Chapter 2: The Foreign Exchange Market Power Points created by: Joseph F. Greco Ph. D., California State University, Fullerton Mihaylo College of Business and Economics Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Chapter 2: The Foreign Exchange Market 2.1 The Organization of the Foreign Exchange Market 2.2 Currency Quotes and Prices 2.3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits 2.4 Inside the Interbank Market II: Communications and Fund Transfers 2.5 Describing Changes in Exchange Rates Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.1 The Organization of the Foreign Exchange Market The Organization: Overview Size of the Market Types of Contracts Traded Foreign Exchange Brokers Computerized Trading Systems The Competitive Marketplace Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.1 The Structure of the Foreign Exchange Market Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.1 The Organization of the Foreign Exchange Market Size of the Market Largest financial market in the world,measured by dollar volume of trade Types of Contracts Traded Focus in this chapter is on a spot market contract that is settled in 48 hours Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall London、NewYork、Paris等市场 at the third day;香港市场，HongKong dollars exchange for dollars at the trading day for delivery;HongKong dollars exchange for JPY at the next day. Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.2 Foreign Exchange Trading Activity Around the World Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.1 The Organization of the Foreign Exchange Market Foreign Exchange Dealers Foreign exchange dealers Market makers Liquidity Easy to match buyers and sellers Low transaction costs Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Foreign Exchange brokers market matching financial intermediary Easy to match buyers and sellers Low transaction costs Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.1 The Organization of the Foreign Exchange Market Computerized Trading Systems Dealing 3000 EBS The Competitive Marketplace low cost no abnormal profits no single dealer dorminates market Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.3 The Top 20 Dealers in the Foreign Exchange Market Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.2 Currency Quotes and Prices Currency Quotes and Prices: Overview Exchange Rates Exchange Rate Quotes Vehicle Currencies and Currency Cross-Rates Example: Trading currency in the New York market where both currencies are not expressed in U.S. dollars Triangular Arbitrage Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Example of cross rate 1.USD/DEM=1.8421/28,USD/HKD=7.8085/95 so,DEM/HKD Answer: bid price of DEM=7.8085/1.8428=4.2373 ask price of DEM=7.8095/1.8421=4.2395 DEM/HKD=4.2373/95 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 2.GBP/USD=1.6125/35,AUD/USD=0.7120/30 so,GBP/AUD Answer bid price of GBP=1.6125/0.7130=2.2616 ask price of GBP=1.6135/0.7120=2.2662 GBP/AUD=2.2616/62 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 3.GBP/USD=1.6125/35,USD/JPY=150.80/90 so,GBP/JPY Answer bid price of GBP=1.6125*150.80=243.17 ask price of GBP=1.6135*150.90=243.48 GBP/JPY=243.17/48 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.2 Currency Quotes and Prices Exchange Rates Exchange Rate Quotes Direct quotes Indirect Quotes European Quote American Quote Dollar price of a foreign currency Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.4 Currencies and Currency Symbols Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.5 Currency Quotes in the Wall Street Journal Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.2 Currency Quotes and Prices Vehicle Currencies and Currency Cross-Rates Vehicle currency Cross-rates Example: Trading currency in the New York market where both currencies are not expressed in U.S. dollars Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.6 Cross-rates Quotes in the Wall Street Journal Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.2 Currency Quotes and Prices Triangular Arbitrage An arbitrage process involving three currencies Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.7 Triangular Arbitrage Diagram Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.8 Good and Bad Triangular Arbitrages Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall NewYork:USD/DEM,1.5020/30 NewYork:USD/GBP,0.5875/0.5885 London:GBP/DEM,2.5610/2.5620 if customer holding 1000,000,first NewYork1000000*0.5875=£587500 London587500*2.5610=DM1504587.5 NewYork1504587.5/1.503=1001056 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall customer hold 1000,000 Pound, London1000000*2.5610=DM2561000 NewyorkDM2561000/1.503=＄1703925.5 Newyork＄1703925.5*0.5875=£1001056 customer hold 1000000DM, NewYork1000000/1.503=＄665336 NewYork＄665336*0.5875=£390885 London£390885*2.5610=DM1001056 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits The Interbank Market: Overview Introduction Bid-Ask Spreads The difference between the ask rate and the bid rate The Magnitude of Bid-Ask Spreads Bid-Ask Spreads All Day Around the Work Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits Introduction Bid rate Ask Rate Bid-Ask Spread Bid-Ask Spreads Offer Price Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits The Magnitude of Bid-Ask Spreads Pip Fourth decimal place in a dealer’s quote percentage spread=100*(ask-bid)/ask ask rate is ＄1.1895/*,bid rate is ＄1.1891/* the spread is 100*1.1895-1.1891/1.1895=0.03% Bid-Ask Spreads The difference between the bid and the ask rates Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.4 Inside the Interbank Market II: Communications and Fund Transfers Communication Systems Society of Worldwide Interbank Financial Telecommunications (SWIFT) Clearing House Interbank Payments System (CHIPS) Trans-European Automated Real-time Gross Settlement Express Transfer (TARGET) Fedwire Cross-Currency Settlement (Herstatt Risk) Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.9 The Reciprocal Nature of Bid and Ask Exchange Rates Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

the reciprocal nature of bid ask spread from the picture, we can see in selling yen for dollars , the seller will receive the bid price of ＄/¥ which is the reciprocal of the bank's ask yen price per dollar 1/(¥/＄), in selling dollar for yen, receive bank' s bid price of yen to dollar is the reciprocal of bank's ask price of dollars for yen. Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.10 Communication Systems in the Forex Market Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.4 Inside the Interbank Market II: Communications and Fund Transfers Cross-Currency Settlement (or Herstatt) Risk The risk that a financial institution may not deliver the currency on one side of a completed transaction Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

2.5 Describing Changes in Exchange Rates Introduction Appreciation Depreciation Devaluations Revaluations Rates of Appreciation and Depreciation are used to describe changes in exchange rates when exchange rates are allowed to be flexible Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall devalution and revaluation means some country use fixed or peg exchange rate system if the monetary authorities increase the demestic currency price of foreign exchange , they are devaluating their money , or is revaluating P61 Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.11 Netting Arrangements Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall

Exhibit 2.11 Netting Arrangements Copyright © 2009 Pearson Education, Inc.  Publishing as Prentice Hall