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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

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The foreign exchange market l.jpg

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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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