Currency Markets

Prof. Banerjee
FIM
Currency among asset classes
Currency Markets

• 5 Trillion Dollar a day

• 24 hour trade
• USD, Euro, JPY and GBP predominate
• Integrated markets
• Mostly round tripping
• Arbitrage is the key driver
• An asset class that has lower
correlation
• Policy variables play an important role

Note: round-trip transactions or "Lazy Susans“a form of barter that involves a company selling "an unused
asset to another company, while at the same time agreeing to buy back the same or similar assets at about
the same price.
Foreign Exchange Market

The Foreign Exchange Market aids in:

(1) Facilitates the conversion of one country’s currency into another.
• Through the buying and selling of currencies.
• Allows global firms to move in and out of foreign currency as needed.
(2) Sets and quotes exchange rates.
• This is the ratio of one currency to another.
• These rates determine costs and returns to global businesses.
(3) Offers contracts to manage foreign exchange exposure.
• These hedging contracts allow global firms to offset their foreign currency exposures and
manage foreign exchange risk.
• Thus, they can concentrate on their core business.
Quick Review

• World’s largest financial market.

– Estimated at $ 5 trillion dollars per day in trades.
• Market is a 24/7 over-the-counter market.
– There is no central trading location.
– Trades take place through a network of computer and telephone connections all over
the world.
• Major trading center is London, England.
– 34% of all trades take place through London (New York second at 17%).
• Most popular traded currency is the U.S. dollar.
– Accounts for 86% of all trades
• Most popular traded currency pair is the U.S. dollar/Euro.
– Represents 27% of all trades (dollar yen second at 13%)
• Currencies are either traded for immediate delivery (spot) or some specified future
delivery (forward).
Currency Market Trades
• Spot FX
• Outright Forwards
• FX Swaps
• Trading methods: Inter-dealer, Voice broker, Customer direct, & Electronic methods
How does the FX Market Quote Currencies?

(1) American Terms:

• Expresses the exchange rate as the number of U.S. dollars per one unit of some foreign
currency.
• For example, $1.50 per 1 British pound.
(2) European Terms:
• Expresses the exchange rate as the number of foreign currency units per one U.S. dollar.
• For example, 120 yen per (1) U.S. dollar.
(3) Most of the world’s currencies are quoted for trade purposes on the basis of European terms.
• Exceptions include: British pound, Euro, Australian dollar.
Quotes are Given by Time of Settlement
Spot Exchange Rate:
• Quotes for immediate transactions (actually within 1 or 2 business days)

Forward Exchange Rate:

• Quotes for future transactions in a currency (3 business days and out).
• Forward markets are used by businesses to protect against unexpected future changes in
exchange rates.
• Forward rate allows businesses to “lock” in an exchange rate for some future period
of time.
Changes in Spot Exchange Rates: What do they imply?

Appreciation (or strengthening) of a currency:

• When the currency’s spot rate has increased in value in terms of some other currency.

Depreciation (or weakening) of a currency:

• When the currency’s spot rate has decreased in value in terms of some other currency.
Forward Rate Quotes
As a rule, forward exchange rates are set at either a premium or discount of their spot rates.

• If a currency’s forward rate is higher in value than its spot rate, the currency being quoted at
a forward premium.
• For example: the Japanese 1 month forward is greater than its spot (0.009034 versus
0.008999)
• If a currency’s forward rate is lower in value than its spot rate, the currency is being quoted at
a forward discount.
• For example, the British pound 6 month forward is less than its spot (2.0417 versus
2.056).
Contango and Backwardation

Market is in contango, if the forward price of a futures contract is higher than the spot price.

Market is in backwardation, the forward price of the futures contract is lower than the spot price.
Major Players in FX market

Large banks like Deutsche Bank, HSBC, UBS, Citibank

They acting as:
(1) “External” clients” primarily global firms: exporters and importers in the capacity of a
broker to meet the foreign currency needs of their clients.
(2) Their own banks (trading to generate profits).
• Acting in a “dealer” (i.e., trading) capacity
• Taking positions in currencies to make a profit.
Note : In order to meet the needs of their clients and their own trading activities, these global banks
“establish” the “tone” of the market through a “market maker” function.
Market Maker

The market maker function of any bank involves two primary foreign exchange activities:
(1) Willingness of the market maker to provide the market with “on-going” (i.e., continuous) two
way quotes upon request:
• Provide a price at which they will buy a currency
• Provide a price at which they will sell a currency
• This function provides the market with transparency
(2) Willingness of the market maker to actually buy and/or sell at the prices they quote:
• Thus the market maker offers “firm” prices into the market
• This function provides the market with liquidity.
ISO Currency Destinations
• All foreign currencies are assigned an International Standards Organization (ISO) abbreviation.
E.g., USD; JPY; GBP; EUR; AUD; HKD; INR
• Since the exchange rate is simply the ratio of one currency against another, market makers
express this relationship using the two currencies’ ISO designations.
• For Example:
• USD/JPY
• USD/MXN
• EUR/USD
• GBP/USD
• INR/USD
Base and Quote Currency
Market maker quote must have two ISO designations (e.g., EUR/USD or USD/JPY):

• The first ISO currency quoted is called the base currency.

• The second ISO currency quoted is called the quote currency.

For examples above:

• EUR/USD: EUR is the base currency and USD is the quote currency.
• USD/JPY: USD is the base currency and JPY is the quote currency.
Bid and Ask quotes
Market maker always provides both a buy and sell quote (or price) for a currency.
For Example: EUR/USD: 1.2102/1.2106
• The first number quoted by the market maker is the market maker’s buy price ($1.2102).
• It is called the market maker’s bid quote (or buy price)

• The second quoted number is the market marker’s sell price ($1.2106).
• It is called the market maker’s ask quote (or sell price)

Note: The bid quote is always lower than the ask quote.
Spot Rates: Bid-Ask Prices
What currency Market Maker is buying and Selling

Q: EUR/USD: 1.2102/1.2106, which currency is the market maker selling and which currency is the
market maker buying?

Answer: Market makers are always quoting prices at which they will buy or sell ONE UNIT of the
base currency (against the quote currency).

Therefore:
The market maker will buy euros for $1.2102
This is the bid price for euros.
The market maker will sell euros for $1.2106
This is the ask price for euros.
How to read and understand quotes
Foreign exchange quote, assign a value of 1 to the base currency (the base currency is the first in
the ISO pair). The quotes you see refer to one unit of this base currency.

For example, if a market maker’s ask price for the EUR/USD of 1.2811, it that if you were to buy
one Euro (the base currency) you are going pay $1.2811.

And if a market maker’s bid price for the USD/JPY of 120.10 that means if you were to sell one
dollar (the base currency) you are going to get 120.10 for it.

Note: Whenever the bid and ask prices are moving up, that means that the base currency is getting
stronger and the quote currency is getting weaker.
FX Trading, Arbitrage & Speculation
Forex Trading: Involves the sale of one currency and the purchase of another at an agreed
exchange rate

Arbitrage: Trading with risk less profits

Spatial
Triangular
Covered
Speculation:
Keep open position while trading (e.g. carry trade)
Private information is an important determinant of currency trading
Spatial Arbitrage

• Exploits mis-pricing between locations

• trader may buy at Bank A and sell at Bank B
• market will realign prices to eliminate arbitrage opportunity

Bank A Bank B
Bid Ask Bid Ask
Rs/$ 61.8899 61.9000 61.9400 61.9600
Triangular Arbitrage

Triangular arbitrage (also referred to as cross currency arbitrage or three-point arbitrage) is the
act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three
different currencies in the foreign exchange market.
Covered Arbitrage (Interest Rate Parity)

• Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on

theinterest rate differential between two countries by using a forward contract
to cover (eliminate exposure to) exchange rate risk.
• Forward exchange rate will be equal to interest differential:

(1  rinr )
f t 1  st
(1  rusd )
Interest Rate Parity

Home Interest Rate - Foreign Interest Rate (%)

4 IRP line

Zone where
2 covered
interest
Forward arbitrage is
Discount (%) not feasible
-1
-3 1 3

Forward
Premium (%)
-2

-4
Forwards Rates
Forwards and Expected Spot
• Depends on speculators and hedgers, if they are net long or net short
• If speculators are net long, and hedgers are net short, the forward price would be higher
than the spot
• If speculators are net short, and hedgers are net long, the forward price would be lower than
the spot
Forward Contracts
• You entered into this forward contract to buy $ 1
million by paying 66.48 million INR in One Year.
• Your pay-offs looks as below:
Pay-offs

65.00 67.00
0
66.48
 Such contracts help you to fix the future
Dollar costs of buying in INR
Forward Hedging

• Hedging involves eliminating uncertainly about future exchange rate and interest rate movements
• Objective:
• To lock in today (or on the day of the contract) an exchange rate or interest rate for future
transactions
• To eliminate the uncertainly of future exchange rate and interest rate movements
Speculation & Carry Trade

• Carry" trade: Simply a game of interest rate arbitrage

• Borrowing a currency with a low interest rate, and using the funds to purchase a
different currency asset yielding a higher interest rate
• Yen Carry: Borrowing in Yen and putting the money into US Treasuries received a double pay-off
in recent years due to interest differentials

Q: How long these imperfections to continue?

Theory – FX rate determination in LR
• Exchange rates are determined in markets by the interaction of supply and demand.
• An important concept that drives the forces of supply and demand is the Law of One Price.
• The Law of One Price states that the price of an identical good will be the same throughout the
world, regardless of which country produces it.
• Example: American steel costs $100 per ton, while Japanese steel costs 10,000 yen per ton.
Exchange Rates in the Long Run: Law of One Price

If E = 50 yen/$ then price are:

American Steel Japanese Steel
In U.S. $100 $200
In Japan 5000 yen 10,000 yen

If E = 100 yen/$ then price are:

American Steel Japanese Steel
In U.S. $100 $100
In Japan 10,000 yen 10,000 yen

• Law of one price  E  100 yen/$

Exchange Rates in the Long Run: Theory of Purchasing Power
Parity (PPP)
• The theory of PPP states that exchange rates between two currencies will adjust to reflect
changes in price levels.
• PPP  Domestic price level  10%, domestic currency  10%
─ Application of law of one price to price levels
─ Works in long run, not short run
Cont..

• Problems with PPP

─ All goods are not identical in both countries
(i.e., Toyota versus Chevy)
─ Many goods and services are not traded
(e.g., haircuts, land, etc.)
Thanks