The Foreign Exchange and Eurocurrency Markets

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Symbols and acronyms
Upper Case Symbols = Prices lower case symbols = changes in a price level
Ptd (or Ptf) = price of an asset at time t in currency d (or f) ptd (or ptf) = inflation in currency d (or f) during period t Std/f = spot exchange rate at time t between d and f std/f = change in the spot exchange rate during period t Fd/f = forward exchange rate between currencies d and f ftd/f = change in the forward rate during period t

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Foreign exchange (fx) markets
Markets
» Spot market
– trade in cash today with delivery in two business days

» Forward market
– trade at a pre-specified price and on a pre-specified future date

Volume
» volume in April 2003 averaged $2.0 trillion per day » about 75% in the interbank market

Operational eINRiciency
» small retail transactions can be expensive » large interbank transactions have very low costs
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Major foreign exchange trading centers
(Average daily volume during April of 1989, 1992, 1995, and 1998)
700 600

1989

1992

1995

1998

500

400 300

200

100 0

London

New York

Tokyo

Source: Bank for International Settlements triennial survey of central banks.

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Rule #1 Keep track of your units.
An example:
S$/INR = $.0250/INR ⇔ SINR/$ = 1/ S$/INR =INR 40/$

Dollar value of a bottle of Champagne:
Buy 1 bottle of wine PINR = INR400/btl Spot exchange rate SINR/$ = INR40/$ How much is this in dollars? P$ = PINR/SINR/$= (INR400/btl)/(INR4.00/$) = PINRS$/INR= (INR400/btl)($.025/INR) = $10/btl = $10/btl

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Rule #2: Always buy or sell the currency in the denominator of a foreign exchange quote.
Example of buying low and selling high:
Buy wine at INR400/btl and sell at INR500/btl ⇒ INR100/btl Profit Buy INRs at $.020/INR ≡ Sell INRs at $.025/INR ≡ $.005/INR Profit Sell $s at INR50/$ Buy $s at INR40/$ INR10/$ Profit

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Forward premiums or discounts
Percentage forward premium or discount = (F1d/f − S0d/f ) / S0d/f
Forward premium » nominal value in the forward exchange market is higher than in the spot exchange market Forward discount » nominal value in the forward exchange market is lower than in the spot exchange market

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An example of forward premiums and discounts
Suppose
S0$/INR = $0.020/INR and F1$/INR = $0.025/INR

Rupee forward premium = ($.025/INR−$.020/INR)/($.020/INR) = +25% so the Rupee is selling at a 25% forward premium.

Alternatively, S0INR/$ = INR50.00/$ ⇔ S0$/INR = $0.020/INR
F1INR/$ = INR40.00/$ ⇔ F1$/INR = $0.025/INR
Dollar forward premium = (INR40/$−INR50/$)/(INR50/$) = −20% so the dollar is selling at a 20% forward discount.

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Percentage changes in foreign exchange rates
Percentage change in the value of a foreign currency = (S1d/f − S0d/f ) / S0d/f An example: S0INR/$ = INR50/$ ⇔ S0$/INR = $0.020/INR S1INR/$ = INR40/$ ⇔ S1$/INR = $0.025/INR
Percentage change in the franc = (S1$/INR−S0$/INR ) / S0$/INR = ($0.025/INR−$0.020/INR)/($0.020/INR) = +25% Percentage change in the dollar = (S1INR/$−S0INR/$ ) / S0INR/$ = (INR40/$−INR50/$)/(INR50/$) = −20%

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The interbank Eurocurrency market
Eurocurrencies are bank deposits or loans residing outside of the country issuing the currency
» Few regulations
– No reserve requirements, interest rate regulations or caps, withholding taxes, deposit insurance requirements, or credit allocation regulations; less stringent disclosure requirements

» Low risk
– Relatively short maturities: Maturities of less than 5 years – Low interest rate risk: Interest rates tied to a variable rate base such as the London Interbank Offer Rate (LIBOR) – Low default risk: Traded between large commercial banks, investment banks and multinational corporations

» Highly competitive
– Daily volume of several hundred billion dollars ensures competitive bid and offer prices
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Spreads in domestic and Eurocurrency credit markets
Domestic loan rate for commercial accounts Eurocurrency loan rate for commercial accounts

Eurocurrency loan rate in the interbank market

LIBOR

2%

1/2%
Eurocurrency deposit rate for commercial accounts

1/8%
Eurocurrency deposit rate in the interbank market

1/8%
LIBID

Domestic deposit rate for commercial accounts

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Linkages between credit & currency markets
U.S. internal credit market

$

Eurocurrencies

¥

external credit markets

£
U.K. internal credit market

Japanese internal credit market

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Exposure to foreign exchange risk
(contract price INR400,000)
Expected receipt in Rupees at E[S1$/INR] = $.025/INR Actual exchange S1$/INR = $.020/INR Net loss from original position ∆V$/INR Risk (or payoff) profile of underlying exposure + slope
− $.05/IN R

+INR400,000 ⇔ +$10,000 at $.025/INR +INR400,000 ⇔ +$8,000 at $.020/INR

−$2,000

∆S$/INR
−$.05/INR

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Currency hedging with forwards
(contract price INR400,000)
Buy $10,000 forward at F1$/INR = $.025/INR Sell INR400,000 forward Market exchange of INR for $ at S1$/INR = $.020/INR Net gain on forward Risk profile of a forward contract ∆V$/INR
+$0.05/IN R -$0.05/INR

+$10,000 −INR400,000 +$8,000 −INR400,000 +$2,000

∆S$/INR

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Net currency exposure
Underlying position (long INR) Sell INR forward (short INR and long dollars) Net position Net exposure ∆V$/INR +INR400,000 +$10,000 − INR40,0000 +$10,000

short francs

long francs

∆S$/INR

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Example of foreign exchange trading
Market Participants
Dealers: make a market in foreign currency (quote bid & offer prices) Traders: trade for their own acct

Rules of the Game - “Buy ringgits low and sell ringgits high”
One contract ≡ Rg1,000,000,000 (Malaysian ringgits) Trades can be for up to 10 contracts Record transactions as either a ringgit purchase or sale Dealer quotes are good for two minutes

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Arbitrage profit in the Malaysian ringgit market
Bank A: “$0.26602/Rg BID and $0.26612/Rg OFFER” Bank B: “$0.26617/Rg BID and $0.26627/Rg OFFER” Bank A Bank B $0.26627/Rg Offer $0.26617/Rg Bid $0.26612/Rg Offer $0.26602/Rg Bid
1. Buy Rg1 billion from Bank A at $0.26612/Rg offer price 2. Sells Rg1 billion to Bank B at its $0.26617/Rg bid price Arbitrage Profit = ($0.00005/Rg)(Rg1 billion) = $50,000 with NO NET INVESTMENT and NO RISK.
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Sell to B Buy from A

Sample foreign exchange ledger
NAME Bank of Cash, Credit, and Industry 1. 2. 3. 4. 5. Counterparty Penn Square Citicorp Bk of Tokyo Bk of Tokyo ... Contracts BUY 1 BUY 3 SELL 2 SELL 4 Price 0.22004 0.22010 0.22016 0.22020 DATE October 19, 2003 Total $/Rg Cumulative Rg balance −$0.22004 +1 −$0.66030 +4 +$0.44032 +2 +$0.88080 −2

FINAL CLOSING RATES: $.22018/Rg BID and $0.22023/Rg OFFER Closing trade BUY 2 Sum of dollar transactions: Times contract size Profit (loss) 0.22023 −$0.44046 +$0.00032/Rg x Rg1,000,000,000 +$320,000 0

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Opening prices:
$0. 21945/Rg BID & $0.21950/Rg OFFER
News announcements:
The member nations of the G7 have announced that they are buying dollars in an effort to stabilize the dollar. The U.S. Federal Reserve announces that in an effort to stimulate economic activity it is lowering the discount rate on overnight loans to commercial banks. The U.S. government reports that the U.S. money supply M1 increased by $1 billion more than expected in the most recent quarter.

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The Impact of News Events
The member nations of the G7 have announced that they are buying dollars in an effort to stabilize the dollar.
Value of the U.S. dollar S$ P’$ P$ D’$ D$ Q$ Value of the Malaysian ringgit PRg P’Rg SRg DRg D’Rg QRg

The Malaysian ringgit depreciates and the spot rate S$/Rg falls
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The Impact of News Events
The U.S. Federal Reserve announces that in an effort to stimulate economic activity it is lowering the discount rate on overnight loans to commercial banks.

This makes it easier for U.S. businesses to borrow and increases economic activity. If this also increases U.S. inflation, then the value of the U.S. dollar should fall. This will result in an appreciation of the ringgit against the dollar. Increases in the domestic discount rate usually, but not always, lead to increases in the value of the domestic currency.

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The Impact of News Events
The government reports that U.S. money supply M1 increased by $1 billion more than expected in the most recent quarter.
While this would seem to result in a larger supply of dollars and hence a lower value for the dollar, the increase in the money supply has already occurred and hence should be reflected in the market price of the dollar. On the other hand, if the U.S. Federal Reserve is likely to react to this announcement by increasing the discount rate to slow down the economy, then the dollar may rise in anticipation of Fed policy. If the dollar rises against the ringgit, then the ringgit will fall against the dollar.

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