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The Foreign Exchange Market

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The Foreign Exchange Market

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The Foreign Exchange Market

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  1. The Foreign Exchange Market • Description • Functions • Market Participants • Types of Transactions • Foreign Exchange Rates and Quotations • Direct vs Indirect • European vs American • Bid and Ask quotations • Cross- Rates • Inter-Market (Triangular) Arbitrage • Forward Quotations • Currency Futures

  2. The Foreign Exchange Market cont’d • The Foreign Exchange Markets: • Currency traded, exchange rates determined; and exchange rate risk management implemented • consists of the currency spot, forward, futures and options markets • Types of Transactons • Spot Transactions • trade in cash today with delivery in two business days • Forward Transactions • trade at a pre-specified price and on a pre-specified future date • Swap Transactions • Simultaneous purchase and sale of an amount of currency at different delivery dates • e.g. “spot against forward” • Options Transactions • trade of rights (not obligations) to buy or sell a currency at a pre-specified price on a pre-specified future date (during a pre-specified period) • Volume • volume in April 1998 averaged $1.5 trillion per day • about 75% in the interbank market

  3. The Foreign Exchange Market cont’d • Operational efficiency • small retail transactions can be expensive • large interbank transactions have very low costs Aside: Alternative Forms of Market Efficiency • Informational efficiency: • prices reflect all relevant information • Operational efficiency: • market frictions have little influence • Allocational efficiency: • market channels capital toward its most productive uses

  4. The Foreign Exchange Market cont’d Major foreign exchange trading centers(Average daily volume during April of 1989, 1992, 1995, and 1998) Source: Bank for International Settlements triennial survey of central banks

  5. The Foreign Exchange Market cont’d • Functions: • Transfer of purchasing power • Provision of Credit • Minimizing Foreign Exchange Risk • Participants Interbank (wholesale) Market Foreign Exchange Market Client (Retail) Market • Foreign Exchange Dealers (Bank &Non-bank) • act as “Market Makers” • Profit in form of “spread” between bid and ask • Individuals and Firms Conducting Transactions • Use for “Hedging” risk • Speculators and Arbitrageurs • Central Banks • Foreign Exchange Brokers

  6. The Foreign Exchange Market cont’d Foreign Exchange Rates and Quotations • Exchange Rate - price of one currency in terms of another • Exchange Rate Conventions • Direct vs Indirect Quotations • Direct Quote: Local currency price of a foreign currency • e.g. $ 0.5784 / Guilder • Indirect Quote: Price in foreign currency of one unit of local currency • e.g. Guilders 1.729 /$ • reciprocal of direct quote • European vs American Terms • European Terms: Foreign currency price of a $ • e.g. DM 1.5417 / $ (direct quote of dollar) • American Terms: $ price of one unit of foreign Currency • e.g. $0.6486 / DM • (indirect quote of dollar)

  7. The Foreign Exchange Market cont’d • Bid vs Offer (Ask) Quotations • Bid: rate at which dealer is willing to buy • Ask: rate at which dealer is willing to sell • bid for one currency is an offer (ask) for opposite currency • Measuring Changes in Spot Rates • Direct Quote e.g FF - last month (S0d/f $0.20 /FF FF - current quote (S1d/f $0.186/FF ==> ($0.186 - $0.20)/ $0.20 X 100 = - 7% • Indirect Quote e.g. FF - last month (S0f/d FF 5/$ ==> (5 - 4)/4 X 100 = +25% FF - current quote (S1f/d FF 4/$

  8. The Foreign Exchange Market cont’d Alternatively, express the exchange rate as a direct quote of the foreign currency Percentage change in the value of a foreign currency = (S1d/f - S0d/f ) / S0d/f An example: S0FF/$ = FF5/$ Û S0$/FF = $0.20/FF S1FF/$ = FF4/$ Û S1$/FF = $0.25/FF Percentage change in the franc = (S1$/FF-S0$/FF ) / S0$/FF = ($0.25/FF-$0.20/FF)/($0.20/FF) = +25% Percentage change in the dollar = (S1FF/$-S0FF/$ ) / S0FF/$ = (FF4/$-FF5/$)/(FF5/$) = -20%

  9. The Foreign Exchange Market cont’d • Cross Rates: Exchange rates between two currencies determined through their relationship to a third currency. • Low liquidity • Check for internal consistency of rates among markets Example: Australian $ A$ 1.3450/US $ Danish Krone DK 6.0913/US $ Cross Rate (A$/DK) = (A$ 1.3450/ US $)/ (DK 6.0913/ US $) = A$ 0.2208/DK • Inter market (Triangular) Arbitrage Divergence of published quotes from cross rates imply existence of an arbitrage opportunity Example 1:Dutch Guilders per US $ fl 1.9025/US $ Canadian Dollars per US $ C$ 1.2646/US $ Dutch Guilders per C $ fl 1.5214/ C$ Cross rate (fl/ C$) = fl 1.9025 /C$ 1.2646 = fl 1.5044/C$ => An investor with Dutch Guilders can profit by buying C$ at the implied cross rate and selling C$ at the actual rate.

  10. The Foreign Exchange Market cont’d

  11. The Foreign Exchange Market cont’d Example 2: US $ quote for C$ US $ 0.85/C$ US $ quote for German Mark US $ 0.60/DM DM quote for C$ DM 1.43/C$ Investor has US $ 1,000,000 Step 1. See if there is an arbitrage opportunity Cross rate (DM/C$) = $0.85 /$ 0.60 = DM 1.417 / C$ => ignoring transaction costs, there exists an arbitrage opportunity Step 2. Strategy: BUY LOW, SELL HIGH (depends on which currency you start with) Buy C$ @ DM 1.417/C$ which involves - Sell DM @ $0.60/DM - Buy C$ @ $ 0.85/C$ Sell C$ @ DM 1.43/C$ (same as buy DM @ DM 1.43/C$) a. Start with US$ 1,000,000 b. Buy C$: US$1,000,000/ US$ 0.85 = C$ 1,176,471 c. With C$, buy DM: C$1,176,471 X DM 1.43/C$ = DM 1,682,353 d. With DM, buy US $ : DM 1,682,353 X US $ 0.60/DM = US $ 1,009,412 e. Profit = US$ 1,009,412 - US $ 1,000,000 = US $ 9,412

  12. The Foreign Exchange Market cont’d • Forward Quotations • “outright Quotations” : full price to all decimal places • Point Quotations: Deviations of forward rates from spot rates • Forward premium • nominal value in the forward exchange market is higher than in the spot exchange market • Forward discount • nominal value in the forward exchange market is lower than in the spot exchange market Example (DM/$) ($/DM) Outright Quotes Bid Ask Bid Ask Spot rate 1.8215 1.8225 ___ 30 day forward 1.8157 1.8169 90 day forward 1.8040 1.8056 Point Quotes: 30 day forward 58 - 56 17 - 18 90 day forward 175 - 169 51 - 53 ** Point Quotes as ‘swap rates” - They represent net differential in national interest rates

  13. The Foreign Exchange Market cont’d • Forward Quotations in % age terms • with direct quotes: Forward premium (discount) = (Forward (F1) - Spot (S0))/ Spot X 100 • with indirect quote Forward premium (discount) = (Spot (S0) - Forward (F1))/ Forward X 100 Example: Suppose S0$/FF = $0.20/FF and F1$/FF = $0.25/FF Franc forward premium = ($.25/FF-$.20/FF)/($.20/FF) = +25% so the franc is selling at a 25% forward premium. Alternatively, S0FF/$ = FF5.00/$ Û S0$/FF = $0.20/FF F1FF/$ = FF4.00/$ Û F1$/FF = $0.25/FF Dollar forward premium = (FF4/$-FF5/$)/(FF5/$) = -20% so the dollar is selling at a 20% forward discount.

  14. Foreign Currency Futures • An exchange traded contract for delivery of a standard amount of foreign currency at a fixed time, place and price. • Forward contracts and default risk • Forward contracts are a pure credit instrument; one party always has an incentive to default. • The futures contract solution • An exchange clearinghouse takes one side of every transaction • Futures contracts are marked-to-market on a daily basis • Initial and maintenance margins are required on futures contracts

  15. Foreign Currency Futures Financial futures exchanges • The International Monetary Market (IMM) (a subsidiary of the Chicago Mercantile Exchange) • The Philadelphia Board of Trade (PBOT) (a subsidiary of the Philadelphia Stock Exchange) • The Bolsa Mercadorias & de Futuros (BM&F) in Brazil • The London International Financial Futures Exchange (LIFFE) • The Marché à Terme des Instruments Financiers (MATIF) • The Singapore International Monetary Exchange (SIMEX) • The Tokyo International Financial Futures Exchange (TIFFE) (a subsidiary of the Tokyo Stock Exchange)

  16. Foreign Currency Futures • A comparison of currency forward and CME futures contracts ForwardsFutures Location Interbank Exchange floor Maturity Negotiated 3rd week of the month Amount Negotiated Standard contract (e.g. ¥12,500,000 ) Fees Bid-ask Commissions (e.g. $30 per contract) Counterparty Bank CME Clearinghouse Collateral Negotiated Margin account Settlement At maturity Most are settled early Trading hours 24 hours During exchange hours