Foreign Exchange Market(FEM)

FF

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The Functions of FEMThe Functions of FEM

1. Transfer of Purchasing Power.

2. International Credit such as L.C.

3. Minimize Exposure to Foreign Exchange Risk

4 Market for Hedging & Arbitrageur

5 Market for currency Swaps, futures &

forward/Spot Transactions

1. Transfer of Purchasing Power.

2. International Credit such as L.C.

3. Minimize Exposure to Foreign Exchange Risk

4 Market for Hedging & Arbitrageur

5 Market for currency Swaps, futures &

forward/Spot Transactions

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Participants in FEM1. Banks & Non-banks2. FEM Dealers- benefited from bid-ask spread3. Market Makers-Position on certain Currencies4. FEM Brokers (56%)5. Exporter, Importer, Tourists MNCs, Portfolio Managers6. Speculators & Arbitrageur7. Central Banks

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Types of FEM Transactions Spot Transactions: one day settlement (63% of market) Forward Transactions: one, two, six & 12 month (6%) Swaps Transactions: Simultaneous purchase or sale of FE,

with two value dates: spot-forward, forward-forward

Spot Transactions

Forward Transactions

Swaps TransactionsExample: sell £20 mil forward for $ deliver in two monthsat $1.4870/£ & simultaneouslybuy back £20 mil forward fordelivery in three month at$1.4820/£.

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Types of QuotationsTypes of Quotations Direct Quotation : Direct Quotation :

Home currency in terms of foreign currency.Home currency in terms of foreign currency. $/ff=$.1265/ff: American Way$/ff=$.1265/ff: American Way

Indirect Quotation:Indirect Quotation: Foreign currency in terms of home currencyForeign currency in terms of home currency ff/$=ff7.9045/$.ff/$=ff7.9045/$.

Bid & ask spread:Bid & ask spread: buy(bid) at ff7.9030/$ & ask(offer) at ff7.9070/$buy(bid) at ff7.9030/$ & ask(offer) at ff7.9070/$ Difference between bid-ask is dealerDifference between bid-ask is dealer

premium=transaction costpremium=transaction cost

Cross Rates:Cross Rates: Dutch Guilder/$ over Danish KoranDutch Guilder/$ over Danish Koran

DF3.0245/DK9.7215=DG.3111/KoranaDF3.0245/DK9.7215=DG.3111/Korana

Point Quotation:Point Quotation: Difference between forward rate & spot rate (swap rate).Difference between forward rate & spot rate (swap rate).

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TRIANGULAR ARBITRAGEURTRIANGULAR ARBITRAGEUR

U.S $U.S $ UK £UK £ DMDM

$$ 1 1 S($/£)=1.8930 S($/DM)=0.453 S($/£)=1.8930 S($/DM)=0.453

££ S(£/$)=0.526 1 0.239 S(£/$)=0.526 1 0.239

DMDM 2.205 4.190 1 2.205 4.190 1

If S(DM/$)*S(£/DM)*S($/£) is greater than one, successful arbitrageur.

(2.205*0.239*1.893)=$0.9979, not successful arbitrageur

Buying & selling of one currency for another & returning to the original one.

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The Interest Rate Parity The Interest Rate Parity TheoryTheory

DEF:DEF: Except for transaction costs, Except for transaction costs, the differences in the differences in national interest rate,national interest rate, for security of similar risk & for security of similar risk & maturity maturity should be equal should be equal but opposite in sign, to but opposite in sign, to forward exchange rateforward exchange rate discount or premium for foreign discount or premium for foreign currency.currency.

It links National Monetary Market Rate to Foreign It links National Monetary Market Rate to Foreign Exchange Rate.Exchange Rate.

Forward Exchange Rate Discount & Premium:Forward Exchange Rate Discount & Premium:

(Forward Rate-(Forward Rate-Spot RateSpot Rate))/(Spot Rate)*12/n*100/(Spot Rate)*12/n*100

((Spot RateSpot Rate--Forward RateForward Rate)/(Forward Rate)*12/n*100 )/(Forward Rate)*12/n*100

DM2.5885-2.5639/2.5639*12/3*100=+3.8379 per year:DM2.5885-2.5639/2.5639*12/3*100=+3.8379 per year:

It means DM is in 3.8379%, 3-month forward It means DM is in 3.8379%, 3-month forward premium or the U.S. $ is in 3.8379%, 3-month premium or the U.S. $ is in 3.8379%, 3-month forward discountforward discount..

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Test for ParityTest for Parity– UK 3-Month Interest Rate=12% per year UK 3-Month Interest Rate=12% per year – U.S. 3-month Interest Rate=7% per yearU.S. 3-month Interest Rate=7% per year– Transaction Cost=.15% should be calculated at the Transaction Cost=.15% should be calculated at the

beginning of transactionbeginning of transaction– Size of Transaction=$2,800,000.00Size of Transaction=$2,800,000.00

Covered Interest Arbitrageur actions:Covered Interest Arbitrageur actions:– Step 1. Borrow $2.8mil at 7%/year for 3-monthStep 1. Borrow $2.8mil at 7%/year for 3-month– Step 2. Exchange $2.8 mil for £ at spot rate of $1.4000/£ & Step 2. Exchange $2.8 mil for £ at spot rate of $1.4000/£ &

receive £2mil.receive £2mil.– Step 3. Invest £2mil for 3-month in UK at 12%/year or Step 3. Invest £2mil for 3-month in UK at 12%/year or

3%/Quarter.3%/Quarter.– Step 4. Sell £2.06mil forward at 3-month forward rate of Step 4. Sell £2.06mil forward at 3-month forward rate of

$1.3860/£: which include £2mil principal & £60,000 interest $1.3860/£: which include £2mil principal & £60,000 interest for the 3-month (3%*2mil=for the 3-month (3%*2mil=££60mil 60mil

– Step 5. Pay transaction cost of $4,200 ($2.8*.15)Step 5. Pay transaction cost of $4,200 ($2.8*.15)

The operation of Covered Interest The operation of Covered Interest ArbitrageurArbitrageur

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Covered Interest Arbitrageur actions-con..:Covered Interest Arbitrageur actions-con..:– Step 6. Three month after, redeem UK investment of £2,06milStep 6. Three month after, redeem UK investment of £2,06mil

– Step 7. Fulfill forward contract by selling £2060mil at $1.3860/£ Step 7. Fulfill forward contract by selling £2060mil at $1.3860/£ forward rate & receive $2.855160.forward rate & receive $2.855160.

– Step 8. Repay loan of $2.8mil plus 3-month interest at Step 8. Repay loan of $2.8mil plus 3-month interest at 1.75%/Quarter ($2.8*1.75%=$49000).1.75%/Quarter ($2.8*1.75%=$49000).

Profit Calculation:Profit Calculation:– Proceed from investment in UK=$2,855,160.Proceed from investment in UK=$2,855,160.

– Principal+interest from borrowing=$2,849,000Principal+interest from borrowing=$2,849,000

– Transaction cost=$4200Transaction cost=$4200

– Net profitNet profit=$2,855160-2,849000-4200==$2,855160-2,849000-4200=$1,960.00$1,960.00

The operation of Covered Interest The operation of Covered Interest Arbitrageur-Con...Arbitrageur-Con...

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Speculation in FEMSpeculation in FEM Spot Market Speculation:Spot Market Speculation:

•Spot rate:DG2.9000/$,Forward Spot rate:DG2.9000/$,Forward Rate=DG2.8000/$Rate=DG2.8000/$

• 6-month expected spot rate=DG2.700/$6-month expected spot rate=DG2.700/$•With $40,000, buy:$40,000*DG2.9=DG116000With $40,000, buy:$40,000*DG2.9=DG116000•Sell at DG2.7/$ for $42965 (116000/2.7)Sell at DG2.7/$ for $42965 (116000/2.7)•Make profit of 2965 or14.82%/YearMake profit of 2965 or14.82%/Year

Forward Market SpeculationForward Market Speculation BBuy $40,000*DG2.8=DG112000uy $40,000*DG2.8=DG112000

BBuy back $ at DG2.7=$41,481uy back $ at DG2.7=$41,481

Profit=$1,481Profit=$1,481

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Factors to be considered in forecasting the ER

Factors to be considered in forecasting the ER

1. Expected changes in spot rate,

2. Inflation rate differential,

3. Interest rate differential,

4. BOP problems,

5. Growth of Money supply

6. Business Cycle,

7. Change in International Monetary Reserve,

8. Increase in official-nonofficial rate spread

9. FE policies such as , FE. control, ceilings on interest rate, high import

duties, export subsidies, excess G-Spending,

10. Elasticity of demand for exchange rate, Forward rate discount or premium

1. Expected changes in spot rate,

2. Inflation rate differential,

3. Interest rate differential,

4. BOP problems,

5. Growth of Money supply

6. Business Cycle,

7. Change in International Monetary Reserve,

8. Increase in official-nonofficial rate spread

9. FE policies such as , FE. control, ceilings on interest rate, high import

duties, export subsidies, excess G-Spending,

10. Elasticity of demand for exchange rate, Forward rate discount or premium

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Foreign Change Market Foreign Change Market Cont..Cont.. Purchasing power Parity (PPP)Theory :Purchasing power Parity (PPP)Theory :

Def: If the Def: If the spot ratespot rate between two countries starts in equilibrium, any between two countries starts in equilibrium, any change in the difference of change in the difference of rate of inflationrate of inflation between them tends to be between them tends to be offset over the long run by equal, but opposite change in spot offset over the long run by equal, but opposite change in spot exchange rate. exchange rate.

If inflation rate in China increases by 4%, Chin's Ys deprecate by 4%If inflation rate in China increases by 4%, Chin's Ys deprecate by 4% Current Account Balances are very sensitive to change in inflation Current Account Balances are very sensitive to change in inflation

RateRate

International Fisher Effect (Fisher Open):International Fisher Effect (Fisher Open): Difference in Difference in interest rateinterest rate between two countries is equal, but between two countries is equal, but

opposite in sign to the opposite in sign to the spot exchange ratespot exchange rate of foreign currency to of foreign currency to home currencyhome currency

Fisher Effect (Irving Fisher):Fisher Effect (Irving Fisher): Differences in Differences in inflation rateinflation rate between countries is equal to the between countries is equal to the interest interest

raterate differential between them. differential between them.

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Foreign Change Market Foreign Change Market Cont..Cont.. Foreign Currency Option (FCO) :Foreign Currency Option (FCO) :

DefDef: FCO is a contract that gives buyers the: FCO is a contract that gives buyers the right right to buy or sell a to buy or sell a given given amount of foreign exchangeamount of foreign exchange at a at a fixed price fixed price (exercise price or strike price) (exercise price or strike price) per unit for a specific period of time.. per unit for a specific period of time..

Types of FCOTypes of FCO: : American OptionAmerican Option: Right to exercise on any day before the : Right to exercise on any day before the expiration date, expiration date, European Option: European Option: only on the expiration date.only on the expiration date.

In-the Money Option: In-the Money Option: When you make profit, When you make profit, At-the-money option:At-the-money option: when when profit is zero, andprofit is zero, and Out of-the money option: Out of-the money option: when you have a losswhen you have a loss

FCP is a flexible transaction of over 1 mil in major trading currencies for FCP is a flexible transaction of over 1 mil in major trading currencies for any time period up to one year, tailored to the customer's need. any time period up to one year, tailored to the customer's need.

This is a good alternative to the forward market. This is a good alternative to the forward market.

FCP Premium: A percentage of transaction:FCP Premium: A percentage of transaction: paid advance & according to following factorspaid advance & according to following factors

1. Strike price relative to spot rate1. Strike price relative to spot rate 2. Supply & demand for option2. Supply & demand for option 3. Relative interest rate between countries3. Relative interest rate between countries 4. Relative currency risk, and4. Relative currency risk, and 5. Maturity of the option.5. Maturity of the option.

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Foreign Exchange Market Foreign Exchange Market Cont..Cont.. Maturity dates & size of FCO:Maturity dates & size of FCO:

Saturday proceeding the third Wednesday of expiration MonthSaturday proceeding the third Wednesday of expiration Month March March, , June,June, September, September, and and December.December.

Contract size:Contract size: Cited as fixed contract per unit, such as DM62,500/per unit of Cited as fixed contract per unit, such as DM62,500/per unit of option: with one mil$ one can buy:$ one mil/¨DM62,500=16 FCP contractoption: with one mil$ one can buy:$ one mil/¨DM62,500=16 FCP contract

Price of FCP: Price of FCP: No of cents per unit: £12,500*.02=$250.No of cents per unit: £12,500*.02=$250.

An Exercise on FCP:An Exercise on FCP: March $1.45 call option payees $.02 per £ ( purchase £12,500 at $1.45 March $1.45 call option payees $.02 per £ ( purchase £12,500 at $1.45

option with expiration date of March.option with expiration date of March. If price of £ increase to $1.5100, buy £ at £1.4500 & sell £ 1.5000 & make If price of £ increase to $1.5100, buy £ at £1.4500 & sell £ 1.5000 & make

$1.5100-1.4500=.06 per £ or 12500*.06=$750. $1.5100-1.4500=.06 per £ or 12500*.06=$750. Subtract transaction cost of 250, & make a net profit of $750-250=$500.Subtract transaction cost of 250, & make a net profit of $750-250=$500.

Currency Future Market (CFM):Currency Future Market (CFM): Def of CFM: CF are contract between the future dealers & client.Def of CFM: CF are contract between the future dealers & client. It does not involve commercial banks & tradersIt does not involve commercial banks & traders Difference between CFM & Forward Exchange Market, as inflation, Difference between CFM & Forward Exchange Market, as inflation,

contract is drawn up between banks & client;contract is drawn up between banks & client; Major Participants in CFM are: Importer & Exporter, Speculators & Major Participants in CFM are: Importer & Exporter, Speculators &

Arbitrageur, and those who invest abroad. Arbitrageur, and those who invest abroad. MENU

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