Foreign Exchange Market

Reading: Chapter 6

Lecture Outline
 Describe the FX market  Identify participants and currencies  Understand spot and forward rates  Calculate & use cross and forward rates  Triangular arbitrage  Changes in exchange rates


Functions of FX Market
The foreign exchange market is the mechanism by which participants:
– transfer purchasing power between countries; – obtain or provide credit for international trade transactions, and – minimize exposure to the risks of exchange rate changes.


 Only 11% of daily spot transactions involve nonfinancial customers. 4 .  US dollar involved in 87% of all transactions.  London is the largest FX market.Characteristics of FX Market  Largest of all financial markets with average daily turnover of over $2 trillion!  66% of all foreign exchange transactions involve cross-border counterparties.

Market Activity – 24hrs 5 .

Increasing Turnover Daily foreign exchange market turnover in billions of US dollars (Bank for International Settlements Triennial Central Bank Survey 2004) 6 .

Important Currencies 7 .

Types of Transactions A Spot transaction in the interbank market is the purchase of foreign exchange. 8 . normally. with delivery and payment between banks to take place. on the second following business day. The date of settlement is referred to as the value date.

) 9 .  Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced. but payment and delivery are not required until maturity. six and twelve months.Types of Transactions  An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. three.  Forward exchange rates are usually quoted for value dates of one. two.  The exchange rate is established at the time of the agreement.

– forward-forward. Both purchase and sale are conducted with the same counterparty. 10 . Some different types of swaps are: – spot against forward.Types of Transactions 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. – nondeliverable forwards (NDF).

Types of Transactions 11 .

speculators and arbitragers. Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers. smaller amounts). and foreign exchange brokers. 12 . central banks and treasuries. and – the client or retail market (specific. individuals and firms.Market Participants The foreign exchange market consists of two tiers: – the interbank or wholesale market (multiples of $1M US or equivalent in transaction size).

Dealers in the foreign exchange department of large international banks often function as “market makers.Market Participants Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets. 13 .” These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.

14 . exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose. Some of the participants use the market to “hedge” their foreign exchange risk.Market Participants Individuals (such as tourists) and firms (such as importers.

speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets. 15 .Market Participants Speculators and arbitragers seek to profit from trading in the market itself. While dealers seek the bid/ask spread. They operate in their own interest. without a need or obligation to serve clients or ensure a continuous market.

 The motive is not to earn a profit as such. central banks and treasuries differ in motive from all other market participants. but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.Market Participants  Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. 16 .  As willing loss takers.  They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.

 Spatial (or Locational) Arbitrage  Triangular Arbitrage  Covered Interest Arbitrage – Lecture 3 17 .Types of Activities  Speculation  An activity that leaves one open to exchange rate fluctuations where one aims to make a profit.  Hedging  Allows the firm to transfer exchange rate risk inherent in foreign currency transactions or positions. These profits are unlikely to last long.  Arbitrage – take advantage of inconsistent prices to make risk-free profits.

com/currency 18 .  A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced Exchange Rates & Quotations  A foreign exchange rate is the price of one currency expressed in terms of another currency.  http://finance.

 It is always the case that the Ask Price > Bid Price. Ask Price: Price at which the dealer is willing to sell foreign currency to you. The difference is the Bid-Ask spread.  The less traded and more volatile a currency. the greater is the spread. 19 .Bid & Ask Quotes  Foreign currency dealers provide two quotes: Bid Price: Price at which the dealer is willing to buy foreign currency from you.

g. the reciprocal of a direct quote is an indirect quote: AUD 1  EUR EUR AUD  Also.6499  Indirect Quote: Foreign currency per unit of Home currency .g. €/AUD quote of 0. 20 .e. you might encounter an exchange rate quotation in American terms (US$/FC) or European terms (FC/US$).Direct & Indirect Quotes  Direct Quote: Home currency per unit of Foreign currency (FC) .6061 – 0.6249  Note that in all cases. AUD/€ quote is 1.e.6003 – 1.

.4484 Bid: Dealer buys £ for $ at the Bid.000 for $1.e.4482 Ask 1.000. Client buys £ with $ (i..000. dealer will buy £1. Client sells £ for $ (i. dealer will sell £1. Ask: Dealer sells £ for $ at the Ask.e.200). 21 .448.000 for $1.400).448.Example Bid $/£ 1.

4482  100  1.38% % spread  1.Bid – Ask Spread  Banks act as market makers and realise their profits from the spread: Bid-Ask Spread = (Ask-Bid)/Ask  Consider the DIRECT quote of $ 1.4484  1.4482 – 1.4484/£ 1.4484 22 .

points or as an annualised % forward premium or discount. 23 .Forward Quotes  Forward rates can be quoted as either as an outright quote.

you subtract the points from the spot rate to get the outright forward quote.  If the Bid Points < Ask Points.Forward Quotes – Points  A forward quotation expressed in points is not a foreign exchange rate as such. It is the difference between the forward rate and the spot rate. you add the points to the spot rate to get the outright forward quote 24 .  When the Bid Points > Ask Points.

Forward Quotes – Percentage For quotations expressed in foreign currency terms (Indirect quotations) the formula becomes: f ¥ = Spot – Forward 360 x n x 100 Forward For quotations expressed in home currency terms (Direct quotations) the formula becomes: f ¥ = Forward – Spot 360 x n x 100 Spot 25 .

so their exchange rate is determined through their relationship to a widely traded third currency.  The Australian dollar (symbol A$) is not widely quoted against the Danish kroner (symbol DKr).5431/US$ DKr7. both currencies are quoted against the U.  For example.  However.S. Assume the following quotes: Australian dollar Danish kroner A$1.0575/US$ 26 . dollar.Cross Rates  Many currency pairs are inactively traded. an Australian importer needs Danish currency to pay for purchases in Copenhagen.

S. calculating cross-rates is usually not as easy as this! 27 .5431/US$   0. The cross-rate calculation would be: Australian dollar/U.2186 A$/DKr Danish kroner/U.S.0575/ US$  However.0575. dollar A$1.Cross Rates  The Australian importer can buy one U.5431 and with that dollar buy DKr7. dollar DKr7.S . dollar for A$1.

4419 – 36 / GBP US$0.Cross Rates – Example We have the following rates: US$1.3008 – 98 / GBP. 28 .6250 – 67 / CHF Calculate the CHF / GBP rate! = CHF 2.

Cross Rates – Example First: How do I get CHF/GBP from the two rates? CHF/GBP = (US$/GBP)/(US$/CHF) Second: Bid = go from bottom (GBP) to top (CHF) (use GBP to buy US$. 29 . then US$ to buy GBP) Fourth: Apply rule from part one to currency rate pairs. CHF 2.3008 – 98 / GBP. Therefore. then US$ to buy CHF) Third: Ask = go from top (CHF) to bottom (GBP) (use CHF to buy US$.

Cross Rates – Tips  As you do more cross rate questions you will start to see patterns emerging.  For example if both rates are something per USD or USD per something then you will have to divide the rates somehow and you will be matching bids with asks.  Or if the rates are in different forms (USD is in different places) then you will be multiplying and you will match bid with bid and ask with ask. 30 .

Triangular Arbitrage  Cross rates can be used to check on opportunities for inter-market arbitrage.$ fl1.S.S. dollar fl1.2646/U.2646/U S$ 31 .S. Suppose the following exchange rates are available: Bank of America: Dominion Bank: ABN Amro Bank: Dutch guilders (fl) per U. $ Dutch guilders per Canadian $ fl1.9025/US$   1.S. $ Canadian dollars per U.S. dollar C$1.5214/C$ You get more guilders from ABN Amro  The synthetic cross rate between Dutch guilders and Canadian dollars is: Dutch guilders/U.S.5044fl/C$ Canadian dollars/U.$ C$1.9025/U.

011.000 (Start) Divided by 1.2646 C$/US$ US$525.Triangular Arbitrage – Example Netherlands fl1.5214 fl/C$ fl1.000.704 Canada Multiplied by 1.9025 fl/US$ Profit = fl 11.624 United States 32 .281 C$664.281 (End) Multiplied by 1.

Measuring a Change in the Spot Rate • Measuring a change in the foreign currency for quotations expressed in home currency terms (direct): %∆ = Ending rate – Beginning Rate Beginning Rate x 100 • Quotations expressed in foreign currency terms (indirect): %∆ = Beginning Rate – Ending Rate x 100 Ending Rate 33 .

2002. What is the appreciation/depreciation of the US$? 34 . 2004 it was quoted at A$1.8445/US$ on Aug 19. while on March 2.335/US$.Example  The Australian dollar was quoted at A$1.

8445 /$ Thus.S.335/$  A$1. the appreciation/depreciation of the US$. the U.8445 /$    27.Example  Thus.t St  St 1 A$1.6% St 1 A$1.$ has depreciated relative to the A$ by 27.6% 35 . relative to the A$ from t-1 to t is: Rt 1.

2% 36 .t St  St 1 $0.5422/A$ At t: A$1.5422 / A$    38. we want the denominator currency to be the A$:   At t-1: A$1. the A$ has appreciated relative to the US $ by 38.7491/A$ Rt 1.Example  To calculate the appreciation/depreciation of the Australian dollar.8445/US$ = US$0. relative to the US dollar.5422 / A$ Thus.2% St 1 $0.335/US$ = US$0.7491  $0.

the percentage appreciation in one currency is not equal to the percentage depreciation in the other currency. A$ appreciation not equal  In general. Instead… 1 ________________________ 1 + RA$ = (1 + RUS$) 37 .$ depreciation.

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