CHAPTER 7

THE FOREIGN EXCHANGE MARKET

CHAPTER OVERVIEW
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
between countries

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

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

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

transactions take place at a specified future date .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market: .

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

hedgers d. speculators .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c.

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

FedWire .operated by the Fed .used for domestic transfers .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. Automated Trading .genuine screen-based market . ELECTRONIC TRADING A.

3. 2. Results: 1. Reduces cost of trading Threatens traders’ oligopoly of information Provides liquidity .ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.

SIZE OF THE MARKET A.2 trillion daily . Largest in the world 1995: $1.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV.

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

spot price 30-day 90-day 180-day . c. SPOT QUOTATIONS A. All major newspapers 2. Major currencies have four different quotes: a. d. Sources 1. THE SPOT MARKET I.PART III. b.

Method of Quotation 1. American terms example: $. European terms example: dm1. For interbank dollar trades: a.THE SPOT MARKET B.713/$ .5838/dm b.

EXAMPLE: dm0.25/FF .THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency.

Transactions Costs 1.THE SPOT MARKET C. 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 .

Percent Spread Formula (PS): Ask  Bid PS  x100 Ask .THE SPOT MARKET 4.

The exchange rate between 2 non .US$ currencies. Cross Rates 1. .THE SPOT MARKET D.

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

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

Buy cheap in one int’l market.THE SPOT MARKET 2. sell at a higher price in another Role of Available Information 3. .

Settlement Date Value Date: 1.THE SPOT MARKET F. Date monies are due 2. 2nd Working day after date of original transaction. .

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

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

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

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

MECHANICS OF SPOT TRANSACTIONS Step 3.S. . Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date. U. bank debits importer’s account.

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.

Outright Rate: quoted to commercial customers. Two Methods: a. . Swap Rate: quoted in the interbank market as a discount or premium. b.THE FORWARD MARKET B. Forward Rate Quotations 1.

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 .

Forward Contract Maturities 1. 180-day d.THE FORWARD MARKET C. . 30-day b. 90-day c. 360-day Longer-term Contracts 2. Contract Terms 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. INTRODUCTION A. INTEREST RATE PARITY THEORY I. .PART IV.

INTEREST RATE PARITY THEORY 2. The forward premium or discount equals the interest rate differential.S)/S = (rh . (F .rf) where rh = the home rate rf = the foreign rate .

In equilibrium. returns on currencies will be the same i.INTEREST RATE PARITY THEORY 3. e. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S .

2. Funds will move to a country with a more attractive rate. Covered Interest Arbitrage 1.INTEREST RATE PARITY THEORY B. . Conditions required: interest rate differential does not equal the forward premium or discount.

. Inflow of fund depresses interest rates. Market pressures develop: a. As one currency is more demanded spot and sold forward. b.INTEREST RATE PARITY THEORY 3.

Lower interest rates are offset by forward premiums.INTEREST RATE PARITY THEORY C. Summary: Interest Rate Parity states: 1. Higher interest rates on a currency offset by forward discounts. 2. .

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