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Topic 3: The Foreign Exchange Market

(Shapiro, Chapter 7)
A. The Foreign Exchange (Forex or FX) Market:
where money denominated in one currency is
bought and sold with money denominated in another
B. International Trade and Capital Transactions:
facilitated with the ability to transfer
purchasing power between countries.


A. Participants at 2 Levels
Wholesale Level (95%) - major banks
Retail Level - business customers
B. Two Types of Currency Markets
Spot Market:
- immediate transaction
- recorded by 2nd business day
Forward Market:
- transactions take place at a specified
future date

C. Participants by Market
1. Spot Market
- commercial banks
- brokers
- customers of commercial & central banks
2. Forward Market: arbitrageurs, traders,
hedgers, and speculators

A. Automated Trading - genuine screen-based
1. Reduces cost of trading
2. Threatens traders oligopoly of information
3. Provides liquidity


The foreign exchange market is the largest and
most liquid financial market in the world.
A.Daily turnover: USD3.98 trillion in April 2007
reported by the Bank for International
Settlements (BIS).

Of the $3.98 trillion daily global turnover, trading in

London accounted for around $1.36 trillion, or 34.1%
of the total, making London by far the global centre
for foreign exchange. In 2nd and 3rd places
respectively, trading in New York accounted for
16.6%, and Tokyo accounted for 6.0%

Method of Quotation (from American point of view)

a. American terms: example: US$1.3700/
b. European terms: example: 0.7299/US$,
(ie., 1/1.3700)

Direct quote gives the home currency price

(always in the numerator) of one unit of
foreign currency, eg., US$1.3700/
Indirect quote gives the foreign currency
price (always in the numerator) of one unit
of home currency, eg., 0.7299/US$.
So, American terms means direct quote and
European terms means indirect quote

Australian quote: USD0.9000/AUD

This means the price of AUD1 is USD0.9000.
By definition, AUD is the foreign (or commodity)
currency, its price is expressed in terms of USD.
As indirect quotes are used in Australia,
USD0.9000/AUD actually means
AUD(1/0.9000)/USD or AUD1.1111/USD
Where USD is the foreign (or commodity) currency.

Transactions Costs
- Bid-Ask Spread: used to calculate the profit
charged by the bank.
Bid = the price at which the bank is
willing to buy
Ask = the price it will sell the currency
Eg., USD0.8600/30/AUD
The bid for Australian dollar (AUD) is
USD0.8600 and the ask is 0.8630. Bid-ask
spread is USD0.0030. This is the profit made
by the bank in a round trip transaction, a cost
to the client.

- Percent Spread (PS) Formula:

Ask Bid
D. Cross Rates: the exchange rate between 2
non-US$ currencies.
Suppose you want to calculate the / cross rate.
You know 0.5556/$ and 0.8334/$, then
/ = ($/)(/$)
= (1/0.8334)(0.5556) = 0.6667/

E. Triangular Arbitrage (Shapiro, page. 280)

1. If cross rates differ from one financial center

another, and profit opportunities exist.
2. Buy cheap in one market, sell at a higher
price in another to conduct a triangular
3. The Critical Role of Available Information


In the previous example, if the bank quotes you

0.6670/, there is a triangular arbitrage opportunity
because: there are two different prices for :
0.6667/ < 0.6670/
calculated rate < market quoted rate
One can buy at the lower price and sell it at the
higher price at the same time to make a profit!

Golden Rule to arbitrage: to profit, buy low and sell

high. Since quoted rate is higher, sell 1 for
and you will get 0.6670, then sell 0.6670 for $
at 0.5556/US$. When you convert the $ back to
, you will have more than 1. An arbitrage profit
of 0.0005 (or 5 points) is made.

Arbitrage is defined as buying and selling at the

same time the same currency at different prices in
two different markets to make a small profit
without bearing any risk and without any net

Triangular arbitrage:
1 $
= 0.6670(1/0.5556)(0.8334)
= 1.0005

Arbitrage profit = 1.0005 - 1.000 = 0.0005

A 5 points arbitrage profit (ie., 0.05%) is made in this
triangular transaction. Note that 0.05% profit will
be made no matter your arbitrage is begun with the
buying/selling of , or $.

Forward market (page 283-289)

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.
Purpose of a Forward: For hedging, the act
of reducing exchange rate risk.


B. Forward Rate Quotations: Two Methods:

a. Outright Rate: quoted to commercial
customers, eg., 3-month forward rates:
b. Swap Rate: quoted in the interbank
market as a discount or premium, eg., 3month forward rates:
Spot rates: USD0.8520/0.8530/AUD
Margin: 20/10 (discount)
This gives an outright forward rates of
(More on forward rates in later lectures.)


Spot: 0.7240/30; bid-ask spread = 10

Swap rate: 3-month forward: 10/15

Outright forward rate a premium or discount?

Fwd margin
Fwd rate


0.7230 (spread = 10)

0.7215 (correct fwd rates)
Spread = 15
Fwd margin
Fwd rate
Bid-ask spread = 5 < 10 (wrong!)

Note that bid-ask spread of forwards must be greater

than that in spot markets because forward markets
are more uncertain (risky).
So the correct forward quotes =
USD0.7230/15/AUD, lower than spots.
This means that Australian interest rates are higher
than that of the U.S. (See interest rate parity later).

According to interest rate parity, if Australian interest

rates are higher, AUD is selling at a forward
discount (ie., forward rates are quoted lower than
spot rates), and vice versa.


Forward margin is also called swap point. This is the

number of points required to swap spot into
forward. It is known as foreign exchange swap.

F S 12

S n
F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the forward

Changes in Exchange Rates

Appreciation and depreciation are changes in
exchange rate (e) determined by the market forces
of supply and demand.
Devaluation and revaluation are changes in exchange
rate determined by the monetary authority.

Calculating Currency Appreciation:

(e1 - e0)/e0
where e0 = exchange rate at time 0
e1 = exchange rate at time 1

Example: USD Appreciation

If the AUD value of the USD goes from AUD1.3500
(e0) to AUD1.4850 (e1), then the USD has
appreciated by

(1.485 1.35)/1.35 = 10%

Calculating Currency Depreciation:

(e0 - e1)/e1
Example: AUD Depreciation
If the AUD value of the USD goes from AUD1.3500
(e0) to AUD1.4850 (e1), then the AUD has
depreciated by
(1.35 1.485)/1.485= -9.09%%

Australian Quotes with bid-ask

In Australia, exchange rates are quoted in European
term or indirect quote. This is different from
international practice.
Lets assume USD0.9000/AUD. This means the price
of AUD ( the commodity currency) in terms of USD
(the term currency) is USD0.9000. For the price of
USD0.9000, one can buy one Australian dollar or
one Australian dollar is worth USD0.9000. This is
using indirect quote.
In fact, this actually means, one USD is worth
(1/0.9000) = AUD1.1111, or the price of one USD is

Note that exchange rates are always quoted to the

4th decimal place. In FX markets, one basis point
is equal to 0.0001. The same is used in interest
rate quotes.
In practice, Two-way (bid-ask) quotes are used, eg.,
USD0.7240/30/AUD =
USD0.7240/0.7230 (bid/ask)
Note: the commodity currency in the quote is AUD.
The price of AUD (a commodity) is expressed in
terms of USD.
Bid rates are banks buying rates and ask rates (or
offer rates) are banks selling rates of the
commodity currency.

Since indirect quotes are used in Australia, the above

quotes are in fact for the buying and selling of USD.
This means the dealers buying rate (bid) is
AUD(1/0.7240) = AUD1.3812 for one USD.
The dealers selling rate (ask or offer rate) is
AUD(1/0.7230) = AUD1.3831 for one USD
Note that banks must make a profit, they must buy low
(bid) and sell high (ask/offer), ie., Bid rate < Ask rate.
As a result, the bid-ask spread (ask rate minus bid
rate) becomes a transaction cost for the clients


The International Monetary System

(Read Shapiro, Chapter 3)

IMS is the set of policies, institutions, practices,

regulations, and mechanisms that determine the
rate at which one currency is exchanged for another.

Evolution of the IMS

Bimetallism: Before 1875
A double standard in the sense that both gold and
silver were used as money.
Some countries were on the gold standard, some on
the silver standard, some on both.

Both gold and silver were used as international

means of payment and the exchange rates among
currencies were determined by either their gold or
silver contents.
Greshams Law implied that it would be the least
valuable metal that would tend to circulate.

Classical Gold Standard: 1875-1914

During this period in most major countries:
Gold alone was assured of unrestricted
There was two-way convertibility between
gold and national currencies at a stable ratio.
Gold could be freely exported or imported.

The exchange rate between two countrys

currencies would be determined by their relative
gold contents.
For example, if the dollar is pegged to gold at
U.S.$30 = 1 ounce of gold, and the British pound is
pegged to gold at 6 = 1 ounce of gold, it must be
the case that the exchange rate is determined by
the relative gold contents, ie.,
$30 = 6
Exchange rate: $5 = 1
Highly stable exchange rates under the classical
gold standard provided an environment that was
conducive to international trade and investment.

Misalignment of exchange rates and international

imbalances of payment were automatically
corrected by the price-specie-flow mechanism.
There are shortcomings:
The supply of newly minted gold is so
restricted that the growth of world trade and
investment can be hampered for the lack of
sufficient monetary reserves.
Even if the world returned to a gold standard,
any national government could abandon the


Interwar Period: 1915-1944

Exchange rates fluctuated as countries widely
used predatory depreciations of their currencies
as a means of gaining advantage in the world
export market.
Attempts were made to restore the gold standard,
but participants lacked the political will to follow
the rules of the game.
The result for international trade and investment
was profoundly detrimental.


Bretton Woods System: 1945-1972

Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
The purpose was to design a postwar
international monetary system.
The goal was exchange rate stability without the
gold standard.
The result was the creation of the IMF and the
World Bank.
Under the Bretton Woods system, the U.S. dollar
was pegged to gold at $35 per ounce and other
currencies were pegged to the U.S. dollar.

Each country was responsible for maintaining its

exchange rate within 1% of the adopted par value
by buying or selling foreign reserves as necessary.
The Bretton Woods system was a dollar-based gold
exchange standard.
Gold was abandoned as an international reserve
Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.


The Flexible Exchange Rate Regime:

1973 to present
Flexible exchange rates were declared acceptable
to the IMF members.
Central banks were allowed to intervene in the
exchange rate markets to iron out unwarranted
Gold was abandoned as an international reserve
Non-oil-exporting countries and less-developed
countries were given greater access to IMF funds.

Current Exchange Rate Arrangements:

Free Float - allow market forces to determine their
currencys value freely.
Managed Float - combine government intervention
with market forces to set exchange rates.
Pegged to another currency - Such as the U.S.
dollar or euro (through franc or mark).
No national currency- Some countries do not bother
printing their own, they just use the U.S. dollar. For
example, Ecuador has recently dollarized.


Fixed vs Flexible Exchange Rate Regimes

Arguments in favor of flexible exchange rates:
Easier external adjustments.
National policy autonomy.
Arguments against flexible exchange rates:
Exchange rate uncertainty may hamper
international trade.
No safeguards to prevent crises.



A. Freely Floating (Clean Float)
1. Market forces of supply and demand
determine rates.
2. Forces influenced by
a. price levels
b. interest rates
c. economic growth
3. Rates fluctuate over time randomly.
B. Managed Float (Dirty Float)
1. Market forces set rates unless
excess volatility occurs.
2. Then, central bank determines rate.


C. Target-Zone Arrangement
Rate Determination:
a. Market forces constrained to upper and
lower range of rates.
b. Members to the arrangement adjust their
national economic policies to maintain
D. Fixed Rate System
1. Rate determination
- Government maintains target rates.
- If rates are threatened, central
banks buy/sell currency to maintain
the fixed rates.
- Monetary policies coordinated.

2. Some Government Controls:

- On global portfolio investments.
- Ceilings on direct foreign direct
- Import restrictions.
E. Current System: A hybrid system
- Major currencies: use freely-floating
- Others move in and out of various
fixed-rate systems.


Seigniorage: The profit to the central bank

from money creation; it equals the difference
between the cost of issuing the money and
the value of the goods and services that
money can buy.
U.S. government has been making lot of
seigniorage as lot of USD is held in foreign
hands. More and more USD will be held in
foreign hands as US trade deficit is financed
by the export of USD.