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MODULE 2
THE FOREIGN
EXCHANGEMARKET
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CHAPTER OVERVIEW
I. INTRODUCTION
II. ORGANIZATION OF THE
FOREIGN EXCHANGEMARKET
III. THE SPOT MARKET
IV. THE FORWARD MARKET
V. INTEREST RATE PARITY
THEORY
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PART I. INTRODUCTION
I. INTRODUCTION
A. The Currency Market:
where moneydenominated in onecurrency is bought and
sold with moneydenominated in anothercurrency.
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INTRODUCTION
B. International Trade andCapital Transactions:
- facilitated with the abilityto transfer purchasing power
between countries
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INTRODUCTION
C. Location
1. OTC-type: no specific
location2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for WorldwideInterbank Financial
Telecommunications
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PART II.
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
I . PARTICIPANTS IN THEFOREIGN EXCHANGE
MARKETA. Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level- businesscustomers.
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
B. Two Types of CurrencyMarkets
1. Spot Market:- immediate transaction
- recorded by 2nd
business day
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
2. Forward Market:
- transactions take place at a
specified future date
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
C. Participants by Market
1. Spot Market
a. commercial banksb. brokers
c. customers of commercialand central banks
O GA A O O
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
b. tradersc. hedgers
d. speculators
ORGANIZATION OF THE
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
II. CLEARING SYSTEMS
A. Clearing House Interbank
Payments System(CHIPS)
- used in U.S. for electronic
fund transfers.
ORGANIZATION OF THE
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic transfers
ORGANIZATION OF THE
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
III. ELECTRONIC TRADING
A. Automated Trading
- genuine screen-basedmarket
ORGANIZATION OF THE
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
B. Results:
1. Reduces cost of trading
2. Threatens traders
oligopoly of information
3. Provides liquidity
ORGANIZATION OF THE
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
IV. SIZE OF THE MARKET
A. Largest in the world
1995: $1.2 trillion daily
ORGANIZATION OF THE
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ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
B. Market Centers (1995):
London = $464 billion
dailyNew York= $244 billion
daily
Tokyo = $161 billiondaily
PART III
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PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers2. Major currencies have
four different quotes:a. spot priceb. 30-dayc. 90-dayd. 180-day
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THE SPOT MARKET
B. Method of Quotation
1. For interbank dollar
trades:a. American terms
example: $0.5838/dm
b. European terms
example: dm1.713/$
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THE SPOT MARKET
2. For nonbank customers:
Direct quote
gives the home currency
price of one unit of foreign
currency.
EXAMPLE: INR 0.5/JPY
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THE SPOT MARKET
C. Transactions Costs
1. Bid-Ask Spread
used to calculate the feecharged by the bank
Bid = the price at which
the bank is willing to buy Ask = the price it will sell
the currency
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THE SPOT MARKET
4. Percent Spread Formula (PS):
100x
Ask
BidAskPS
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THE SPOT MARKET
D. Cross Rates
1. The exchange rate
between 2 non - US$
currencies.
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THE SPOT MARKET
2. Calculating Cross RatesWhen you want to knowwhat the dm/JPY cross
rate is, and you knowdm2/US$ and
JPY0.55/US$
then dm/ = dm2/US$ JPY.55/US$
= dm3.636/ JPY
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THE SPOT MARKET
E. Currency Arbitrage
1. If cross rates differ from
one financial center toanother, and profitopportunities exist.
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THE SPOT MARKET
F. Settlement Date Value Date:
1. Date monies are due
2. 2nd Working day after date of
original transaction. Following
Preceding
Modified Following
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THE SPOT MARKET
G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverseexchange rate moves.
b. Increased uncertaintyabout future exchangerate requires spread.
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THE SPOT MARKET
1.) Demand for higher risk
premium
2.) Bankers widen bid-askspread
ME H NI F P T
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ME H NI F P T
TRANSACTIONS
SPOT TRANSACTIONS: AnExample
Step 1. Currency transaction:verbal agreement, U.S.importer specifies:
a. Account to debit (his acct)b. Account to credit
(exporter)
MECHANICS OF SPOT
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MECHANICS OF SPOT
TRANSACTIONS
Step 2. Bank sends importer
contract note including:
- amount of foreigncurrency
- agreed exchange rate- confirmation of Step 1.
MECHANICS OF SPOT
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MECHANICS OF SPOT
TRANSACTIONS
Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ fromnostro account to exporters.
Value Date.
U.S. bank debits importersaccount.
P RT III
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P RT III.
THE FORWARD MARKET
I. INTRODUCTION
A. Definition of a Forward
Contractan agreement between a bank anda customer to deliver a specified
amount of currency againstanother currency at a specifiedfuture date and at a fixed exchange
rate.
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THE FORWARD MARKET
2. Purpose of a Forward:
Hedging
the act of reducing exchange
rate risk.
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THE FORWARD MARKET
B. Forward Rate Quotations
1. Two Methods:
a. Outright Rate: quoted tocommercial customers.
b. Swap Rate: quoted in the
interbank market as adiscount or premium.
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THE FORWARD MARKET
CALCULATING THE FORWARDPREMIUM OR DISCOUNT
= F-S x 12 x 100S n
where F = the forward rate of exchangeS = the spot rate of exchange
n = the number of months in the
forward contract
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THE FORWARD MARKET
C. Forward Contract Maturities
1. Contract Terms
a. 30-dayb. 90-day
c. 180-day
d. 360-day
2. Longer-term Contracts
PART IV
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PART IV.
INTEREST RATE PARITY THEORY
I. INTRODUCTION
A. The Theory states:
the forward rate (F) differsfrom the spot rate (S) atequilibrium by an amount
equal to the interestdifferential (rh - rf) betweentwo countries.
INTERE T R TE P RITY
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INTERE T R TE P RITY
THEORY
2. The forward premium or
discount equals the interest
rate differential.(F - S)/S = (rh - rf)
where rh = the home rate
rf = the foreign rate
INTERE T R TE P RITY
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INTERE T R TE P RITY
THEORY
3. In equilibrium, returns on
currencies will be the same
i. e. No profit will be realizedand interest parity existswhich can be written
(1 + rh) = F(1 + rf) S
INTERE T R TE P RITY
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INTERE T R TE P RITY
THEORY
B. Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward
premium or discount.2. Funds will move to a country
with a more attractive rate.
INTEREST RATE PARITY
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INTEREST RATE PARITY
THEORY
3. Market pressures develop:
a. As one currency is more
demanded spot and sold
forward.
b. Inflow of fund depresses
interest rates.
INTEREST RATE PARITY
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INTEREST RATE PARITY
THEORY
C. Summary:
Interest Rate Parity states:
1. Higher interest rates on acurrency offset by
forward discounts.
2. Lower interest rates are
offset by forward
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