The Foreign Exchange Market

Chapter 7

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PART I. INTRODUCTION

INTRODUCTION
The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency.

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INTRODUCTION
International Trade and Capital Transactions:

facilitated with the ability to transfer purchasing power between countries exports and imports activities accounts for less than 5% of foreign exchange trading. more than 95% of foreign exchange transactions relates to cross border purchases and sales of assets. i.e., international capital flows

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INTRODUCTION

C.

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

SWIFT:

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Types of Markets
 Exchange

(ex. NYSE) vs. over the counter market (ex. Nasdaq)

 Exchange:

central location, tend to be auction market  OTC: no location, dealer markets

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OTC Market
 

An informal exchange of brokers and dealers negotiating trades, without centralized order flow NASDAQ: largest OTC market since 1971

• • •

Computer-linked system providing information on dealers’ quotation of bid and ask prices Stocks, bonds and some derivatives Most secondary bonds transactions

Traded securities:

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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
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Two Types of Currency Markets
1.

Spot Market:
- immediate transaction - recorded by 2nd business day

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

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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

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Brokers

 

Specialists in matching net supplier and demander banks. Receive a small commission on all trades (traditionally, 1/32 of 1% in the U.S market). Brokers supply information Help bank minimize their contacts with other traders. Increasing share of electronic brokers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

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

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Speculators versus hedgers and traders

In contrast to all the other type of players, they expose themselves to currency risk by buying or selling currency forward in order to profit from exchange rates fluctuations. Their degree of participation does not depend on their business transactions.

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

II.

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

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B.

FedWire
- operated by the Fed - used for domestic transfers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

III. ELECTRONIC TRADING
A. Automated Trading - genuine screen-based market - prices are visible to all market participants.

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B.

Results:
1. 2. 3. Reduces cost of trading Threatens traders’ oligopoly of information Provides liquidity

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET
A. Largest in the world 2004: US$1.9 trillion daily or US$475 trillion a year In 1999 the US GDP was US$9.1 trillion
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

 According to the BIS, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion. Trading in the world's main financial markets accounted for $3.21 trillion of this.
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B.

Market Centers (2004):
#1: London =$753 billion daily #2: New York= $461 billion daily

#3: Tokyo = $199 billion daily

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PART III. THE SPOT MARKET

I.

SPOT QUOTATIONS
A. Sources 1. All major newspapers 2. Major currencies have four different quotes:

a.
b. c. d.

spot price 30-day 90-day 180-day

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THE SPOT MARKET

B.

Method of Quotation
1. For interbank dollar trades: a. American terms example: $1.21/€ b. European terms example: Peso 1.713/$

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THE SPOT MARKET

2. For nonbank customers:
gives the home currency price (always in the numerator) of one unit of foreign currency. EXAMPLE: $1.81/£ Since this is a direct quote, we know that in the U.S., one pound transacted at $1.81.
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Direct quote

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

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THE SPOT MARKET

4.

Percent Spread Formula (PS):

Ask − Bid PS = x100 Ask
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THE SPOT MARKET

For widely traded currencies, such as the pound, euro, Swiss franc, yen, the spread used to be on the order of 0.05%-0.08%. Sophisticated electronic trading pushed the spread to a tiny 0.02%. systems

Less traded currencies and currencies having greater volatility have higher trading costs.
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THE SPOT MARKET

D.

Cross Rates
1. The exchange rate between 2 non - US$ currencies.

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THE SPOT MARKET

2.

Suppose you want to calculate the £/€ cross rate. You know £.5556/US$ and €.8334/US$ then £/ € = £.5556/US$ ÷ €.8334/US$ = £.6667/ €
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Calculating Cross Rates

THE SPOT MARKET

E.

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

2. Buy cheap in one int’l market, sell at a higher price in another 3. The Critical Role of Available Information

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THE SPOT MARKET

F.

Settlement Date - Value Date:
1. 2. Date monies are due 2nd Working day after date of original transaction.

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THE SPOT MARKET

G.
1.

Exchange Risk Bankers = middlemen a. b. Incurring risk of adverse exchange rate moves. Increased uncertainty about future exchange rate requires 1.) Demand for higher risk premium 2.)Bankers widen bid-ask spread
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MECHANICS OF SPOT TRANSACTIONS

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

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MECHANICS OF SPOT TRANSACTIONS

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

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MECHANICS OF SPOT TRANSACTIONS

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

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PART IV. 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.

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THE FORWARD MARKET

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

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THE FORWARD MARKET

B.

Forward Rate Quotations

1. Two Methods: a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market as a discount or premium.

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THE FORWARD MARKET

CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n
where F= S= n= the forward rate of exchange the spot rate of exchange the number of months in the forward contract
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Forward Contracts: Payoff Profiles
profit

Long forward

profit

Short forward

F(0,T)

S(T)

F(0,T)

S(T)

The long profits if the spot price at delivery, S(T), exceeds the original forward price, F(0,T).

The short profits if the price at delivery, S(T), is below the original forward price, F(0,T).

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Default Risk for Forwards, I.

If the forward price is “fair” at initiation:

• •

The contract is valueless. There is no immediate default risk.

As time goes by, the forward price (for delivery on the same date as the original contract subsequently) can change:

• •

Existing forward contracts acquire value: They become an asset for one party and a liability for the other. Default risk appears. (Q: Which party faces default risk?)
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Default Risk for Forwards, II.

At any time, only one counter-party has the incentive to default. It is the counter-party for whom the forward contract has become a liability. The amount exposed to default risk at time t is: PV{ F(0,T) - F(t,T) }, 0 < t < T
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Profits and Losses for Forward FX Contracts

Define F(0,T) as the forward exchange rate at origination, for N units of FX to be delivered at time T S(T) = the spot exchange rate at delivery. F(0,T) and S(T) are in $/fx. If S(T) > F(0,T), the long profits by: N [S(T) - F(0,T)]. If S(T) < F(0,T), the short profits by: N [F(0,T) - S(T)].

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Pricing Forward contract

We can replicate the pricing of a forward contract by assuming a similarity between holding the contract and having the following positions:

• • • •

Buying a bond which is denominated at one currency Selling a bond which is denominated at the other currency. The net position is equal to the value of the forward contract. Since at time zero, the price of the contract is zero, the value of the long position is exactly offset by the value of the short position.

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Pricing Forward contract

Or 365 days
days 360

F = S (1+ R ⋅ ) /(1+ R ⋅ )
1 days 360 2

F=The forward rate in terms of payment currency S=The spot rate in terms of payment currency )R1=Interest on payment currency )yearly( )R2=Interest on basic currency )yearly(
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Pricing Forward contract
 We want to buy a 6 months Euro dollar forward contract. The spot rate is equal $1.41/Euro and the 6 months interest rates are equal 4% and 5% respectively.  What is the forward rate?  What is the forward price?

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Pricing Forward contract (Cont’d)
 The spot price has been changed to 1.44  What is the new forward rate at the market?  What is the value of our forward contract is we bought 1,000 Euro against US dollars?

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