Foreign Exchange Market

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Lecture Outline

Describe the FX market Identify participants and currencies Understand spot and forward rates Calculate & use cross and forward rates Triangular arbitrage Changes in exchange rates

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The foreign exchange market is the mechanism by which participants:

– transfer purchasing power between countries;

– obtain or provide credit for international trade transactions, and

– minimize exposure to the risks of exchange rate changes.

Functions of FX Market

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Characteristics of FX Market Largest of all financial markets with average daily

turnover of over $2 trillion! 66% of all foreign exchange transactions involve

cross-border counterparties. Only 11% of daily spot transactions involve non-

financial customers. London is the largest FX market. US dollar involved in 87% of all transactions.

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Market Activity – 24hrs

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Increasing Turnover

Daily foreign exchange market turnover in billions of US dollars

(Bank for International Settlements Triennial Central Bank Survey 2004)

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Important Currencies

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A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day.

The date of settlement is referred to as the value date.

Types of Transactions

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An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.

The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.

Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.

Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.)

Types of Transactions

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A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

Both purchase and sale are conducted with the same counterparty.

Some different types of swaps are:– spot against forward,

– forward-forward,

– nondeliverable forwards (NDF).

Types of Transactions

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Types of Transactions

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The foreign exchange market consists of two tiers:– the interbank or wholesale market (multiples of $1M US or

equivalent in transaction size), and

– the client or retail market (specific, smaller amounts).

Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

Market Participants

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Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.

They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.

Dealers in the foreign exchange department of large international banks often function as “market makers.”

These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

Market Participants

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Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.

Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose.

Some of the participants use the market to “hedge” their foreign exchange risk.

Market Participants

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Speculators and arbitragers seek to profit from trading in the market itself.

They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.

While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

Market Participants

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Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.

The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.

As willing loss takers, central banks and treasuries differ in motive from all other market participants.

Market Participants

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Types of Activities Speculation

An activity that leaves one open to exchange rate fluctuations where one aims to make a profit.

Hedging Allows the firm to transfer exchange rate risk inherent in

foreign currency transactions or positions. Arbitrage – take advantage of inconsistent prices to

make risk-free profits. These profits are unlikely to last long. Spatial (or Locational) Arbitrage Triangular Arbitrage Covered Interest Arbitrage – Lecture 3

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Foreign Exchange Rates & Quotations

A foreign exchange rate is the price of one currency expressed in terms of another currency.

A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

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Bid & Ask Quotes

Foreign currency dealers provide two quotes:

Bid Price: Price at which the dealer is willing to buy foreign currency from you.

Ask Price: Price at which the dealer is willing to sell foreign currency to you.

It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread.

The less traded and more volatile a currency, the greater is the spread.

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Direct & Indirect Quotes

Direct Quote: Home currency per unit of Foreign currency (FC) - e.g. AUD/€ quote is 1.6003 – 1.6499

Indirect Quote: Foreign currency per unit of Home currency - e.g. €/AUD quote of 0.6061 – 0.6249

Note that in all cases, the reciprocal of a direct quote is an indirect quote:

Also, you might encounter an exchange rate quotation in American terms (US$/FC) or European terms (FC/US$).

AUDEUREUR

AUD 1

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Example

Bid Ask

$/£ 1.4482 1.4484

Bid: Dealer buys £ for $ at the Bid, Client sells £ for $ (i.e., dealer will buy £1,000,000 for $1,448,200).

Ask: Dealer sells £ for $ at the Ask, Client buys £ with $ (i.e., dealer will sell £1,000,000 for $1,448,400).

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Bid – Ask Spread

Banks act as market makers and realise their profits from the spread:

Bid-Ask Spread = (Ask-Bid)/Ask

Consider the DIRECT quote of $ 1.4482 – 1.4484/£

%38.1100

4484.1

4482.14484.1%

spread

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Forward Quotes

Forward rates can be quoted as either as an outright quote, points or as an annualised % forward premium or discount.

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Forward Quotes – Points

A forward quotation expressed in points is not a foreign exchange rate as such. It is the difference between the forward rate and the spot rate.

When the Bid Points > Ask Points, you subtract the points from the spot rate to get the outright forward quote.

If the Bid Points < Ask Points, you add the points to the spot rate to get the outright forward quote

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For quotations expressed in foreign currency terms (Indirect quotations) the formula becomes:

f ¥ = Spot – Forward 360

For quotations expressed in home currency terms (Direct quotations) the formula becomes:

f ¥ = Forward – Spot 360

100nForward xx

100n Spot xx

Forward Quotes – Percentage

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Cross Rates

Many currency pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency.

For example, an Australian importer needs Danish currency to pay for purchases in Copenhagen.

The Australian dollar (symbol A$) is not widely quoted against the Danish kroner (symbol DKr).

However, both currencies are quoted against the U.S. dollar. Assume the following quotes:

Australian dollar A$1.5431/US$ Danish kroner DKr7.0575/US$

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Cross Rates

The Australian importer can buy one U.S. dollar for A$1.5431 and with that dollar buy DKr7.0575. The cross-rate calculation would be:

A$/DKr 0.2186US$DKr7.0575/

S$A$1.5431/U

dollar .kroner/U.SDanish

dollar .dollar/U.S Australian

However, calculating cross-rates is usually not as easy as this!

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Cross Rates – Example

We have the following rates:

US$1.4419 – 36 / GBP

US$0.6250 – 67 / CHF

Calculate the CHF / GBP rate!

= CHF 2.3008 – 98 / GBP.

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Cross Rates – Example

First: How do I get CHF/GBP from the two rates?CHF/GBP = (US$/GBP)/(US$/CHF)

Second: Bid = go from bottom (GBP) to top (CHF) (use GBP to buy US$, then US$ to buy CHF)

Third: Ask = go from top (CHF) to bottom (GBP) (use CHF to buy US$, then US$ to buy GBP)

Fourth: Apply rule from part one to currency rate pairs.

Therefore, CHF 2.3008 – 98 / GBP.

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Cross Rates – Tips

As you do more cross rate questions you will start to see patterns emerging.

For example if both rates are something per USD or USD per something then you will have to divide the rates somehow and you will be matching bids with asks.

Or if the rates are in different forms (USD is in different places) then you will be multiplying and you will match bid with bid and ask with ask.

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Triangular Arbitrage

Cross rates can be used to check on opportunities for inter-market arbitrage. Suppose the following exchange rates are available:

Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025/U.S.$

Dominion Bank:Canadian dollars per U.S. $ C$1.2646/U.S.$

ABN Amro Bank: Dutch guilders per Canadian $ fl1.5214/C$

The synthetic cross rate between Dutch guilders and Canadian dollars is:

/C$fl1.5044S$C$1.2646/U

1.9025/US$fl

dollar S.dollars/U.Canadian

dollar .S.guilders/UDutch

You get more guilders from ABN Amro

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Triangular Arbitrage – Example

Divided by1.9025 fl/US$

US$525,624United States

Multiplied by 1.2646 C$/US$

C$664,704Canada

Multiplied by 1.5214 fl/C$

(Start)(End)

Netherlandsfl1,000,000fl1,011,281

Profit = fl 11,281Profit = fl 11,281

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• Measuring a change in the foreign currency for quotations expressed in home currency terms (direct):

%∆ = Ending rate – Beginning Rate

• Quotations expressed in foreign currency terms (indirect):

%∆ = Beginning Rate – Ending Rate

Beginning Rate x 100

Ending Rate x 100

Measuring a Change in the Spot Rate

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Example

The Australian dollar was quoted at A$1.8445/US$ on Aug 19, 2002, while on March 2, 2004 it was quoted at A$1.335/US$.

What is the appreciation/depreciation of the US$?

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Example

Thus, the appreciation/depreciation of the US$, relative to the A$ from t-1 to t is:

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A$1.335/$ $1.844527.6%

$1.8445t t

t tt

S S A /$R

S A /$

Thus, the U.S.$ has depreciated relative to the A$ by 27.6%

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Example

To calculate the appreciation/depreciation of the Australian dollar, relative to the US dollar, we want the denominator currency to be the A$:

At t-1: A$1.8445/US$ = US$0.5422/A$ At t: A$1.335/US$ = US$0.7491/A$

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$0.7491 $0.5422 / $38.2%

$0.5422 / $t t

t tt

S S AR

S A

Thus, the A$ has appreciated relative to the US $ by 38.2%

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$ depreciation, A$ appreciation not equal

In general, the percentage appreciation in one currency is not equal to the percentage depreciation in the other currency. Instead…

1 ________________________

1 + RA$ = (1 + RUS$)