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Chapter 2: The Foreign Exchange
Market
Power Points created by:
Joseph F. Greco Ph. D.,
California State University, Fullerton
Mihaylo College of Business and Economics
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall
1
Chapter 2: The Foreign Exchange
Market
2.1
The Organization of the Foreign Exchange
Market
2.2
Currency Quotes and Prices
2.3
Inside the Interbank Market I: Bid-Ask Spreads
and Bank Profits
2.4
Inside the Interbank Market II: Communications
and Fund Transfers
2.5
Describing Changes in Exchange Rates
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2.1 The Organization of the Foreign
Exchange Market
• The Organization: Overview
• Size of the Market
• Types of Contracts Traded
• Foreign Exchange Brokers
• Computerized Trading Systems
• The Competitive Marketplace
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Exhibit 2.1
The Structure of the Foreign Exchange Market
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2.1 The Organization of the Foreign
Exchange Market
• Size of the Market
• Largest financial market in the
world,measured by dollar volume of trade
• Types of Contracts Traded
• Focus in this chapter is on a spot market
contract that is settled in 48 hours
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London、NewYork、Paris等市场 at the third
day;香港市场，HongKong dollars
exchange for dollars at the trading day for
delivery;HongKong dollars exchange for
JPY at the next day.
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Exhibit 2.2
Foreign Exchange Trading Activity
Around the World
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2.1 The Organization of the Foreign
Exchange Market
• Foreign Exchange Dealers
– Foreign exchange dealers
– Market makers
– Liquidity
• Easy to match buyers and sellers
• Low transaction costs
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• Foreign Exchange brokers
– market matching
– financial intermediary
• Easy to match buyers and sellers
• Low transaction costs
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2.1 The Organization of the Foreign
Exchange Market
• Computerized Trading Systems
• Dealing 3000
• EBS
The Competitive Marketplace
• low cost
• no abnormal profits
• no single dealer dorminates market
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Exhibit 2.3
The Top 20 Dealers in the Foreign
Exchange Market
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2.2 Currency Quotes and Prices
Currency Quotes and Prices: Overview
• Exchange Rates
• Exchange Rate Quotes
• Vehicle Currencies and Currency Cross-Rates
•
Example:
Trading currency in the New York market where both
currencies are not expressed in U.S. dollars
•
Triangular Arbitrage
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Example of cross rate
•
•
•
•
•
•
1.USD/DEM=1.8421/28,USD/HKD=7.8085/95
so,DEM/HKD
Answer:
bid price of DEM=7.8085/1.8428=4.2373
ask price of DEM=7.8095/1.8421=4.2395
DEM/HKD=4.2373/95
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•
•
•
•
•
•
2.GBP/USD=1.6125/35,AUD/USD=0.7120/30
so,GBP/AUD
Answer
bid price of GBP=1.6125/0.7130=2.2616
ask price of GBP=1.6135/0.7120=2.2662
GBP/AUD=2.2616/62
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• 3.GBP/USD=1.6125/35,USD/JPY=150.80/
90
• so,GBP/JPY
• Answer
• bid price of GBP=1.6125*150.80=243.17
• ask price of GBP=1.6135*150.90=243.48
• GBP/JPY=243.17/48
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2.2 Currency Quotes and Prices
• Exchange Rates
• Exchange Rate Quotes
• Direct quotes
• Indirect Quotes
• European Quote
• American Quote
• Dollar price of a foreign currency
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Exhibit 2.4
Currencies and Currency Symbols
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Exhibit 2.5
Currency Quotes in the Wall Street Journal
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2.2 Currency Quotes and Prices
• Vehicle Currencies and Currency Cross-Rates
• Vehicle currency
• Cross-rates
• Example:
Trading currency in the New York market
where both currencies are not expressed in
U.S. dollars
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Exhibit 2.6
Cross-rates Quotes in the
Wall Street Journal
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2.2 Currency Quotes and Prices
• Triangular Arbitrage
• An arbitrage process involving three
currencies
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Exhibit 2.7
Triangular Arbitrage Diagram
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Exhibit 2.8
Good and Bad Triangular Arbitrages
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•
•
•
•
NewYork:USD/DEM,1.5020/30
NewYork:USD/GBP,0.5875/0.5885
London:GBP/DEM,2.5610/2.5620
if customer holding 1000,000,first
NewYork1000000*0.5875=£587500
• London587500*2.5610=DM1504587.5
• NewYork1504587.5/1.503=1001056
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• customer hold 1000,000 Pound,
London1000000*2.5610=DM2561000
• NewyorkDM2561000/1.503=＄1703925.5
• Newyork＄1703925.5*0.5875=£1001056
• customer hold 1000000DM,
• NewYork1000000/1.503=＄665336
• NewYork＄665336*0.5875=£390885
• London£390885*2.5610=DM1001056
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2.3 Inside the Interbank Market I: Bid-Ask Spreads
and Bank Profits
The Interbank Market: Overview
• Introduction
• Bid-Ask Spreads
• The difference between the ask rate and the bid
rate
• The Magnitude of Bid-Ask Spreads
• Bid-Ask Spreads All Day Around the Work
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2.3 Inside the Interbank Market I: Bid-Ask Spreads
and Bank Profits
• Introduction
• Bid rate
• Ask Rate
• Bid-Ask Spread
• Bid-Ask Spreads
• Offer Price
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2.3 Inside the Interbank Market I: Bid-Ask Spreads
and Bank Profits
• The Magnitude of Bid-Ask Spreads
• Pip
• Fourth decimal place in a dealer’s quote
• percentage spread=100*(ask-bid)/ask
• ask rate is ＄1.1895/*,bid rate is ＄1.1891/*
• the spread is 100*1.18951.1891/1.1895=0.03%
• Bid-Ask Spreads
• The difference between the bid and the ask rates
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2.4 Inside the Interbank Market II:
Communications and Fund Transfers
• Communication Systems
• Society of Worldwide Interbank Financial
Telecommunications (SWIFT)
• Clearing House Interbank Payments System
(CHIPS)
• Trans-European Automated Real-time Gross
Settlement Express Transfer (TARGET)
• Fedwire
• Cross-Currency Settlement (Herstatt Risk)
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Exhibit 2.9
The Reciprocal Nature of Bid and Ask Exchange Rates
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the reciprocal nature of bid ask spread
• from the picture, we can see in selling yen
for dollars , the seller will receive the bid
price of ＄/¥ which is the reciprocal of the
bank's ask yen price per dollar 1/(¥/＄), in
selling dollar for yen, receive bank' s bid
price of yen to dollar is the reciprocal of
bank's ask price of dollars for yen.
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Exhibit 2.10
Communication Systems in the Forex Market
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2.4 Inside the Interbank Market II:
Communications and Fund Transfers
• Cross-Currency Settlement (or Herstatt) Risk
• The risk that a financial institution may not deliver
the currency on one side of a completed
transaction
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2.5 Describing Changes in Exchange Rates
• Introduction
• Appreciation
• Depreciation
• Devaluations
• Revaluations
• Rates of Appreciation and Depreciation are used to
describe changes in exchange rates when exchange
rates are allowed to be flexible
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• devalution and revaluation means some
country use fixed or peg exchange rate
system if the monetary authorities
increase the demestic currency price of
foreign exchange , they are devaluating
their money , or is revaluating
• P61
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Exhibit 2.11
Netting Arrangements
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Exhibit 2.11
Netting Arrangements
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