INT. Finance- FX Market

INTERNATIONALFINANACE

Function and Structure of the FX MarketFunction and Structure of the FX Market The Spot MarketThe Spot Market The Forward MarketThe Forward Market

Function and Structure of the FX MarketFunction and Structure of the FX Market FX Market ParticipantsFX Market Participants Correspondent Banking RelationshipsCorrespondent Banking Relationships

The Spot MarketThe Spot Market The Forward MarketThe Forward Market

Function and Structure of the FX MarketFunction and Structure of the FX Market The Spot MarketThe Spot Market

Spot Rate QuotationsSpot Rate Quotations The Bid-Ask SpreadThe Bid-Ask Spread Spot FX TradingSpot FX Trading Cross Exchange Rate QuotationsCross Exchange Rate Quotations Triangular ArbitrageTriangular Arbitrage Spot Foreign Exchange Market MicrostructureSpot Foreign Exchange Market Microstructure

The Forward MarketThe Forward Market


Forward Rate QuotationsForward Rate Quotations Long and Short Forward PositionsLong and Short Forward Positions Forward Cross-Exchange RatesForward Cross-Exchange Rates Swap TransactionsSwap Transactions Forward PremiumForward Premium


Chapter OutlineChapter Outline

The Function and Structure of The Function and Structure of the FX Marketthe FX Market

FX Market ParticipantsFX Market Participants Correspondent Banking RelationshipsCorrespondent Banking Relationships

FX Market ParticipantsFX Market Participants The FX market is a two-tiered market:The FX market is a two-tiered market:

1.1. Interbank Market (Wholesale)Interbank Market (Wholesale)• About 700 banks worldwide stand ready to make a About 700 banks worldwide stand ready to make a

market in foreign exchange.market in foreign exchange.• Nonbank dealers account for about 20% of the Nonbank dealers account for about 20% of the

market.market.• There are FX brokers who match buy and sell orders There are FX brokers who match buy and sell orders

but do not carry inventory and FX specialists.but do not carry inventory and FX specialists.

2.2. Client Market (Retail)Client Market (Retail) Market participants include international Market participants include international

banks, their customers, nonbank dealers, FX banks, their customers, nonbank dealers, FX brokers, and central banks.brokers, and central banks.

International Banks-around 100to 200 banks International Banks-around 100to 200 banks worldwide ‘make a market’ i.e. they stand worldwide ‘make a market’ i.e. they stand willing to buy or sell foreign currency for their willing to buy or sell foreign currency for their own account.own account.

Customers broadly include MNCs, Money Customers broadly include MNCs, Money managers and private speculators. managers and private speculators.

Circadian Rhythms of the FX Circadian Rhythms of the FX MarketMarket

Electronic Conversations per Hour

05000

1000015000200002500030000350004000045000

1:00 10 am inTokyo

3:00Lunchhour inTokyo

5:00 Europe

coming in

7:00 9:00 Asia

going out

11:00Lunchhour inLondon

1:00 Americascoming in

15:00 5:00London

going out

19:00 9:00 New

Zealandcoming in

11:00 6 pm in

NY

average peak

Correspondent Banking Correspondent Banking RelationshipsRelationships

Large commercial banks maintain demand Large commercial banks maintain demand deposit accounts with one another which deposit accounts with one another which facilitates the efficient functioning of the facilitates the efficient functioning of the FX market.FX market.

Correspondent Banking RelationshipsCorrespondent Banking Relationships Bank A is in London, Bank B is in New York.Bank A is in London, Bank B is in New York. The current exchange rate is £1.00 = $2.00. The current exchange rate is £1.00 = $2.00. A currency trader employed at Bank A buys A currency trader employed at Bank A buys

£100m from a currency trader at Bank B for £100m from a currency trader at Bank B for $200m settled using its correspondent $200m settled using its correspondent relationship.relationship.

Bank A

London

Bank B

NYC

$200

£100

Correspondent Banking Correspondent Banking RelationshipsRelationships

Assets Liabilities

£ deposit at B £300m

Other Assets £600m

B’s Deposit$1,000m

Other L&E £600m

Total Assets £1,300m Total L&E £1,300m

Assets Liabilities

$ deposit at A$1000m

Other Assets $800m

A’s Deposit £300m

Other L&E $800m

Total Assets $2,200m Total L&E$2,200m

£400m $1,200m $1200m £400m

$600mB’s Deposit £200m

$600m

£ deposit at A £200m

£100m

A’s Deposit $800m

Bank A

London

Bank B

NYC

$200

£100

$ deposit at B $800m

£100m

Correspondent Banking RelationshipsCorrespondent Banking Relationships

International commercial banks International commercial banks communicate with one another with:communicate with one another with: SWIFT: The SWIFT: The SSociety for ociety for WWorldwide orldwide IInterbank nterbank FFinancial inancial TTelecommunications.elecommunications.

CHIPS: CHIPS: CClearing learing HHouse ouse IInterbank nterbank PPayments ayments SSystem ystem

ECHO ECHO EExchange xchange CClearing learing HHouse ouse LLimited, the imited, the first global clearinghouse for settling interbank first global clearinghouse for settling interbank FX transactions.FX transactions.

The Spot MarketThe Spot Market

Spot Rate QuotationsSpot Rate Quotations The Bid-Ask SpreadThe Bid-Ask Spread Spot FX tradingSpot FX trading Cross RatesCross Rates

Spot Rate QuotationsSpot Rate Quotations Direct quotationDirect quotation

A foreign exchange rate quoted as the domestic A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other currency per unit of the foreign currency. In other words, it involves quoting in fixed units of foreign words, it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency against variable amounts of the domestic currency. currency.

e.g.e.g. Rs 50 = $1 Rs 50 = $1

Indirect QuotationIndirect Quotation

A foreign exchange rate quoted as the foreign currency A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. In an indirect quote, per unit of the domestic currency. In an indirect quote, the foreign currency is a variable amount and the the foreign currency is a variable amount and the domestic currency is fixed at one unit.domestic currency is fixed at one unit.- e.g. $2 = Rs. 100- e.g. $2 = Rs. 100

American and European QuoteAmerican and European Quote A quote can be classified as European or A quote can be classified as European or

American only if one of the currencies is the American only if one of the currencies is the dollardollar

American Quote- number of dollars expressed American Quote- number of dollars expressed per unit of any other currency e.g.$2=1pound per unit of any other currency e.g.$2=1pound or $ 2.5=Rs.100or $ 2.5=Rs.100

European Quote- no. of units of any other European Quote- no. of units of any other currency expressed per dollar e.g. Rs.45= $1currency expressed per dollar e.g. Rs.45= $1

Spot Rate Quotations

CountryCountryUSD equiv USD equiv FridayFriday

USD equiv USD equiv ThursdayThursday

Currency per USD Currency per USD FridayFriday

Currency per Currency per USD ThursdayUSD Thursday

Argentina (Peso)Argentina (Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377

Australia (Dollar)Australia (Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762

Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774 2.63782.6378

Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242 0.52260.5226

1 Month Forward1 Month Forward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235

3 Months Forward3 Months Forward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253


Canada (Dollar)Canada (Dollar) 0.80370.8037 0.80680.8068 1.24421.2442 1.23951.2395





The direct quote for British pound is:

£1 = $1.9077

CountryCountryUSD equiv USD equiv FridayFriday


Currency per Currency per USD FridayUSD Friday


Argentina (Peso)Argentina (Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377

Australia (Dollar)Australia (Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762




3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268 0.52530.5253



The indirect quote for British pound is:

£.5242 = $1

CountryCountry

USD USD equiv equiv FridayFriday




Argentina Argentina (Peso)(Peso) 0.33090.3309 0.32920.3292 3.02213.0221 3.03773.0377

Australia Australia (Dollar)(Dollar) 0.78300.7830 0.78360.7836 1.27711.2771 1.27621.2762



1 Month 1 Month ForwardForward 1.90441.9044 1.91011.9101 0.52510.5251 0.52350.5235




Note that the direct quote is the reciprocal of the indirect quote:

5242.

11.9077

CountryCountry












The Bid-Ask SpreadThe Bid-Ask Spread

The bid (buying) price is the price a dealer The bid (buying) price is the price a dealer is willing to pay you for something.is willing to pay you for something.

The ask (selling) price is the amount the The ask (selling) price is the amount the dealer wants you to pay for the thing.dealer wants you to pay for the thing.

The bid-ask spread is the difference The bid-ask spread is the difference between the bid and ask prices.between the bid and ask prices.

The Bid-Ask SpreadThe Bid-Ask Spread A Bank could offer A Bank could offer

bid price of $1.25/€bid price of $1.25/€ ask price of $1.26/€ask price of $1.26/€ While there are a variety of ways to quote While there are a variety of ways to quote

that,that,

$/€: 1.25/1.26 or Rs./$: 45.45/45.50 or 45.45/50$/€: 1.25/1.26 or Rs./$: 45.45/45.50 or 45.45/50

The bid-ask spread represents the The bid-ask spread represents the dealer’s expected profit.dealer’s expected profit.

Interbank Quote vs Merchant QuoteInterbank Quote vs Merchant Quote

Merchant quote is the quote given by a Merchant quote is the quote given by a bank to its retail customersbank to its retail customers

The Bid-Ask SpreadThe Bid-Ask Spread

A dealer would likely quote these prices as 72-77.A dealer would likely quote these prices as 72-77. It is presumed that anyone trading $10m already It is presumed that anyone trading $10m already

knows the “big figure”.knows the “big figure”.

Bid Ask

1.9072

.5242

S($/£)

S(£/$)

1.9077

.5243

big figure

small figure

Spot FX tradingSpot FX trading

In the interbank market, the standard size In the interbank market, the standard size trade is about U.S. $10 million.trade is about U.S. $10 million.

A bank trading room is a noisy, active A bank trading room is a noisy, active place.place.

The stakes are high.The stakes are high. The “long term” is about 10 minutes.The “long term” is about 10 minutes.

Cross RatesCross Rates Suppose that Suppose that SS($/€) = 1.50($/€) = 1.50

i.ei.e. $1.50 = €1.00 . $1.50 = €1.00 and that and that SS(¥/€) = 50(¥/€) = 50

i.ei.e. €1.00 = ¥50. €1.00 = ¥50 What must the $/¥ cross rate be?What must the $/¥ cross rate be?

$1.50

¥50=

$1.50 €1.00

€1.00 ¥50×

$1.00 = ¥33.33

$0.0300 = ¥1

Triangular ArbitrageTriangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate any implied cross rate to see if an arbitrage exists. £1.00

¥80=

£1.50 $1.00

$1.00 ¥120×


$

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

The implied S(¥/£) cross rate is

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.So, how can we make money?

¥ £

£1.00

¥80=

£1.50 $1.00

$1.00 ¥120×

Then trade yen for your preferred currency.

Buy the £ @ ¥80; sell @ ¥85.


$

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell our $ for £,

2. Sell our £ for ¥,

3. Sell those ¥ for $.¥ £

1

2

3

$


Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000

Sell our £150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥12,750,000 for $ at S(¥/$) = 120receive $106,250

profit per round trip = $106,250 – $100,000 = $6,250


$

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Here we have to go “clockwise” to make money—but it doesn’t matter where we start.

¥ £1

2 3

$

If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient!

Spot Foreign Exchange Spot Foreign Exchange MicrostructureMicrostructure

Market Microstructure refers to the Market Microstructure refers to the mechanics of how a marketplace mechanics of how a marketplace operates.operates.

Bid-Ask spreads in the spot FX market:Bid-Ask spreads in the spot FX market: increase with FX exchange rate volatility and increase with FX exchange rate volatility and decrease with dealer competition.decrease with dealer competition.

Private information is an important Private information is an important determinant of spot exchange rates.determinant of spot exchange rates.


Forward Rate QuotationsForward Rate Quotations Long and Short Forward PositionsLong and Short Forward Positions Forward Cross Exchange RatesForward Cross Exchange Rates Swap TransactionsSwap Transactions Forward PremiumForward Premium


A forward contract is an agreement to buy A forward contract is an agreement to buy or sell an asset in the future at prices or sell an asset in the future at prices agreed upon today.agreed upon today.

If you have ever had to order an out-of-If you have ever had to order an out-of-stock textbook, then you have entered into stock textbook, then you have entered into a forward contract.a forward contract.

Forward Rate QuotationsForward Rate Quotations

The forward market for FX involves The forward market for FX involves agreements to buy and sell foreign agreements to buy and sell foreign currencies in the future at prices agreed currencies in the future at prices agreed upon today.upon today.

Bank quotes for 1, 3, 6, 9, and 12 month Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward maturities are readily available for forward contracts.contracts.

Longer-term swaps are available.Longer-term swaps are available.


Consider the example from above:Consider the example from above:

for British pounds, the spot rate is for British pounds, the spot rate is

$1.9077$1.9077 = = ££1.001.00

While the 180-day forward rate is While the 180-day forward rate is

$1.8904$1.8904 = = ££1.001.00 What’s up with that?What’s up with that?


Clearly the market participants expect that the pound will be worth less in dollars in six months.

CountryCountry












Canada Canada (Dollar)(Dollar) 0.80370.8037 0.80680.8068 1.24421.2442 1.23951.2395





Consider the (dollar) holding period return Consider the (dollar) holding period return of a dollar-based investor who buys of a dollar-based investor who buys ££1 1 million at the spot and sells them forward:million at the spot and sells them forward:

$HPR=gainpain

$1,890,400 – $1,907,700$1,907,700=

–$17,300$1,907,700=

$HPR = –0.0091

Annualized dollar HPR = –1.81% = –0.91% × 2

Forward PremiumForward Premium

The interest rate differential implied by The interest rate differential implied by forward premium or discount.forward premium or discount.

For example, suppose the € is appreciating For example, suppose the € is appreciating from from SS($/€) = 1.25 to ($/€) = 1.25 to FF180180($/€) = 1.30($/€) = 1.30

The 180-day forward premium is given by:The 180-day forward premium is given by:

= 0.08 1.30 – 1.25

1.25 × 2=f180,€v$

F180($/€) – S($/€) S($/€)= ×

360180

Long and Short Forward PositionsLong and Short Forward Positions

If you have agreed to If you have agreed to ssell anything (spot or ell anything (spot or forward), you are “forward), you are “sshort”.hort”.

If you have agreed to buy anything (forward If you have agreed to buy anything (forward or spot), you are “long”.or spot), you are “long”.

If you have agreed to If you have agreed to ssell FX forward, you ell FX forward, you are are sshort.hort.

If you have agreed to buy FX forward, you If you have agreed to buy FX forward, you are long.are long.

Payoff ProfilesPayoff Profiles

0 S180($/¥)

F180($/¥) = .009524

Short positionloss

profitIf you agree to sell anything in the future at a set price and the spot price later falls then you gain.

If you agree to sell anything in the future at a set price and the spot price later rises then you lose.


loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

profit

Whether the payoff profile slopes up or

down

depends upon whether you use the

direct or indirect quote:

F180(¥/$) = 105 or F180($/¥) = .009524.

short position


loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105

profitshort position


loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

120

If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105.

15¥

profitshort position


loss

0 S180(¥/$)

F180(¥/$) = 105

Long position-F180(¥/$)

F180(¥/$) short positionprofit

Since this is a zero-sum game, the long position payoff is the

opposite of the short.


loss

0 S180(¥/$)

F180(¥/$) = 105

Long position

-F180(¥/$)profit

The long in this forward contract agreed to BUY ¥ in 180 days at F180(¥/$) = 105

If, in 180 days, S180(¥/$) = 120, the long will lose by having to buy ¥ at S180(¥/$) = 120

and delivering ¥ at F180(¥/$) = 105.

120

–15¥

Forward Cross Exchange RatesForward Cross Exchange Rates

It’s just an “delayed” example of the spot It’s just an “delayed” example of the spot cross rate discussed above.cross rate discussed above.

In generic termsIn generic terms

)/($

)/($)/(

and

)/($

)/($)/(

kF

jFjkF

jF

kFkjF

N

NN

N

NN

Notice that the “$”s cancel.

CountryCountry




Argentina Argentina (Peso)(Peso) 0.33090.3309 0.32920.3292 3.02213.0221

Australia Australia (Dollar)(Dollar) 0.78300.7830 0.78360.7836 1.27711.2771

Brazil (Real)Brazil (Real) 0.37350.3735 0.37910.3791 2.67742.6774

Britain (Pound)Britain (Pound) 1.90771.9077 1.91351.9135 0.52420.5242

1 Month 1 Month ForwardForward 1.90441.9044 1.91011.9101 0.52510.5251

3 Months 3 Months ForwardForward 1.89831.8983 1.90381.9038 0.52680.5268


Canada (Dollar)Canada (Dollar) 0.80370.8037 0.80680.8068 1.24421.2442

1 Month 1 Month ForwardForward 0.80370.8037 0.80690.8069 1.24421.2442



Forward Cross Exchange Rates

GBP1.00

CAD2.3464=

GBP1.00 USD1.00

USD1.8904 CAD1.2412×

pound-Canadian dollar cross rate

The forward

Currency SymbolsCurrency Symbols

In addition to the familiar currency symbols In addition to the familiar currency symbols ((e.g.e.g. £, ¥, €, £, ¥, €, $) there are three-letter codes $) there are three-letter codes for all currencies.for all currencies.It is a long list, but selected codes include:It is a long list, but selected codes include:

CHFCHF Swiss francsSwiss francsGBPGBP British poundBritish poundZARZAR South African randSouth African randCADCAD Canadian dollarCanadian dollarJPYJPY Japanese yenJapanese yen

SWAPSSWAPS A swap is an agreement to provide a A swap is an agreement to provide a

counterparty with something he wants in counterparty with something he wants in exchange for something that you want. exchange for something that you want. Often on a recurring basis—e.g. every six Often on a recurring basis—e.g. every six

months for five years.months for five years. Swap transactions account for Swap transactions account for

approximately 56 percent of interbank FX approximately 56 percent of interbank FX trading, whereas outright trades are 11 trading, whereas outright trades are 11 percent.percent.

Swaps are covered fully in chapter 14.Swaps are covered fully in chapter 14.

SummarySummary

Spot rate quotationsSpot rate quotations Direct and indirect quotesDirect and indirect quotes Bid and ask pricesBid and ask prices

Cross RatesCross Rates Triangular arbitrageTriangular arbitrage

Forward Rate QuotationsForward Rate Quotations Forward premium (discount)Forward premium (discount) Forward pointsForward points

Practice ProblemPractice Problem The current spot exchange rate is $1.55/£ and The current spot exchange rate is $1.55/£ and

the three-month forward rate is $1.50/£. Based the three-month forward rate is $1.50/£. Based on your analysis of the exchange rate, you are on your analysis of the exchange rate, you are confident that the spot exchange rate will be confident that the spot exchange rate will be $1.52/£ in three months. Assume that you would $1.52/£ in three months. Assume that you would like to buy or sell £1,000,000.like to buy or sell £1,000,000.

a. What actions do you need to take to speculate a. What actions do you need to take to speculate in the forward market? What is the expected in the forward market? What is the expected dollar profit from speculation?dollar profit from speculation?

b. What would be your speculative profit in dollar b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out terms if the spot exchange rate actually turns out to be $1.46/£?to be $1.46/£?

c. Graph your results.c. Graph your results.

SolutionSolution

a.a. If you believe the spot exchange rate will be If you believe the spot exchange rate will be $1.52/£ in three months, you should buy $1.52/£ in three months, you should buy £1,000,000 forward for $1.50/£. Your expected £1,000,000 forward for $1.50/£. Your expected profit will be: profit will be:

$20,000 = £1,000,000 × ($1.52 – $1.50)$20,000 = £1,000,000 × ($1.52 – $1.50)

b.b. If the spot exchange rate actually turns out to be If the spot exchange rate actually turns out to be $1.46/£ in three months, your loss from the long $1.46/£ in three months, your loss from the long position will be: position will be:

––$40,000 = £1,000,000 × ($1.46 – $1.50)$40,000 = £1,000,000 × ($1.46 – $1.50)

SolutionSolution

loss

0 S180(£/$)

F180(£/$) = 1.50

–$40k

1.52

$20k

profit

1.46

End Chapter FiveEnd Chapter Five

International Financial Management

P G Apte

CURRENCY MARKETSCURRENCY MARKETS•The foreign exchange market is the market in which currencies are bought and sold against each other.

•The interbank foreign exchange market is an over-the-counter (OTC) market. Daily turnover about $1.5 trillion. Average transaction is about USD 4 million

•The participants in the wholesale market are commercial banks, investment institutions, corporations and central banks. Currency brokers act as middlemen between dealers

•A small number of currencies account for bulk of turnover: USD, GBP, EUR, CHF, CAD, JPY, DEM, AUD

CURRENCY MARKETSCURRENCY MARKETS

•Among the participants, primary price makers or professional dealers make a two-way market to each other and to their clients

•Foreign currency brokers act as middlemen between two market makers. Their main function is to provide information to market-making banks

•Corporations usually are price takers. However, some non-bank, non-financial companies do act as market makers.

•Large money centre banks deal in a large number of currencies. Smaller banks have a restricted range.

CURRENCY MARKETSGeographically, the markets span all the time zones from New Zealand to the West coast of the United States. When it is 3.00 p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00 p.m. in Hong Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in Singapore it is 12.00 noon in Bahrain. When it is 3.00 p.m. in Bahrain it is noon in Frankfurt and Zurich and 11.00 a.m. in London. 3.00 p.m. in London is 10.00 a.m. in New York. By the time New York is starting to wind down at 3.00 p.m., it is noon in Los Angeles. By the time it is 3.00 p.m. in Los Angeles it is 9.00 a.m. of the next day in Sydney. The gap between New York closing and Tokyo opening is about 21/2 hours. Thus the market functions 24 hours. Of all these centres, London, Tokyo and New York are the big ones accounting for about 50% volume.

Foreign Exchange Interbank (I/B) Desk of Foreign Exchange Interbank (I/B) Desk of Bank ABank A

Corporate Desk of Bank A or I/B Desk of Bank B

I/B

Desk

of

Bank A

I/B Desk

of Bank C

Corporate Foreign Exchange (CorpFx) Corporate Foreign Exchange (CorpFx) Desk of Bank ADesk of Bank A

Corporate Client

of Bank A

CorpFx

Desk

of

Bank A

I/B Desk

of Bank A

Dealings of Corporate Foreign Exchange Dealings of Corporate Foreign Exchange (CorpFx) Desk of Bank A(CorpFx) Desk of Bank A

Client of Bank A

CorpFx Desk of Bank A

Export / Import Desk of Bank A

Outward / Inward Remittance Desk of Bank A


• Spot Markets : Value date 2 business days from transaction date. If bank holiday in either settlement centre, push to next business day.

•Outright Forwards : Value date 3 days and beyond.

•Standard forward dates : 1,2,3,6,9,12 months. Spot value date plus required calendar months.

•Swaps : A spot plus a forward or two forwards. Buy USD spot vs. EUR, sell USD 3 month forward vs.EUR. Sell USD 1 month forward, buy USD 3 month forward vs. GBP.

CURRENCY MARKETSCURRENCY MARKETS• A spot GBP/USD deal on Friday Dec 8 : Value date Tuesday Dec 11

•If Dec 11 holiday in NY/London, value date 12 Dec.

•A 2-month forward deal USD/CHF on Monday Dec 11: Value date Feb 13 2001. If holiday in NY/Zurich, Feb 14.

•A 2-month forward USD/JPY on Dec 26. Value date Feb 28. If holiday Tokyo/NY, push forward? NO. Pushing forward must not carry to next calendar month. Push back to Feb 27.

• Spot deals in some currency pairs such as US dollar-Canadian dollar settled in one business day


ACI QUOTATION CONVENTIONS

SPOT RATE QUOTATIONS:• Base Currency/Quoted Currency Bid Rate/Offer Rate•USD/CHF : USD base, CHF quoted•GBP/USD : GBP base, USD quoted

•Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD

•Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate.

•Bid rate applies to market maker buying base currency. Offer rate applies to market maker selling base currency.

CURRENCY MARKETS• Currency Codes : All currencies have a 3-letter code used by SWIFT for all interbank transactions. DEM : Deutsche Mark CHF : Swiss Franc NLG : Dutch Guilder BEF : Belgian Franc FRF : French Franc DKK : Danish Kroner ESP : Spanish Peseta ITL : Italian Lira USD : US Dollar AUD : Australian Dollar CAD : Canadian Dollar JPY : Japanese Yen GBP : British Pound IEP : Irish Pound (punt) INR : Indian Rupee SAR : Saudi Riyal EUR : Euro

CURRENCY MARKETSCURRENCY MARKETSSPOT QUOTES : EXAMPLES

USD/CHF SPOT: 1.4575/1.4580

Bid Offer

Bank will buy 1 USD and give CHF 1.4575

Bank will sell 1 USD and want to be paid CHF 1.4580.

Shortened to 1.4575/80 or even 75/80 between dealers. “1.45” is the “big figure”


SPOT QUOTES : EXAMPLES

Interpret these quotes :

GBP/USD : 1.5665/70 USD/DEM : 1.9995/05

GBP/EUR : 1.2545/50 USD/INR : 46.7585/46.7685

USD/JPY : 110.25/35

•Most currencies quoted up to six significant figures. Last two figures known as “points” or “pips”. GBP/USD the bid-offer spread is 10 pips. Smaller currencies quoted to 2 decimals.

CURRENCY MARKETS• Quotations in European Terms: Units of a currency per US dollar. Example : USD/INR : 46.7560/7675

• Quotations in American Terms : US dollars per unit of a currency. Example : GBP/USD : 1.5060/65

• Direct Quotations: Units of “home” currency per unit of “foreign” currency. Example : USD/INR above, a direct quote in India.

• Reciprocal or Indirect Quotations: Units of “foreign” currency per unit of “home currency”. Example:

USD/GBP : 0.6638/0.6640, an indirect quote in UK.

CURRENCY MARKETS

Interbank Arbitrage : Suppose banks A and B are quoting : A BGBP/USD : 1.4550/1.4560 1.4538/1.4548

--------- Bank A bid ask ---------- Bank B bid askBuy GBP from bank B, sell to bank A. Prices will move. A BGBP/USD : 1.4550/1.4560 1.4548/1.4558 --------- Bank A ---------- Bank B

No arbitrage. Quotes must “overlap”.

INVERSE QUOTES AND 2-POINT ARBITRAGE

USD/CHF : 1.4955/1.4962 A bank in Zurich

CHF/USD : 0.6695/0.6699 A bank in NY

Arbitrage Opportunity? Buy Swiss francs 1 million in Zurich sell in New York.

$(1,000,000/1.4955) i.e. $6,68,700 needed to acquire the Swiss francs.

$(0.6695 1000000) i.e. $6,69,500, obtained on selling, a riskless profit of $800. Zurich USD/CHF quotes imply certain CHF/USD quotes:

Implied (CHF/USD)bid = 1/(USD/CHF)ask

Implied (CHF/USD)ask = 1/(USD/CHF)bid

INVERSE QUOTES AND 2-POINT ARBITRAGE

To prevent arbitrage, the New York bank's (CHF/USD) quotes must overlap the (CHF/USD) quotes implied by the Swiss bank's quotes. The latter work out to 0.6684/0.6687. A quote such as 0.6686/0.6689 will not lead to arbitrage though it may lead to a one-way market for the banks. The rates actually found in the markets will obey the above relations to a very close approximation.

GBP/USD: 1.5465/70 USD/GBP ?USD/INR: 46.7550/46.7650 (100)INR/USD ?GBP/EUR: 1.3035/45 EUR/GBP?

Cross-Rates and Three-Point ArbitrageA New York bank is currently offering these quotes :

USD/JPY : 110.25/111.10 USD/AUD : 1.6520/1.6530

At the same time, a bank in Sydney is quoting : AUD/JPY : 68.30/69.00

Is there an arbitrage opportunity?

Consider this sequence of transactions: Sell yen against US dollars and the US dollars against Australian dollars both in New York and finally sell the AUD for yen in Sydney. This is known as 3-point arbitrage : Sell A, buy B; Sell B buy C; Finally sell C buy A.

Cross-Rates and Three-Point ArbitrageThe calculations are :(N: NY S: Sydney)

1 JPY in NY gets USD [1/(USD/JPY)ask(N)] = USD (1/111.10)

Sell USD [1/(USD/JPY)ask(N)] in NY to get AUD

{[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } = AUD (1/111.10)(1.6520)

Sell AUD {[1/(USD/JPY)ask(N)](USD/AUD)bid(N) } in Sydney to get

JPY{[1/(USD/JPY)ask(N)](USD/AUD)bid(N)(AUD/JPY bid(S) }

= JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156

EUR Locking RatesEUR Locking RatesEUR Locking RatesEUR/ATS= 13.760300EUR/BEF= 40.339900EUR/DEM= 1.955830EUR/ESP= 166.386000EUR/FIM= 5.945730EUR/FRF= 6.559570EUR/IEP= 0.787564EUR/ITL= 1936.270000EUR/LUF= 40.339900EUR/NLG= 2.203710EUR/PTE= 200.482000

INTERBANK SPOT DEALINGINTERBANK SPOT DEALING

•Monday September 21 10.45 amBANK A: "Bank A calling. DLR-FRF 25 please.•BANK B: "Forty -Fiftytwo” (Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 4.1540/4.1552.)

•BANK A: “Mine”

(Bank A dealer finds bank B’s price acceptable and wishes to buy USD 25 million. She conveys this by saying “mine”)

SPOT DEALING (Contd.)SPOT DEALING (Contd.)

•BANK B: OK. I sell you USD 25 million against FRF at 4.1552 value 23 September. BNP Paris for my FRF.•BANK A: CITIBANK NYK for my dollars. Thanks & Bye.

• Deal is consummated. Back office staff will retrieve details, exchange confirmatory faxes/telexes and arrange settlement.

•Spot deals account for about 60 % of total turnover.

•Dealers work within limits assigned by management

•Counterparty must be acceptable credit.

FORWARD AND SWAP QUOTESFORWARD AND SWAP QUOTES

• Forward outrights can be given like spot quotes.

• USD/CHF 3-months 1.5655/65 bid/ask

•More commonly given as a spot quote plus a pair of swap points

USD/CHF Spot : 1.6525/35

1 month : 15/10 2 months : 25/18 3 months : 35/25

GBP/USD Spot : 1.4925/35

1 month : 12/15 2 months : 20/25 3 months : 28/35


• To find outrights : Spot quote ± Swap Points

• Each swap point is 0.0001 ( or 0.01)

•When to add, when to subtract?

•Take USD/CHF Spot : 1.6525/35 1 month : 15/10

•If you add : 1 month outright : 1.6540/45

• If you subtract 1 month outrights : 1.6510/1.6525

•Which is correct?

•Two “rules” : 1 Ask > Bid 2 Bid-Ask spread must widen as you go farther into future


• Using rule 2, 1.6540/1.6545 is wrong. 1.6510/25 is correct.

• Now take GBP/USD Spot 1.4925/35 2 months : 20/25

• If add, 2 month outrights 1.4945/1.4960, if subtract

1.4905/1.4910. The latter is correct.

•Mechanical rule : If swap points are Big/Small, subtract, base currency at forward discount, quoted currency at premium. If swap points Small/Big, add. Quoted currency at discount, base currency at premium.


• A quote like : USD/SEK Spot 8.4565/70 3 month : 10/20

•Bank will do either swap:

(1) Buy USD spot, sell USD 3 months forward agnst SEK. The forward rate would be 20 points above the spot rate.

(2) Sell USD spot, buy 3 months forward, forward rate 10 points above spot.

In a swap, amount of one currency - usually the base currency- kept same in the spot and the forward leg. Buy USD 1m spot, sell USD 1m forward. Amount of SEK will be different.

INTERBANK FORWARD DEALINGINTERBANK FORWARD DEALING

DEC 4 2000BANK A : "Bank A calling. Three-month yen-dollar please.”

BANK B : "Thirty two; twenty five."

BANK A : "Fifteen dollars yours at thirty two".

BANK B : "OK. Let's use a spot of 120.50 which is for value December 6; I buy at 120.18 for value March 6."

OPTION FORWARDSOPTION FORWARDS•Delivery date to be chosen by the contract buyer within a specified interval.

•A 3 month forward with delivery option over 3rd month

•A 6 month forward with delivery option over last three months.

•Banks extract maximum premium or give least discount

•GBP/USD spot : 1.4565/70 2 Mth. 15/10 3 Mth 22/17

•Customer wants to buy USD, 3 mths forward, option over

3rd month. USD at premium at 2 mths, greater premium at 3 mths. Bank will charge 3 mths premium.

OPTION FORWARDS•If customer wanted to sell USD, bank would give only 2 months premium.

•USD/CHF Spot 1.6570/75 3 Mths 15/20

(1) Customer wants to buy USD 3 mths forward option period from spot to 3 months. Rates?

(2) Customer wants to buy CHF. Rates?

•In the Indian market, length of option period cannot exceed one month.

FORWARD QUOTESINR1F=

Bid AskINR= 46.4425 46.4625 INRON= 0.25 0.50 INRTN= 0.75 1.00 INRDECM= 5.00 6.00 INRJANM= 20.75 21.75 INRFEBM= 34.50 35.50 INRMARM= 51.00 52.00 INRAPRM= 67.25 68.25 INRMAYM= 83.50 84.50 INRJUNM= 98.50 99.50 INRJULM= 116.50 117.50 INRAUGM= 133.50 134.50 INRSEPM= 150.50 152.00 INROCTM= 167.50 169.00 INRNOVM= 184.00 185.50

BROKEN DATESBROKEN DATES• Standard forward are whole months. Banks will do any number of days forward - 63 days, 135 days etc. These are “broken date” or “odd date” forwards.

•Interpolate between two whole month dates. OK if the gap between the two dates is not too long and no special technical factors are at work.

•USD/INR spot 46.95/96 1 month 10/12 2 mths 20/27

•Customer wants to buy USD 43 days forward.

•15 paise premium from 1 mth to 2 mths. Suppose 30 days in 2nd month. 0.5 paisa per day, 6 paise for 12 days. Rate would be 46.96+0.12+0.06 = 47.14

SHORT DATESSHORT DATES

• Delivery same day- cash

•Delivery next day - Tomorrow or “Tom”.

•Markets quote overnight O/N, tomorrow/next T/N and Spot/Next S/N swaps. These are used to compute rates for short date transactions.

•Reverse swap points and follow add/subtract rule.

•USD/DEM Spot 1.9545/50 T/N : 5/3 3/5

•Outright for tom : 1.9548/50

FOREX AND MONEY MARKETSFOREX AND MONEY MARKETS• Annualised %Premium/Discount, T-year forward

= [(Forward-Spot)/(Spot)] × (1/T) × 100

•Use mid rates for quick calculations.

•Annualised forward margin = Interest rate differential

True for fully convertible currencies with no capital controls.

• Currency with higher interest rate will be at discount.

•3-month Euro LIBOR : 8% p.a. 3-month USD LIBOR : 6%

•USD will be at a 3-month forward premium of 2% p.a.

FOREX AND MONEY MARKETS

This relation between interest rate differential and spot-forward margin is known as Covered Interest Parity.

It holds for freely convertible currencies with no capital controls.

It is a result of investors arbitraging between money markets in different currencies in search of highest return.

Holds with Euromarket interest rates.

It is not a causal relation but an equilibrium relationship.

It will be analysed in detail in the next chapter

FORWARD-FORWARDS AND FORWARD-FORWARDS AND RELATED PRODUCTSRELATED PRODUCTS

• Buy USD 1 month sell 3 months vs.GBP. A 1-3 swap.

•Related products are FSAs, ERAs and FXAs

•Third currency forwards in the Indian market.

•Forward contracts can be cancelled. Settlement payments

depend upon current forward rates.

•Forward contracts tie up credit limits and attract capital adequacy norms. FSAs, ERAs and FXAs are innovations to get around these problems. Analysed in next chapter

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INT. Finance- FX Market

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