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Transcript of PP Chap 5 FX Markets
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NTERNAT ONAL F NANC AL MANAG
EMENT
UNIVERSITY OF MASSACHUSETTSDARTMOUTH
Instructor: Professor Trib Puri
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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
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FX Trading
Continuous TradingDaily volume approximately !"# Trillion
!
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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!* "
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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$ial %an& o' C(inaCredit )uisse Group
*)%C *oldings +,-.
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Function and Structure of
the FX Market: Segments)pot Mar&et
For/ard mar&et
Futures and Options mar&et
)/ap Mar&et
Ex$(ange Traded Funds +ETFs.
$
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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
%
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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$eso/ned 1y any one 1an& to anot(er and 'or payme
nt 1y 6788 4M t(at same day in FED2 Ne/ 5or& 'un
ds"
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S$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.
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Two+way #ricing( 5-7"'S
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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
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5-7+'S
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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 $osition in 5#H The ;uotes are:
1!
,.?=,I E /0
.I0=, E =/
S &AJK*
S &KJA*
5id 'sk
T5e tr67er c6n 6ssu8e 6 3on9 osition in ; ,)u2 ; 6t)ID of 1'%1#0 4 4 ;#(%&
T5e tr67er c6n t6
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'n xa%$!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 $rovides this ;uotation:• G%49,)D 8"#80# : ;6
• ,)D9E,R
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So!ution%id pri$e o' ?
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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$
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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$$ose a trader ;uotes the fo!!owing: L,>2./ JA( and A,.2,,JK
hat is the i%$!ied $rice of K in L.
Cross Rate 9 @¥ £
@ @ "!#9¥ £
1%
¥ $
$ £
x
¥134.2 $1.411
$ £ x
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Cross RatesB Example 0Su$$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
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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 $resented( then it is a bit %ore cu% berso%e to ca!cu!ate cross+ 5id and cross+ 'sk.
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xa%$!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.
(
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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.
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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 @*
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-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
!
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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
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#
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Market Seg%ents+ The Forward MarketForward 4ate uotations
9ong and Short Forward #ositions
Forward #re%iu%
$
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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
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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.
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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
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)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
!(
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Example7
So SF 0.2I0JA S, SF 0.?I/IJA
Appre$iation o' against )F
@ @
@ 0.,/=/ or ,/.=/ 3
!1
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Depre$iation o' )F against dollar
@
@
@ +0.,,/? or +,,./?3
!
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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$$reciation or de$reciation( as the case %ay b
e( of 5raGi!ian 4ea! against the 8S A fro% Pan ,2 to Pan /?.
!!
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!"
9et S0 be exchange rate on Panuary ,2 and St be the exchange rat
e on Panuary /?.
@ + 0.>I?> or E >I.?>3
#ercentage a$$reciation of do!!ar against 4ea!
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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$on whether FQ S0( or FR S0. !#
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xa%$!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 $re%iu% or discount on SF against A in
the ,0+days forward %arket.
!$
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'nnua!iGed forward $re%iu% on SF against A
>.23 $.a.
'nnua!iGed forward discount on A against SF in ,0+days
+>.=03 $.a.
!%
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9ong and Short Forward #ositions-f you have agreed to se!! anything &s$ot or forward*( you
are short.
-f you have agreed to buy anything &forward or s$ot*( you
are !ong.
-f you have agreed to se!! FX forward( you are short.
-f you have agreed to buy FX forward( you are !ong.
!&
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Function and Structure of
the FX Market + Curren$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"
!'
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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"
"(
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Function and Structure of
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
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Function and Structure of
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."
"
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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 $rice
e;ua!iGation of a si%i!ar good( security( and asset across %
arkets.
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Ar1itrage +Lo$ational. : Example <Trader ' observes that do!!ar is ;uoted as S
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The arbitrage $rofit on a transaction of S
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'rbitrage &9ocationa!* E
xa%$!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 ,.???
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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
"%
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'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 $rofit on AJ4ea! rate.
>. 4ea!JSF 4ate
'ction Cash f!ow
5uy SF in 1 +4ea! ,.?I,JSF
Se!! SF in #aris V4ea! ,.???JSF
'rbitrage #rofit 4ea! 0.0>>JSF
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Mar&et A$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&"
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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 $osition &,.20/I + ,.2/I0* x K,0%
+A0.//I %i!!ion
#(
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xa%$!e /
&S$ecu!ation in the Forward Market*:
Su$$ose today is Feb ,( /0,/. The current s$ot rate is A,.>>I0J@. ?0+day
forward rate is A,.>I00J@. The s$ot rate at the %aturity of the forward
contract is unknown today and the forecast is to ,./=0J@. @ wi!! de$reciate
against A in ?0+days.
Ca!cu!ate the s$ecu!ative gains and !osses on a !ong forward $osition and
a!so on a short forward $osition. 7raw the contingency $rofit and !oss gra$h
#1
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ot&'ecy s(otrate & 90)days
*1+$,€-
o'/rot,loss
+*1)-
*ortoss,/rot
+*1)-
1( +(1# >(1#
1# +(1( >(1(
1% +((& >((&
1!( +((# >((#
1!# ( (
1"( >((# +((#1"# >(1( +(1(
#
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Contingency #rofit and 9oss 6ra$h
#!
0 S ,&AJ@*
1.35
Short $osition&0.15
0.15 9ong $osition $rofit
1.20 1.25 1.30 1.40 1.45
0.10
&0.10
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Mar&et A$tivityB *edging)edging invo!ves taking %easures to $rotect against unfavorab!e %ove%ents in $rice of an under!ying asset or !iab
i!ity or a cash f!ow( or a va!ue of a business.
#"
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Example7
Su$$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 $a
y%ent in %onthsH
##
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1. hat is 5est 5uyBs concernH hat asset or !iabi!ity is ex$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$$ose the +%onth forward exchange rate is L?./JA. 5y buyin
g a forward contract( 5est 5uy ensures that it can buy L at the rate of
L?./JA( when the $ay%ent to SO1 wi!! be due in +%onths.
#$
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#%
5est 5uyBs $ortfo!io contains a !iabi!ity &short $osition in L* and a
forward contract &9ong forward+!ong $osition in L *.-t does not have to
worry about the a$$reciation of L against do!!ar.
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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
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E!