Page 1
INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICKSecond Edition
4Chapter Four
The Market for
Foreign Exchange
Chapter Objectives:
•This chapter serves to introduce the student to the
institutional framework within which exchange rates
are determined.
•This chapter lays the foundation for much of the
discussion throughout the remainder of the text, thus
it deserves your careful attention.
Page 2
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-1
Chapter Outline
� Function and Structure of the FOREX Market
� The Spot Market
� The Forward Market
Page 3
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-2
Chapter Outline
� Function and Structure of the FOREX Market
� FX Market Participants
� Correspondent Banking Relationships
� The Spot Market
� The Forward Market
Page 4
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-3
Chapter Outline
� Function and Structure of the FOREX Market
� The Spot Market
� Spot Rate Quotations
� The Bid-Ask Spread
� Spot FX Trading
� Cross Exchange Rate Quotations
� Triangular Arbitrage
� Spot Foreign Exchange Market Microstructure
� The Forward Market
Page 5
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-4
Chapter Outline
� Function and Structure of the FOREX Market
� The Spot Market
� The Forward Market
� Forward Rate Quotations
� Long and Short Forward Positions
� Forward Cross-Exchange Rates
� Swap Transactions
� Forward Premium
Page 6
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-5
The Function and Structure of the
FOREX Market
� FOREX Market Participants
� Correspondent Banking Relationships
Page 7
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-6
FOREX Market Participants
� The FOREX market is a two-tiered market:� Interbank Market (Wholesale)
�About 700 banks worldwide stand ready to make a market in Foreign exchange.
�Nonbank dealers account for about 20% of the market.
�There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.
� Client Market (Retail)
� Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.
Page 8
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-7
Correspondent Banking Relationships
� Large commercial banks maintain demand deposit
accounts with one another which facilitates the efficient
functioning of the forex market.
� International commercial banks communicate with one
another with:
� SWIFT: The Society for Worldwide Interbank Financial
Telecommunications.
� CHIPS: Clearing House Interbank Payments System
� ECHO Exchange Clearing House Limited, the first global
clearinghouse for settling interbank FOREX transactions.
Page 9
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-8
The Spot Market
� Spot Rate Quotations
� The Bid-Ask Spread
� Spot FX trading
� Cross Rates
Page 10
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-9
Spot Rate Quotations
� Direct quotation
� the U.S. dollar equivalent
� e.g. “a Japanese Yen is worth about a penny”
� Indirect Quotation
� the price of a U.S. dollar in the foreign currency
� e.g. “you get 100 yen to the dollar”.
Page 11
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-10
Spot Rate Quotations
The direct
quote for
British
pound is:
£1 = $1.688
Page 12
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-11
Spot Rate Quotations
The indirect
quote for
British
pound is:
£.5924 = $1
Page 13
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-12
Spot Rate Quotations
Note that
the direct
quote is the
reciprocal of
the indirect
quote:
Page 14
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-13
The Bid-Ask Spread
� The bid price is the price a dealer is willing to pay
you for something.
� The ask price is the amount the dealer wants you
to pay for the thing.
� The bid-ask spread is the difference between the
bid and ask prices.
Page 15
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-14
Spot FX trading
� In the interbank market, the standard size trade is
about U.S. $10 million.
� A bank trading room is a noisy, active place.
� The stakes are high.
� The “long term” is about 10 minutes.
Page 16
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-15
Cross Rates
� Suppose that S($/DM) = .50
� i.e. $1 = 2 DM
� and that S(¥/DM) = 50
� i.e. DM1 = ¥50
� What must the $/¥ cross rate be?
Page 17
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-16
Triangular Arbitrage
$
£¥
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
Suppose we
observe these
banks posting
these exchange
rates.
First calculate the
implied cross
rates to see if an
arbitrage exists.
Page 18
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-17
Triangular Arbitrage
$
£¥
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
The implied S(¥/£) cross
rate is S(¥/£) = 80
Credit Agricole has
posted a quote of S(¥/£)=85 so there is an
arbitrage opportunity.
So, how can we make money?
Page 19
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-18
Triangular Arbitrage
$
£¥
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
As easy as 1 – 2 – 3:
1. Sell our $ for £,
2. Sell our £ for ¥,
3. Sell those ¥ for $.
Page 20
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-19
Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
Page 21
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-20
Spot Foreign Exchange Microstructure
� Market Microstructure refers to the mechanics of
how a marketplace operates.
� Bid-Ask spreads in the spot FX market:
� increase with FX exchange rate volatility and
� decrease with dealer competition.
� Private information is an important determinant of
spot exchange rates.
Page 22
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-21
The Forward Market
� Forward Rate Quotations
� Long and Short Forward Positions
� Forward Cross Exchange Rates
� Swap Transactions
� Forward Premium
Page 23
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-22
The Forward Market
� A forward contract is an agreement to buy or sell
an asset in the future at prices agreed upon today.
� If you have ever had to order an out-of-stock
textbook, then you have entered into a forward
contract.
Page 24
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-23
Forward Rate Quotations
� The forward market for FOREX involves
agreements to buy and sell foreign currencies in
the future at prices agreed upon today.
� Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
� Longer-term swaps are available.
Page 25
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-24
Forward Rate Quotations
� Consider the example from above:
for Japanese yen, the spot rate is
¥115.75 = $1.00
While the 180-day forward rate is
£112.80 = $1.00
� What’s up with that?
Page 26
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-25
Spot Rate Quotations
Clearly the
market
participants
expect that
the yen will
be worth
MORE in
dollars in
six months.
Page 27
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-26
Long and Short Forward Positions
� If you have agreed to sell anything (spot or
forward), you are “short”.
� If you have agreed to buy anything (forward or
spot), you are “long”.
� If you have agreed to sell forex forward, you are
short.
� If you have agreed to buy forex forward, you are
long.
Page 28
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-27
Payoff Profiles
0S180($/¥)
F180($/¥) = .009524
Short positionloss
profitIf you agree to sell anything in the
future at a set price and the spot
price later falls then you gain.
If you agree to sell anything in the
future at a set price and the spot
price later rises then you lose.
Page 29
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-28
Payoff Profiles
loss
0 S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
profit
Whether the
payoff profile
slopes up or
down depends
upon whether
you use the direct
or indirect quote:
F180(¥/$) = 105 or
F180($/¥) = .009524.
short position
Page 30
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-29
Payoff Profiles
loss
0S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
When the short entered into this forward contract,
he agreed to sell ¥ in 180 days at F180(¥/$) = 105
profitshort position
Page 31
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-30
Payoff Profiles
loss
0S180(¥/$)
F180(¥/$) = 105
-F180(¥/$)
120
If, in 180 days, S180(¥/$) = 120, the short will make
a profit by buying ¥ at S180(¥/$) = 120 and
delivering ¥ at F180(¥/$) = 105.
15¥
profitshort position
Page 32
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-31
Payoff Profiles
loss
0S180(¥/$)
F180(¥/$) = 105
Long position-F180(¥/$)
F180(¥/$) short positionprofit
Since this is a zero-sum game, the
long position payoff is the
opposite of the short.
Page 33
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-32
Payoff Profiles
loss
0S180(¥/$)
F180(¥/$) = 105
Long position
-F180(¥/$)
profitThe long in this forward contract agreed to BUY ¥
in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at S180(¥/$) = 120 and
delivering ¥ at F180(¥/$) = 105.
120
–15¥
Page 34
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-33
Forward Cross Exchange Rates
� It’s just an “delayed” example of the spot cross
rate discussed above.
� In generic terms
Page 35
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-34
SWAPS
� A swap is an agreement to provide a counterparty
with something he wants in exchange for
something that you want.
� Swap transactions account for approximately 51
percent of interbank FX trading, whereas outright
trades are less than 9 percent.
Page 36
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-35
Comparative Advantage
as the Basis for Swaps
Consider two firms A and B: firm A is a U.S.–based
multinational and firm B is a U.K.–based
multinational.
Both firms wish to finance a project in each other’s
country of the same size. Their borrowing
opportunities are given in the table below.
Page 37
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-36
A is the more credit-worthy of the two firms.
A pays 2% less to borrow in dollars than B and A
pays .4% less to borrow in pounds than B:
Comparative Advantage
as the Basis for Swaps
A has a comparative advantage in borrowing in dollars
B has a comparative advantage in borrowing in pounds.
Page 38
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-37
One Feasible Swap:
Company
A
Swap
Bank
$8% £12%
$8%
£11%£12%
$9.4%
Company
B
Page 39
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-38
$8% £12%
$8%
£11%£12%
$9.4%
A’s net position is to
borrow at £11%
One Feasible Swap:
Company
A
Swap
Bank
Company
B
Page 40
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-39
$8% £12%
$8%
£11%£12%
$9.4%
B’s net position is to
borrow at $9.4%
One Feasible Swap:
Company
A
Swap
Bank
Company
B
Page 41
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-40
$8% £12%
$8%
£11%£12%
$9.4%
One Feasible Swap:
Company
A
Swap
Bank
Company
B
A saves £.6%
Page 42
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-41
$8% £12%
$8%
£11%£12%
$9.4%
B saves $.6%
One Feasible Swap:
Company
A
Swap
Bank
Company
B
A saves £.6%
Page 43
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-42
$8% £12%
$8%
£11%£12%
$9.4%
B saves $.6%
One Feasible Swap:
Company
A
Swap
Bank
Company
B
A saves £.6%
The swap bank
makes money too.
Page 44
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-43
SWAPS
� A swap can be viewed as a portfolio of spot and
forward positions.
� In the above example, firm A would borrow in
dollars and then swap for pounds with the bank
and simultaneously enter into a series of forward
contracts with the bank to exchange dollars for
pounds.
Page 45
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-44
Forward Premium
� It’s just the interest rate differential implied by
forward premium or discount.
� For example, exhibit 4.4 shows the DM
appreciating from S($/DM) = .5235 to
F180($/DM) = .5307
� The forward premium is given by:
Page 46
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights
reserved. 4-45
End Chapter Four