Chapter 06

1

Chapter 06

The Foreign Exchange Market

2

The Foreign Exchange Market• Characteristics of the FOREX market• Geographic extent of the foreign exchange (FOREX) market• Functions of the FOREX market• Market participants• Foreign exchange transactions – spot, forward, and swaps • Review of currency quotations used by currency dealers,

financial institutions, and agents• Cross exchange rates and opportunities arising from inter-

market arbitrage

3

Characteristics of the FOREX Market

• The FOREX market provides the physical and institutional structure through which currencies are exchanged

• A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate

4

Geographic Extent of the Market

• Geographically, the FOREX market spans the globe with prices moving and currencies trading on a 24 hour basis

• Major exchanges are located in Singapore, Hong Kong, and Tokyo in the East

• Then it moves to Bahrain, and London for the European area

• And on to New York, San Francisco, and Sydney

5

Geographic Extent of the Market

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Greenwich Mean Time

Tokyoopens

Asiaclosing

10 AMIn Tokyo

Afternoonin America

Londonclosing

6 pmIn NY

Americasopen

Europeopening

LunchIn Tokyo

Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.

6

Functions of the FOREX Market

• The FOREX market functions to transfer purchasing power between countries, obtain or provide credit for international trade, and manage the exchange rate risk– Transferring purchasing power – allow trade partners to

convert foreign currency revenues into their own currency– Credit for trade – the movement of goods between

countries takes time which requires financing for products in transit (letters of credit)

– Managing FX exposure – the FOREX market provides “hedging” instruments to transfer exchange rate risk to someone else who is more willing to take that risk

7

Market Participants

• The FOREX market has two parts, the interbank or wholesale market, and the client or retail market– Five broad categories of participants operate

within these two parts– Bank and non-bank foreign exchange dealers– Individuals and firms– Speculators and arbitragers– Central banks and treasuries

8

Market Participants:Bank and Non-bank Dealers

• These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price

• Competition among dealers narrows the spread between the bid and offer rate contributing to the market’s efficiency – lower the spread lower the costs of trading

• Dealers at large international banks often act as market makers – willing to buy or sell these currencies without having a counterpart with which to unload the “inventory”

• Dealers trade to keep their inventory levels at manageable levels providing liquidity

• Currency trading is profitable and often contributes between 10% – 20% of a banks’ average net income

9

Market Participants:Individuals and Firms Conducting

Commercial/Investment Transactions• Importers, exporters, portfolio investors,

MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions

• Some of these participants use the market to hedge foreign exchange rate risk

10

Market Participants:Speculators and Arbitragers

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

• They operate for their own interest• Speculators seek all their profit from favorable

exchange rate changes• Arbitragers try to profit from simultaneous differences

in exchange rates in different markets – without risk• A large proportion of speculation and arbitrage is

executed by traders employed by large banks

11

Market Participants:Central Banks and Treasuries

• Central banks and treasuries use FOREX to influence the value of their own currency – this is the mechanism in which reserves balances are placed at work

• Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests

12

Transactions in the Interbank Market

• Transactions in FOREX: spot, forward, and swap– A spot transaction requires almost immediate

delivery of foreign exchange– A forward transaction requires delivery of foreign

exchange at some future date– A swap transaction is the simultaneous exchange

of one foreign currency for another

13

Transactions in the Interbank Market

• A spot transaction in the interbank market is the purchase of foreign exchange with delivery and payment between banks to take place on the second following business day– The settlement date is often referred to as the

value date– This is the date when most dollar transactions are

settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York

14

Transactions in the Interbank Market

• Outright forward transaction requires delivery at a future value date of a specified amount of one currency for another

• The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed

• Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months– A contract to deliver dollars for euros in six months is

both buying euros forward for dollars and selling dollars forward for euros

15

Transactions in the Interbank Market

• 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 counter party

• A common type of swap is a spot against forward– The dealer buys a currency in the spot market and

simultaneously sells the same amount back to the same bank in the forward market. Why a dealer would do this?

– The dealer incurs no exchange rate exposure

16

Transactions in the Interbank Market

• Forward-forward swaps – A dealer sells £20,000 forward for dollars for delivery in two months at $1.6400/£ and simultaneously buys £20,000 forward for delivery in three months at $1.6350/£– The dealer’s motive is to take advantage of the interest rate differentials

• Non-deliverable forwards (NDFs) – NDFs have the same characteristics as traditional forward contracts except that they are settled only in US dollars at maturity (dollars change hands, the amount is determined by the difference between agreed upon forward rate and actual spot rate at maturity)– The dollar-settlement feature reflects the fact that NDFs are contracted

offshore and are beyond the reach and regulatory frameworks of the home country governments

– Pricing of NDFs reflects basic interest rate differentials

17

Size of the FOREX Market• Global Foreign Exchange Market Turnover, 1989-2007 (daily averages in April,

billions of US$)

18

Size of the FOREX Market• Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1992–2007

(daily averages in April, billions of U.S. dollars)

19

Size of the FOREX Market• Foreign Exchange Market Turnover by Currency Pair (Daily averages in April)

20

Foreign Exchange Rates & Quotations

• A foreign exchange quote is a statement of willingness to buy or sell at an announced rate– In the retail market (newspapers and exchange booths),

quotes are often given as the home currency price of the foreign currency

• Interbank quotes – professionals state forex quotes in one of two ways– The foreign currency price of one dollar (European Quote)

• Sfr1.6000/$, read as 1.600 Swiss francs per dollar– The dollar price of a unit of foreign currency (American Quote)

• $0.6250/Sfr, read as 0.6250 dollars per Swiss franc

21

Foreign Exchange Rates & Quotations

• Direct and Indirect Quotes– A direct quote is a home currency price of a unit

of a foreign currency• Sfr1.6000/$ is a direct quote in Switzerland

– An indirect quote is a foreign currency price of a unit of the home currency• Sfr1.6000/$ is an indirect quote in the US, • $0.6250/Sfr is a direct quote in the US and an indirect

quote in Switzerland

22

Foreign Exchange Rates & Quotations• AUD/USD bid quote should be read as 1 AUD is 0.7740 USD ($0.7740/AUD)• In the FX markets, the US Dollar is normally considered to be the “base” currency (the

currency in which an investor or issuer maintains its book of accounts) for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair (European). The primary exceptions to this rule are the British Pound, the Euro and the Australian Dollar (American) (indicated by *)

• Rates USD/CHF show the number of Swiss franks to be paid for one US dollar, but rates GBP/USD show the number of US dollars having to be paid for one British pound

Major Rates Bid AskAUD/USD* 0.7740 0.7745USD/CAD 1.3002 1.3007USD/CHF 1.2366 1.2371

EUR/USD* 1.2668 1.2673GBP/USD* 1.8296 1.8301USD/HKD 7.7620 7.7642USD/JPY 106.88 106.93

Bid Ask Bid Ask1.2366 1.2371 0.80834 0.80867

0.0005 0.00033Note: Ask is always higher.

CHF (Confederation Helvetica Franc) is Swiss FrancCHF Price of one Dollar a

Dealer is willing to Buy (Bid) and Sell (Ask)

Dollar Price of one CHF a Delar is willing to Buy

(Bid) and Sell (Ask)

Bid/Ask Spread Bid/Ask Spread

23

Foreign Exchange Rates & Quotations

• Expressing Forward Quotations on a Points Basis– The previously mentioned rates for yen were considered

outright quotes– Forward quotes are different and typically quoted in

terms of points– A point is the last digit of a quotation, with convention

dictating the number of digits to the right of the decimal• Hence a point is equal to 0.0001 for most currencies =>

point(s) / 10,000 will convert points into decimal form• For Japanese Yen one point is 0.01 => point(s) / 100 will

convert points into decimal form

24

Foreign Exchange Rates & Quotations• Expressing Forward Quotations on a Points Basis

– A forward quotation on a point basis is not a foreign exchange rate, rather the difference between the spot and forward rates

– Example: Bid = 106.91Ask = 106.96

Period Bid Ask1 Month -13 -82 Month -23 -183 Month -34 -276 Month -66 -58

12 Month -152 -1312 Year -420 -370

Forward Points

Spot Rate

Bid = 106.91 Ask = 106.96

Period Bid Ask Period Bid Ask1 Month -0.13 -0.08 1 Month 106.78 106.882 Month -0.23 -0.18 2 Month 106.68 106.783 Month -0.34 -0.27 3 Month 106.57 106.696 Month -0.66 -0.58 6 Month 106.25 106.38

12 Month -1.52 -1.31 12 Month 105.39 105.652 Year -4.20 -3.70 2 Year 102.71 103.26

Forward Points in Decimals Outright Forward Rates

Spot Rate USD/JPY = 106.91/106.96

25

Foreign Exchange Rates & Quotations

• Forward Quotations in Percentage Terms– Forward quotations may also be expressed as the percent-

per-annum deviation from the spot rate– The important thing to remember is which currency is

being used as the home or base currency• For direct quotes (i.e. quote expressed in home currency terms),

the formula is

• For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is

100360 x days

x Spot

SpotForward - f $/FC

100360 x days

x Forward

wardSpot - For f FC/$

26

Foreign Exchange Rates & Quotations

• Cross Rates– Many currencies pairs are inactively traded, so their

exchange rate is determined through their relationship to a widely traded third currency

– Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and Japanese yen (¥) are quoted in US dollars• Assume the following quotes: • Japanese yen ¥121.13/$ and Mexican peso Ps9.190/$• The Mexican importer can buy one US dollar for Ps9.190 and

with that dollar buy ¥121.13; the cross rate would bes¥13.1806/P

Ps9.190/$¥121.13/$

dollar US / pesos Mexicandollar US / yen Japanese

==

27

Cross Currency Arbitrage• Intermarket Arbitrage

– Cross rates can be used to check on opportunities for intermarket arbitrage

– Example: Assume the following exchange rates are quoted• Citibank $0.9045/€• Barclays Bank $1.4443/£• Dresdner Bank€1.6200/£• The cross rate between Citibank and Barclays is

• This cross rate is not the same as Dresdner’s rate quote of €1.6200/£, so an opportunity exists for risk-less profit

• What is the cross rate between Citibank and Dresdner?

Eurofor Dresdner to£ Sell£/5968.1/9045.0$

£/4443.1$ Euro

Euro

£for Barclays to$ Sell$1.4653/££/6200.1/9045.0$ EuroEuro

28

Cross Currency Arbitrage

• Intermarket Arbitrage– Citibank $0.9045/€– Barclays Bank $1.4443/£– Dresdner Bank €1.6200/£

• What is the cross rate between Barclays and Dresdner?

• If you have $ at the start then the order of currency conversions (locations) is:• $ => £ (Barclays) => € (Dresdner) => $ (Citibank)

$for Citibank to Sell/8915.0$£/6200.1

£/4443.1$ EuroEuroEuro

29

Cross Currency ArbitrageCitibank

Dresdner Bank Barclays Bank

End with $1,014,533 Start with $1,000,000

(3) Sell £692,377 to Dresdner Bank at €1.6200/£(4) Receive €1,121,651

(1) Sell $1,000,000 to Barclays Bank at $1.4443/£

(2) Receive £692,377(5) Sell €1,121,651 to Citibank at $0.9045/€

(6) Receive $1,014,533

30

Foreign Exchange Rates & Quotations

• Direct and Indirect Quotes• A direct quote is a home currency price of a

unit of a foreign currency– Sfr1.6000/$ is a direct quote in Switzerland

• An indirect quote is a foreign currency price of a unit of the home currency– Sfr1.6000/$ is an indirect quote in the US, – $0.6250/Sfr is a direct quote in the US and an

indirect quote in Switzerland

31

Measuring a Change in Spot Rates• Assume that Swiss franc is quoted at Sfr1.6000/$ (same as

$0.6250/Sfr). Suddenly it strengthens to Sfr1.2800/$ (same as $0.78125/$). What is the percentage change in the dollar value of the franc? (Home currency is dollar)

• Using Direct Quotes:

• Using Indirect Quotes:

%=+x/Sfr.$

/Sfr.Sfr-$.$xRateBeginning

g Ratee-BeginninEnding Rat%ΔDQ 2510062500

62500781250100

FC/$

FC/$FC/$

S-SS

1

12

%=+x/$.Sfr

/$./$-Sfr.SfrxeEnding Rat

g RateRate-EndinBeginning %ΔIQ 2510028001

2800160001100

$/FC

$/FC$/FC

S-SS

2

21

SAME