the foreign exchange market
Download
Skip this Video
Download Presentation
The Foreign Exchange Market

Loading in 2 Seconds...

play fullscreen
1 / 31

Session 2 - PowerPoint PPT Presentation


  • 596 Views
  • Uploaded on

The Foreign Exchange Market 2 Outline Function and structure of the FX market The spot market Quotations Cross-rates Triangular Arbitrage Currency forecasting The foreign exchange market Why do we need foreign currency? Import/Export demand and supply

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Session 2' - johana


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
the foreign exchange market

The Foreign Exchange Market

2

Outline

Function and structure of the FX market

The spot marketQuotationsCross-rates

Triangular Arbitrage

Currency forecasting

© Prof. Ingrid M. Werner, Bus-Fin 725

the foreign exchange market2
The foreign exchange market
  • Why do we need foreign currency?
    • Import/Export demand and supply
    • Foreign direct investment (physical capital)
    • Portfolio investments (financial securities)
    • “Speculation”
  • The FX market establishes the price of each (domestic) currency in terms of (other) foreign currencies
  • The FX market encompasses:
    • Conversion of purchasing power from one currency to another; bank deposits of foreign currency; credit denominated in foreign currency; foreign trade financing; trading in foreign currency options & futures, and currency swaps
  • No central market place
    • Worldwide linkage of bank currency traders, non-bank dealers, and FX brokers – like an international OTC market

© Prof. Ingrid M. Werner, Bus-Fin 725

the foreign exchange market3
The foreign exchange market
  • Largest financial market in the world
    • Daily trading is estimated to be US$1.9 trillion* (in comparison, busiest trading day on the NYSE was April 19, 1999 at U$58.5 billion)
    • Trading occurs 24 hours a day
    • The major dealing centers today are: London (with over 50% of the market), followed by New York, Tokyo, Zurich, Frankfurt, Hong Kong and Singapore, Paris and Sydney
  • Over 85% of all FX transactions involve 7 major currencies
    • US Dollar, Japanese Yen, Euro (EUR), Swiss Frank, British Pound, Canadian Dollar, and Australian Dollar
  • The US dollar is the major currency
    • All currencies are quoted against the US dollar with some regional exceptions as the yen in Asia and now the euro in Europe

*Source: As of April, 2004 (www.bis.org)

© Prof. Ingrid M. Werner, Bus-Fin 725

slide4

The foreign exchange market

  • The FX market is a two-tiered market:
    • Interbank Market (Wholesale)
      • Accounts for about 87% of FX trading volume—mostly speculative or arbitrage transactions
      • About 100-200 international banks worldwide stand ready to make a market in foreign exchange
      • Non-bank dealers account for 28% of the interbank market
      • FX brokers match buy and sell orders but do not carry inventory and FX specialists
    • Client Market (Retail)
      • Accounts for about 13% of FX trading volume
  • Market participants include international banks, their customers, non-bank dealers, FX brokers, and central banks

© Prof. Ingrid M. Werner, Bus-Fin 725

slide5

The spot market

  • The spot market involves the immediate purchase or sale of foreign exchange
    • Cash settlement occurs 1-2 days after the transaction
  • Currencies are quoted against the US dollar
  • Interbank FX traders buy currency at the bid price
  • Interbank FX traders sell currency at the ask price
  • Bid price is less than the ask price
  • Bid-ask spread is a transaction cost

© Prof. Ingrid M. Werner, Bus-Fin 725

slide6

Spot rate quotes

  • Direct quotes
    • US dollar price of 1 unit of foreign currency—$ are in the numerator (foreign currency is priced in terms of dollars)
      • $/€ = 1.1862 (1€ costs $1.1862)
      • $/£ = 1.7548 (1£ costs $1.7548)
    • Currency changes
      • Suppose that today, $/€ = 1.1862 and in 1 month, $/€ = 1.2500
        • The $ has depreciated in value
        • Alternatively, the € has appreciated in value
      • Suppose that today, $/£ = 1.7548 and in 1 month, $/£ = 1.5000
        • The $ has appreciated in value
        • Alternatively, the £ has depreciated in value

© Prof. Ingrid M. Werner, Bus-Fin 725

slide7

Spot rate quotes

  • Indirect quotes
    • Foreign currency price of $1—$ are in the denominator (US dollar is priced in terms of foreign currency)
      • €/$ = 0.8431 ($1costs €0.8431)
      • £/$ = 0.5699 ($1 costs £0.5699)
    • Currency changes
      • Suppose that today, €/$ = 0.8431 and in 1 month, €/$ = 0.8000
        • The $ has depreciated in value
        • Alternatively, the € has appreciated in value
      • Suppose that today, £/$ = 0.5699 and in 1 week, £/$ = 0.6000
        • The $ has appreciated in value
        • Alternatively, the £ has depreciated in value

© Prof. Ingrid M. Werner, Bus-Fin 725

spot rate quotes
Spot rate quotes
  • Example
    • Direct quote: in our notation, S(C$/$) = 1.1720
    • Indirect quote: in our notation, S($/C$) = 0.8533
    • Note that S($/C$) = 1/S(C$/$)
  • FX trading and information: www.oanda.com

Benchmark Currency Rates

Source: http://www.bloomberg.com/markets/currencies/fxc.html

© Prof. Ingrid M. Werner, Bus-Fin 725

slide9

Spot rate quotes

  • Conventions:
    • Denote the spot rate as S(.)
    • For most currencies, use 4 decimal places in calculations
      • With exceptions: i.e. S(¥/$)= 117.1500, but S($/¥)=0.008536
    • If we are talking about the US, always quote spot rates as the dollar price of the foreign currency
      • i.e. as direct quotes, S($/€), S($/C$), S($/£), etc
    • If we are talking about France, always quote spot rates as the euro price of the foreign currency
    • Increase in the exchange rate  the US dollar is depreciating
      • Costs more to buy 1 unit of foreign currency
    • Decrease in the exchange rate  the US dollar is appreciating
      • Costs less to buy 1 unit of foreign currency

© Prof. Ingrid M. Werner, Bus-Fin 725

spot rate quotes10
Spot rate quotes
  • Warning: Currency traders and data vendors use indirect quotes.
  • Instead of C$/$ 1.1727-1.1732, they say USD/CAD 1.1727-1.1732.
    • Think of it as US dollars “as expressed in Canadian dollars.”
  • Exceptions: AUD, EUR, GBP, and NZD…

!

Source: http://www.ozforex.com.au/cgi-bin/spotrates.asp?sBase=CAD

© Prof. Ingrid M. Werner, Bus-Fin 725

spot rate quotes example
Spot rate quotes – example
  • The exchange on December 20 was S($/€)= 1.1862. Suppose that on January 20, the exchange rate will be S(€/$)= 0.8500.
    • Has the US dollar appreciated or depreciated?
    • By what % has the exchange rate changed?
    • Hint: (S1(.)-S0(.))/S0(.)

© Prof. Ingrid M. Werner, Bus-Fin 725

bid ask spread
Bid-Ask spread
  • FX traders quote a bid-ask spread
  • In our notation: S(C$/$b) = 1.1727 and S(C$/$a) = 1.1732
    • Bid: the price at which the FX trader buy $
      • The FX trader will buy $1 for C$1.1727, i.e., trader pays you the lower price when you sell $
    • Ask: the price at which the FX trader sell $
      • The FX trader will sell $1 for C$1.1732, i.e., you pay trader the higher price when you buy $
  • Note that you (customer) receives the less favorable rate

© Prof. Ingrid M. Werner, Bus-Fin 725

bid ask spread13
Bid-Ask spread
  • Now suppose we write S($/C$) – is the bid greater than the ask? No.
    • S($/C$b) = 1/S(C$/$a) and S($/C$a) = 1/S(C$/$b)
    • S($/C$b) = 1/1.1732 = 0.8524; S($/C$a) = 1/1.1727 = 0.8527
  • S($/C$b) = 0.8524 and S($/C$a) = 0.8527
    • Bid: the price at which the FX trader buy C$
      • The FX trader will buy C$1 for $0.8525, i.e., trader pays you the lower price when you sell C$
    • Ask: the price at which the FX trader sell C$
      • The FX trader will sell C$1 for $0.8527, i.e., you pay trader the higher price when you buy C$
  • For brevity, the trader would write the quote as: 0.8524-27

© Prof. Ingrid M. Werner, Bus-Fin 725

equilibrium spot exchange rates
Equilibrium spot exchange rates
  • The exchange rate
    • The price of one nation’s currency in terms of another nation’s currency (can be spot or forward)
  • Assume
    • Free floating exchange rates
    • No market frictions
    • No government intervention
  • Given these assumptions, what determines the value of a currency?
  • Why do exchange rates change?

© Prof. Ingrid M. Werner, Bus-Fin 725

equilibrium spot exchange rates15

Value of $

£0.5800

£0.5699

£0.5600

D: Demand for $

Quantity of $

Equilibrium spot exchange rates
  • Demand for $
    • Demand for goods, services, and assets that the $ is used to purchase
    • Graph shows quantity of $ demanded at various exchange rates
    • Changes in demand for $ shift the demand curve

Increase in demand for $

© Prof. Ingrid M. Werner, Bus-Fin 725

equilibrium spot exchange rates16

Value of $

S: Supply of $

£0.5800

£0.5699

£0.5600

Quantity of $

Equilibrium spot exchange rates
  • Supply of $
    • Demand for goods, services, and assets that £ are used to purchase
    • Graph shows quantity of $ supplied at various exchange rates
    • Changes in supply of $ shift the supply curve

Increase in supply of $

© Prof. Ingrid M. Werner, Bus-Fin 725

equilibrium spot exchange rates17

Value of $

S: Supply of $

£0.5800

£0.5699

£0.5600

Quantity of $

Equilibrium spot exchange rates
  • Equilibrium exchange rate
    • The rate at which the quantity demanded is equal to the quantity supplied
    • At £0.5800, quantity of $ demanded is less than quantity supplied
    • At £0.5600, quantity of $ demanded is greater than quantity supplied

Equilibrium exchange rate

D: Demand for $

© Prof. Ingrid M. Werner, Bus-Fin 725

equilibrium spot exchange rates18
Equilibrium spot exchange rates
  • Example: A change in demand for $
    • Initial equilibrium at E
    • Increase in demand for $: New demand curve is D1
    • New equilibrium at E1: $ appreciates, S increases from 0.5699 to 0.5800 and quantity demanded is greater than QE

Value of $

S

E1

£0.5800

E

G

£0.5699

£0.5600

D1

D

Quantity of $

QE

QG

© Prof. Ingrid M. Werner, Bus-Fin 725

cross rates
Cross-rates
  • Recall: Most currencies are quoted against the $
  • Why? Think about how many quotes we would need for all possible combinations of different currencies
    • Go back to the currency table from Bloomberg
      • There are 8 currencies so the table is 8  8
      • The 8  8 table has 82 or 64 components
      • The diagonal terms refer to same market so they are either 1’s or blanks as is the case here
      • Half of the terms are redundant because refer to the same market-pair
      • There are (½)(N2 – N), or 28 different combinations of currency-pairs
      • Most of the information in table is redundant => 1 row or column generates entire table

© Prof. Ingrid M. Werner, Bus-Fin 725

cross rates20
Cross-rates
  • Cross exchange rate: exchange rate between 2 currencies where neither currency is the US dollar
  • We know the dollar rates from the 1st column of the table
  • What if we want to know other rates, i.e. S(HK$/$) or S(€/¥)
  • S(HK$/C$) = S(HK$/$)  S($/C$) = 7.7524  (1/1.172) = 6.6147
  • S(€/¥) = S(€/$)  S($/¥) = 0.8431  (1/117.15) = 0.00720
  • Compare the cross-rates to the numbers in the rest of the table
  • Note: this ignores the bid-ask spread
  • Almost all trades that do not involve $ are actually two trades
  • Cross-rates must be internally consistent

© Prof. Ingrid M. Werner, Bus-Fin 725

cross rates example
Cross-rates -- example
  • A South Korean importer owes SEK4.5 million to a Swedish exporter. To compute her costs in won, she gets the following quotes from her bank:
    • Korean won: S($/W)=0.0012364, or S(W/$)=808.80
    • Swedish krona: S($/SEK)=0.1703, or S(SEK/$)=5.8720
  • What are the won costs?

© Prof. Ingrid M. Werner, Bus-Fin 725

triangular arbitrage
Triangular arbitrage
  • Cross-rates must be internally consistent; otherwise arbitrage profit opportunities exist
  • Suppose that dollar-euro cross-rate is 1.4000
  • Suppose that the actual spot rate, S(C$/€) is 1.3901
  • Profit opportunity exists because either
    • S(C$/€) is too low
    • S($/€) is too high
    • S(C$/$) is too high
  • How can we make money? Sell high and buy low

© Prof. Ingrid M. Werner, Bus-Fin 725

triangular arbitrage23
Triangular arbitrage
  • Rules to make money
    • Check the cross-rates against the quotes
    • Sell the overvalued currency, or conversely, buy the undervalued currency
      • It depends on what currency you have to start with
    • Need to buy or sell at 3 different banks
    • One transaction per bank
    • End up with the same currency that you started with
  • In the real world,
    • Have to act fast
    • Consider the impact of transaction costs

© Prof. Ingrid M. Werner, Bus-Fin 725

triangular arbitrage example 1
Triangular arbitrage – example 1
  • You observe the following quotes at 3 banks
    • Bank 1: S($/¥) = 0.0084
    • Bank 2: S($/€) = 1.0500
    • Bank 3: S(€/¥) = 0.0081
  • The implied cross rate between Bank 1 and 2 is: S(€/¥)=0.0080.
  • You have ¥1,250,000.
    • Is there an arbitrage opportunity?
    • What should you do to make money?

© Prof. Ingrid M. Werner, Bus-Fin 725

triangular arbitrage example 125
Triangular arbitrage – example 1
  • You observe the following quotes at 3 banks
    • Bank1: S($/¥)=0.0084; Bank2: S($/€)=1.0500; Bank3: S(€/¥)=0.0081
    • The implied cross rate between Bank 1 and 2 is: S(€/¥)=0.0080.
    • You have ¥1,250,000. What should you do?
      • Go to Bank 3. Convert ¥1,250,000 to €10,125.00 @ 0.0081.
      • Go to Bank 2. Convert €10,125 to $10,631.25 @ 1.0500.
      • Go to Bank 1. Convert $10,631.25 to ¥1,265,625.00 @ (1/0.0084).
    • The initial ¥1,250,000 becomes ¥1,265,625. You earn a risk-free profit of ¥15,625, or 1.25%.
    • This is a simplified example

© Prof. Ingrid M. Werner, Bus-Fin 725

slide26

Triangular arbitrage —example 2

A new currency trader observes these quotes and computes the Bank of America/Dominion Bank cross-rate to be S(C$/€)=1.5020.

C$

Bank of America

S($/C$)=0.5265

ABN Amro Bank

S(C$/€)=1.5214

He has C$1,000,000 available for trading, but doesn’t know what to do. What should we tell him to do?

$

Dominion Bank

S($/€)=0.7908

© Prof. Ingrid M. Werner, Bus-Fin 725

slide27

Triangular arbitrage —example 2

1. Sell C$1,000,000 to BofA and get $525,600.

(End)

(Start)

C$

2. Sell $525,600 to DB and get €664,644.

Bank of America

S($/C$)=0.5256

ABN Amro Bank

S(C$/€)=1.5214

3. Sell €664,644 to ABN and get C$1,011,189.

$

Dominion Bank

S($/€)=0.7908

4. Tell boss we just made C$11,189 risk-free. Ask for a raise.

© Prof. Ingrid M. Werner, Bus-Fin 725

triangular arbitrage28
Triangular arbitrage
  • Such arbitrage transactions take place until ABN’s direct quote equals the cross-rate. How does this happen?
    • S($/C$) decreases—dollar appreciates against the Canadian dollar
    • S($/€) increases—dollar depreciates against the euro
    • S(C$/€) decreases—Canadian dollar appreciates against the euro

 Cross-rate for S(C$/€) increases; ABN’s direct quote for S(C$/€) decreases

  • Markets are very active—these opportunities rarely exist. Transactions have to take place almost instantly.
  • Not available to the average investor—only FX traders
  • Examples ignore the bid-ask spread. Transactions costs reduce potential profits.

© Prof. Ingrid M. Werner, Bus-Fin 725

currency forecasting
Currency forecasting
  • Currency forecasting is incredibly difficult!
  • There are three basic approaches:
    • Efficient markets (Random walk)
      • The current spot exchange rate is the most accurate predictor of future spot exchange rates.
    • Fundamental analysis
      • Exchange rates are related to the domestic versus the foreign: money supply; output growth rates; velocity of money (inflation).
      • By first fitting this relationship based on historical data, and then forecasting the fundamental variables variables, the future spot exchange rate can be predicted.
    • Technical analysis
      • Exchange rates follow predictable patterns, hence simple rules can be profitable trading strategies.
      • SMA vs. LMA, filter rules, other patterns…

© Prof. Ingrid M. Werner, Bus-Fin 725

wrap up
Wrap-up
  • The foreign exchange market is by far the largest financial market in the world.
  • Currency traders trade currencies for spot and forward delivery.
  • Exchange rates are by convention quoted against the U.S. dollar, but cross-rates can easily be calculated from bilateral rates.
  • Triangular arbitrage forces the cross-rates to be internally consistent.
  • The euro has enhanced trade within Europe, and the currency has the potential of becoming a major world currency.

© Prof. Ingrid M. Werner, Bus-Fin 725

for next time
For next time…
  • Next class will be on purchasing power parity (Chapter 5).
  • Come prepared to discuss the mini-case:

Shrewsbury Herbal Products, Ltd. (p. 98)

© Prof. Ingrid M. Werner, Bus-Fin 725

ad