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Chapter 06
The Foreign Exchange Market
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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
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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
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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
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Geographic Extent of the Market
0
5,000
10,000
15,000
20,000
25,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Greenwich Mean Time
Tokyoopens
Asiaclosing
10 AMIn Tokyo
Afternoonin America
Londonclosing
6 pmIn NY
Americasopen
Europeopening
LunchIn Tokyo
Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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 $1.6350/£– The dealer’s motive is to take advantage of the interest rate differentials
• Non-deliverable forwards (NDFs) – NDFs have the same characteristics as traditional forward contracts except that they are settled only in US dollars at maturity (dollars change hands, the amount is determined by the difference between agreed upon forward rate and actual spot rate at maturity)– The dollar-settlement feature reflects the fact that NDFs are contracted
offshore and are beyond the reach and regulatory frameworks of the home country governments
– Pricing of NDFs reflects basic interest rate differentials
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Size of the FOREX Market• Global Foreign Exchange Market Turnover, 1989-2007 (daily averages in April,
billions of US$)
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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)
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Size of the FOREX Market• Foreign Exchange Market Turnover by Currency Pair (Daily averages in April)
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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)
• $0.6250/Sfr, read as 0.6250 dollars per Swiss franc
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Foreign Exchange Rates & Quotations
• Direct and Indirect Quotes– A direct quote is a home currency price of a unit
of a foreign currency• Sfr1.6000/$ 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
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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 Bid AskAUD/USD* 0.7740 0.7745USD/CAD 1.3002 1.3007USD/CHF 1.2366 1.2371
EUR/USD* 1.2668 1.2673GBP/USD* 1.8296 1.8301USD/HKD 7.7620 7.7642USD/JPY 106.88 106.93
Bid Ask Bid Ask1.2366 1.2371 0.80834 0.80867
0.0005 0.00033Note: Ask is always higher.
CHF (Confederation Helvetica Franc) is Swiss FrancCHF Price of one Dollar a
Dealer is willing to Buy (Bid) and Sell (Ask)
Dollar Price of one CHF a Delar is willing to Buy
(Bid) and Sell (Ask)
Bid/Ask Spread Bid/Ask Spread
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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
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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 = 106.91Ask = 106.96
Period Bid Ask1 Month -13 -82 Month -23 -183 Month -34 -276 Month -66 -58
12 Month -152 -1312 Year -420 -370
Forward Points
Spot Rate
Bid = 106.91 Ask = 106.96
Period Bid Ask Period Bid Ask1 Month -0.13 -0.08 1 Month 106.78 106.882 Month -0.23 -0.18 2 Month 106.68 106.783 Month -0.34 -0.27 3 Month 106.57 106.696 Month -0.66 -0.58 6 Month 106.25 106.38
12 Month -1.52 -1.31 12 Month 105.39 105.652 Year -4.20 -3.70 2 Year 102.71 103.26
Forward Points in Decimals Outright Forward Rates
Spot Rate USD/JPY = 106.91/106.96
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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
• For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is
100360 x days
x Spot
SpotForward - f $/FC
100360 x days
x Forward
wardSpot - For f FC/$
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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/$• The Mexican importer can buy one US dollar for Ps9.190 and
with that dollar buy ¥121.13; the cross rate would bes¥13.1806/P
Ps9.190/$¥121.13/$
dollar US / pesos Mexicandollar US / yen Japanese
==
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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 $1.4443/£• Dresdner Bank€1.6200/£• The cross rate between Citibank and Barclays is
• This cross rate is not the same as Dresdner’s rate quote of €1.6200/£, so an opportunity exists for risk-less profit
• What is the cross rate between Citibank and Dresdner?
Eurofor Dresdner to£ Sell£/5968.1/9045.0$
£/4443.1$ Euro
Euro
£for Barclays to$ Sell$1.4653/££/6200.1/9045.0$ EuroEuro
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Cross Currency Arbitrage
• Intermarket Arbitrage– Citibank $0.9045/€– Barclays Bank $1.4443/£– Dresdner Bank €1.6200/£
• What is the cross rate between Barclays and Dresdner?
• If you have $ at the start then the order of currency conversions (locations) is:• $ => £ (Barclays) => € (Dresdner) => $ (Citibank)
$for Citibank to Sell/8915.0$£/6200.1
£/4443.1$ EuroEuroEuro
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Cross Currency ArbitrageCitibank
Dresdner Bank Barclays Bank
End with $1,014,533 Start with $1,000,000
(3) Sell £692,377 to Dresdner Bank at €1.6200/£(4) Receive €1,121,651
(1) Sell $1,000,000 to Barclays Bank at $1.4443/£
(2) Receive £692,377(5) Sell €1,121,651 to Citibank at $0.9045/€
(6) Receive $1,014,533
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Foreign Exchange Rates & Quotations
• Direct and Indirect Quotes• A direct quote is a home currency price of a
unit of a foreign currency– Sfr1.6000/$ 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, – $0.6250/Sfr is a direct quote in the US and an
indirect quote in Switzerland
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Measuring a Change in Spot Rates• Assume that Swiss franc is quoted at Sfr1.6000/$ (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:
• Using Indirect Quotes:
%=+x/Sfr.$
/Sfr.Sfr-$.$xRateBeginning
g Ratee-BeginninEnding Rat%ΔDQ 2510062500
62500781250100
FC/$
FC/$FC/$
S-SS
1
12
%=+x/$.Sfr
/$./$-Sfr.SfrxeEnding Rat
g RateRate-EndinBeginning %ΔIQ 2510028001
2800160001100
$/FC
$/FC$/FC
S-SS
2
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SAME