Size of FX marketcomparisons

1
Size of FX marketcomparisons

• FX market is huge, almost USD 1.9 trillion/day
  (Bank for International Settlements, 2004)
• 2 b shares at 50 / share 100 b/day
• 1500 NYSE stocks vs. 5 to 15 major currencies
• U.S. GDP (2004) 12.1988 trillion/year (St.
  Louis Fed)
• Budget deficit (2004, 2005) 412 billion/year,
  427 billion/year (White House)
• M1 1.364 trillion MZM 6.683 trillion (2004
  St. Louis Fed)

2
International Finance

• The FX Market
• Dick Sweeney

3
Take Aways

• Become familiar with
• Foreign exchange markets their mechanics,
  conventions and participants
• Size, locations of foreign exchange markets, key
  currencies, key instruments
• Introduce
• Arbitrage plays
• Next in FX markets covered interest arbitrage

4
I. Introduction

• Importance of international economic
  relationshipsglobalization
• Trade grows faster than world economy
• Capital flows are massiveand volatile
• Foreign ownership growing in most countries
• Much of international activity goes through
  foreign exchange markets (imports/exports,
  repatriated profits stocks, bonds, FDI)

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Introduction (cont.)

• FX market can have big effectsboth immediate and
  long-term
• U.K. in 1992 EMS crisis change in U.K.s
  competitive position in single day
• Financial crisis in Asia, 1997 Thailand,
  Indonesia, Malaysia, Korea Russia, Brazil
  exchange-rate crises

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I. Introduction (cont.)

• Participants Manufacturers, service firms.
  Bankers, FX brokers. Hedgers, speculators.
• Always openbut liquidity, thickness
• Or Tokyo, Hong Kong, Singapore, Australia
• (London NYC) open vs. New Zealand open
• USD is dominant currencyinvoicing
• Will the Euro offer stability?

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Will Euro Add Stability?

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FX Volume by Instrument, 2004(Traditional
Derivatives)
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A Swap in the FX Market

• Simultaneous trades that offset each other but at
  different maturities
• Example Sell EUR spot, buy EUR 3-months forward
• Take EUR from bank deposit, sell of USD, invest
  in GE commercial paper for 3-months, make
  3-months forward contract to sell proceeds for
  EUR
• Get a better rate on GE commercial paper than a
  USD bank deposit

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FX volume by location, 2004(TraditionalSpot,
Forwards, Swaps)
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Percent of currency traded against USD, 2004
(Traditional)
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Making FX Trades

• Call a bank, get quotes, decide (fast!)
• Call a broker, get quotes, decide (fast!)
• Look at computer indicative quotesif
  interested, call bank or broker (quotes change
  fast)
• Look at computer hard quotes (Reuters, for
  example)if interested, press the buttons to buy
  or sell (fast!)

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II. Quotations Bid/Ask

• One share of IBM 100, 101. Dealer will buy
  one share from you for 100, sell one to you for
  101. Bid price always first.
• Bid always less than askcompensation for risk
  dealer has to make a living, pay tuition
• Quotes always from dealers viewpoint
• Sign at airport booth
• One pound sterling 1.5000, 1.5010. Dealer
  will buy, sell what? For how much per unit?

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II. Quotations Bid/Ask (cont.)

• Or, 1.5000/10, meaning...
• Replace last digits...
• Spread in pips
• Percentage spread 1/16th of 1 for majors
• What is usual spread? In crises?
• What about JPY 120.00, JPY 120.10?
• Who is buying or selling what?
• If USD strengthens, what happens to quotes?

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Quotations Bid-Ask (cont.)

• CHF bid 1.8943, ask 1.8951 ? Dealer will buy
  USD1 for CHF 1.8943, will sell USD1 for CHF
  1.8951 (dollars are being bought and sold)
• Suppose you sell CHF 100m. Dealer sells USD for
  CHF, at CHF 1.8951 ? CHF 100m buys USD 52.767664m
  CHF 100m /(CHF 1.8951/USD) 52,767,664
  dimensions cancel (!)
• American terms
  1/1.8951 0.5276766, 1/1.8943
  0.5279552
• Remember, bid always less than ask
• 1.8951 is ask in CHF, so 1/1.8951 is bid in USD
• Delivery date?

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Quotations Bid-Ask (cont.)

• EUR bid 1.3000, ask 1.3010
• Spread is approximately 1/13th of 1, here
• Suppose you sell USD 50 million, at 1.3010 ? USD
  50 million buys EUR 38.43198m USD 50 m / (USD
  1.3010 / EUR)
• EUR (50 m / 1.3010) EUR 38.43198m.
• Dimensions cancel.
• Delivery date?
• European terms for quotes?

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Quotations Bid-Ask (cont.)

• EUR bid 1.3000, ask 1.3010
• Spread is 1/13th of 1, here
• Suppose you sell EUR 50 million, at 1.3000 ? EUR
  50 million buys USD 65.000m
• (EUR 50 m) x (USD 1.3000 / EUR)
• Dimensions cancel.
• Delivery date?
• European terms for quotes?

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III. Forward rate quotes

• Add to/subtract from last digits of spot, not
  replace
• How do you know when to add? when to subtract?
• Rule versus experiment
• Bid-ask spread generally widens with maturity of
  contract markets thinner ? dealers risk larger

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III. Forward rate quotes (cont.)

• Dealer quotes CHF 1.8943 to 51, 52 to 48, 150 to
  144, 337 to 205 for spot, 1-month, 3-months and
  1-year. Suppose you buy 100m 3-mth CHF.
• Spot 1.8943 to 1.8951 (substitute
  into bid)
• Forward 150 to 144 (subtract
  from spot)
  1.8793 1.8807 (14 pip
  spread)
• Rule versus experiment
• Spread widens with maturitythinness, liquidity
• Spread goes from 8 to 14
• CHF 100m / (CHF 1.8793/USD) USD 53.211302m
  53,211,302dimensions cancel (!)
• Delivery date?

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III. Forward rate quotes (cont.)

• Dealer quotes EUR 1.2903 to 906 or 6, or 06,
  19 to 20, 52 to 54, 168 to 175 for spot,
  1-month, 3-months and 1-year. Suppose you buy USD
  50m 1-year.
• Spot 1.2903 to 1.2906 (substitute
  into bid)
• Forward 168 to 175 (add to
  spot)
  1.3071 1.3081 (10 pip
  spread)
• Add or subtract? Rule versus experiment
• Spread widens with maturitythinness, liquidity
• Spread goes from 3 to 10
• USD 50m / (USD 1.3071 / EUR)
• EUR (50m / 1.3071) EUR
  38.25262m dimensions cancel
• Spread is 0.076505 of 1, or is about 1/13th of 1

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IV. Forward Premia, Discounts Definitions

• Spot and three month bid for CAD 1.8943 and
  1.8793.
• Find premium/discount from New York viwpoint
• If the foreign-currency price is used
• prCAD,NY (S - F) / F x 4 x 100
  (1.8943 - 1.8793) / 1.8793 x 400 0.0079817 x
  400 3.19268/yr
• If the domestic-currency price is used
• prCAD,NY (F - S) / S x 400 (0.532113
  - 0.5278995) / 0.5278995 x 400 0.0079817
  3.19268/yr (same!)
• In Montreal, domestic-currency price used
• prCAD,Mon (F - S) / S x 4 x 100
  (1.8793 - 1.8943) / 1.8943 x 400 -0.0079185 x
  400 - 3.167397/yr (different!)

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Why the difference?

• Example Xt 100, Xt1 101, ?Xt1 1, (?Xt1
  / Xt) x 100 (1 / 100) x 100 1.0
• Take Yt 1 / Xt then, (?Yt1 / Yt) x 100
• (1 / Xt1) - (1 / Xt) / (1 / Xt) x 100
• (0.009901 - 0.0100) / 0.0100 x 100
• -0.009901 x 100 -0.990099 -1.0

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V. Cross Rates(Note this neglects bid-ask
spreads for simplicity but think about how to
use bid and ask rates. Also, do not be fooled by
fact that these rates are both in American terms.
What if one is in European terms?)

• Market rates USD 1.15 / EUR USD 1.45 / GBP
• What is Euro cost of GBP 1?
• Sell EUR 1 to buy USD 1.l5
• USD 1.15 buys
  USD 1.15 / (USD 1.45 / GBP) GBP
  0.7931034
• GBP 0.7931034 / EUR
• 1/(GBP 0.7931034 / EUR)
  EUR 1.2608696 / GBP
• See triangular arbitrage discussion in Chapter 4

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V. Cross Rates (cont.)(Note this neglects
bid-ask spreads for simplicity, but think about
how to use bid and ask rates. Bid-ask spreads
come up in CIP, so you will get practice with
them.

• Market rates USD 1.15 / EUR JPY 130 / USD
• What is Euro cost of JPY 100?
• Sell EUR 1 to buy USD 1.l5
• USD 1.15 buys
  USD 1.15 x (JPY 130 / USD)
  JPY 149.5 / EUR
• JPY 100 / (JPY 149.5 / EUR)
• EUR 0.6699 per JPY 100
• For currency with many units per USD, quotes are
  in hundreds (even thousands) of foreign-currency
  units