The Foreign Exchange Market Assoc . Prof. Phd. Codruța Maria Făt

Main Topics Geographical extent of the foreign exchange market Functions of the foreign exchange market Market participants Transactions in the Interbank market Foreign exchange rates and quotations

Geographical extent of the foreign exchange market Major world trading starts early in the morning at Hong Kong and in short time at Singapore, moves to Tokyo and Sydney, passes to Bahrain, shifts to Europe: Frankfurt, Zurich and London, jumps the Atlantic to North America right to New York, goes west to Chicago and ends in san Francisco and Los Angeles. Many large international banks operate foreign exchange trading rooms in each major geographic trading center in order to serve their clients 24 hours per day. Global currency trading is indeed a 24-hour-a-day process. Banks engaged in foreign exchange trading are connected by highly sophisticated telecommunications networks. Reuters, Telerate and Bloomberg are the leading suppliers of foreign exchange information and trading systems.

The foreign exchange market: DEFINITION Is the mechanism by which participants transfer purchasing power between countries, obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes.

Functions of the foreign exchange market Transfer of purchasing power. Provides a source of credit. Provides hedging facilities.

The tiers of Foreign Exchange Market The Interbank or Wholesale Market: the transactions on this tier of market are usually for large sums that are multiples of a million USD. The Client or Retail Market: heir the contracts between the bank and its clients are usually for a specific amount.

The main categories of market participants Bank and nonbank foreign exchange dealers Operate on both tiers of the market They make a profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask (offer) price. Dealers in the foreign exchange department of big banks often function as market makers: they stand willing at all times to buy and sell those currencies in which they are specialized and thus maintain an inventory position in those currencies in order to maintain inventories in trading limits set by bank policy. The individual dealers are compensated on a profit incentive basis.

Individuals and firms conducting commercial and investment transactions Importers and exporters International portfolio investors Tourists, etc Some of them use the market to hedge foreign exchange risk.

Central Banks and Treasuries Use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. The motive is not to earn a profit, but to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.

Speculators and Arbitragers Seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve a client or to ensure a continuous market. Where dealers seek profit from the spread between bid and ask in addition to what they might gain from changes in exchange rates, speculators seek all their profit from exchange rates changes. Arbitragers try to profit from simultaneous exchange rate differences in different markets.

Foreign Exchange rates and quotations A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (quote) is a statement of willingness to buy or to sell at an announced rate. In the retail market quotes are most often given as the home currency price of the foreign currency. The practice is not uniform worldwide.

Interbank quotations Professional dealers and brokers may state foreign exchange quotations in one of two ways: The foreign currency price for one dollar – the European terms RON 2,79/ USD 2. The dollar price for one unit of foreign currency - American terms. USD 0,3584/ RON Most interbank quotations around the world are settled in European terms. European terms were adopted as the universal way of expressing foreign exchange rates for most (but not all) currencies in 1978 to facilitate worldwide trading through telecommunications.

Direct and Indirect quotes Critical in this approach is the home or base country for the currencies being discussed. Direct quote - a home currency price of a unit of foreign currency. Indirect quote – a foreign currency price of one unit of home currency. The form of the quote depends on what the speakers regards as home.

Example RON 2.79/ USD Is a direct quote in Romania and an indirect quote in USA It can be referred as “the internal value of RON” USD 0,3584/ RON Is a direct quote in USA and an indirect quote in Romania It can be referred as the “external value of RON” that is, the value of one RON outside Romania

IMPORTANT Direct and indirect quotations are not synonyms for American and European terms, because the home (base) currency will change depending on who is doing the calculation, and European terms are always the foreign currency price of a dollar. In the meantime American terms are the USD price of a foreign currency.

Bid and Ask Quotations BID – the price (exchange rate) in one currency in which a dealer will buy the other currency. Ask (offer) - the price (exchange rate) in one currency in which a dealer will sell the other currency. The bid for one currency is also the offer for the opposite currency The outright quotation ( the full price to all its decimal points) is shown only for the current spot rate. The mid rate is the numerical average of bid and ask.

Expressing forward quotations on a point basis The forward rates are quoted in terms of POINTS, also referred to as cash rates or swap rates, depending on maturity. Swap rates if the maturity is bigger than 2 years. A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal point. Currency prices for USD are usually expressed to 4 decimal points. So, a point is equal to 0.0001 of most currencies. Some currencies like JPY are quoted only with 2 decimal points. A forward quotation expressed in points is not a foreign exchange rate as such. Rather is the difference between the forward rate and the spot rate.

How is determined the forward exchange rate? The bank establish a bid and an ask exchange rate for the spot and for the forward exchange rate. The forward exchange rate is established on the basis of: The bid or ask spot rate – S the interest rate paied by the bank on deposit - the interest rate received on credits - the maturity for which we determine trhe forward rate - t

Forward Rate determination

Forward Rate determination – short formulas

Forward Rate determination – Application We know that: SC BID ASK USD/ RON spot 2,4000 2,4500 3 months interest rate for USD 3,00 3,5 3 months interest rate for RON 8 11,5 Which would be the 3 months forward rate for USD?

Cross rates A cross rate is an exchange rate between two currencies, calculated from their common relationships with a third currency. Many currency pairs are only inactive traded, so their exchange rate is determined through their relationship to a widely traded third currency. Cross rates often appears in financial publications in the form of a matrix.

Discount If the currency in which is expressed the foreign currency it’s in train to appreciate the number of the bid forward points will be higher than the ask forward points. We will say that the exchange rate is with discount and the forward exchange rate will be determined by substracting the forward points from the spot rate. BID forward points > ASK forward points FWD = Spot –forward points The foreign currency is depreciated in report with the currency in which is expressed.

Discount - Example USD/CHF BID ASK SPOT 3M FWD 3M 1,5012 1,5500 660 630 FWD 3M 1,4352 1,4370 „Competenţe avansate – profesionale şi de cercetare – în managementul riscului internaţional” POSDRU/86/1.2/S/53202 Proiect cofinanţat din Fondul Social European prin Programul Operaţional Sectorial Dezvoltarea Resurselor Umane 2007­-2013

REPORT If the currency in which is expressed the foreign currency it’s in train to depreciate the number of the bid forward points will be smaller than the ask forward points. We will say that the exchange rate is in report and the forward exchange rate will be determined by adding the forward points from the spot rate. BID forward points < Ask forward points FWD = Spot + forward points The foreign currency is appreciated in report with the currency in which is expressed. „Competenţe avansate – profesionale şi de cercetare – în managementul riscului internaţional” POSDRU/86/1.2/S/53202 Proiect cofinanţat din Fondul Social European prin Programul Operaţional Sectorial Dezvoltarea Resurselor Umane 2007­-2013

REPORT - EXAMPLE USD/CHF BID ASK SPOT 3M FWD 3M 1,5012 500 660 665 1,5672 1,6165 „Competenţe avansate – profesionale şi de cercetare – în managementul riscului internaţional” POSDRU/86/1.2/S/53202 Proiect cofinanţat din Fondul Social European prin Programul Operaţional Sectorial Dezvoltarea Resurselor Umane 2007­-2013

Application Cross Rate We have the next exchange rates: GBP/USD USD/CAD USD/DKK BID ASK SPOT 1,6920 40 1,4610 15 4,9575 80 1M 88 86 27 32 125 130 2M 164 161 50 55 250 255 3M 240 237 85 90 415 425

Aplicaţie Cross Rate The clients want to know at what exchange rate they realize the following transactions: The client wants to buy from the bank USD for CAD spot. The client wants to sell to the bank CAD for USD spot. The client wants to sell to the bank DKK for CAD spot. The client wants to buy from the bank CAD for DKK at 3 months. The client wants to sell to the bank GBP for DKK at 2 months. The client wants to buy from the bank GBP for DKK at 2 months.