7/23/2019 ch6(1) fin329

1/22

Copyright 2010 Pearson Prentice Hall. All rights reserved.

Chapter 6

The Foreign

Exchange Market

7/23/2019 ch6(1) fin329

2/22

6-2

The Foreign Exchange (FX) Market

The FX Market: Different currencies are exchanged

and FX rates are determined. Foreign exchange(FX) = money of a foreign

country (foreign currency bank balancesbanknotes checks and drafts).

The FX market s!ans the globe "ith !ricesmo#ing and currencies trading some"here e#eryhour of e#ery business day.

The #olume of currency transactions ebbs and

flo"s across the globe$ as the ma%or currencytrading centers o!en and close throughout theday.

7/23/2019 ch6(1) fin329

3/22

Exhibit 6.1 Measuring Foreign &xchange Market'cti#ity: '#erage &lectronic on#ersions er *our

6-3

7/23/2019 ch6(1) fin329

4/22

Exhibit 6.2 +lobal urrency Trading:The Trading Day

6-4

7/23/2019 ch6(1) fin329

5/22

6-5

Functions of the Foreign ExchangeMarket

The FX Market !artici!ants:

obtain or !ro#ide credit for international tradetransactions and

risk,hedging: minimi-e ex!osure to the risks ofexchange rate changes.

!urchasein#est currencies as assets ex!ectingcertain !rice mo#ements.

7/23/2019 ch6(1) fin329

6/22

6-6

Market Participants

The FX market consists of t"o tiers:

the interbank or "holesale market (multi!les of /0MM12 or e3ui#alent in transaction si-e 4 banks dealersfinancial institutions)

the client or retail market (s!ecific smaller amounts 4

general firms indi#iduals). !artici!ants: banks nonbank foreign exchange

dealers other financial institutions generalfirms indi#iduals and central banks and

treasuries5 there are s!eculators andarbitrageurs.

7/23/2019 ch6(1) fin329

7/22

6-7

ank an! "onbank FX #ea$ers % others&..

6anks and nonbank foreign exchange dealers o!erate in boththe interbank and client markets.

They carry in#entory of currencies and !ost bid,ask !rices:buy at a 7bid8 !rice and sell at a slightly higher 7offer8 or7ask8 !rice FX market is a dealer market; these dealers -market makers

(FX brokers: match buysell orders5 not taking in#entory

!osition)

As in other areas of global marketplace, technologyinternetis rapidly changing the market microstr!ct!redynamics" #e$g$eFX % online c!rrency trading&

7/23/2019 ch6(1) fin329

8/22

6-8

2!eculators and arbitragers seek to !rofit from trading, 9hile dealers seek the bidask s!read s!eculatorsseek all the !rofit from exchange rate changes5arbitragers try to !rofit from simultaneous exchangerate differences in different markets.

entral banks and treasuries 4 buy or sell theircountrys F reser#es5 influence FX rate.

, The moti#e is not to earn a !rofit !er se but toinfluence FX rates in a manner that "ill benefit theinterests of their citi-ens "illing loss takers.

'pecu$ators an! rbitragers Centra$anks an! Treasuries

7/23/2019 ch6(1) fin329

9/22

6-9

Transactions in the *nterbank Market

' spot transaction: settlement date ('al!e date& %!s!ally the second follo"ing business day in the

"holesale mkt5 settlement sooner in the retail mkt. 'n o!tright for(ard transaction (or %ust for(ard)

re3uires deli#ery at a future #alue date of a s!ecifiedamount of one currency for a s!ecified amount of

another currency.The exchange rate 4 agreeddetermined no"5 but

!ayment deli#ery are not re3uired until maturity.- For"ard exchange rates , !s!ally )!oted for 'al!e

dates of one, t(o, three, six and t(el'e months.

, b!ying for(ard or selling for(ardcan describe thesame transaction: e.g. euro #s dollar , b!ying e!rosfor(ard #( dollars& * selling dollars for(ard #fore!ros&$

7/23/2019 ch6(1) fin329

10/22

6-10

Transactions in the *nterbank Market ' foreign exchange #FX& s(ap transaction in the interbank

market , simultaneous !urchase and sale of a gi#en amount

of foreign exchange for often t(o different 'al!e dates. 6oth !urchase and sale are often conducted "ith the same

co!nterparty("hy; buy foreign bonds and stocks 4 need tohedge future currency #alues5

7/23/2019 ch6(1) fin329

11/22

6-11

"on!e$i+erab$e for,ar! ("#F)

>o actual deli#ery of currencies

2ettle "ith dollars @ffshore contract 4 to a#oid regulations by the

currency country Many emerging market currencies 4 Aatin 'merican

nations 'sian countries , BCs 'sian financial crisis

booming >DF markets orean 9on5 Tai"anese dollar5 hilean !eso hinese

M6 >on,internationali-ed currencies5 con#ertibilityrestrictions (recently M6 4 going globalinternational)

(

7/23/2019 ch6(1) fin329

12/22

FX -arket sie

' triennial sur#ey by the 6ank for ) Bth

O (asurgeO).

6-12

7/23/2019 ch6(1) fin329

13/22

Exhibit 6./ +lobal Foreign &xchange MarketTurno#er 0BQB,GC0C (a#erage daily turno#er in'!ril billions of 1.2. dollars)

swaps

6-13

7/23/2019 ch6(1) fin329

14/22

Exhibit 6.0 To! 0C +eogra!hic Trading enters inthe Foreign &xchange Market 0BB0,GC0C (a#eragedaily turno#er in '!ril)

6-14

7/23/2019 ch6(1) fin329

15/22

Exhibit 6.6 Foreign &xchange Market Turno#er byurrency air (daily a#erage in '!ril)

6-15

7/23/2019 ch6(1) fin329

16/22

6-16

FX ates 3uotations(Most foreign exchange transactions in#ol#e 12D.) , &uro!ean term: foreign currency !rice of one dollar

, 'merican term: dollar !rice of a unit foreign currency$

&x) 2F 0.LCCC/ (&uro!ean term)5 /C.LGRC2F ('mericanterms)

, direct3uote: home currency !rice of a unit foreign currency- indirect3uote: foreign currency !rice of a unit homecurrency

&x) 2F 0.LCCC/ (&uro!ean term) direct 3uote for a 2"issS indirect 3uote for an 'merican

onfusingly enough using ?last page of the book):

- 2F 0.LCCC/ (&uro!ean term) = 12D*F 0.L- /C.LGRC2F ('merican term) = *F12D C.LGRCi$e$ is 345 a di'isor #6&

ho"e#er in !ractice con#entions #ary5 in this class either 2F0.LCCC/ or *F 0.L12D i$e$ is a di'isor"

7/23/2019 ch6(1) fin329

17/22

6-17

FX ates an! 3uotations

7/23/2019 ch6(1) fin329

18/22

6-18

Foreign Exchange ates an! 3uotes see my re#ie"5 alternati#ely the follo"ing:

For 3uotations ex!ressed in foreigncurrency terms (

7/23/2019 ch6(1) fin329

19/22

6-19

Foreign Exchange ates an! 3uotes

Many currency !airs , inacti#ely traded

their exchange rate , determined through theirrelationshi! to a "idely traded third currency (crossrate).

&x) Mexican !eso 4 dollar5 dollar 4 yen cross rate:!eso #s en

, 7ross rated can be calc!lated for ma8or c!rrencies too.

, ross rates can be used to check on o!!ortunities forintermarkettriangular arbitrage.

7/23/2019 ch6(1) fin329

20/22

6-20

*nter-arket4Triangu$ar arbitrage N,,!ossiblebecause one banks (Dresdner) 3uotation on UV W crossrate bet"een /V (6arclays) and /U (itibank).

itibank 3uote , /U /0.IGBHU

6arclays 3uote , /V /0.RRQRV

Dresdner 3uote , UV U0.0HGGV

ross rate calculation:

=U 0.0HG0V

=

7/23/2019 ch6(1) fin329

21/22

Exhibit 6.11 Triangular 'rbitrage by a MarketTrader

6-21

7/23/2019 ch6(1) fin329

22/22

6-22

(iskfree) arbitrage opportunit5

2hort,li#ed relati#ely rare o!!ortunity es!ecially

considering transaction cost @!!ortunity if any #anishes #ery 3uickly

om!uter based algorithmic trading instantaneouslyca!tures it and executes trades (*FT: high fre3uency

trading) 4ften some risk may be ass!med

@nly large institutionsbanks "ith huge ca!ital accesscan do it.