina +CN52C5%.2 t(e Euro +FE2ERO2E,.2 India +INR2ICN.2 apan +F525N.2 Mexi$o +FM.2 Ne/ ealand +%N.2 Russia +R,.2 )out( A'ri$a +)R.2 )/eden +F). and )/it3erland +FF."

"


43/59

Market 'ctivities+ 'rbitrage'rbitrage is the $rocess of %aking $rofit through si%u!ta

neous buying and se!!ing of two si%i!ar or e;uiva!ent asse

ts at two different $rices( without incurring any risk. &5uy

!ow and se!! high without any risk*

'rbitrage is an i%$ortant econo%ic force that brings $rice

e;ua!iGation of a si%i!ar good( security( and asset across %

arkets.

43


44/59

Ar1itrage +Lo$ational. : Example <Trader ' observes that do!!ar is ;uoted as S


45/59

The arbitrage $rofit on a transaction of S


46/59

'rbitrage &9ocationa!* E

xa%$!e /"#e%:

AJSF xchange 4ate in 1 0.?>I

AJ549 xchange 4ate in 1 0. >I/?549JA xchange 4ate in #aris /.>>

549JSF xchange 4ate in #aris ,.???

46


47/59

Exchange

rate

New York Paris Remars

$!"# .6%3& x' '0.=0I2

ise*ili+ri*m! ,r+itrage

$!-R .3&2% (1!2./336)'.3&2% E*ili+ri*m!

0o ,r+itrage

-R!"#

'1.%6&1

1.%%/% ise*ili+ri*m!

,r+itrage

Exchange

rate

New York Paris Remars

$!"# .6%3& ise*ili+ri*m! ,r+itrage

$!-R .3&2% (1!2./336)'.3&2% E*ili+ri*m!

0o ,r+itrage

-R!"# 1.%%/% ise*ili+ri*m!

,r+itrage

"%


48/59

'rbitrage #rofits

'ction Cash f!ow

5uy SF in 1 + A 0.?>IJSF

Se!! SF in #aris V A0.=0I2JSF

'rbitrage #rofit A 0.0,,?JSF

"&

,. AJSF 4ate

/. AJ4ea!: 1o arbitrage $rofit on AJ4ea! rate.

>. 4ea!JSF 4ate

'ction Cash f!ow

5uy SF in 1 +4ea! ,.?I,JSF

Se!! SF in #aris V4ea! ,.???JSF

'rbitrage #rofit 4ea! 0.0>>JSF


49/59

Mar&et A$tivity B )pe$ulation)pe$ulation involves 1etting on pri$e movement" I't(e pri$e movement is 'avora1le2 t(e spe$ulator ma&es a pro'it ot(er/ise a loss" T(us a spe$ulators inv

estment is exposed to ris&"

"'


50/59

Example 1

&S$ecu!ation in the S$ot Market*:

Su$$ose a currency trader ac;uires a !ong $osition of K,0 %i!!ion at A,.2/I0JK. Further su$$ose the exchange rate %oves to A,.20/IJK when the trader is r

e;uired to net out of this !ong $osition in K. hat is the $rofit or !oss in AH

First( understand that the traderBs !ong $osition of K,0% is ex$osed to unex$e

cted changes in the exchange rate.

9oss on this $osition &,.20/I + ,.2/I0* x K,0%

+A0.//I %i!!ion

#(


51/59

xa%$!e /

&S$ecu!ation in the Forward Market*:

Su$$ose today is Feb ,( /0,/. The current s$ot rate is A,.>>I0J@. ?0+day

forward rate is A,.>I00J@. The s$ot rate at the %aturity of the forward

contract is unknown today and the forecast is to ,./=0J@. @ wi!! de$reciate

against A in ?0+days.

Ca!cu!ate the s$ecu!ative gains and !osses on a !ong forward $osition and

a!so on a short forward $osition. 7raw the contingency $rofit and !oss gra$h

#1


52/59

ot&'ecy s(otrate & 90)days

*1+$,€-

o'/rot,loss

+*1)-

*ortoss,/rot

+*1)-

1( +(1# >(1#

1# +(1( >(1(

1% +((& >((&

1!( +((# >((#

1!# ( (

1"( >((# +((#1"# >(1( +(1(

#


53/59

Contingency #rofit and 9oss 6ra$h

#!

0 S ,&AJ@*

1.35

Short $osition&0.15

0.15 9ong $osition $rofit

1.20 1.25 1.30 1.40 1.45

0.10

&0.10


54/59

Mar&et A$tivityB *edging)edging invo!ves taking %easures to $rotect against unfavorab!e %ove%ents in $rice of an under!ying asset or !iab

i!ity or a cash f!ow( or a va!ue of a business.

#"


55/59

Example7

Su$$ose 5est 5uy $!aces an order on SO1 for #!as%a TW

sets. The consign%ent is due in six %onths( when 5est 5uy

wi!! be re;uired to %ake a $ay%ent of L/I00 %i!!ion. The c

urrent s$ot rate is L?.?0JA. The exchange rate six+%onths fr

o% now is not known today.

a. -f the exchange rate does not change( what wi!! be the do!!ar $a

y%ent in %onthsH

##


56/59

1. hat is 5est 5uyBs concernH hat asset or !iabi!ity is ex$osed to exchange rate changesH )ow can 5est 5uy hedge its A $ay%entH

5est 5uyBs accounts $ayab!e &a current !iabi!ity* deno%inated in en isex$osed to the changes in exchange rate. -ts concern is that yen wi!! a$

$reciate in %onths against do!!ar so that the $ay%ent in do!!ar is !ike!

y to go u$.

5est 5uy can buy a +%onth forward contract to !ock in the $rice of L i

n A. Su$$ose the +%onth forward exchange rate is L?./JA. 5y buyin

g a forward contract( 5est 5uy ensures that it can buy L at the rate of

L?./JA( when the $ay%ent to SO1 wi!! be due in +%onths.

#$


57/59

#%

5est 5uyBs $ortfo!io contains a !iabi!ity &short $osition in L* and a

forward contract &9ong forward+!ong $osition in L *.-t does not have to

worry about the a$$reciation of L against do!!ar.


58/59

Forward Market )edge

#&

The red !ine

shows the

$ayoff of the

hedged $ayab!e. 1ote

that gains on

one $osition

are offset by!osses on the

other $osition.

A/=.?%

A %

EA %

8nhedged

$ayab!e in A

Forward

Contract

)edged $ayab!e


59/59

E!

pp chap 5 fx markets

Documents