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International finance Foreign exchange market

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  1. International finance Foreign exchange market Dr. Vasja Rant

  2. Definition of FX market FX marketis the market where individuals, enterprises and banksbuy and sell foreign exchange, • Foreign exchange (FX, Forex) is the money of foreign countries; it includes foreign currency in circulation (banknotes, coins), foreign currency denominated bank accounts and international payments instruments (checks, drafts), • Equilibrium of supply and demand determine the price of foreign exchange, i.e. exchange rate; • FX market provides the physical and institutional infrastructure for execution of foreign exchange transactions; • Trading does not occur through organized exchanges but through telecommunication networks and electronic trading platforms, established between sellers and buyers of foreign exchange throughout the world.

  3. Definition of FX market – size The FX market is the largest and most liquid financial market in the world • Table on the RHS shows the comparison between average daily trading volumes in the FX and stock markets and the annual U.S. and Slovenian GDP.

  4. Definition of FX market – geographic domain The FX market spans the entire globe, with trading taking place 24 hours a day • On working days FX transactions and exchange rate changes occur continuously throughout the day in at least one of the world financial centers, • The volume of FX transactions “ebbs and flows” across the globe as the major currency trading centers open and close throughout the day (see exhibit on next slide),

  5. Definition of FX market – geographic domain Average electronic conversions per hour

  6. Interbank market Client market Definition of FX market – two segments • Interbank market – the “wholesale” market between largest banks; typical amounts in multiples of mio USD; extremely high liquidity, extremely low spreads ~ 0,02% • Client market – the “retail” market between banks and their customers (enterprises, individuals); specific amounts, lower liquidity, higher margins ~ 1-2%

  7. Definition of FX market – information & trading platforms

  8. Definition of FX market– electronic trading exhibit

  9. FX market functions – clearing, purchasing power transfer & credit • Currency clearing • FX market enables exchange of one currency for another • Transfer of purchasing power • Exchanging one currency for another allows transfer of purchasing power between countries, which is a precondition for international trade and international capital flows. • Provision of credit • FX market provides instruments to finance international trade (goods in transport) – e.g. letters of credit, drafts, bankers’ acceptances

  10. FX market functions – managing currency risk • Hedging (avoiding) currency risk • Intentional pursuit of activities by FX market participants that result in avoidance of currency risk = closing of FX positions, • Transfer of currency risk to other market participants, willing to take it, is provided by specialized instruments (currency forward and futures contracts and currency options), • Speculating (taking) currency risk • Intentional pursuit of activities by FX market participants that result in exposure to currency risk = opening of FX positions with profict objective in mind,

  11. Participants of FX market Participants of the FX market can be segmented according to: • Activities (primary functions), which they perform on the market, • Incentives driving their behavior when they engage in foreign exchange transactions.

  12. Participants of FX market based on type of activity • Bank clients (individuals, enterprises, non-bank financial institutions): • All groups of legal entities and persons, which require foreign exchange in order to engage their primary commercial and/or investment activity, • Predominantly seek to hedge currency risk & do not have a profit motive in the FX market – exception: certain non-bank financial institutions (e.g. hedge funds),

  13. Participants of FX market based on type of activity • Commercial banks: • The most important group of participants in the FX market (they operate the interbank market), • Buy and sell foreign exchange for their clients, • Trade for their own account & act as dealers • May act as market makers – by maintaining an inventory position in the foreign currency in which they specialize & always quoting its bid (buying) and ask/offer (selling) price they stand willing to buy and sell that currency at any given moment in time • Have a profit motive; their FX profits are derived from spreads (the difference between the ask and bid quotes), but also arbitrage and speculation.

  14. Participants of FX market based on type of activity • Brokers • Agents that connect dealers, interested in buying and selling foreign exchange; they do not trade for their own account • Provide information to dealers about exchange rate quotes • Are becoming increasingly less important due to shift in trading to electronic trading platforms, which enable comparison of quotes and execution of FX transactions in real time. • Have a profit motive; their profits are derived from fees which they charge for their services

  15. Participants of FX market based on type of activity • Central banks • Intervene in the FX market with the objective of influencing the exchange rate of domestic currency in a way which benefits the domestic economy and, hence, the home country as a whole • Do not have a profit motive; often act as willing loss takers in order tho achieve broader societal objectives.

  16. Participants of FX market based on incentives • Speculators • Seek profit from engaging currency risk; • Try to “guess” future exchange rate movements and use it to earn money; they risk a loss if their “bet” turns out to be wrong. • Hedgers • Seek avoidance of currency risk, • Usually eliminate profit possibilities but also the danger of loss due to exchange rate changes.

  17. Participants of FX market based on incentives • Arbitrageurs • Seek riskless profit opportunities in the FX market, • Take advantage of simultaneous differences in prices (quotes) of the same currency in different financial centers; this enables them to make profit without taking risk by conducting arbitrage. • Two basic rules of arbitrage: • Buy currency where it’s cheap; • Sell currency where it’s worth more.

  18. Types of foreign exchange transactions • Spot FX transactions • Purchases and sales of foreign exchange for immediate delivery (2 working days in the interbank market). • Spot rate – the price of foreign exchange for immediate delivery • Forward FX transactions • Purchases and sales of foreign exchange for future delivery (delivery date more than 2 working days in the future). • Forward rate – the price of foreign exchange for future delivery (i.e. the price, agreed at the opening of the forward transaction and valid at the time of its execution) • Typical forward rates quotes: 1, 3, 6, 9 and 12 months.

  19. Types of foreign exchange transactions • Foreign exchange swaps • Simultaneous purchase and sale of the same amount of foreign exchange in two parts of the FX market with two different maturity dates; 2 types: • Spot-forward swaps • Forward-forward swaps • Equivalet to borrowing foreign exchange for a specified time period; the implied interest rate is the relative difference between both exchange rates used in the swap transaction.

  20. Size and structure of FX market – transactions Average daily turnover (bn USD)

  21. Size and structure of FX market – transactions % of average daily turnover (amounts in the graph in bn USD)

  22. Size and structure of FX market – participants Average daily turnover (bn USD)

  23. Size and structure of FX market – currencies

  24. Size and structure of FX market – currency pairs

  25. Size and structure of FX market – financial centers

  26. Foreign exchange quotations – currency pairs • Currency pairs • Depict a quotation of two different currencies in FX trading convention. • Example: EUR-USD (FX convention) = USD/EUR (ordinary convention)

  27. Foreign exchange quotations – base and quote (terms) currency • Base currency • The first currency in a currency pair. Exchange rates are quoted in per unit of base currency • Example: EUR-USD 1,3545 (= 1,3545 USD per EUR or 1,3545 USD/EUR) • Quote currency (also counter or terms currency) • The second currency in a currency pair. • Example: EUR-USD 1,3545 (= 1,3545 USD per EUR or 1,3545 USD/EUR)

  28. Foreign exchange quotations – points in point quotations • Pip = percentage in point • The smallest measure of price movement that exchange rate can make in FX trading • Usually (not always) 1/100th of 1% (= 0.0001) • Examples: • if USD/EUR changes 1.3500  1.3501, the change is equivalent to 1 Pip • But also in JPY/USD 100.00  100.01, change is equivalent to 1 Pip • Similar, but not the same concept as basis points (1 Bps is always = 0.0001)

  29. Foreign exchange quotations – types of quotations • Direct quotation • price of foreign (F) currency, expressed in terms (units) of home (H) currency (H/F) • Indirect quotation • price of home (H) currency, expressed in terms (units) of foreign (F) currency (F/H) • American quotation • price of USD, expressed in terms (units) of foreign (F) currency (USD/F) • European quotation • price of foreign (F) currency expressed in terms (units) of USD (F/USD)

  30. Foreign exchange quotations – bid and ask (offer) quotes • Bid quoteis the price (exchange rate) at which the dealer (bank) is willing to buy the base currency. • Ask (offer) quoteis the price (exchange rate) at which the dealer (bank) is willing to sell the base currency. • Margin or spread is the difference between the ask and bid price and is the profit collected by the dealer (bank).

  31. Foreign exchange quotations – spot rates USD/EUR 1,3427-58 Bid quote 1,3427 Ask/offer quote 1,3458 Spread (margin)

  32. How are changes in spot rates over time measured? • Direct formula: • Calculates apreciation/depreciation of the base (denominator) currency; • Calculates apreciation/depreciation of theforeign currency in direct quotation. • Indirect formula: • Calculates apreciation/depreciation of the quote (numerator) currency; • Calculates apreciation/depreciation of theforeign currency in indirect quotation.

  33. Apreciation and depreciation • Apreciation • The currency is gaining value over time in the spot market in terms of another currency • Example: spot rate (t) – 1,35 USD/EUR, spot rate(t+1) – 1,40 USD/EUR  EUR apreciates against USD • Depreciation • The currency is losing value over time in the spot market in terms of another currency • Example: spot rate (t) – 1,35 USD/EUR, spot rate(t+1) – 1,30 USD/EUR  EUR depreciates against USD • What about revaluation and devaluation? • Relate to changes in the official rate set by the central bank

  34. Foreign exchange quotations – forward rates USD/EUR 10–13 (pips) Point quotation Bid quote 1,3427 +0,0010 1,3437 Ask/offer quote 1,3458 +0,0013 1,3471 Outright quotation Ask points > Bid points  add pips to spot rate Bid points > Ask points  subtract pips from spot rate

  35. How are differences in forward vs. spot rates measured? • Direct formula: • Calculates forward premium/discount of the base (denominator) currency; • Calculates forward premium/discount of the foreign currency in direct quotation. • Indirect formula: • Calculates forward premium/discount of the quote (numerator) currency; • Calculates forward premium/discount of the foreign currency in indirect quotation.

  36. Forward premium and discount • Forward premium • The currency isvalued more in the forward market relative to the spot market in terms of another currency. • Example: spot rate – 1,35 USD/EUR, forward rate – 1,40 USD/EUR  EUR in forward premium against USD. • Forward discount • The currency is valued less in the forward market relative to the spot market in terms of another currency. • Example: spot rate – 1,35 USD/EUR, forward rate – 1,30 USD/EUR  EUR in forward discount against USD.

  37. Foreign exchange quotations – cross rates • Exchange rate between two currencies that are inactively traded and do not have an outright quote against each other. Cross-rate is calculated from their quotes against a widely traded third currency. • Example: A. 1,20 USD/EUR B. 0,80 USD/CHF C. Cross-rate: A/B=1,5 CHF/EUR • Triangular currency arbitrage • Conducting arbitrage between several financial centers based on the differences between the cross-rates. C. Cross-rate = 1,5 CHF/EUR D. 1,55 CHF/EUR Buy EUR Sell EUR