CHAPTER 7

THE FOREIGN
EXCHANGE
MARKET

CHAPTER OVERVIEW
I. INTRODUCTION
II. 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
between countries

INTRODUCTION
C. Location
1. OTC-type: no specific
location
2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide
Interbank Financial
Telecommunications

PART II.
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET

I . PARTICIPANTS IN THE
FOREIGN EXCHANGE MARKET
A. Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level
- business
customers.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. Two Types of Currency
Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd
business day

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
2.

Forward Market:
- transactions take place at a
specified future date

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial
and central banks

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
II. CLEARING SYSTEMS
A. Clearing House Interbank
Payments System
(CHIPS)
- used in U.S. for electronic
fund transfers.

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic transfers

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
III. ELECTRONIC TRADING
A. Automated Trading
- genuine screen-based
market

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. Results:
1.

Reduces cost of trading

2.

Threatens traders
oligopoly of information

3.

Provides liquidity

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
IV. SIZE OF THE MARKET
A. Largest in the world
1995: $1.2 trillion daily

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. Market Centers (1995):
London = $464 billion
daily
New York= $244 billion
daily
Tokyo = $161 billion
daily

PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have
different quotes:
a.
b.
c.
d.

spot price
30-day
90-day
180-day

four

THE SPOT MARKET

B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $.5838/dm

b.

European terms
example: dm1.713/$

THE SPOT MARKET

2. For nonbank customers:
Direct quote
gives the home currency
price of one unit of foreign
currency.

EXAMPLE: dm0.25/FF

THE SPOT MARKET

C. Transactions Costs
1. 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

4.

Percent Spread Formula (PS):

Ask Bid
PS
x100
Ask

THE SPOT MARKET

D. Cross Rates
1.

The exchange rate

between 2 non - US$
currencies.

THE SPOT MARKET

2. Calculating Cross Rates
When you want to know
what
the dm/ cross rate
is, and
you know
dm2/US$ and .55/US$
then dm/ = dm2/US$ .55/US$
= dm3.636/

THE SPOT MARKET

E. Currency Arbitrage
1. If cross rates differ from
one financial center to
another, and profit
opportunities exist.

THE SPOT MARKET

2.

Buy cheap in one intl market,

sell at a higher price in
another

3.

Role of Available Information

THE SPOT MARKET

F.

Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of
original transaction.

THE SPOT MARKET

G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty
about future exchange
rate requires

THE SPOT MARKET

1.) Demand for higher risk
premium
2.) Bankers widen bid-ask
spread

PART II.
MECHANICS OF SPOT
SPOT
TRANSACTIONS:
An
TRANSACTIONS

Example
Step 1. Currency transaction:
verbal agreement, U.S. importer
specifies:
a. Account to debit (his acct)
b. Account to credit
(exporter)

MECHANICS OF SPOT
TRANSACTIONS
Step 2. Bank sends importer
contract note including:
- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.

MECHANICS OF SPOT
TRANSACTIONS
Step 3. Settlement

Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporters.
Value Date.
U.S. bank debits importers
account.

PART III.
THE FORWARD MARKET

I. INTRODUCTION
A. 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.

THE FORWARD MARKET

2. Purpose of a Forward:
Hedging
the act of reducing exchange
rate risk.

THE FORWARD MARKET

B.
1.
a.

Forward Rate Quotations

Two Methods:
Outright Rate: quoted to

commercial customers.

b. Swap Rate: quoted in the

interbank market as a
premium.

discount or

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

THE FORWARD MARKET

C. Forward Contract Maturities
1. Contract Terms

2.

a. 30-day
b. 90-day
c. 180-day
d. 360-day
Longer-term Contracts

PART IV.
INTEREST RATE PARITY THEORY
I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs from
the spot rate (S) at equilibrium by
an amount
equal to the
interest
differential (rh - rf)
between two countries.

INTEREST RATE PARITY

THEORY
2.

The forward premium or

discount equals the interest
rate differential.
(F - S)/S = (rh - rf)
where

rh = the home rate

rf = the foreign rate

INTEREST RATE PARITY

THEORY
3.

In equilibrium, returns on
currencies will be the same
i. e. No profit will be realized
and interest parity exists
which can be written
(1 + rh) = F
(1 + rf)
S

INTEREST RATE PARITY

THEORY
B. Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward
discount.

premium or

2. Funds will move to a country

with a more attractive rate.

INTEREST RATE PARITY

THEORY
3. Market pressures develop:
a. As one currency is more
demanded spot and sold
forward.
b.

Inflow of fund depresses

interest rates.
c. Parity eventually

reached.

INTEREST RATE PARITY

THEORY
C. Summary:
C. Summary:
Interest Rate Parity states:

1. Higher interest rates on a

currency offset by forward
discounts.
2. Lower interest rates are
offset by forward premiums.