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The Foreign Exchange Market

The Foreign Exchange Market. Chapter 7. The Foreign Exchange Markets. I. INTRODUCTION A. The Market: the place where money denominated in one currency is bought and sold with money denominated in another currency. INTRODUCTION.

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The Foreign Exchange Market

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  1. The Foreign Exchange Market Chapter 7

  2. The Foreign Exchange Markets • I. INTRODUCTION • A. The Market: • the place where money denominated in one currency is bought and sold with money denominated in another currency.

  3. INTRODUCTION • B. International Trade and Capital Transactions: • - facilitated with the ability to transfer purchasing power • between countries

  4. INTRODUCTION • C. Location • 1. OTC-type: no specific location • 2. Most trades by phone or SWIFT* • *SWIFT: Society for Worldwide Interbank Financial Telecommunications

  5. PART II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET • A. Participants at 2 Levels • 1. Wholesale Level (95%) • - major commercial banks • 2. Retail Level • - banks dealing for business customers.

  6. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • B. Two Types of Currency Markets • 1. Spot Market: • - immediate transaction • - recorded by 2nd business day • 2. Forward Market: • - transactions take place at a specified future date

  7. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • C. Participants by Market • 1. Spot Market • a. Commercial banks • b. Brokers • c. Customers of commercial banks • d. Central banks

  8. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • 2. Forward Market • a. Arbitrageurs • (holds currency) • b. Speculators • c. Hedgers

  9. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • II. SIZE OF THE CURRENCY MARKET • A. Largest in the world (1999): • $1.5 trillion daily • B. Market Centers (1998): • London = $637 billion daily • New York= $351 billion daily • Tokyo = $149 billion daily • C. Benchmark: • 1999 USGDP = $9.1 trillion

  10. PART III. THE SPOT MARKET • I. SPOT QUOTATIONS • A. Sources • 1. All major newspapers • 2. Major currencies have four different quotes: • a. spot price • b. 30-day • c. 90-day • d. 180-day

  11. THE SPOT MARKET • B. For nonbank customers: • Direct quote • gives the home currency price of one unit of foreign currency. • EXAMPLE in France : €.80/US$ • Indirect quote is the reciprocal

  12. THE SPOT MARKET • C. Transactions Costs • 1. Bid-Ask Spread • used to calculate the fee • charged by the bank • 2. Bid = the price at which the bank is willing to buy 3. Ask = the price it will sell the currency

  13. THE SPOT MARKET • 4. Percent Spread Formula: • Percent Spread = (Ask-Bid)/Ask x 100

  14. Sample Problem • Suppose the spot quote for the Swedish Krona is $.1395-99, what is the percent spread? • PS = Ask –Bid x 100 • Ask • = .1399 - .1395 x 100 • .1399 • = .29% or 29 basis points

  15. THE SPOT MARKET • D. Cross Rates • 1. The exchange rate between 2 non-US$ currencies. • 2. Purpose: to identify arbitrage opportunities

  16. Sample Problem • Suppose the spot quote for the Swedish • Krona and the French franc are $.1395/kr and $.1133/FF, what is the quote for the krona in Paris? • $.1133 • FF = _FF_ = 8.826 x US$ = 8.826 • kr $.1395 US$ 7.168 7.168 • kr • = FF1.23/kr

  17. THE SPOT MARKET • E. Currency Arbitrage • 1. When cross rates differ from • one financial center to another, • profit opportunities exist. • 2. Buy cheap in one int’l market, • sell at a higher price in another • 3. Importance of Arbitrage

  18. Sample Problem • Suppose the euro is quoted in London at £.6064-80 and the £ is quoted in Frankfurt at € 1.6244-59. Is there a profitable arbitrage situation?

  19. Sample Problem • LondonFrankfurt • £.6064-80/€€1.6244-59/£ • Bid Ask Bid Ask • .6064 .6080 .6150 .6156

  20. Sample Problem • 1. Buy euros for £ .6080 / € in London. • Use them in Frankfurt to buy pounds at €1.6259 (same as selling euros at £.6150). • This is a net profit is • .6150-.6080= £.0070 per euros • 4. A yield of 1.16% (.0070/.6080)

  21. Compute the percent spread • Pound spread = (1.6259-1.6244)/1.6259 = .09% • Euro spread = (.6080-.6064)/.6080 = .26%

  22. CURRENCY ARBITRAGE • What is The Critical Role of Arbitrage in the Global Financial Markets?

  23. PART III. THE FORWARD MARKET • I. INTRODUCTION • A. Definition of a Forward Contract • an agreement between a bank and a • customer to deliver a specified amount • of currency against another currency • at a specified future date and at a fixed • exchange rate.

  24. THE FORWARD MARKET • 2. Purpose of a Forward: • Hedging • the act of reducing exchange rate risk.

  25. THE FORWARD MARKET • C. Forward Contract Maturities • 1. Contract Terms • a. 30-day • b. 90-day • c. 180-day • d. 360-day • 2. Longer-term Contracts • 3. Require performance

  26. THE FORWARD MARKET • CALCULATING THE FORWARD PREMIUM OR DISCOUNT • = F-S x 12 x 100 • S n • where F = the forward rate of exchange • S = the spot rate of exchange • n = the number of months in the • forward contract

  27. Sample Problem • What is the forward discount or premium if the 30 day forward rate is $1.4498/£ and the spot is $1.4487?

  28. Sample Problem • What is the forward discount or premium if the 3 month forward rate is $1.4511/£ and the spot is $1.4487?

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