The Foreign Exchange Market

1
The Foreign Exchange Market

• Chapter 6

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The Foreign Exchange Markets

• I. INTRODUCTION
• A. The Market
• the anyplace where money denominated in one
  currency is bought and sold with money
  denominated in another currency.

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INTRODUCTION

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

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INTRODUCTION

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

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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.

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Mondays Direct Quote
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• B. Two Sub markets of Currency Markets
• 1. Spot Market
• - immediate transaction
• - recorded by 2nd business day
• 2. Forward Market
• - transactions take place at a specified
  future date

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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

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• 2. Forward Market
• a. arbitrageurs
• (hold currency)
• b. speculators
• c. hedgers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• II. SIZE OF THE CURRENCY MARKET
• A. Largest in the world
• 2005 1.9 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

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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

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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 of the
  direct quote

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THE SPOT MARKET

• C. Transactions Costs
• 1. Bid-Ask Spread
• used to calculate the fee
• charged by the broker
• 2. Bid the price at which the broker is
  willing to buy
• 3. Ask the price the broker will sell the
  currency

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THE SPOT MARKET

• Sample bid-ask quote
• .7353-75/ or .7375/

If you are selling dollars for euros, this is the
rate at which the broker will buy them from you
If you want to buy dollars wit euros, this is
the rate at which the broker will sell them to you
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THE SPOT MARKET

• 4. Percent Spread Formula
• Percent Spread (Ask-Bid)/Ask x 100

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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

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THE SPOT MARKET

• D. Cross Rates
• 1. The exchange rate between 2 non-US
  currencies.
• 2. Purpose to identify arbitrage
  opportunities

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Sample Problem

• Suppose the spot quote for the Swedish
• Krona and the Swiss franc are .1395/kr and
  .1133/SF, what is the quote for the krona in
  Geneva?
• .1133
• SF _SF_ 8.826 x US 8.826
• kr .1395 US 7.168 7.168
• kr
• SF1.23/kr

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The Impact of Arbitrage
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THE SPOT MARKET

• E. Currency Arbitrage
• 1. When cross rates differ from
• one financial center to another,
• arbitrage profit opportunities exist.
• 2. Strategy Buy cheap in one intl
  market,
• Sell at a higher price in another

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CURRENCY ARBITRAGE

• What is The Critical Role of Arbitrage in the
  Global Financial Markets?

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PART III.THE FORWARD MARKET

• I. INTRODUCTION
• A. Definition of a Forward Contract
• an agreement between a bank and a customer to
  buy or sell
• 1. a specified amount of currency against
  another currency
• 2. at a specified future date and
• 3. at a fixed exchange rate.

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THE FORWARD MARKET

• 2. Purpose of a Forward
• Hedging
• the process of reducing or mitigating
  exchange
• rate risk.

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Hedging Tools

• Type Contract Features
• Forward 1. Fixed currency amount
• Future 2. Fixed exchange rate
• Option 3. Fixed expiration date

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THE FORWARD MARKET

• C. Forward Contracts Require performance
  by both parties
• 1. Contract Terms may be
• a. 30-day
• b. 90-day
• c. 180-day
• d. 360-day
• 2. Longer-term Contracts possible

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CALCULATING THE FORWARD PREMIUM OR DISCOUNT

• P or D F-S x 12 x 100
• S n
• Alternate F-S x 360 x 100
• S n
• where
• F the forward rate of exchange
• S the spot rate of exchange
• n the number of months or
• days in the forward contract

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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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Sample Problem

• What is the forward discount or premium if the 30
  day forward rate is 1.4498/ and the spot is
  1.4487/ ?