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The Foreign Exchange Market

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  1. 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

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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