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SPOT FOREIGN EXCHANGE (FX) MARKETS

SPOT FOREIGN EXCHANGE (FX) MARKETS. * Dealer market, no centralized exchange * A typical interbank quotation: 1.4244/48 Bid: 1.4244 Ask: 1.4248 Bid-ask spread in this example is 4 pips. Quotes may be binding or indicative. * Determinants of the size of the Bid-Ask spread:

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SPOT FOREIGN EXCHANGE (FX) MARKETS

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  1. SPOT FOREIGN EXCHANGE (FX) MARKETS * Dealer market, no centralized exchange * A typical interbank quotation:1.4244/48Bid: 1.4244 Ask:1.4248 Bid-ask spread in this example is 4 pips. Quotes may be binding or indicative. *Determinants of the size of the Bid-Ask spread: Volatility, Trading volume, Asymmetric information, Competition among dealers.

  2. American (academic) style: USD 1.4240 /EUR (means: 1.4240 USD’s per 1 Euro). OUR STYLE: EUR/USD = 1.4240 EUR/HUF = 271.50, GBP/USD = 1.6526, USD/CNY = 6.825, USD/JPY = 95.14 (means: USD is 95.14 times bigger than JPY) World Currencies: US$, CAD, T$, AUD, HK$, NZD (Kiwi), € (EUR), ₤ (GBP, cable), JPY, CNY (Renminbi), CHF, HUF, DKK, CZK, SEK, TL (TRY), SAR, ZAR, Zloty, Ruble, Lei, BRL, INR, Malaysian Ringgit, Thai Baht, Egyptian Pound, Kuwait Dinar, Azerbaijan Manat,

  3. Major Participants of the FX Markets: Commercial Banks (as dealers, as traders, sometimes as speculators, as hedgers), Central Banks, Speculators (Hedge funds), Exporters and Importers, International Portfolio Investors, FDI flows. • Central Bank Interventions: When CB’s see excessive imbalances in the FX markets with harmful effects to the economy, they may intervene by buying or selling huge amounts of their currencies. (Concerted interventions: Many CB’s acting together). CB’s have also power to influence exchange rates by changing interest rates (e.g. during the 1992 attack, Irish CB raised the overnight rate to 100% for about 1 month). • Major World Central Banks: Fed, ECB, BoE, BoJ, Bundesbank, BoF, MNB, CBTR.

  4. Calculating Cross Rates • EUR/USD=1.4030 EUR/HUF=271 USD/HUF=? • EUR/HUF=271 EUR/TL=2.073 TL/HUF=? Calculating Dealer’s Cross-Quotations: • EUR/USD=1.4028/32 EUR/HUF=270.40/90 USD/HUF=? Learn it in 2 steps: 1) From the bank’s viewpoint, obtain the largest spread. 2) Then, check from the costumer’s viewpoint who can synthetically create the same quotation.

  5. Problem 1: A meal in a street restaurant in Bangkok costs 40 baht. Is a meal in Budapest cheaper? (Info: EUR/HUF = 268.90; EUR/USD = 1.4167; USD/Baht = 34.01) Problem 2: A bank has the following quotes: USD/CHF = 1.4166/71 USD/Ruble = 31.10/20 CHF/Ruble = 21.82/99 Is there any mispricing (i.e. arbitrage opportunities)?

  6. Solution 1: That is, 1 Thai baht equals 5.581 HUF. Then, a 40 baht meal in Bangkok is HUF 223. Solution 2:A systematic way of checking triangular arbitrage possibilities is to calculated the implied (synthetic) quotation of the third FX rate, using the quotations of the first two. The implied CHF/Ruble quotation is calculated as follows: Bid: 31.10 / 1.4171 = 21.95 Ask: 31.20 / 1.4166 = 22.02 As it is not possible to buy (sell) at a lower (higher) rate, there is no profitable arbitrage opportunity.

  7. Exchange Rate Regimes: * Fixed Exchange Rates (fixed vis-à-vis another currency, a basket, or gold), Currency board, * Dirty float (managed float), Crawling peg, * Free float. * International Payments: SWIFT (Society for Worldwide Interbank Financial Telecommunication) * Euro-currencies: Euro-dollar, Euro-euro * Currency basket: e.g. trade-weighted dollar index

  8. The US Dollar Index (USDX) is an index (or measure) of the value of the US dollar relative to a basket of foreign currencies. • It is a weighted geometric mean of the dollar's value compared only with • Euro (EUR), 57.6% weight • Japanese yen (JPY), 13.6% weight • Pound sterling (GBP), 11.9% weight • Canadian dollar (CAD), 9.1% weight • Swedish krona (SEK), 4.2% weight and • Swiss franc (CHF) 3.6% weight. • Trade-weighted dollar index: An index of 26 currencies, computed as the geometric mean of the bilateral exchange rates of the included currencies. The weight assigned to the value of each currency in the calculation is based on trade data, and is updated annually

  9. 1.2. An Introduction to International Economics • A Brief History of World Currency System: Before World War I: gold-silver money (gold standard) Between World War I and II: bilateral agreements 1946 – 1972: Bretton Woods Agreement (Gold = $ 35/ounce; all other currencies pegged to US$; US guarantees convertibility of US$ banknotes to Gold; IMF ensures the safety of the international payment system). Since 1972: Major currencies are under free float

  10. PPPComparing values in two currencies, one should also adjust for relative price level (P/P*) as well as the exchange rate. This is called PPP adjustment.

  11. Real Exchange Rate: real = inflation adjusted E: the price of foreign currency in domestic currency ! Pf: foreign price index Pd: domestic price index RE: real exchange rate ER is an index.

  12. Exchange Rate Determination PPP Theory: Law of 1 price: P = S P* i.e: ΔS ≈ inf. − inf* (foreign currency will rise by the difference of domestic minus foreign inflation rates) IRPT Theorem: i.e: Δ S ≈ r − r* (foreign currency will rise by the difference of domestic minus foreign interest rates)

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