International Finance FINA 5331 Lecture 7: The market for foreign exchange Read: Chapters 5

1. International Finance FINA 5331 Lecture 7: The market for foreign exchange Read: Chapters 5 Aaron Smallwood Ph.D.

2. Official reserves • The official settlements balance, sometimes referred to as the overall balance, is the total balance on the current account plus the balance on all NON-OFFICIAL reserve transactions. • It must be exactly offset by the balance on official reserves transactions

3. Official reserves • When a country buys foreign reserves (for example, if the People’s Bank of China acquires dollars): • China’s assets increase: Debit entries in official reserves (a deficit) • Offset by an official settlements surplus • If a country must sell official reserves (Thailand in 1997 because of speculative attacks): • The country’s reserve assets decrease: Credit entries in official reserves (a surplus) • Offset by an official settlements deficit.

4. Foreign Exchange MarketProducts and Activities A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

5. Foreign Exchange MarketProducts and Activities Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery. Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

6. Foreign Exchange MarketProducts and Activities Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation. Arbitrage is the simultaneous, or nearly simultaneous, purchase of asset in one market for sale in another market with (for our purposes) the expectation of a risk-free profit.

7. FOREX Players Broadly speaking the FX market consists of 5 groups International banks Bank customers Non-bank dealers Include investment banks, mutual funds, and hedge funds. FX brokers Central banks

8. FX Market Participants • The FX market is a two-tiered market: • Interbank market (wholesale) • About 100-200 banks worldwide stand ready to make a market in foreign exchange. • Other financial institutions account for about 53% 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, FX brokers, and central banks.

9. Size of the FOREX market (billions of US $)

10. Currency shares

11. Trends in CNY

12. Recent changes • In 2010, PBOC establishes a target value against the dollar. The actual value of the exchange rate was maintained within bands of +/-0.50%. • Daily parity value is changed everyday, creating a “crawling peg” system • In April 2012, the band was widened to +/- 1% creating more flexibility. • In March of this year, the band was again increased to +/- 2%, again creating more flexibility.

13. Another example • According to an article published in Bloomberg on June 6, 2014: • “China’s yuan strengthened as the central bank raised the currency’s daily fixing rate by the most in five months following an overnight slide in the dollar…. • The currency posted the biggest gain in a week in onshore and offshore trading as the People’s Bank of China raised its reference rate by 0.14 percent to 6.1623 per dollar.”

14. Example, continued • Knowing what we know about China’s exchange rate system, how high could the yuan price of the dollar go? • In actual markets, could have gone as high as RMB 6.1623*1.02 = RMB 6.2855 • How low could we go? • In actual markets, could have gone as low as RMB6.1623*0.98 = RMB 6.0391

15. What happened • According to the article: • “The yuan advanced … to close at 6.2502 per dollar in Shanghai, its biggest gain since May 29… The onshore rate was 1.4% weaker than the fixing, within the 2% limit.”

16. Spot Rate Quotations • A direct quotation for the US is: • The U.S. dollar equivalent. • E.g.,“a Japanese Yen is worth about a penny.” For China: direct quote for the dollar is about RMB 6.25. • An indirect quotation is: • The price of a U.S. dollar in the foreign currency. • E.g.,“you get 100 yen to the dollar.

17. Spot rate quotations

18. 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 a dealer wants you to pay for something. • It doesn’t matter if we’re talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices.

19. Use these quotes to find… • The pound price of the euro. • The SF price of the yuan.

20. The Bid-Ask Spread • A dealer could offer: • A bid price of $1.3731 per €. • An ask price of $1.3739 per €. • While there are a variety of ways to quote the above, the bid-ask spread represents the dealer’s expected profit. • Percent spread =