Download The Foreign Exchange Market

Chapter 06
The Foreign Exchange Market
1
The Foreign Exchange Market
• Characteristics of the FOREX market
• Geographic extent of the foreign exchange (FOREX)
market
• Functions of the FOREX market
• Market participants
• Foreign exchange transactions – spot, forward, and
swaps
• Review of currency quotations used by currency
dealers, financial institutions, and agents
• Cross exchange rates and opportunities arising from
inter-market arbitrage
2
Characteristics of the FOREX Market
• The FOREX market provides the physical and
institutional structure through which
currencies are exchanged
• 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 rate
3
Geographic Extent of the Market
• Geographically, the FOREX market spans the
globe with prices moving and currencies
trading on a 24 hour basis
• Major exchanges are located in Singapore,
Hong Kong, and Tokyo in the East
• Then it moves to Bahrain, and London for the
European area
• And on to New York, San Francisco, and
Sydney
4
Geographic Extent of the Market
25,000
20,000
15,000
10,000
5,000
Greenwich Mean
Time
0
1
2
10 AM
In Tokyo
3
4
5
6
Lunch Europe
In Tokyo opening
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Asia
closing
Americas London
open
closing
Afternoon
in America
6 pm
In NY
Tokyo
opens
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
5
Functions of the FOREX Market
• The FOREX market functions to transfer purchasing
power between countries, obtain or provide credit for
international trade, and manage the exchange rate risk
– Transferring purchasing power – allow trade partners to
convert foreign currency revenues into their own currency
– Credit for trade – the movement of goods between
countries takes time which requires financing for products
in transit (letters of credit)
– Managing FX exposure – the FOREX market provides
“hedging” instruments to transfer exchange rate risk to
someone else who is more willing to take that risk
6
Market Participants
• The FOREX market has two parts, the
interbank or wholesale market, and the client
or retail market
– Five broad categories of participants operate
within these two parts
– Bank and non-bank foreign exchange dealers
– Individuals and firms
– Speculators and arbitragers
– Central banks and treasuries
7
Market Participants:
Bank and Non-bank Dealers
• These participants profit from buying currencies at a bid
price and then reselling them at an offer or ask price
• Competition among dealers narrows the spread between
the bid and offer rate contributing to the market’s
efficiency – lower the spread lower the costs of trading
• Dealers at large international banks often act as market
makers – willing to buy or sell these currencies without
having a counterpart with which to unload the “inventory”
• Dealers trade to keep their inventory levels at manageable
levels providing liquidity
• Currency trading is profitable and often contributes
between 10% – 20% of a banks’ average net income
8
Market Participants:
Individuals and Firms Conducting
Commercial/Investment Transactions
• Importers, exporters, portfolio investors,
MNEs, tourists and others use the FOREX
market to facilitate execution of commercial
or investment transactions
• Some of these participants use the market to
hedge foreign exchange rate risk
9
Market Participants:
Speculators and Arbitragers
• Speculators and arbitragers seek to profit from
trading in the market itself
• They operate for their own interest
• Speculators seek all their profit from favorable
exchange rate changes
• Arbitragers try to profit from simultaneous
differences in exchange rates in different markets
– without risk
• A large proportion of speculation and arbitrage is
executed by traders employed by large banks
10
Market Participants:
Central Banks and Treasuries
• Central banks and treasuries use FOREX to
influence the value of their own currency –
this is the mechanism in which reserves
balances are placed at work
• Consequently their motive is not to profit but
rather influence the foreign exchange value of
their currency in a manner that will benefit
their interests
11
Transactions in the Interbank Market
• Transactions in FOREX: spot, forward, and
swap
– A spot transaction requires almost immediate
delivery of foreign exchange
– A forward transaction requires delivery of foreign
exchange at some future date
– A swap transaction is the simultaneous exchange
of one foreign currency for another
12
Transactions in the Interbank Market
• A spot transaction in the interbank market is
the purchase of foreign exchange with
delivery and payment between banks to take
place on the second following business day
– The settlement date is often referred to as the
value date
– This is the date when most dollar transactions are
settled through the computerized Clearing House
Interbank Payment Systems (CHIPS) in New York
13
Transactions in the Interbank Market
• Outright forward transaction requires delivery at a
future value date of a specified amount of one
currency for another
• The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed
• Forward rates are contracts quoted for value dates of
one, two, three, six, nine and twelve months
– A contract to deliver dollars for euros in six months is both
buying euros forward for dollars and selling dollars forward
for euros
14
Transactions in the Interbank Market
• A swap transaction in the interbank market is 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
counter party
• A common type of swap is a spot against forward
– The dealer buys a currency in the spot market and
simultaneously sells the same amount back to the same
bank in the forward market. Why a dealer would do this?
– The dealer incurs no exchange rate exposure
15
Transactions in the Interbank Market
• Forward-forward swaps – A dealer sells £20,000 forward for
dollars for delivery in two months at $1.6400/£ and
simultaneously buys £20,000 forward for delivery in three
months at $1.6350/£
– The dealer’s motive is to take advantage of the interest rate
differentials
• Non-deliverable forwards (NDFs) – NDFs have the same
characteristics as traditional forward contracts except that
they are settled only in US dollars at maturity (dollars
change hands, the amount is determined by the difference
between agreed upon forward rate and actual spot rate at
maturity)
– The dollar-settlement feature reflects the fact that NDFs are
contracted offshore and are beyond the reach and regulatory
frameworks of the home country governments
– Pricing of NDFs reflects basic interest rate differentials
16
Size of the FOREX Market
• Global Foreign Exchange Market Turnover, 1989-2007 (daily
averages in April, billions of US$)
17
Size of the FOREX Market
• Top 10 Geographic Trading Centers in the Foreign Exchange Market,
1992–2007
(daily averages in April, billions of U.S. dollars)
18
Size of the FOREX Market
• Foreign Exchange Market Turnover by Currency Pair (Daily averages
in April)
19
Foreign Exchange Rates & Quotations
• A foreign exchange quote is a statement of willingness
to buy or sell at an announced rate
– In the retail market (newspapers and exchange booths),
quotes are often given as the home currency price of the
foreign currency
• Interbank quotes – professionals state forex quotes in
one of two ways
– The foreign currency price of one dollar (European Quote)
• Sfr1.6000/$, read as 1.600 Swiss francs per dollar
– The dollar price of a unit of foreign currency (American
Quote)
• $0.6250/Sfr, read as 0.6250 dollars per Swiss franc
20
Foreign Exchange Rates & Quotations
• Direct and Indirect Quotes
– A direct quote is a home currency price of a unit
of a foreign currency
• Sfr1.6000/$ is a direct quote in Switzerland
– An indirect quote is a foreign currency price of a
unit of the home currency
• Sfr1.6000/$ is an indirect quote in the US,
• $0.6250/Sfr is a direct quote in the US and an indirect
quote in Switzerland
21
Foreign Exchange Rates & Quotations
•
•
•
AUD/USD bid quote should be read as 1 AUD is 0.7740 USD ($0.7740/AUD)
In the FX markets, the US Dollar is normally considered to be the “base” currency
(the currency in which an investor or issuer maintains its book of accounts) for
quotes, meaning that quotes are expressed as a unit of $1 USD per the other
currency quoted in the pair (European). The primary exceptions to this rule are the
British Pound, the Euro and the Australian Dollar (American) (indicated by *)
Rates USD/CHF show the number of Swiss franks to be paid for one US dollar, but
rates GBP/USD show the number of US dollars having to be paid for one British
pound
Major Rates
AUD/USD*
USD/CAD
USD/CHF
EUR/USD*
GBP/USD*
USD/HKD
USD/JPY
Bid
0.7740
1.3002
1.2366
1.2668
1.8296
7.7620
106.88
Ask
0.7745
1.3007
1.2371
1.2673
1.8301
7.7642
106.93
CHF (Confederation Helvetica Franc) is Swiss Franc
CHF Price of one Dollar a Dollar Price of one CHF a
Dealer is willing to Buy
Delar is willing to Buy
(Bid) and Sell (Ask)
(Bid) and Sell (Ask)
Bid
Ask
Bid
Ask
1.2366
1.2371
0.80834
0.80867
Bid/Ask Spread
Bid/Ask Spread
0.0005
0.00033
Note: Ask is always higher.
22
Foreign Exchange Rates & Quotations
• Expressing Forward Quotations on a Points Basis
– The previously mentioned rates for yen were
considered outright quotes
– Forward quotes are different and typically quoted in
terms of points
– A point is the last digit of a quotation, with convention
dictating the number of digits to the right of the
decimal
• Hence a point is equal to 0.0001 for most currencies =>
point(s) / 10,000 will convert points into decimal form
• For Japanese Yen one point is 0.01 => point(s) / 100 will
convert points into decimal form
23
Foreign Exchange Rates & Quotations
• Expressing Forward Quotations on a Points Basis
– A forward quotation on a point basis is not a foreign exchange rate, rather the
difference between the spot and forward rates
– Example:
Bid =
106.91
Spot Rate
Ask =
106.96
Forward Points
Period
Bid
Ask
1 Month
-13
-8
2 Month
-23
-18
3 Month
-34
-27
6 Month
-66
-58
-152
-131
12 Month
2 Year
-420
-370
Spot Rate USD/JPY = 106.91/106.96
Bid =
106.91
Ask =
106.96
Forward Points in Decimals
Outright Forward Rates
Period
Bid
Ask
Period
Bid
Ask
1 Month
-0.13
-0.08
1 Month
106.78
106.88
2 Month
-0.23
-0.18
2 Month
106.68
106.78
3 Month
-0.34
-0.27
3 Month
106.57
106.69
6 Month
-0.66
-0.58
6 Month
106.25
106.38
-1.52
-1.31
105.39
105.65
12 Month
12 Month
2 Year
-4.20
-3.70
2 Year
102.71
103.26
24
Foreign Exchange Rates & Quotations
• Forward Quotations in Percentage Terms
– Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate
– The important thing to remember is which currency is
being used as the home or base currency
• For direct quotes (i.e. quote expressed in home currency
terms), the formula is
f
$/FC
Forward - Spot
360

x
x 100
Spot
days
• For indirect quotes (i.e. quote expressed in foreign currency
terms), the formula is
f
FC/$
Spot - Forward
360

x
x 100
Forward
days
25
Foreign Exchange Rates & Quotations
• Cross Rates
– Many currencies pairs are inactively traded, so their
exchange rate is determined through their
relationship to a widely traded third currency
– Example: A Mexican importer needs Japanese yen to
pay for purchases in Tokyo. Both the Mexican peso
(Ps) and Japanese yen (¥) are quoted in US dollars
• Assume the following quotes:
• Japanese yen ¥121.13/$ and Mexican peso Ps9.190/$
• The Mexican importer can buy one US dollar for Ps9.190 and
with that dollar buy ¥121.13; the cross rate would be
Japanese yen / US dollar
¥121.13/$
=
= ¥13.1806/Ps
Mexican pesos / US dollar Ps9.190/$
26
Cross Currency Arbitrage
• Intermarket Arbitrage
– Cross rates can be used to check on opportunities for
intermarket arbitrage
– Example: Assume the following exchange rates are quoted
•
•
•
•
Citibank
$0.9045/€
Barclays Bank
$1.4443/£
Dresdner Bank
€1.6200/£
The cross rate between Citibank and Barclays is
$1.4443 / £
 Euro1.5968 / £  Sell £ to Dresdner for Euro
$0.9045 / Euro
• This cross rate is not the same as Dresdner’s rate quote of
€1.6200/£, so an opportunity exists for risk-less profit
• What is the cross rate between Citibank and Dresdner?
$0.9045 / Euro  Euro1.6200 / £  $1.4653/£  Sell $ to Barclays for £
27
Cross Currency Arbitrage
• Intermarket Arbitrage
– Citibank
– Barclays Bank
– Dresdner Bank
$0.9045/€
$1.4443/£
€1.6200/£
• What is the cross rate between Barclays and Dresdner?
$1.4443 / £
 $0.8915 / Euro  Sell Euro to Citibank for $
Euro1.6200 / £
• If you have $ at the start then the order of currency
conversions (locations) is:
• $ => £ (Barclays) => € (Dresdner) => $ (Citibank)
28
Cross Currency Arbitrage
Citibank
End with $1,014,533
(6)
Receive $1,014,533
Start with $1,000,000
(1)
Sell $1,000,000 to Barclays
Bank at $1.4443/£
Dresdner Bank
(5)
Sell €1,121,651 to Citibank
at $0.9045/€
(4)
Receive €1,121,651
Barclays Bank
(2)
Receive £692,377
(3)
Sell £692,377 to Dresdner Bank
at €1.6200/£
29
Foreign Exchange Rates & Quotations
• Direct and Indirect Quotes
• A direct quote is a home currency price of a
unit of a foreign currency
– Sfr1.6000/$ is a direct quote in Switzerland
• An indirect quote is a foreign currency price of
a unit of the home currency
– Sfr1.6000/$ is an indirect quote in the US,
– $0.6250/Sfr is a direct quote in the US and an
indirect quote in Switzerland
30
Measuring a Change in Spot Rates
• Assume that Swiss franc is quoted at Sfr1.6000/$ (same as
$0.6250/Sfr). Suddenly it strengthens to Sfr1.2800/$ (same
as $0.78125/$). What is the percentage change in the
dollar value of the franc? (Home currency is dollar)
• Using Direct Quotes:
%ΔDQ 
Ending Rat e-Beginnin g Rate
$0.78125Sfr-$0.6250 /Sfr
x100 
x100=+25%
Beginning Rate
$0.6250 /Sfr
S2$ / FC -S1$ / FC
S1$ / FC
SAME
• Using Indirect Quotes:
%ΔIQ 
Beginning Rate-Endin g Rate
Sfr1.6000 /$-Sfr1.2800 /$
x100 
x100=+25%
Ending Rat e
Sfr1.2800 /$
S1FC / $ -S 2FC / $
S 2FC / $
31