Download The Foreign Exchange Market

The Foreign Exchange Market
The Foreign Exchange Market
 The Foreign Exchange Market provides:
 The physical and institutional structure through which the money of one country is
exchanged for that of another country
 The determination rate of exchange between currencies
 A foreign exchange transaction is an agreement between a buyer and a seller that a fixed
amount of one currency will be delivered for some other currency at a specified date.
Functions of the Foreign Exchange Market
 The foreign exchange Market is the mechanism by which participants:
 Transfer purchasing power between countries
 Obtain or provide credit for international trade transactions
 Minimize exposure to the risks of exchange rate changes
Market Participants
 The foreign exchange market consists of two tiers:
 The interbank or wholesale market
 The client or retail market
 Five categories of participants:
 Bank and nonbank foreign exchange dealers
 Individuals and firms
 Speculators and arbitragers
 Central banks and treasuries
 Foreign exchange brokers
Types of Transactions
 Spot transaction:
 The purchase of foreign exchange, with delivery and payment between banks to take
place, normally, on the second following business day
 Forward transaction:
 To require delivery at a future date of a specified amount of one currency for a specified
amount of another currency
 The exchange rate is established at the time of the agreement, but payment and delivery
are not required until maturity
 Swap transaction:
 The simultaneous purchase and sale of a given amount of foreign exchange for two
different value dates
 Both purchase and sale are conducted with the same counterparty
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Foreign Exchange Rates and Quotations
 A foreign exchange rate is the price of one currency expressed in terms of another currency
 A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an
announced rate
 Foreign exchange rates (or quotations) can be displayed:
 The foreign currency price of one dollar
 The dollar price of a unit of foreign currency
For example, the exchange rate between US dollars and the Swiss franc is stated:
SF 1.6000/$ (European terms)
or
$0.6250/SF (American terms)
 Foreign exchange quotes are at times described as either direct or indirect:
 A direct quote is a home currency price of a unit of foreign currency
 An indirect quote is a foreign currency price of a unit of home currency
Using above example, in the United States
SF 1.6000/$ (?)
and
$0.6250/SF (?)
When the home currency is SF then…..
 Foreign exchange quotations are given as a bid and ask (also referred to as offer):
 A bid is the price (i.e. exchange rate) in one currency at which a dealer will buy another
currency.
 An ask is the price (i.e. exchange rate) at which a dealer will sell the other currency.
 Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit
from the spread between the buying and selling prices.
 A bid for one currency is also the offer for the opposite currency.
For example, assume a bank makes the quotations for the Japanese yen as follow:
Bid
Ask
118.27 yen/$
118.37yen/$
If you want to buy $ for yen from the bank then ....
If you want to sell $ for yen to the bank then ....
If you want to buy yen for $ from the bank then ....
If you want to sell yen for $ to the bank then ....
 A forward quotation is usually expressed in points:
 It is the difference between the forward rate and the spot rate
 Forward quotations may also be expressed as the percent-per-annum deviation from the
spot rate.
For quotations expressed in direct quotations:
(Spot – Forward)/Forward *(360/n)*100
or
For quotations expressed in indirect quotations:
(Forward – Spot)/Spot *(360/n)*100
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Example:
Foreign currency/home currency
Home currency/foreign currency
Spot rate
105.65yen/$
0.009465215$/yen
3-month forward
105.04yen/$
0.009520183$/yen
Using indirect quotations:
Premium (or discount) = (Forward-Spot)/Spot *(360/n)*100
=(105.04-105.65)/105.65 *(360/90)*100
= -2.31%
Or using direct quotations:
Premium (or discount) =(Spot-Forward)/Forward *(360/n)*100
=(0.009465215-0.009520183)/ 0.009520183 * (360/90)*100
= -2.31%
Classroom
problem:
Forward Premiums and Discounts
Calculate the percentage premium or discount.
Assumptions
Days forward
European euro ($/euro)
British pound ($/pound)
Japanese yen (yen/$)
Swiss franc (SF/$)
Hong Kong dollar (HK$/$)
Quoted
Spot rate
0.8000
1.5620
120.00
1.6000
8.0000
180-day
Forward rate
180
0.8160
1.5300
118.00
1.6200
7.8000
Percent premium
or discount
Cross Rates and Intermarket Arbitrage
 Many currency pairs are only inactively traded, so their exchange rate is determined through
their relationship to a widely traded third currency (cross rate)
Example:
Quote
yen/$: 121.13yen/$
peso/$:
9.19Ps/$
peso/yen
NA
peso/yen = (peso/$)/(yen/$)=(9.19Ps/$)/(121.13yen/$)=0.0759Ps/yen
or
yen/peso = (yen/$)/(peso/$)=(121.13yen/$)/(9.19Ps/$)=13.1806yen/Ps
 Intermarket arbitrage (triangular arbitrage)
Example
Citibank quote - $/€
$0.9045/€
Barclays quote - $/£
$1.4443/£
Dresdner quote - €/£
€1.6200/£
Cross rate calculation: ($1.4443/£)/($0.9045/€)=€1.5968/£
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Start with 1£ → buy € from Dresdner bank, receive 1.6200 € → buy back £
using cross rate €1.5968/£ will receive 1.0145 £ (1.6200 €/€1.5968/£) → get net
profit 0.0145 £.
Classroom
problem:
Riskless profit on the franc
Can you make a profit via triangular
arbitrage?
Assumptions
Values
Beginning funds in Swiss francs (SF)
10,000,000.00
Mt. Fuji Bank (yen/$)
120.00
Mt. Rushmore Bank (SF/$)
1.6000
Matterhorn Bank (yen/SF)
80.00
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