CHAPTER 5 THE FOREIGN EXCHANGE MARKET

CHAPTER 7CHAPTER 7

THE FOREIGN THE FOREIGN EXCHANGE EXCHANGE

MARKETMARKET

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. INTRODUCTIONINTRODUCTIONII.II. ORGANIZATION OF THE ORGANIZATION OF THE

FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKETIII.III. THE SPOT MARKETTHE SPOT MARKETIV.IV. THE FORWARD MARKETTHE FORWARD MARKETV.V. INTEREST RATE PARITY INTEREST RATE PARITY

THEORYTHEORY

PART I. INTRODUCTIONPART I. INTRODUCTION

I.I. INTRODUCTIONINTRODUCTIONA.A. The Currency Market:The Currency Market:where money where money denominated in one denominated in one currency is bought and currency is bought and sold with sold with money money denominated in another denominated in another currency.currency.

INTRODUCTIONINTRODUCTION

B. International Trade and B. International Trade and Capital Transactions:Capital Transactions:- facilitated with the ability- facilitated with the abilityto transfer purchasing powerto transfer purchasing powerbetween countriesbetween countries

INTRODUCTIONINTRODUCTION

C.C. LocationLocation1.1. OTC-type: no specific OTC-type: no specific locationlocation2.2. Most trades by phone, Most trades by phone, telex, or SWIFTtelex, or SWIFTSWIFT: 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 MARKETMARKETA.A. Participants at 2 LevelsParticipants at 2 Levels1.1. Wholesale Level (95%)Wholesale Level (95%)- major banks- major banks2.2. 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 Market1. 1. Spot MarketSpot Market

a.a. commercial bankscommercial banksb.b. brokersbrokersc.c. customers of customers of

commercial commercial and central and central banksbanks


2.2. Forward MarketForward Marketa.a. arbitrageursarbitrageursb.b. traderstradersc.c. hedgershedgersd.d. speculatorsspeculators


II.II. CLEARING SYSTEMSCLEARING SYSTEMSA. 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 TRADINGA.A. Automated TradingAutomated Trading

- genuine screen-based - genuine screen-based marketmarket


B.B. Results:Results:1.1. Reduces cost of tradingReduces cost of trading2.2. 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

dailydailyNew York= $244 billion New York= $244 billion

dailydailyTokyo = $161 billion Tokyo = $161 billion

dailydaily

PART III.PART III.THE SPOT MARKETTHE SPOT MARKET

I.I. SPOT QUOTATIONSSPOT QUOTATIONSA.A. Sources Sources 1.1. All major newspapersAll major newspapers2.2. Major currencies have Major currencies have four four different quotes: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 Quotation1.1. For interbank dollar For interbank dollar

trades:trades:a.a. American termsAmerican terms

example: $.5838/dmexample: $.5838/dmb.b. European termsEuropean terms

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


2.2. For nonbank customers:For nonbank customers:Direct quoteDirect quotegives 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 Costs1. 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):

100xAskBidAskPS


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 what the dm/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 Arbitrage1.1. 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 Risk1.1. Bankers = middlemenBankers = middlemen

a.a. Incurring risk of adverseIncurring risk of adverseexchange 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 riskpremiumpremium

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 ExampleExampleStep 1.Step 1. Currency transaction: Currency transaction: verbal verbal

agreement, U.S. 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 importercontract note including:contract note including:- amount of foreign- amount of foreigncurrencycurrency- 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. SettlementSettlementCorrespondent 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

I.I. INTRODUCTIONINTRODUCTIONA. Definition of a Forward A. Definition of a Forward ContractContractan agreement between a bank and an agreement between a bank and a a customer to deliver a specified customer to deliver a specified amount amount of currency against of currency against another another currency at a specified currency at a specified future date and future date and at a fixed exchange at a fixed exchange rate.rate.

THE FORWARD MARKETTHE FORWARD MARKET

2. Purpose of a Forward:2. Purpose of a Forward:HedgingHedgingthe act of reducing the act of reducing

exchangeexchangerate risk.rate risk.


B.B. Forward Rate QuotationsForward Rate Quotations1. 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 theinterbank market as a interbank market as a discount or discount or premium.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 nwhere 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 Maturities1. 1. Contract TermsContract Termsa.a. 30-day30-dayb.b. 90-day90-dayc.c. 180-day180-dayd.d. 360-day360-day2.2. Longer-term ContractsLonger-term Contracts

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

I.I. INTRODUCTIONINTRODUCTIONA. The Theory states:A. The Theory states:the forward rate (F) differs the forward rate (F) differs from from the spot rate (S) at the spot rate (S) at equilibrium equilibrium by an amount by an amount equal to the equal to the interest 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 ordiscount 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 raterrff = the foreign rate = the foreign rate


3.3. In equilibrium, returns onIn equilibrium, returns oncurrencies will be the samecurrencies will be the samei. 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 Arbitrage1. Conditions required:1. Conditions required:interest rate differential doesinterest rate differential doesnot equal the forward not equal the forward premium or premium or discount.discount.2.2. Funds will move to a countryFunds will move to a countrywith a more attractive rate.with a more attractive rate.

INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY3. 3. Market pressures develop:Market pressures develop:

a.a. As one currency is moreAs one currency is moredemanded spot and solddemanded spot and soldforward.forward.b. Inflow of fund depressesb. Inflow of fund depressesinterest 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 forwardforwarddiscounts.discounts.2.2. Lower interest rates are Lower interest rates are offset by forward offset by forward premiums.premiums.

CHAPTER 5 THE FOREIGN EXCHANGE MARKET

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