The Market for Foreign Exchange

1

• The Market for Foreign Exchange
• (chapter 4)

2
FOREX Market Participants

• FX market involves participants buying and
  selling currencies all over the world
• It includes trading currencies spot and forward
  bank deposits of foreign currencies foreign
  trade financing trading in currency options,
  futures and swaps
• FOREX market is a global over-the-counter market
• Market participants include international banks,
  their customers, nonbank dealers, FOREX brokers,
  and central banks

3
Size of the FX market
Largest in the world (1995) 1.2 trillion
daily Market Centers (1995) London 464
billion daily New York 244 billion
daily Tokyo 161 billion daily Trading
systems - Screen based dealing using a phone or
an e-mail type system - EBS Electronic
Brokerage System
4
FOREX Market Participants

• The FOREX market is a two-tiered market
• Interbank Market (Wholesale)
• About 700 banks worldwide stand ready to make a
  market in Foreign exchange.
• Nonbank dealers account for about 20 of the
  market.
• There are FX brokers who match buy and sell
  orders but do not carry inventory and FX
  specialists.
• Client Market (Retail)
• Why is the trading volume so large in the FOREX
  market?

5
The Spot Market

• The spot market involves immediate purchase or
  sale of foreign exchange
• Direct quotation from US perspective
• the U.S. dollar equivalent
• the price of one unit of the foreign currency in
  US Dollars
• Indirect Quotation from US perspective
• the price of a U.S. dollar in the foreign
  currency
• e.g. you get 100 yen to the dollar
• The direct quote is the reciprocal of the
  indirect quote

6
The Bid-Ask Spread

• In general, banks do not charge commissions on
  foreign currency transactions. They profit from
  bid-ask spread
• The bid-ask spread is the difference between the
  bid and ask prices
• The bid price is the price a dealer is willing to
  pay you for something (our case foreign
  currency) always listed first
• The ask price is the amount the dealer wants you
  to pay for the thing (our case foreign currency)
  listed second

7
The Bid-Ask Spread

• Interbank dealer quotes
• - American terms Euro, British Pound,
  Australian Dollar
• - European terms all others
• Ex You want to transact with a dealer that gives
  you the following
• quotations 1.6625(bid) - 1.6635(ask)/.
• The dealer buys (gets) one pound from you for
  1.6625
• The dealer sells (gives) one pound to you for
  1.6635
• The bid-ask spread is a function of liquidity of
  the market, the XR
• volatility as well as dealers inventory
• The retail bid-ask spread is wider than interbank
  spread

8
Cross Rates

• The cross rate is the rate of exchange between
  two non-US currencies
• Suppose that S(/Euro) 1.25 and that S(Yen/)
  110 Yen What must the Yen/Euro cross rate be?
• Yen/Euro (Yen/)x(/Euro) 110x1.25 137.5
• Suppose that S(/Euro) 1.25 and that S(/AUD)
  0.5
• What must the AUD/Euro cross rate be?

9
The Forward Market

• A forward contract is an agreement to buy or sell
  an asset in the future at prices agreed upon
  today
• If you have ever had to order an out-of-stock
  textbook, then you have entered into a forward
  contract
• The forward market for FOREX involves agreements
  to buy and sell foreign currencies in the future
  at prices agreed upon today
• Bank quotes for 1, 3, 6, 9, and 12 month
  maturities are readily available for forward
  contracts

10
Forward Rate Quotations
S (USD/CAD) 0.7537 S(CAD/USD) 1.3268 F30
(USD/CAD) 0.7528 This is 1 month forward
rate F90 (USD/CAD) 0.7512 This is 3 month
forward rate F180 (USD/CAD) 0.7492 This is 6
month forward rate Market expects that USD will
appreciate (CAD depreciate) A forward currency
is at a forward discount if the forward rate
expressed in USD (/FC) is below the spot rate A
forward currency is at a forward premium if the
forward rate expressed in USD is above the spot
rate What about CAD?
11
Long and Short Forward Positions

• If you have agreed to sell anything (spot or
  forward), you are short.
• If you have agreed to buy anything (forward or
  spot), you are long.
• If you have agreed to sell forex forward, you are
  short.
• If you have agreed to buy forex forward, you are
  long.

12
Payoff Profiles/FC
profit
If you agree to sell anything in the future at a
set price and the spot price later falls then you
gain.
S180(/CAD)
0
F180(/CAD) .7492
If you agree to sell anything in the future at a
set price and the spot price later rises then you
lose.
Short position
loss
13
Payoff Profiles /FC
profit
When the short entered into this forward
contract, he agreed to sell CAD in 180 days at
F180(/CAD) 0.7492 If, in 180 days,
S180(/CAD) 0.6, the short will make a profit
by buying spot CAD at S180(/CAD) 0.6 and
delivering/selling CAD at F180(/CAD) 0.7492
S180(/CAD)
0
F180(/CAD) .7492
Short position
loss
14
Profit and losses of forward positionsexamples

• The following quotations exist for the Australian
  dollar (AUD)
• Present spot rate(/AUD) 0.50
• 90-day forward rate 0.52
• Your expectation of the spot rate in
  90days 0.55
• If your expectations prove correct, what would
  be your
• US dollar profit or loss from investing 4,000 in
  the spot market?
• If your expectations prove correct, what would be
  your US dollar
• profit or loss from investing 4,000 in the
  forward market?

15
Forward Premium/Discount

• For example, for CAD, we have S(/CAD) .7537
• and F180(/CAD) .7492
• The annualized percentage forward
  premium/discount is given by
• The CAD sells at a discount

16

• The following sections in chapter 4 are not
• required for the exam
• Triangular Arbitrage
• Spot Foreign Exchange Microstructure
• Swap transactions

17
Learning outcomes

• Know the structure of the FX market
• Know the difference between wholesale
  (interbank) market and retail market
• Who are the participants in the FX market?
• Explain how are foreign exchange transactions
  between international
• banks settled
• Know how to read/use spot and forward quotes
  direct and indirect method
• Calculate currency cross-rates, without bid-ask
  quotes, when
• given two spot or forward FX quotations
  involving three currencies
• Calculate the profit or loss of short and long
  forward positions
• Define and calculate the forward discount or
  premium, both as the
• difference and as an annualized from the spot
• Recommended end-of-chapter questions 1, 2, 3,
  4, 5
• Recommended end-of-chapter problems 1, 6, 9