unit_4- foreign exchange market

8/2/2019 Unit_4- Foreign Exchange Market

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UNIVERSITY OF LJUBLJANAFACULTY OF ECONOMICS

CONTENTS ENDInternational Finance Mojmir Mrak

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1. Definition and Organization of the Foreign Exchange Markets

2. Foreign Exchange Market Functions

3. Foreign Exchange Market Participants

4. Size and Structure of Foreign Exchange Market Transactions

5. Types of Foreign Exchange Market Transactions

6. Quotations of Currencies on Foreign Exchange Markets

CONTENTS AND PURPOSE

"

purpose: enhance theoretical knowledge from the first two chapters with

practical issues of foreign exchange markets functioning

principles for the analysis of the international business finance

problems


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1. Definition and Organization of the ForeignExchange Markets

"foreign exchange markets are markets on which

individuals, firms and banks buy and sell foreign

currencies: foreign exchange trading occurs with the help of the

telecommunication net between buyers and sellers of foreign

exchange that are located all over the world

can actually talk about a single international foreign exchange

market for every single currency

foreign exchange trading takes place at least in some of the world

financial centers in every moment

interbank-markets client markets


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"Clearing of currencies:

service of exchanging one currency for another

"Provision of Credit:

trader that bought a certain good from the manufacturer, needs

time to sell this good to the final customer and to pay the

manufacturer with the money he received from the customer

2. Foreign Exchange Market Functions

Clearing of Currencies and Provision of Credit


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Foreign Exchange Market and Insurance AgainstForeign Exchange Risk

"hedging: activities with which the foreign exchange market participants

avoid exchange rate risk or activities with which they are closingtheir open foreign exchange position

closed foreign exchange position:size of the assets in a certain currency is equal to the size of the

liabilities in the same currencyfull insurance against exchange rate risk with respect to this currency

open foreign exchange position:

long: net assets in a certain currencyshort: net liabilities in a certain currency

in the spot or forward foreign exchange market standardized forward contracts and options


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Foreign Exchange Markets and Conscious ForeignExchange Risk Acceptance

"activities in which economic agents consciously open their

foreign exchange positions long or short hoping to get

profits

"in all foreign exchange market segments


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3. Foreign Exchange Market ParticipantsEconomic Agents and Types of Activities on

Foreign Exchange Markets Client buy s $

with

Local bank

Main banks

interbank market

Local bank

Client buys

with $

Purchases and sales

of big mu ltinational

companiesBro kers


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CONTENTS ENDInternational Finance Mojmir Mrak Page 8

Economic Agents and Types of Activities onForeign Exchange Markets

"bank clients (individuals, firms, non-banking financial

institutions):

all those groups of legal and physical persons that need foreign

currency in doing their commercial or investment business

"commercial banks: the most important group of foreign exchange market participants

they buy and sell foreign currencies for their clients and trade for

themselves


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Economic Agents and Types of Activities onForeign Exchange Markets

"brokers: agents that connects dealers interested in buying and selling

foreign exchange, but does not become an active client in thetransaction

they provide their client, the bank, with the information about theexchange rates at which banks are willing to buy or sell a particularcurrency

"central banks:

foreign exchange market interventions are meant to influence the

exchange rate of the domestic currency in a way that is beneficial

for the domestic economy and, consequently, for the country

it does not necessarily have a profit, it can also have a loss


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Economic Agents and Motivation for the ForeignExchange Market Participation

"arbitragers: they want to earn a profit without taking any kind of risk (usually

commercial banks):try to profit from simultaneous exchange rate differences in different

markets

making use of the interest rate differences that exist in nationalfinancial markets of two countries along with transactions on spot andforward foreign exchange market at the same time (covered interest

parity)


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Economic Agents and Motivation for the ForeignExchange Market Participation

"hedgers and speculators:

hedgers do not want to take risk while participating in the market, theywant to insure themselves against the exchange rate changes

speculators think they know what the future exchange rate of a particularcurrency will be, and they are willing to accept exchange rate risk with thegoal of making profit

every foreign exchange market participant can behave either as a hedgeror as a speculator in the context of a particular transaction


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4. Size and Structure of Foreign ExchangeMarket Transactions

Table 4.1: Size and Structure of Transactions in the Foreign Exchange Markets,1989 1998 (mia $)

1989 1992 1995 1998

Traditional fore ign exchange

transactions590 820 1190 1490

y Spot market transactions 350 400 520 590y Forward market

transactions240 420 670 900

Untraditional fore ign exchangetransactions

- - 45 97

Source: Roberts, 1999, p. 33.

"the biggest share of all financial markets in the worldCurrency Percentage

$ 87

DEM 30 21

11

FRF 5

CHF 7

Other 39

All currencies 200,00


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5. Types of Foreign Exchange Market Transactions

SpotForeign Exchange Transactions

"almost immediate delivery of foreign exchange

"buyer and seller establish the exchange rate at the time ofthe agreement, payment and delivery are not required until

maturity"forward exchange rates:

1, 3, 6, 9 months, one year

OutrightForward Transactions


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Swap Transactions

"simultaneous purchase and sale of a given amount of

foreign exchange for two different value dates:

spot against forward swaps:

dc

ba *!

a annual swap rate (%),

b premium/discount during the time of the currency swap,

c spot exchange rate, andd - 1/part of the year, for which the currency swap is agreed upon

(if the contract is valid for a three-month period, then this is one

quarter of a year)

forward-forward swaps


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Futures

"basic characteristics of futures: the amount of the currency that is being traded

type of currency quotation

contract expiration

last day of trading with the contract

settlement day

margin requirements

"information about futures trading

"futures usage: arbitrage between outright forward contract and futures

rarely used as an insurance instrument (rigidity!)


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"similarities and differences between outright forward contract andfutures:

both need to be executed unconditionally

they are usually established for at most one year

Characteristic Futures Outright Forward Contract

Size of the contracts standardized for a given currency depends on the individual needs of the

clientLocation and trade

activityat the stock exchange or at a given

location; actively traded in anorganized market

with the provision of agents, connected

among each other with the help oftelecommun ications ; not traded in anorganized market

Duration of the

contract

standardized, but at most a year depends on the individual needs of the

client , but not more than a yearContract has to be

executed

yes yes

Insurance and

Security of doingBusiness with the

Instrument

insurance explicitly required (marginrequirements); high security of doing

bus iness with the instrument

insurance not required explicitly(implicit insurance are affiliat ions oftwo partners up till now); lower

security than futuresTrade regulation regulated with the stock exchange

rulesregulation not explicitly determined


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Characteristic Futures Outright Forward ContractContract partners not in direct contact in direct contact

Price determination based on supply and demand based on quotationsDetermination of the

dayof the settlementstandardized depends on the individual needs of the

clientAccesibility of the

contract for non-

bank agents

accessible to anyone in practice access ible to big clients

with good ratings

Liquidity of the

instrument and the

contract amounts

high liquidity; small contract amountsand small size of transactions

low liquidity; high contract amountsand large size of transactions compared

to the size of futuresCosts of the

instrumentbased on costs that the broker zaraunafor the purchase of the instrument andits sale later on

higher than for futures; based on thedifference in offer and bid price of thecurrency that the bank offers the client

Currency quotation number of units of $ for one unit of a

foreign currency (American quotation)

number of domestic currency units for

one unit of a foreign currency(European quotation)

Riskiness of the

instrumentvery limited; stock exchange enters thecontract, exp licitly required insurance

higher than for futures; for this reason,bus iness is done only with c rediblepartners

Profit yield/loss

payment

daily once; at contract execution or when the

contract expires


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Options

"basic characteristics of options:

financial instrument that gives the buyer the right, but not the

obligation, to buy or sell a standardized amount of a foreign

currency, that is traded, at a fixed price at a particular time, or until

a particular time in the future

call option and put option

American and European options

three different prices:

exercise/strike price

cost, price or value of the option

underlying or actual spot exchange rate

at-the-

money

in-the-

money

out-of-money


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Options

"types of options trading:

in organized markets:

standardized contracts with given strike prices, standardized durations

(1, 3, 6, 9, 12 months) and expirations

only certain currencies, contract amounts are standardized

over-the-counter trading:

expiration date, strike price and contract amount depend on the

individual needs of the client

counterparty risk!

retail and interbank market

"information about options trading


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"Usage of options:

when the economic agent expects that the exchange rate trend of a

particular currency could change drastically

when the economic agent does not know for sure that a certain

foreign exchange flow will occur in the future

advantages:

fixed option costs

options do not need to be executed

Options


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Profit/

loss

Limited

loss

Unlimited

profit

A. Buyer of a calloption

Profit/

loss

Limited

loss

Unlimited

profit

C. Buyer of a putoption

Profit/

loss

Limitedprofit

Unlimited

loss

B. Seller of a calloption

Profit/

loss

Unlimited

loss

Limitedprofit

D. Seller of a putoption


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6. Quotations of Currencies on ForeignExchange Markets

"quotation of a currency tells us at what price is a financial

mediator willing to buy or sell a certain currency

Currency Quotations in SpotForeign ExchangeMarkets

"European and American quotation

"

direct and indirect quotation (which currency is regardedas a domestic/basis currency)

100*

0

0

s

sss

t

!( 100*0

t

t

s

sss

!(


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CONTENTS ENDInternational Finance

Mojmir Mrak

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Currency Quotations in SpotForeignExchange Markets

American quotation European quotation

Definition:

number of units of $ needed to buy a unit of

a foreign currency

Definition:

number of units of a foreign currency needed

to buy $1

Direct quotation in the USA:

number of units of a domestic currency ($)

needed to buy a unit of foreign currency

Direct quotation outside the USA:

number of units of a domestic currency

needed to buy a unit of a foreign currency

($)

Indirect quotation outside the USA:

number of units of a foreign currency ($)

needed to buy a unit of a domestic currency

Indirect quotation in the USA :

number of units of a foreign currency needed

to buy a unit of a domestic currency ($)


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Mojmir Mrak

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"bid price and offer/sell price quotation:

bid price is the exchange rate at which a bank is willing to buy

another currency offer/sell price is the exchange rate at which the same bank is

willing to sell the currency in question

"transaction costs:

banks usually do not charge provision

difference between the bid and offer/sell price represents thebanks profit and is called a margin or spread

priceoffer/sell

pricebid-priceoffer/sellmargin !


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Mojmir Mrak

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"cross exchange rate:

can be calculated with the help of the relationship of two

currencies with a third currency

"triangular currency arbitrage:

it enables profit earning because of inconsistency between

currency quotations in different financial centers

buying a particular currency in one financial center and selling it in

another financial center


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Mojmir Mrak

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Currency Quotations in ForwardForeignExchange Markets

"outright quotation

"tokovna quotation, forward premium/discount:

forward discount:

when a currency is worth less (is cheaper relative to another currency) in theforward foreign exchange market than in the spot foreign exchange market

forward premium:

when a currency is worth more (is more expensive relative to another

currency) in the forward foreign exchange rate market than in the spot foreign

exchange market

"annual forward premium and discount

100*360

*ns

sffUSD

!100*

360*

nf

fsfUSD

!


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Mojmir Mrak

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"Financial Times

"Wall Street Journal

Publishing the Currency Quotations in the LeadingWorldFinancial Newspapers

unit_4- foreign exchange market

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