Foreign Exchange Markets

UNIT 4
The Spaniards coming into the West Indies had
many commodities of the country which they
needed, brought unto them by the inhabitants,
to who when they offered them money, goodly
pieces of gold coin, the Indians taking the money,
would put it into their mouths, and spit it out to
the Spaniards again, signifying that they could
not eat it, or make use of it, and therefore they
would not part with their commodities for
money, unless they had such other commodities
as would serve their use.
EDWARD LEIGH (1671)
 Structure of the Forex Markets
• Growth of global trade
• Exports and imports are a significant %age of
GDP
– >10% for USA, over 25% for Canada and UK (in 2010)

2016 figures (source ecb.europa.eu)

– Euro area 25.5% (15.6%), US 9.2% (10.3), Japan 3.8%
(4.3), China13.9% (15.7) (excluding intra-euro area)
• Multiple markets
• Many currencies
• Cross border trade and settlement
• Transfer of purchasing power denominated in
one currency to another
• Investors, say American in Swiss Franc
denominated bonds must convert $ to franc to
complete the purchase
• Receiving the interest and return of capital is also
desired in $
• Ultimately each participant in a trade wishes to
have their own currency
– The forex market is the intermediary that is
developed to make this happen
 Components

Interbank market
• Wholesale market in which major banks
trade with one another
(this is the foreign currency market
accounting for about 95% of forex
transactions)
SPOT MARKET
• Currencies are traded for immediate delivery

IMMEDIATE delivery actually is 2 business

(working) days after the transaction has been
concluded

• SPOT transactions account for about 33% of

the total market
FORWARD MARKET

• Contracts are made to buy or sell currencies

for future delivery

These are about 12% of the market size

Forward trades have several specific settlement

dates
SWAP TRADES
• About 55% of the market size
• Involve a package of a spot and forward
contract
(source: Bank for International Settlements.
Circa 2010-12)
 Where is the
Foreign Exchange Market?
• Not confined to a physical place, or any
geography
• An electronically network of banks, foreign
exchange brokers and brokers who bring
together buyers and sellers of foreign exchange.
Commissions are tiny (US - 1/32 of 1%, which is
$312.50 on $ 1 million trade)
• Dispersed through the leading financial centers of
the world - London, New York, Paris, Zurich,
Amsterdam, Tokyo, Hong Kong, Toronto,
Frankfurt, Milan, Singapore and others
 Process and Platform
• Telephone
• Telex
• SWIFT (Society for Worldwide Interbank
Financial Telecommunications)
– Links more than 7,000 banks and broker-dealers in
almost 200 countries
– Processes more than 5 MILLION transactions a day
– Makes over $5 TRILLION in payments a day
 SWIFT
• All types of customers and bank transfers are
transmitted
• Foreign exchange deals
• Bank account statements
• Administrative messages
• Linkage for corporate through banks
 Dealer locations
• Banks usually have a separate dealing room for
foreign exchange
• Each trader has a board of several telephones,
hotlines and data terminals
• Most transactions are verbal - written confirmation
follows
• Electronic trading is quickly replacing verbal dealing
• The market operates around the clock (24 hours a
day)
• Trade in goods and services is about 5% of
foreign exchange trading

• More than 95% is cross-border purchases and

sale of assets (international capital flows)
• Banks use brokers to have anonymity
• Ease of 1 call instead of a dozen to match a
trade (minimise number of contacts too)
• Specialisation of brokers in particular currency
pairs
• Information, analysis and opinions, even
rumours are value added by brokers
(You have Kamala Aithal’s blog from Poiesis)
 Participants
The biggest participants are
• Arbitrageurs
• Traders
• Hedgers
• Speculators
 Arbitrageurs
Seek to earn risk-free profits
• By taking advantage of differences in interest
rates among countries
• Take advantage of mispricing in currency couples
They use forward contracts to eliminate the
exchange risk involved in transferring funds from
one nation/ currency to another
(one of the early players was LTCM)
 Traders
• Use forward contracts to eliminate or cover
the risk, or profit from the risk of loss on
export or import orders denominated in
foreign currencies.
• A forward covering contract is related to a
specific payment or receipt expected at a
specific point in time
 Hedgers
• Mostly MNCs
• Engage in forward contracts to protect the
home currency value of various home
currency-denominated assets and liabilities in
the BS that are not realised over the life of the
contracts
All these seek to reduce, or eliminate if possible,
their forex risks by locking in the rate for
future trade or financial operations
 Speculators
Speculators may also be traders (or traders be
speculators)
Speculators actively expose themselves to currency
risks by buying and selling currencies in forward to
profit from rate fluctuations or (perceived) value
mismatches.
Their degree of participation is not connected to their
business (trade) valuations, but on current forward
rates and their expectations of future spot rates
 The Clearing System
• Electronic systems for trading are exploding
• Transfer of funds is at the core of clearing, or
settling transactions
• Clearing House Interbank Payment Systems
(CHIPS) is a computerised network of the New
York Clearing House Association for transfer of
International dollar payments
The New York Fed has a settlement system for
member banks - FedWire
Transfers between member banks are netted and
settled each day at 4.30 pm EST (ends at 6 pm)

(gross and net settlement?)

 Electronic Trading
• Introduced by Reuters (who?) in April 1992
(OTCEI was formed in 1990 and started trading in
1992. NSE ALSO IN 1992)
EBS, Telerate and Quotron also followed offering
automated matching systems, with visibility to
all participants but trader anonymity.
Fxall is the biggest internet system with JP
Morgan, Citi, Goldman, Deutsche, CSFB, UBS
Warbrg, Morgan Stanley and Bank of America as
participants
Traders had to just hit 2 buttons
 The Spot Market
• Rates (quotes) shown in papers and web are
normally 4
– Spot price
– 30 day forward
– 90 day forward
– 180 day forward
These are for trades among dealers in the interbank
market
• Interbank trades involve US dollars (about
60% of all trades)
• If European it is in number of foreign currency
units per US dollar
• Indian quotes are also units per dollar (or yen/
euro/ sterling)
• In dealing with non-bank customers, banks in
most countries use direct quotation
• A direct exchange rate quote gives the home
currency price of a certain quantity of the
foreign currency quoted (example - In
Switzerland British Pound (pound sterling)
might be quoted at SFr 0.80 pound, while in
England the franc would be quoted at British
Pound 1.24 SFr
 Indirect quote
• Used only in some markets like Great Britain
• Banks in Great Britain quote the value of the
pound sterling in terms of the foreign currency.
For example, 1 pound = $1.28
• This method of indirect quotation is also used in
the US for domestic purposes and for the
Canadian dollar
• For foreign exchange activities abroad US banks
adhere to direct quotation
 Transaction costs
• Banks do not normally charge a commission
on currency transactions
• Banks profit from the spread between the
buying and selling rates on both spot and
forward transactions
• Quotes are always given in pairs (as with a
jobber or market maker)
• Only the last 2 digits of the decimal are
quoted
 Costs...bid-ask spread
• The spread between the bid (buy) and ask (sell)
for a currency is based on the breadth and
depth of the market for the currency, as well as
on the currency’s volatility
• The spread compensates traders for the costs
incurred, compensates for the cost of holding
stock (of currency), compensates for the risk
and provides a profit including for the cost of
capital and a profit
• Transaction costs are normally a percentage cost
of transacting in the foreign exchange market
%age spread = Ask price - Bid price x 100
Ask price
Example if pound sterling is quoted at $1.8419-28,
then
%age spread = 1.8428 - 1.8419 x 100 = 0.049%
1.8428
• Electronic trading has pushed costs lower than 20 bps
• Spreads are higher in less heavily traded currencies and
more volatile currencies
• There is a growing forward market for currencies
where the spread is reducing as volumes grow.
• The quotes found in the papers are not available to
businesses. The quotes are for above $ 1 million, with
standard transaction being $ 10 million
Corporate normally shop the market for competitive
quotes

Small currency and traveller's cheques have a wider

spread, reflecting higher costs to banks
 Cross Rates
• Necessary to work them out as most
currencies are quoted against the $
Examples:
• IF (rates are hypothetical) euro is selling for
$1.47 and rate for Swiss Franc is $0.98, then
euro/SFr is euro1 = SFr 1.5
• JPY: 105.62/US$; SK Won: 1040.89/US$
Cross rate of yen per won is
Japanese yen/US$ = Yen105.62/US$ = Y0.10147/W
Korean Won/US$ W1040.89/US$
 Currency Arbitrage
• Practice for dealers to quote all currencies against
US$ when trading among themselves
• With more trades not involving the $, banks give
non-$ quotes
• Euro against SFr, pound sterling against euro are
common quotes for European banks
• Exchange traders are continually alert to profiting
through currency arbitrage, of exchange rate
inconsistencies in different money centers
• IF the pound sterling is $1.9422 in NY, euro is
$1.4925 in Frankfurt, pound sterling is euro
1.2998 in London, a trader would sell $ for
euro in Frankfurt, use the euro to buy pounds
in London and sell the pounds in NY (What is
the gain on the trade if he starts with $1
million?)
The arbitrage trades would tend to cause the
euro to appreciate against the $ in Frankfurt,
depreciate against the pound in London, and
sterling would tend to fall against the $ in NY
• The sequence is called triangular currency
arbitrage
• When profitable opportunities disappear a no-
arbitrage condition holds
• High speed online systems take advantage of
even small opportunities bringing exchange
rates to equilibrium almost instantaneously
 Work it out
• If the direct quote for the dollar is euro0.65 in
Frankfurt, transaction costs are 0.3%, what
are the minimum and maximum possible
direct quotes for the euro in NY?
 Solution
Objective is to find the no-arbitrage range of euro quotes (that is
the widest bid-ask spread)
• Consider an arbitrageur who converts $1 into euro = 0.65 x
0.997
• Convert these to $ at a direct quote of e, he would keep 0.65 x
0.997 x e x 0.997
• Alternatively, he would wind up, after paying transaction costs
at both NY and Frankfurt with - (1/e) x 0.997 x (1/0.65) x 0.997
• The no-arbit requires that this must be less than $1,
(0.997)2 x (1/0.65e) < 1, or e > $1.5292

Range yields $1.5292 < e < 1.5477

 Settling Trades
• The value date for spot transactions, i.e. The
date on which money must be paid to the
parties involved is the 2nd working day after the
date of the transaction. T+2 date
• A spot deal struck on Thursday will settled only
on Monday in the West as Saturday and Sunday
are holidays
One-day, or same-day settlement is possible, but unusual. Rates
will be adjusted (negotiated) to reflect interest differentials and
premium for special situation
 Settling the Spot Transaction
Suppose a US importer has to pay SFr$1 million to his Geneva
supplier. On receiving and accepting a verbal quote from a trader
at his US bank he specifies i) the US bank account he wants
debited for the dollar amount at the agreed exchange rate, and
ii) the Geneva supplier’s to be credited with SFR1 million
• Post verbal deal, the trader will forward a deal slip with relevant
info to the settlement section (back office function)
• The same day a contract note including amount of forex, $
equivalent at agreed rate and confirmation of payment
instructions, will be sent to the importer
• Settlement section will cable/ telex the Swiss branch/
correspondent requesting transfer of SFr1 million from its nostro
account to the exporter’s account (specified by importer)
Nostro account are working balances
maintained with the correspondent to
facilitate delivery and receipt of currencies
• On the value date, the US bank will debit the
importer’s account and the exporter will have
his account credited by the Swiss
correspondent
• The trader constantly provides a clerk/ enters
in the system details of trades done. This
position sheet goes into a bank wide position
sheet showing the bank’s position by
currency, as well as by maturity of forward
contracts.
The head trader monitors these for evidence of
possible fraud, or excessive exposure to a
particular currency
• Spot transactions being settled after 2 days
banks have uncertainty of the deal’s
conclusion. Large deals therefore are only done
with prime names (big banks or corporate)
• Settlement Risk (or Herstatt risk) is if a bank
will deliver currency on one side of a deal, only
to find that the counterparty has not sent the
money in return. (Delays in the transfer may
also be because of time zones)
Herstatt was a German bank that went bankrupt after losing a
fortune speculating on foreign currencies
 Forward Market
A forward contract between 2 parties (both could be
banks), calls for delivery, at a fixed future date, of a
specified amount of one currency against $
payment, the exchange fixed at the time of
contract.

Forward markets are active for major, widely traded

currencies, with illiquid currencies of less developed
economies being limited or nonexistent
 Transaction
• A Japanese importer buying German machine tools
worth euro 1 million, payable in 90 days would
consider the current rate of 129.31 yen per euro
would like to avoid the risk of the euro appreciating
during this period.
• He would negotiate a 90 day forward contract with
his bank at say, 132 yen
• The bank would deliver euro 1 million on the 90th day
and receive Y132,000,000 (less any margin amount
paid earlier)
Technically the importer is short euro at the
time of his contracting to import
He offsets this by going long in the forward
market
This eliminates ALL RISK on the exchange part of
the transaction, at a small cost that is known
at the beginning
There is an implicit loss or profit to the importer
on the forward contract if the rate is different
at the time of settlement
The forward contract is NOT an option contract.

Both parties MUST perform on the agreement

 Forward quotations
1. Commercial customers are usually quoted the
actual price, aka outright rate
2. In the interbank market dealers quote the
forward rate only as a discount from, or
premium to, the spot rate, This forward
differential is known as the swap rate. This
may be a forward discount if the rate is below
the spot, or forward premium is it is above
spot
• Expressed as an annualised annual percentage
deviation from the spot
= Forward rate - Spot rate x 360
Spot rate Forward contract number of
days
 Derivatives
• Derivatives are extracts/ contracts that get
(derive) their value from an underlying asset
• Financial derivatives derive value from assets
such as stock, bond, currency, reference rate
(such as 90 day T Bill rate), index (Nifty)
• Common derivatives are futures, options,
swaps, forwards
• Chicago Mercantile Exchange provides currency
futures - contracts for specific quantities of given
currencies
• The pattern is same as for grain and commodities
futures contracts which have been traded on the
CBE for over 100 years
Contracts available - Aus $, Brazilian real, Canadian $,
Chinese renminbi, Czech koruna, Hungarian florint,
Israeli shekel, Jap yen, Korean won, Mexican peso,
NZ $, Norwegian krone, Polish zloty, Russiab ruble,
SA rand, Swedish krona, Swiss franc, euro.
And some cross rates
• Open interest is the number of contracts outstanding
at any time
• Contract sizes are standardised by the amount of
foreign currency
• Contracts have minimum price moves (tick sizes) of
about $10
• Leverage is high. Margins are about 2% of the
contract value
• Exchanges normally set daily price move limits.
Additional margins are charged if prices move
beyond
• Traders charge commissions (rather than the
bid-ask spreads of the inter-bank market
• Commissions on a round trip are very low,
encouraging volumes and speculation
• Some exchanges trade electronically (and
anonymously), while a few are open-outcry
with brokers dealing face to face on a trading
floor
 Forward and Futures
Futures
• Standardised contracts for specific delivery
dates only (the dates are set by the exchange
for deals done and vary from exchange to
exchange)
• Contract sizes and maturities are standardised
• This leads to ease of trading, encouraging
higher trading volumes, superior liquidity,
smaller price fluctuations and lower transaction
costs
Forward
• Private deals between 2 individuals
• No standardisation as they are tailored
• No daily mark to market , or risk monitoring
• Held to maturity
 Safety and margins
• Risk management measures are prescribed by
the exchange
• Margins are used to secure the system from
trader default
• These margins are not static and can be
increased whenever the exchange believes
that volatility is increased - often during a
trading session
Margins have different names (by exchange), but serve a
common purpose. On CME:
• Initial performance bond is the money to be on
deposit before a contract is entered into. This may be
considered the maintenance performance bond to
keep the contract valid and live
• A performance bond call if losses bring the account
balance below maintenance performance bond
• Marking to market is done everyday
• Risk margins may be demanded by the exchange
based on VaR
• Offsetting trades close out a contract
 Futures - advantages and disadvantages
• Small contract size and convenience to liquidate the
contract a any time before maturity, in well organised
market differentiates the futures from forward
contract
• Limited by choices offered
• Cannot be tailored to meet specific needs to a
corporate.

Arbitrageurs translate future rates into interbank

forward rates. This keeps futures rates in line with
bank forward rates. Called “Forward-Futures
Arbitrage”
Forward & Futures - the difference
Forward
Traded by phone or telex
Self-regulating
Mostly settled by delivery
Individually tailored
Large contracts, usually
Delivery date as desired
Settlement as contracted
Costing based on bid-ask spread
No margins
Each party bears credit/ default risk
Future
On arena such as Exchange
Has a regulator
Less than 1% delivered
Standardised
Of small size for public participation
Specific dates called expiry/ maturity
Can be squared off. Marked to market
Transparent brokerage is charged
Margins required on ALL fresh/ open
transactions
Novation provides security of contract
 Currency Options
• First offered by the Philadelphia Stock
Exchange, now traded on its United Currency
Options Market (UCOM)
 Terms
• Call - give the owner the right to purchase
• Put - give the owner the right to sell
In foreign exchange there are 2 sides to a
transaction - a call/ put on a foreign currency
can be considered a put/ call on the domestic
currency. Example: The right to buy euro
against $ payment is equivalent to the right to
sell $ for euro payment
 More Terms

Option Description Strike (or Exercise) Price Effect of Immediate

relative to Spot Rate exercise

In-the-money Strike price<spot Profit

At-the-money Strike price=spot Status quo

Out-of-the-money Strike price>spot Loss

 American and European Option
• The value of an American Option always exceeds its
intrinsic value as time value is always positive till
expiration
• American Option may be exercised at any time before
expiry
• European Option may be exercised only at expiration
• American options cease trading at close of business on
expiration and European Option stop trading a day
earlier
 Settlement of Options
• At the official closing price, if the options are
in the money by 1% or more are auto-
exercised, unless the owner specifically asks
his broker not to exercise