Foreign Exchange Markets (or chapter 6)

1. Foreign Exchange Markets (or chapter 6)

2. Agenda • Description of foreign exchange market • Size? • Functions? • Participants? • Transactions? • Rates & Quotations? • Inter-market Arbitrage?

3. Tokyo opens Asia closing 10 AM In Tokyo Lunch In Tokyo Europe opening Americas open London closing Afternoon in America 6 pm In NY Geographic Extent Singapore, Hong Kong, Tokyo, Bahrain, London, New York, San Fran, & Sydney. Average Electronic Conversations Per Hour Greenwich Mean Time

4. Functions of FOREX Market • Transfer purchasing power between countries. • Obtain/ provide credit for international trade. • Minimize exposure to exchange rate risk.

5. Size, Structure, & Participants • Daily global net turnover in forex US$1.21 trn (April’01), data by Bank for Int’l Settlements - Switzerland • FOREX market has two tiers • interbank (wholesale) market. • client (retail) market. • Five categories participants: • Bank & non-bank forex dealers. • Individuals & firms. • Speculators & arbitragers. • Central banks & treasuries. • Forex brokers.

6. Transactions in the Interbank Market • Transactions: spot, forward, or swap basis • Spot transaction requires almost immediate delivery of foreign exchange • Forward transaction requires delivery of foreign exchange at some future date • Swap transaction is the simultaneous exchange of one foreign currency for another

7. Spot & Outright Forward Transactions • Spot: Purchase of forex, w/ delivery & payment b/n banks to take place on 2nd following business day. • Settlement date referred as value date • Settlement through computerized Clearing House Interbank Payment Systems(CHIPS), New York () • Forward: Requires delivery @ a future value date • Exchange rate is agreed upon at the time of the transaction, payment & delivery are delayed • Quoted for value dates of 1-, 2-, 3-, 6-, 9- & 12-months

8. Swap Transactions • Simultaneous purchase & sale of of foreign exchange for two different value dates • Both purchase & sale w/ same counterparty • Common types of swaps • Spot against forward:buy currency in spot market & simultaneously sells same amount back to same bank in forward market • Forward-forward swaps:Dealer sells £20,000 forward for $, delivery in 2 months @ $1.687/£ & simultaneously buys £20,000 forward for delivery in 3 months @ $1.682/£ • Difference b/n buying and selling price is interest rate differential. • Can be viewed as way for collateralized borrowing another currency. • Non-deliverable forwards (NDF): same as traditional forward contracts except they are settled only in US$. Foreign currency sold/ bought forward not delivered. • NDF contracted offshore & are beyond reach & regulation of home governments • Pricing NDF reflects basic interest rate differentials.

9. Rates & Quotes • What is a quote? • Inter-bank Quotes • Foreign currency for a dollar (SF1.60/$). European quote • Dollar for unit foreign currency ($0.625/SF). American quote • All European currencies quoted in European way, except: • Pound Sterling, Euro, Australian, & New Zealand $. • Direct & Indirect Quotes • Direct: home currency per unit of foreign • Indirect: foreign currency per unit home currency • SF1.60/$ indirect quote in US, $0.625/SF is direct quote in US • Bid & Ask Quotes • Interbank quotes given as bid & ask (offer) • Bid is the price at which a dealer will buy another currency • Ask or offer is the price at which a dealer will sell another currency • E.g.: ¥118.27 - ¥118.37/$ is the bid/ask for Japanese yen • Bank will buy yen @ ¥118.27 per US$ & sell yen @ ¥118.37 per US$ making profit on spread.

10. Rates & Quotes • Forward Quotations on a Points Basis • Outright quotes. • Forward quotes different & usually quoted in points • A point: last digit of quote, w/ convention dictating number of digits to the right of decimal. => a point = 0.0001 most currencies

11. Bid Ask Plus points (3 months)-1.43 -1.40 Rates & Quotes • Expressing Forward Quotations on Points Basis • Yen quoted only to 2 decimal points • Forward quote is not forex rate, but difference b/n spot & forward. • Example: Outright spot:¥118.27 ¥118.37 Outright forward:¥116.84 ¥116.97

12. ¥ Rates & Quotes • Can have forward quotes as % p.a. deviation from spot. • Important: which currency is home currency? • Indirect quotes (i.e. foreign per domestic) • Direct quotes (i.e. domestic per foreign currency) • For example: S =Yen 105.65/$,F30 =Yen 105.04/$

13. £ € £ € ¥ ¥ Cross Rates & Intermarket Arbitrage Japanese yen ¥121.13/$. Mexican peso Ps9.190/$. • Suppose • Cross rate is: • Assume • Cross rate Citibank & Barclays: • Cross rate =/= Dresdner rate €1.62/£. Citibank $0.9045/€. Barclays Bank $1.4443/£. Dresdner Bank €1.6200/£.

14. Citibank (6) Receive $1,014,533 • Sell $1,000,000 to Barclays • Bank at $1.4443/£ Dresdner Bank Barclays Bank • Sell €1,121,651 to Citibank • at $0.9045/€ (2) Receive £692,377 • Sell £692,377 to Dresdner Bank • at €1.6200/£ (4) Receive €1,121,651 Citibank $0.9045/€. Barclays $1.4443/£. Dresdner €1.6200/£. Intermarket Arbitrage End with $1,014,533 Start with $1,000,000

15. Things to remember • Market Participants • Transaction types • Quotations • Inter-market arbitrage