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Chapter 6 Outline. Foreign Exchange Market Spot Market Forward Market. 6.AForeign Exchange Market (1). Foreign exchange market permits transfers of purchasing power denominated in one currency to another.

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Chapter 6 Outline

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Chapter 6 outline

Chapter 6 Outline

  • Foreign Exchange Market

  • Spot Market

  • Forward Market

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 1

6.AForeign Exchange Market (1)

  • Foreign exchange market permits transfers of purchasing power denominated in one currency to another.

  • Interbank market – wholesale market in which major banks trade with one another. Accounts for ~95% of foreign exchange transactions.

Spot market – where currencies are traded for immediate delivery 35%

Forward market – where contracts are made to buy or sell currencies for future delivery 12%

Swap transactions – involve a package of a spot and a forward contract 53%

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 2

6.AForeign Exchange Market (2)

  • Methods of trading

    • Telephone still predominant

    • Telex (dead)

    • SWIFT (Society for Worldwide Interbank Financial Telecommunications) system

    • Internet-based systems

  • Market participants

    • Large commercial banks

    • Foreign exchange brokers in the interbank market

    • Commercial customers (primarily MNCs)

    • Central banks

  • The role of human brokers has declined as electronic brokers have significantly increased their share of the foreign exchange market.

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 3

6.AForeign Exchange Market (3)

  • Quotations

    • Up to four different foreign exchange quotes are displayed in major newspapers.

      • Spot rate

      • Forward rates, including 30-, 90-, and 180-day forward

    • Quotes are for dealers in the interbank market for >$1m in a single transaction. Your rate will suck unless using credit cards (with small fees).

    • When interbank trades involve dollars, rates are expressed in American/Direct terms ($/foreign currency) or European/Indirect terms (foreign currency/$).

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 4

6.AForeign Exchange Market (4)

  • Forward market participants

    • Arbitrageurs – seek to earn risk-free profits by taking advantage of interest rates differentials among countries. Use forward contracts to eliminate the exchange rate risk involved in transferring their funds between countries.

    • Traders – use forward contracts to eliminate or cover the risk on export or import orders denominated in foreign currencies.

    • Hedgers – use forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities.

    • Speculators – actively expose themselves to exchange risk by buying or selling currencies forward to profit from exchange rate fluctuations.

    • Thus, arbitrageurs, traders, and hedgers seek to eliminate or minimize exchange risk while speculators expose themselves to risk through forward market transactions.

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 5

6.AForeign Exchange Market (5)

  • Clearing System

    • In the U.S., where all foreign exchange transactions involving dollars are cleared, electronic funds transfers between banks are processed through the Clearing House Interbank Payments System (CHIPS).

    • Settlement payments are debited from and credited to a settlement account established by the New York Federal Reserve Bank for member banks.

    • Member banks with debit positions deposit funds into their settlement accounts through FedWire to cover their part of a transaction.

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 6

Fuji Bank

-

+

¥1.5 bil.

$15 mil.

Citibank

-

+

$15 mil.

¥1.5 bil.

6.AForeign Exchange Market (6)

  • Example of CHIPS process: Fuji Bank sells $15 million to Citibank for ¥1.5 billion.

Fuji Bank

CHIPS

1

Enters transaction into CHIPS system

Approves and releases transaction

  • Stores transaction

  • Makes appropriate debits and credits to Fuji and Citibank settlement accounts

  • Makes permanent record of transaction

  • Issues a settlement report to each member bank

2

4

3

5

6

Chapter 6: The Foreign Exchange Market


6 a foreign exchange market 7

6.AForeign Exchange Market (7)

  • Electronic trading systems

    • First created in 1992

    • Enable automatic matching and execution of foreign exchange transactions

    • Reduce cost of trading by eliminating brokers and reducing the number of transactions traders had to engage in to obtain market prices

    • Gather and publish information on prices and quantities of currencies as they are traded

    • FXall largest electronic trading system

Chapter 6: The Foreign Exchange Market


6 b spot market 2

6.BSpot Market (2)

  • Spot Quotations, continued

    • Quotes are given in pairs that reflect the bid-ask price.

      • E.g., pound sterling is quoted at $1.9719-28.

      • $1.9719 is the (bid) rate at which banks will buy pounds

      • $1.9728 is the (ask) rate at which banks will sell pounds

      • The spread equals the dealer’s profit

      • The bid-ask spread is often quoted by the last two numbers; e.g., 19-28.

    • Bid-ask quote expressed in American and European terms and as direct and indirect quotes:

*Note that the bid and ask prices are reversed in quoting in European terms.

Chapter 6: The Foreign Exchange Market


6 b spot market 3

Ask price – Bid price

Ask price

x 100

Percent Spread =

6.BSpot Market (3)

  • Spot quotations, continued

    • Bid-ask spreads are expressed as a percentage cost of transacting in the foreign exchange market as follows:

  • Cross rates

    • Most currencies are quoted against the dollar.

    • A cross rate is the exchange rate between two non-dollar currencies

Chapter 6: The Foreign Exchange Market


6 b spot market 4

6.BSpot Market (4)

  • Cross rates, continued

    • Example: Compute direct bid and ask cross rates for the pound in Zurich

    • Direct quote for pound sterling = $1.9719-36

    • Direct quote for SFr = $0.8130-47

Bid rate for £ in $

Ask rate for SFr in $

$1.9719

$0.8147

=

=

SFr2.4204

Bid cross rate =

Ask rate for £ in $

Bid rate for SFr in $

$1.9736

$0.8130

=

SFr2.4227

Ask cross rate =

=

  • Thus, the direct quote for the pound in Zurich is SFr2.4204-27.

Chapter 6: The Foreign Exchange Market


6 b spot market 5

6.BSpot Market (5)

  • Currency arbitrage

    • Triangular currency arbitrage – traders take advantage of exchange rate inconsistencies in different money markets by buying a currency in one market and simultaneously selling it in another.

    • E.g., compute profit given the following exchange rates, FYI

      • $/£ = $1.9724 in New York

      • $/€ = $1.3450 in Frankfurt

      • €/£= €1.4655 in London

New York

Sell pounds in New York for dollars:

£507,332/(1/$1.9724) = $1,000,661

Sell $1,000,000 in Frankfurt for euros:

$1,000,000/($1.3450) = €743,494

Profit = $661

London

Frankfurt

Sell euros in London for pounds:

€743,494/€1.4655 = £507,332

Chapter 6: The Foreign Exchange Market


6 b spot market 7

6.BSpot Market (7)

  • Exchange risk

    • Bank losses and gains from exchange rate transactions result from the immediate adjustment of quotes in response to new political and economic information affecting exchange rates.

    • E.g., given a $/£ exchange rate of $1.9712, a bank buys $985,600 for £500,000 (£500,000/(1/$1.9712) = $985,600) in the foreign exchange market.

    • If no offsetting transaction to cover its position is made simultaneously, it is exposed to exchange rate risk.

    • If the bank then decides to cover its position in the interbank market, increases or decreases in the exchange rate will affect its exchange loss/gain.

      • If the exchange rate increases to $1.9801 before the bank completes its transaction, the bank will pay $990,050 to buy £500,000, thus incurring a loss of $990,050 - $985,600 = $4,450.

      • If the exchange rate increases, the bank will realize an exchange gain.

Chapter 6: The Foreign Exchange Market


6 c forward market 1

6.CForward Market (1)

  • A forward contract between a bank and a customer calls for delivery on a fixed future date of a specified amount of one currency against dollar payment at a fixed exchange rate.

  • Negotiating a forward contract for payment of a future liability eliminates exchange risk by locking in a known future exchange rate.

  • E.g., a U.S. company buys textiles from England, with payment of £1 million due in 90 days.

Day

0

90

e0 = $1.97

e90 > $1.98

f90 = $1.98

Exchange risk:

If e90 > f90, cost of payable will increase

No exchange risk:

£1,000,000 = $1,980,000

  • Implicit gains/losses on forward positions are related to the difference between ftand et at the forward contract’s maturity.

Chapter 6: The Foreign Exchange Market


6 c forward market 2

6.CForward Market (2)

  • Forward rate quotations

    • Actual price of f1is the outright rate

    • Swap rate – quoted as the premium on or discount from eo, e.g.:

      • eo for yen = $0.008225, f1 for yen = $0.008421

      • Swap rate is 0.008421-0.008225 = 196

    • Determining whether swap rate is a premium or discount on f1

      • When forward bid < ask rate, f1 is at a premium.

      • When forward bid > ask rate, f1is at a discount.

    • Converting swap rate to outright rate – add the premium to or subtract the discount from eo

Chapter 6: The Foreign Exchange Market


6 c forward market 3

6.CForward Market (3)

  • Forward cross rates

    • Computed in the same way as spot cross rates

    • Example: Compute the forward cross rates for yen in terms of euros*

    • f30 for €/$ = €0.81070 - €0.81243

    • f30 for ¥/$ = ¥107.347 - ¥107.442

Ask rate for €

Bid rate for ¥

€0.81243

¥107.347

=

=

=

€0.0075683

Bid cross rate

=

Bid rate for €

Ask rate for ¥

€0.81170

¥107.442

Ask cross rate

=

=

=

€0.0075548

  • Forward cross rates for yen in terms of euros are €0.0075683 - €0.0075548.

*Note that this example is in European terms, as opposed to previous example computing bid/ask cross rates for pounds in Zurich, which was in American terms. Thus, ask and bid rates are reversed in the cross rate formulas.

Chapter 6: The Foreign Exchange Market


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