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The Foreign Exchange Market

The Foreign Exchange Market. Description Functions Market Participants Types of Transactions Foreign Exchange Rates and Quotations Direct vs Indirect European vs American Bid and Ask quotations Cross- Rates Inter-Market (Triangular) Arbitrage Forward Quotations Currency Futures.

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The Foreign Exchange Market

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  1. The Foreign Exchange Market • Description • Functions • Market Participants • Types of Transactions • Foreign Exchange Rates and Quotations • Direct vs Indirect • European vs American • Bid and Ask quotations • Cross- Rates • Inter-Market (Triangular) Arbitrage • Forward Quotations • Currency Futures

  2. The Foreign Exchange Market cont’d • The Foreign Exchange Markets: • Currency traded, exchange rates determined; and exchange rate risk management implemented • consists of the currency spot, forward, futures and options markets • Types of Transactons • Spot Transactions • trade in cash today with delivery in two business days • Forward Transactions • trade at a pre-specified price and on a pre-specified future date • Swap Transactions • Simultaneous purchase and sale of an amount of currency at different delivery dates • e.g. “spot against forward” • Options Transactions • trade of rights (not obligations) to buy or sell a currency at a pre-specified price on a pre-specified future date (during a pre-specified period) • Volume • volume in April 1998 averaged $1.5 trillion per day • about 75% in the interbank market

  3. The Foreign Exchange Market cont’d • Operational efficiency • small retail transactions can be expensive • large interbank transactions have very low costs Aside: Alternative Forms of Market Efficiency • Informational efficiency: • prices reflect all relevant information • Operational efficiency: • market frictions have little influence • Allocational efficiency: • market channels capital toward its most productive uses

  4. The Foreign Exchange Market cont’d Major foreign exchange trading centers(Average daily volume during April of 1989, 1992, 1995, and 1998) Source: Bank for International Settlements triennial survey of central banks

  5. The Foreign Exchange Market cont’d • Functions: • Transfer of purchasing power • Provision of Credit • Minimizing Foreign Exchange Risk • Participants Interbank (wholesale) Market Foreign Exchange Market Client (Retail) Market • Foreign Exchange Dealers (Bank &Non-bank) • act as “Market Makers” • Profit in form of “spread” between bid and ask • Individuals and Firms Conducting Transactions • Use for “Hedging” risk • Speculators and Arbitrageurs • Central Banks • Foreign Exchange Brokers

  6. The Foreign Exchange Market cont’d Foreign Exchange Rates and Quotations • Exchange Rate - price of one currency in terms of another • Exchange Rate Conventions • Direct vs Indirect Quotations • Direct Quote: Local currency price of a foreign currency • e.g. $ 0.5784 / Guilder • Indirect Quote: Price in foreign currency of one unit of local currency • e.g. Guilders 1.729 /$ • reciprocal of direct quote • European vs American Terms • European Terms: Foreign currency price of a $ • e.g. DM 1.5417 / $ (direct quote of dollar) • American Terms: $ price of one unit of foreign Currency • e.g. $0.6486 / DM • (indirect quote of dollar)

  7. The Foreign Exchange Market cont’d • Bid vs Offer (Ask) Quotations • Bid: rate at which dealer is willing to buy • Ask: rate at which dealer is willing to sell • bid for one currency is an offer (ask) for opposite currency • Measuring Changes in Spot Rates • Direct Quote e.g FF - last month (S0d/f $0.20 /FF FF - current quote (S1d/f $0.186/FF ==> ($0.186 - $0.20)/ $0.20 X 100 = - 7% • Indirect Quote e.g. FF - last month (S0f/d FF 5/$ ==> (5 - 4)/4 X 100 = +25% FF - current quote (S1f/d FF 4/$

  8. The Foreign Exchange Market cont’d Alternatively, express the exchange rate as a direct quote of the foreign currency Percentage change in the value of a foreign currency = (S1d/f - S0d/f ) / S0d/f An example: S0FF/$ = FF5/$ Û S0$/FF = $0.20/FF S1FF/$ = FF4/$ Û S1$/FF = $0.25/FF Percentage change in the franc = (S1$/FF-S0$/FF ) / S0$/FF = ($0.25/FF-$0.20/FF)/($0.20/FF) = +25% Percentage change in the dollar = (S1FF/$-S0FF/$ ) / S0FF/$ = (FF4/$-FF5/$)/(FF5/$) = -20%

  9. The Foreign Exchange Market cont’d • Cross Rates: Exchange rates between two currencies determined through their relationship to a third currency. • Low liquidity • Check for internal consistency of rates among markets Example: Australian $ A$ 1.3450/US $ Danish Krone DK 6.0913/US $ Cross Rate (A$/DK) = (A$ 1.3450/ US $)/ (DK 6.0913/ US $) = A$ 0.2208/DK • Inter market (Triangular) Arbitrage Divergence of published quotes from cross rates imply existence of an arbitrage opportunity Example 1:Dutch Guilders per US $ fl 1.9025/US $ Canadian Dollars per US $ C$ 1.2646/US $ Dutch Guilders per C $ fl 1.5214/ C$ Cross rate (fl/ C$) = fl 1.9025 /C$ 1.2646 = fl 1.5044/C$ => An investor with Dutch Guilders can profit by buying C$ at the implied cross rate and selling C$ at the actual rate.

  10. The Foreign Exchange Market cont’d

  11. The Foreign Exchange Market cont’d Example 2: US $ quote for C$ US $ 0.85/C$ US $ quote for German Mark US $ 0.60/DM DM quote for C$ DM 1.43/C$ Investor has US $ 1,000,000 Step 1. See if there is an arbitrage opportunity Cross rate (DM/C$) = $0.85 /$ 0.60 = DM 1.417 / C$ => ignoring transaction costs, there exists an arbitrage opportunity Step 2. Strategy: BUY LOW, SELL HIGH (depends on which currency you start with) Buy C$ @ DM 1.417/C$ which involves - Sell DM @ $0.60/DM - Buy C$ @ $ 0.85/C$ Sell C$ @ DM 1.43/C$ (same as buy DM @ DM 1.43/C$) a. Start with US$ 1,000,000 b. Buy C$: US$1,000,000/ US$ 0.85 = C$ 1,176,471 c. With C$, buy DM: C$1,176,471 X DM 1.43/C$ = DM 1,682,353 d. With DM, buy US $ : DM 1,682,353 X US $ 0.60/DM = US $ 1,009,412 e. Profit = US$ 1,009,412 - US $ 1,000,000 = US $ 9,412

  12. The Foreign Exchange Market cont’d • Forward Quotations • “outright Quotations” : full price to all decimal places • Point Quotations: Deviations of forward rates from spot rates • Forward premium • nominal value in the forward exchange market is higher than in the spot exchange market • Forward discount • nominal value in the forward exchange market is lower than in the spot exchange market Example (DM/$) ($/DM) Outright Quotes Bid Ask Bid Ask Spot rate 1.8215 1.8225 ___ 30 day forward 1.8157 1.8169 90 day forward 1.8040 1.8056 Point Quotes: 30 day forward 58 - 56 17 - 18 90 day forward 175 - 169 51 - 53 ** Point Quotes as ‘swap rates” - They represent net differential in national interest rates

  13. The Foreign Exchange Market cont’d • Forward Quotations in % age terms • with direct quotes: Forward premium (discount) = (Forward (F1) - Spot (S0))/ Spot X 100 • with indirect quote Forward premium (discount) = (Spot (S0) - Forward (F1))/ Forward X 100 Example: Suppose S0$/FF = $0.20/FF and F1$/FF = $0.25/FF Franc forward premium = ($.25/FF-$.20/FF)/($.20/FF) = +25% so the franc is selling at a 25% forward premium. Alternatively, S0FF/$ = FF5.00/$ Û S0$/FF = $0.20/FF F1FF/$ = FF4.00/$ Û F1$/FF = $0.25/FF Dollar forward premium = (FF4/$-FF5/$)/(FF5/$) = -20% so the dollar is selling at a 20% forward discount.

  14. Foreign Currency Futures • An exchange traded contract for delivery of a standard amount of foreign currency at a fixed time, place and price. • Forward contracts and default risk • Forward contracts are a pure credit instrument; one party always has an incentive to default. • The futures contract solution • An exchange clearinghouse takes one side of every transaction • Futures contracts are marked-to-market on a daily basis • Initial and maintenance margins are required on futures contracts

  15. Foreign Currency Futures Financial futures exchanges • The International Monetary Market (IMM) (a subsidiary of the Chicago Mercantile Exchange) • The Philadelphia Board of Trade (PBOT) (a subsidiary of the Philadelphia Stock Exchange) • The Bolsa Mercadorias & de Futuros (BM&F) in Brazil • The London International Financial Futures Exchange (LIFFE) • The Marché à Terme des Instruments Financiers (MATIF) • The Singapore International Monetary Exchange (SIMEX) • The Tokyo International Financial Futures Exchange (TIFFE) (a subsidiary of the Tokyo Stock Exchange)

  16. Foreign Currency Futures • A comparison of currency forward and CME futures contracts ForwardsFutures Location Interbank Exchange floor Maturity Negotiated 3rd week of the month Amount Negotiated Standard contract (e.g. ¥12,500,000 ) Fees Bid-ask Commissions (e.g. $30 per contract) Counterparty Bank CME Clearinghouse Collateral Negotiated Margin account Settlement At maturity Most are settled early Trading hours 24 hours During exchange hours

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