Foreign Exchange Markets

1. Foreign Exchange Markets Market makers, Market participants Foreign Exchange Market

2. Foreign exchange risk • liquidity in terms of a different currency for international transactions • lags involved (credit transactions) • exposure from a position in a currency • an importer holding a payable denominated in a different currency • an exporter holding a receivable denominated in a different currency • http://www.oanda.com/convert/fxhistory Foreign Exchange Market

3. Market Participants • market makers • banks, foreign exchange dealers, foreign exchange brokers • firms • exporters, importers • individuals (investors) • speculators and arbitragers • central banks & treasuries Foreign Exchange Market

4. Market Makers • Chartered banks – the main market • Hold positions in foreign exchange • Buy and sell spot and forward • Sell over-the-counter options • Hedge open positions buy buying and selling • Exchange traded options and futures • Make money on the bid-ask spread • Exchange dealers • Hold positions specialize in specific currencies • Make money on the bid-ask spread • Exchange brokers • Broker deals paid commissions Foreign Exchange Market

5. Demanders and suppliers of foreign exchange • Firms (primary demanders) • Exporters paid in foreign currency want home currency • When you buy foreign, sellers usually demand payment in their own currency • Some exceptions (all oil transactions denominated in us dollars) • Buying home currency both spot and forward • Individuals (travelers) • Buying foreign currency spot or forward (traveler’s checks) • Individuals (investors) • Buying foreign currency spot Foreign Exchange Market

6. Wild Cards in the Market • Speculators - create volatility? • Trying to profit from a perceived miss-valuation of a currency • If currency is perceived overvalued • More of it will be needed in the future to buy another currency • It will be shorted (puts for example) • Arbitrageurs - create stability? • Profiting from a riskless arbitrage • Triangular arbitrage • Direct price different than price through another currency Foreign Exchange Market

7. Wild Cards in the Market • Central banks • May try to influence the trend of the value of a currency • Buying foreign exchange to prevent depreciation • Selling foreign exchange to prevent appreciation • Trying to prevent appreciation or depreciation of the currency • May try to reduce volatility in the markets • The direction of the trend line is not important • But the volatility around the trend line is important • Reduce the costs of hedging to exporters and importers Foreign Exchange Market

8. Thickness of the market • 1.19 trillion per day (2004) • spot, forward, and swap transactions • major centers • London 700 billion/day • New York 450 billion/day • Japan 200 billion/day • major currencies • usd 45% • Euro 20% • yen 10% Foreign Exchange Market

9. Contracts • spot • Delivery and payment on 2nd business day • forwards • Quotes for 1, 2, 3, 6, 12 month increments • Contracts however are negotiable Foreign Exchange Market

10. The Spot Exchange rate • Price of one currency in terms of another • For delivery today (four business days) • Price fluctuates constantly to reflect market conditions Foreign Exchange Market

11. Spot rate • e0 , cd, terms = cd/usd = 1.1522 • cd cost of the usd • Canadian terms, European terms, direct • interbank quotes usually in European terms • e0 , usd terms = usd/cd = 0.8679 • usd cost of the cd • American terms, indirect http://www.x-rates.com/htmlgraphs/CAD30.html Foreign Exchange Market

12. Bid/ask (Offer) quotations • bid - what the dealer will buy for • ask (offer) - what the dealer will sell for • spread • a function of increased volatility (risk) • Individual firm risk • Increased market risk • Forward exchange rates far into the future • dealers and banks generate revenues from the spread Foreign Exchange Market

13. Example - spot rates Canadian terms, European terms, direct terms American terms, indirect terms Foreign Exchange Market

14. Equilibrium Spot Rate determinants • Demand for CD by holders of foreign currency • foreigners want to buy something Canadian • goods, services, securities, etc. • Supply from Canadians holding CD demanding foreign exchange • Canadians want to buy something foreign • goods, services, securities, etc Foreign Exchange Market

15. Equilibrium Spot Rate Supply of cd - Canadians buying foreign usd/cd e0 Demand for cd - foreigners buying Canadian Q0 Qcd Foreign Exchange Market

16. Efficiency of foreign exchange • Thick (more than 1 billion US/day • Many traders on both sides • Opportunities for speculators (returns) • Information incorporated into price more quickly • Less opportunity to arbitrage • Expected returns compensate for high risk taken • Opportunities for hedgers (costs) • More instruments • Cost prices risks appropriately Foreign Exchange Market

17. Contract • Quantity of goods • Quality of goods • Price of goods • Denominated in which currency • Time of delivery of goods to importer • Time of payment by importer for goods Foreign Exchange Market

18. Source of exchange-rate exposure • Lags • Time lag between contract and production • Variable on production schedule • Time lag between production and delivery • Variable relative to distance and mode of delivery • Time lag between delivery and payment • Variable on credit terms • Exposure directly related to length of lag Foreign Exchange Market

19. Swaps – • Simultaneously purchase and sale on two different value dates • Spot-forward swap • Buy (sell) spot, Sell (buy) forward • Same counter party • Borrowing a currency fully collateralized • Reflects interest rate parity between the two currencies • Essentially adjusts for relative inflation • Forward-forward swaps • Buy (sell) forward, sell (buy) further forward Foreign Exchange Market

20. Mechanics of exchange markets • transactions confirmed by • telephone • telex • SWIFT • Society for Worldwide Interbank Financial Communications • provides liquidity • goods & service flows - 5 % • capital flows - 95% Foreign Exchange Market

21. The clearing system • clearing house interbank pymts sys (chips) • fedwire • electronic trading - direct trading • EBS • Telerate • Quotron • efficiency of the markets increasing • more pricing information • competition has brought transaction costs down Foreign Exchange Market

22. cross rates • calculating the pound price of the usd going through the cd • check for arbitrage possibilities • arbitrage involves trading gains from a riskless series of instantaneous transactions Foreign Exchange Market

23. Arbitrage • assume crcd. Usd > ecd. Usd through the Euro • buy US dollars • sell US dollars for the Euro • sell the Euro for Canadian dollars Foreign Exchange Market

24. Change in the value of the CD Foreign Exchange Market

25. contract today for future delivery of exchange amount contracted, term contracted, rate contracted quotations in points basis points added to or subtracted from spot bid/ask spread if bid points larger than ask points, subtract trading at discount if bid points smaller than ask points, add trading at premium Forward contracts Foreign Exchange Market

26. Factors affecting money & exchange rates 1. economic growth • economic growth increases demandfor base 2. inflation • CB controls the supply of base money 3. interest rates • CB controls the bank rate directly • CB influences term structure of interest rates indirectly 4. political risk Foreign Exchange Market