CHAPTER 7 The Foreign Exchange Market
CHAPTER 7 The Foreign Exchange Market. PART I. INTRODUCTION I. INTRODUCTION A.The Currency Market: where money denominated in one currency is bought and.
Dec 21, 2015
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CHAPTER 7
The Foreign Exchange Market
PART I. INTRODUCTION
I. INTRODUCTIONA. The Currency Market:
where money denominated in one currency is bought
and sold with money denominated in
another currency.
INTRODUCTION
B. International Trade and Capital Transactions:
facilitated with the ability
to transfer purchasing power
between countries
INTRODUCTION
C. Location1. OTC-type: no specific
location2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide Interbank Financial Telecommunications
PART II.ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
A. Participants at 2 Levels1. Wholesale Level (95%)
- major banks2. Retail Level
- business customers
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Two Types of Currency Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business day
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
2. Forward Market:- transactions take place at a
specified future date
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
C. Participants by Market1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial and central banks
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
2. Forward Marketa. arbitrageurs
b. traders
c. hedgers
d. speculators
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
II. CLEARING SYSTEMSA. Clearing House Interbank
Payments System (CHIPS)
- used in U.S. for electronic
fund transfers.
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic transfers
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
III. ELECTRONIC TRADINGA. Automated Trading
- genuine screen-based market
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 FOREIGN EXCHANGE MARKET
IV. SIZE OF THE MARKET
A. Largest in the world
2004: US$1.9 trillion daily
or
US$475 trillion a year
In 1999 the US GDP was US$9.1
trillion
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Market Centers (2004): #1: London = $753 billion daily
#2: New York= $461 billion daily
#3: Tokyo = $199 billion daily
PART III.THE SPOT MARKET
I. SPOT QUOTATIONSA. Sources
1. All major newspapers2. Major currencies have
four different quotes:a. spot priceb. 30-dayc. 90-dayd. 180-day
THE SPOT MARKET
B. Method of Quotation1. For interbank dollar
trades:
a. American terms
example: $1.21/€
b. European terms
example: Peso1.713/$
THE SPOT MARKET
2. For nonbank customers:
Direct quote gives the home
currency price (always in the numerator) of
one unit of foreign currency.
EXAMPLE: $1.81/£
Since this is a direct quote, we know that
in the U.S., one pound transacted at $1.81.
THE SPOT MARKET
C. Transactions Costs1. Bid-Ask Spread
used to calculate the feecharged by the bank
Bid = the price at which the bank is willing to buy
Ask = the price it will sellthe currency
THE SPOT MARKET
4. Percent Spread Formula (PS):
100xAsk
BidAskPS
THE SPOT MARKET
D. Cross Rates
1. The exchange rate
between 2 non - US$
currencies.
THE SPOT MARKET
2. Calculating Cross RatesSuppose you want to calculate the £/€
cross rate.
You know £.5556/US$ and €.8334/US$then
£/ € = £.5556/US$ €.8334/US$
= £.6667/ €
THE SPOT MARKET
E. Currency Arbitrage1. If cross rates differ from one financial center to another, and profit opportunities exist.
2. Buy cheap in one int’l market,sell at a higher price in
another
3. The Critical Role of Available Information
THE SPOT MARKET
F. Settlement Date Value Date:
1. Date monies are due
2. 2nd Working day after date of original transaction.
THE SPOT MARKETG. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty about future exchange rate requires1.) Demand for higher risk
premium2.) Bankers widen bid-ask
spread
MECHANICS OF SPOT TRANSACTIONS
SPOT TRANSACTIONS: ExampleStep 1. Currency transaction:
verbal agreement, U.S. importer specifies:
a. Account to debit (his acct)b. Account to credit (exporter)
MECHANICS OF SPOT TRANSACTIONS
Step 2. Bank sends importer
contract note including:- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.
MECHANICS OF SPOT TRANSACTIONS
Step 3. SettlementCorrespondent bank in HongKong transfers HK$ fromnostro account to exporter’s.
Value Date.
U.S. bank debits importer’saccount.
PART IV.THE FORWARD MARKET
I. INTRODUCTIONA. Definition of a Forward Contract:
an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.
THE FORWARD MARKET
2. Purpose of a Forward:
Hedgingthe act of reducing exchange
rate risk.
THE FORWARD MARKET
B. Forward Rate Quotations1. Two Methods:
a. Outright Rate: quoted to commercial customers.
b. Swap Rate: quoted in the
interbank market as a discount or premium.
THE FORWARD MARKET
CALCULATING THE FORWARDPREMIUM OR DISCOUNT
= F-S x 12 x 100 S n
where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the
forward contract
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