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CHAPTER 5CHAPTER 5
THE FOREIGN THE FOREIGN EXCHANGE EXCHANGE
MARKETMARKET
CHAPTER OVERVIEWCHAPTER OVERVIEW
I.I. INTRODUCTIONINTRODUCTION
II.II. ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE FOREIGN EXCHANGE MARKETMARKET
III.III. THE SPOT MARKETTHE SPOT MARKET
IV.IV. THE FORWARD MARKETTHE FORWARD MARKET
V.V. INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY
PART I. INTRODUCTIONPART I. INTRODUCTION
I.I. INTRODUCTIONINTRODUCTION
A.A. The Currency Market:The Currency Market:
where money where money denominated in one denominated in one currency currency is bought and is bought and sold with sold with money money denominated denominated in another in another currency.currency.
INTRODUCTIONINTRODUCTION
B. International Trade and B. International Trade and Capital Transactions:Capital Transactions:
- facilitated with the ability- facilitated with the ability
to transfer purchasing powerto transfer purchasing power
between countriesbetween countries
INTRODUCTIONINTRODUCTION
C.C. LocationLocation
1.1. OTC-type: no specific OTC-type: no specific locationlocation
2.2. Most trades by phone, Most trades by phone,
telex, or SWIFTtelex, or SWIFT
SWIFT: 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 MARKETMARKET
A.A. Participants at 2 LevelsParticipants at 2 Levels
1.1. Wholesale Level (95%)Wholesale Level (95%)
- major banks- major banks
2.2. 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
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
2.2. Forward Market:Forward Market:
- transactions take place at - transactions take place at a a specified future specified future datedate
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
C.C. Participants by MarketParticipants by Market
1. 1. Spot MarketSpot Market
a.a. commercial bankscommercial banks
b.b. brokersbrokers
c.c. customers of customers of commercial commercial and central and central banksbanks
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
2.2. Forward MarketForward Market
a.a. arbitrageursarbitrageurs
b.b. traderstraders
c.c. hedgershedgers
d.d. speculatorsspeculators
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
II.II. CLEARING SYSTEMSCLEARING SYSTEMS
A. 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.
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. FedWireFedWire
- operated by the Fed- operated by the Fed
- used for domestic - used for domestic
transferstransfers
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
III.III. ELECTRONIC TRADINGELECTRONIC TRADING
A.A. Automated TradingAutomated Trading
- genuine screen-based - genuine screen-based marketmarket
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. Results:Results:
1.1. Reduces cost of tradingReduces cost of trading
2.2. Threatens traders’ Threatens traders’
oligopoly of oligopoly of
information information
3.3. Provides liquidityProvides liquidity
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
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
ORGANIZATION OF THE ORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. Market Centers (1995): Market Centers (1995):
London =London = $464 billion $464 billion dailydaily
New York= $244 billion New York= $244 billion dailydaily
Tokyo = $161 billion Tokyo = $161 billion dailydaily
PART III.PART III.THE SPOT MARKETTHE SPOT MARKET
I.I. SPOT QUOTATIONSSPOT QUOTATIONS
A.A. Sources Sources
1.1. All major newspapersAll major newspapers
2.2. Major currencies have Major currencies have four different quotes:four 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 Quotation
1.1. For interbank dollar For interbank dollar trades:trades:
a.a. American termsAmerican terms
example: $.5838/dmexample: $.5838/dm
b.b. European termsEuropean terms
example: dm1.713/$example: dm1.713/$
THE SPOT MARKETTHE SPOT MARKET
2.2. For nonbank customers:For nonbank customers:
Direct quoteDirect quote
gives 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
THE SPOT MARKETTHE SPOT MARKET
C.C. Transactions CostsTransactions Costs
1. 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
THE SPOT MARKETTHE SPOT MARKET
4.4. Percent Spread Formula Percent Spread Formula (PS):(PS):
100xAsk
BidAskPS
THE SPOT MARKETTHE SPOT MARKET
D.D. Cross RatesCross Rates
1.1. The exchange rate The exchange rate
between 2 non - between 2 non -
US$ US$ currencies.currencies.
THE SPOT MARKETTHE SPOT MARKET
2.2. Calculating Cross RatesCalculating Cross RatesWhen you want to know When you want to know what the dm/what the 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/
THE SPOT MARKETTHE SPOT MARKET
E.E. Currency ArbitrageCurrency Arbitrage
1.1. 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.
THE SPOT MARKETTHE SPOT MARKET
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
THE SPOT MARKETTHE SPOT MARKET
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.
THE SPOT MARKETTHE SPOT MARKET
G.G. Exchange RiskExchange Risk
1.1. Bankers = middlemenBankers = middlemen
a.a. Incurring risk of adverseIncurring risk of adverse
exchange rate moves.exchange rate moves.
b.b. Increased uncertainty Increased uncertainty about future exchange about future exchange rate requiresrate requires
THE SPOT MARKETTHE SPOT MARKET
1.) 1.) Demand for higher riskDemand for higher risk
premiumpremium
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 ExampleExample
Step 1.Step 1. Currency transaction: Currency transaction: verbal agreement, U.S. verbal 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 importer
contract note including:contract note including:
- amount of foreign- amount of foreign
currencycurrency
- 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. SettlementSettlement
Correspondent 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. INTRODUCTIONINTRODUCTION
A. Definition of a Forward A. Definition of a Forward ContractContract
an agreement between a bank and an agreement between a bank and a customer to deliver a specified a customer to deliver a specified amount of currency against amount of currency against another currency at a specified another currency at a specified future date and at a fixed future date and at a fixed
exchange exchange rate.rate.
THE FORWARD MARKETTHE FORWARD MARKET
2. Purpose of a Forward:2. Purpose of a Forward:
HedgingHedging
the act of reducing the act of reducing
exchangeexchange
rate risk.rate risk.
THE FORWARD MARKETTHE FORWARD MARKET
B.B. Forward Rate QuotationsForward Rate Quotations
1. 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 the
interbank market as a interbank market as a discount or premium.discount or 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 n
where 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
THE FORWARD MARKETTHE FORWARD MARKET
C.C. Forward Contract MaturitiesForward Contract Maturities
1. 1. Contract TermsContract Terms
a.a. 30-day30-day
b.b. 90-day90-day
c.c. 180-day180-day
d.d. 360-day360-day
2.2. Longer-term Longer-term ContractsContracts
PART IV.PART IV.INTEREST RATE PARITY THEORYINTEREST RATE PARITY THEORY
I.I. INTRODUCTIONINTRODUCTION
A. The Theory states:A. The Theory states:
the forward rate (F) differs the forward rate (F) differs from the spot rate (S) at from the spot rate (S) at equilibrium by an amount equilibrium by an amount equal to the interest equal to the 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 or
discount 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 rate
rrff = the foreign rate = the foreign rate
INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY
3.3. In equilibrium, returns onIn equilibrium, returns on
currencies will be the samecurrencies will be the same
i. 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
INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY
B.B. Covered Interest ArbitrageCovered Interest Arbitrage
1. Conditions required:1. Conditions required:
interest rate differential doesinterest rate differential does
not equal the forward not equal the forward
premium or discount.premium or discount.
2.2. Funds will move to a countryFunds will move to a country
with a more attractive rate.with a more attractive rate.
INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY
3. 3. Market pressures develop:Market pressures develop:
a.a. As one currency is moreAs one currency is more
demanded spot and solddemanded spot and sold
forward.forward.
b. Inflow of fund depressesb. Inflow of fund depresses
interest rates.interest rates.
c.c. Parity eventually Parity eventually
reached.reached.
INTEREST RATE PARITY INTEREST RATE PARITY THEORYTHEORY
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 forwardforward discounts.discounts.
2.2. Lower interest rates are Lower interest rates are offset by forward offset by forward premiums.premiums.