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THE FOREIGN EXCHANGE MARKET
I. II. INTRODUCTION ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. THE SPOT MARKET IV. THE FORWARD MARKET V. INTEREST RATE PARITY THEORY
PART I. INTRODUCTION
I. INTRODUCTION A. The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency.
INTRODUCTION B. International Trade and Capital Transactions:
- facilitated with the ability
to transfer purchasing power
OTC-type: no specific location 2.INTRODUCTION C. Location 1. or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications . telex. Most trades by phone.
PART II. Retail Level . Participants at 2 Levels 1. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET I . Wholesale Level (95%) .major banks 2. PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET A.business customers. .
recorded by 2nd business day . Two Types of Currency Markets 1. Spot Market: .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.immediate transaction .
transactions take place at a specified future date . Forward Market: .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2.
brokers c. commercial banks b. customers of commercial and central banks .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a.
hedgers d. arbitrageurs b.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. speculators . Forward Market a. traders c.
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II.S. .used in U. for electronic fund transfers. Clearing House Interbank Payments System (CHIPS) . CLEARING SYSTEMS A.
FedWire .used for domestic transfers .operated by the Fed .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. Automated Trading .genuine screen-based market . ELECTRONIC TRADING A.
Reduces cost of trading Threatens traders’ oligopoly of information Provides liquidity . 3. Results: 1. 2.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. Largest in the world 1995: $1. SIZE OF THE MARKET A.2 trillion daily .
Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.
THE SPOT MARKET I. All major newspapers 2. Sources 1. b. Major currencies have four different quotes: a. spot price 30-day 90-day 180-day . d. SPOT QUOTATIONS A.PART III. c.
American terms example: $. Method of Quotation 1.5838/dm b. For interbank dollar trades: a.THE SPOT MARKET B.713/$ . European terms example: dm1.
25/FF .THE SPOT MARKET 2. EXAMPLE: dm0. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency.
Bid-Ask Spread used to calculate the fee charged by the bank Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency .THE SPOT MARKET C. Transactions Costs 1.
THE SPOT MARKET 4. Percent Spread Formula (PS): Ask Bid PS x100 Ask .
.THE SPOT MARKET D. Cross Rates 1.US$ currencies. The exchange rate between 2 non .
55/US$ = dm3.55/US$ then dm/ = dm2/US$ . and you know dm2/US$ and . Calculating Cross Rates When you want to know what the dm/ cross rate is.636/ .THE SPOT MARKET 2.
. and profit opportunities exist. Currency Arbitrage 1. If cross rates differ from one financial center to another.THE SPOT MARKET E.
. sell at a higher price in another Role of Available Information 3.THE SPOT MARKET 2. Buy cheap in one int’l market.
.THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due 2. 2nd Working day after date of original transaction.
Exchange Risk 1.THE SPOT MARKET G. Bankers = middlemen a. Increased uncertainty about future exchange rate requires . Incurring risk of adverse exchange rate moves. b.
THE SPOT MARKET 1.) Bankers widen bid-ask spread .) Demand for higher risk premium 2.
Currency transaction: verbal agreement. Account to credit (exporter) . U.S. importer specifies: a. Account to debit (his acct) b.MECHANICS OF SPOT TRANSACTIONS SPOT TRANSACTIONS: An Example Step 1.
. Bank sends importer contract note including: .agreed exchange rate .amount of foreign currency .confirmation of Step 1.MECHANICS OF SPOT TRANSACTIONS Step 2.
. U. bank debits importer’s account.MECHANICS OF SPOT TRANSACTIONS Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date.S.
PART III. INTRODUCTION A. THE FORWARD MARKET I. Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate. .
Purpose of a Forward: Hedging the act of reducing exchange rate risk.THE FORWARD MARKET 2. .
Swap Rate: quoted in the interbank market as a discount or premium. b. Outright Rate: quoted to commercial customers. Forward Rate Quotations 1.THE FORWARD MARKET B. . Two Methods: a.
THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract .
Contract Terms a. 360-day Longer-term Contracts 2. Forward Contract Maturities 1. 30-day b. . 90-day c.THE FORWARD MARKET C. 180-day d.
rf) between two countries. INTRODUCTION A.PART IV. . The Theory states: the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh . INTEREST RATE PARITY THEORY I.
(F . The forward premium or discount equals the interest rate differential.INTEREST RATE PARITY THEORY 2.rf) where rh = the home rate rf = the foreign rate .S)/S = (rh .
In equilibrium. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S . e. returns on currencies will be the same i.INTEREST RATE PARITY THEORY 3.
. Conditions required: interest rate differential does not equal the forward premium or discount. Funds will move to a country with a more attractive rate.INTEREST RATE PARITY THEORY B. Covered Interest Arbitrage 1. 2.
As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates. Market pressures develop: a.INTEREST RATE PARITY THEORY 3. .
Summary: Interest Rate Parity states: 1. Lower interest rates are offset by forward premiums. . Higher interest rates on a currency offset by forward discounts.INTEREST RATE PARITY THEORY C. 2.