Chapter 5 The Market for Foreign Exchange

Foreign Exchange (FX) Market The FX market is the largest and most active financial market in the world. It is open somewhere in the world 24 hours a day, 365 days a year. In 2013, average daily trading in the foreign exchange markets was $4.95 trillion! London remains the world's largest foreign exchange trading center.  Figure: shares of global foreign exchange turnover.

Function and Structure of the FX Market The foreign exchange market is a worldwide linkage of bank currency traders, nonbank dealers, and FX brokers connected to one another via a network of telephones, computer terminals, and automated dealing systems.  Three major market segments can be identified: Australasia, Europe, and North America. Australasia includes the trading centers of Sydney, Tokyo, Hong Kong, Singapore, and Bahrain Europe includes Zurich, Frankfurt, Paris, Brussels, Amsterdam, and London North America includes New York, Montreal, Toronto, Chicago, San Francisco, and Los Angeles.

FX Market Participants The FX market is divided into two tiers: the retail or client market and the wholesale or interbank market. The retail market is where international banks service their customers who need foreign exchange to conduct international commerce or trade in international financial assets. The great majority of FX trading takes place in the interbank market among international banks that are adjusting inventory positions or conducting speculative and arbitrage trades.

FX Market Participants FX market participants can be categorized into five groups: international banks, bank customers, nonbank dealers, FX brokers, and central banks. International banks provide the core of the FX market. According to 2013 BIS statistics, retail or bank client transactions account for approximately 9% of FX trading volume. The other 91% of trading volume is from interbank trades between international banks or nonbank dealers The vast majority of interbank trades flows over Thomson Reuters and ICAP platforms..  Nonbank dealers are large nonbank financial institutions such as investment banks, mutual funds, pension funds, and hedge funds, whose size and frequency of trades make it cost-effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs

Terminology Exchange rate: price of one currency quoted in units of another currency. e.g. $1.25/€ (i.e. A dollar and 25 cents for one euro) © Prof. Jon Moulton

Depreciation vs. Appreciation Depreciation or weakening of a currency: Your currency becomes less valuable. One unit of your currency is worth less foreign currency. Takes more of your currency to buy one unit of foreign currency. e.g. $1.5 /£  $1.4/£ (The £ weakened or depreciated) Appreciation or strengthening of a currency: Your currency becomes more valuable. One unit of your currency is worth more foreign currency. Takes less of your currency to buy one unit of foreign currency. e.g. $1.2 /€  $1.4/€ (The € strengthened or appreciated)

Depreciation vs. Appreciation Usually the determination is on the denominator currency.. But, Weakening of local currency = Strengthening of foreign currency Strengthening of local currency = Weakening of foreign currency $1.5 /£  $1.4/£ (The $ strengthened or appreciated) $1.2 /€  $1.4/€ (The $ weakened or depreciated)

Calculating the depreciation/appreciation Denominator statement: 𝐸−𝐵 𝐵 ×100 Numerator statement: 𝐵−𝐸 𝐸 ×100 or 1 𝐸 − 1 𝐵 1 𝐵 ×100 Ex. $1.5 /£  $1.4/£ , describe what happened to the £.. Since the £ is the denominator currency we will use the denominator statement: 𝐸−𝐵 𝐵 ×100 = 1.4−1.5 1.5 ×100=−6.667% i.e. the £ depreciated 6.667%

Example The exchange rate changed from $1.3/€  $1.25/€ Did the € depreciate or appreciate against the $? Calculate the percentage change in the euro. Did the $ depreciate or appreciate against the €? Calculate the percentage change in the dollar.

Devaluation of currency: refers to a drop in foreign exchange value of a pegged currency.

Spot vs. Forward Transactions within the F/X markets can be executed on a spot, forward, or swap basis A spot transaction requires almost immediate delivery of foreign exchange. Usually cash settlement is made within 2 business days A forward transaction requires delivery of foreign exchange at some future date. Delivery is beyond a couple of days (1,3,6,9,and 12 months are readily available) © Prof. Jon Moulton

Spot rate F/X quotations An F/X quotation is the price of one currency stated in units of another currency. (e.g. $1.2/€) S(j/k) will refer to the spot price of one unit of currency k in terms of currency j. (e.g. $1.2/€ can be expressed as S($/€)= 1.2) 𝑺( 𝒋 𝒌 ) = 𝟏 𝑺( 𝒌 𝒋 ) © Prof. Jon Moulton

Direct vs. indirect quotes A direct quotation is written as Home Curr./Foreign Curr. e.g. $1.5/£ (assuming $ is the home currency) An indirect quotation is written as Foreign Curr./Home Curr. E.g. £0.67/$ © Prof. Jon Moulton

American vs. European As USD has been prevalent currency of exchange for decades: American quotation: USD / Foreign Curr. European quotation: Foreign Curr./ USD American quote = 1 / European quote © Prof. Jon Moulton

S($/€)= American or European? S(€/$)= S($/¥)= S(£/$)=

Cross-exchange rate quotations  A cross-exchange rate is an exchange rate between a currency pair where neither currency is the U.S. dollar.  The cross-exchange rate can be calculated from the U.S. dollar exchange rates for the two currencies. S(j/k)=S(j/$) x S($/k) S(€/£)=S(€/$) x S($/£)= Exercise: S(¥/€)= S(KWD/SAR)=

The Bid-Ask Spread Up to this point in our discussion, we have ignored the bid- ask spread in FX transactions. Interbank quotations are given as a bid and ask (also refered to as an offer) A bid is the price at which a dealer is willing to buy a currency. Bid price=Dealer’s buying price, Client’s selling price An ask(or offer) is the price at which a dealer will sell a currency. Ask price= Dealer’s selling price, client’s buying price © Prof. Jon Moulton

The Bid-Ask Spread Dealers buy at the bid and sell at the ask, making their profit from the spread between the buying and selling prices. Thus, always Ask>Bid Always remember: Dealer buys denominator currency at the bid. Dealer sells denominator currency at the ask. © Prof. Jon Moulton

The Bid-Ask Spread Bid and ask quotes in the foreign exchange markets are confusing because buying one currency is equivalent to selling the opposite currency. A dealer offering to buy dollars in exchange for pounds at the Bid is simultaneously offering to sell pounds in exchange for dollars. © Prof. Jon Moulton

Sample quotations 𝑆 𝑎 𝑈𝑆𝐷 𝐸𝑈𝑅 = 𝑈𝑆𝐷 𝐸𝑈𝑅 𝑎𝑠𝑘 𝑞𝑢𝑜𝑡𝑒= Currency Bid Ask USD/EUR 1.2516 1.2518 USD/GBP 1.5807 1.5809 JPY/USD 78.69 78.70 CHF/USD 0.9595 0.9596 CAD/USD 0.9896 0.9899 USD/AUD 1.0377 1.0387 𝑆 𝑎 𝑈𝑆𝐷 𝐸𝑈𝑅 = 𝑈𝑆𝐷 𝐸𝑈𝑅 𝑎𝑠𝑘 𝑞𝑢𝑜𝑡𝑒= 𝑆 𝑏 𝑈𝑆𝐷 𝐸𝑈𝑅 = 𝑈𝑆𝐷 𝐸𝑈𝑅 𝑏𝑖𝑑 𝑞𝑢𝑜𝑡𝑒= © Prof. Jon Moulton

The Bid-Ask Spread Since a dealer offering to buy dollars in exchange for pounds at the Bid is simultaneously offering to sell pounds in exchange for dollars.. 𝑆 𝑎 $ £ = 1 𝑆 𝑏 £ $ Example: suppose 𝑆 𝑎 $ £ = 1.5809 When the dealer is willing to sell 1£ for $1.5809 he is implicitly also willing to buy (bid) $1 for 1 1.5809 =0.6326£ i.e. 𝑆 𝑏 £ $ = 1 𝑆 𝑎 $ £ = 1 1.5809 =0.6326 © Prof. Jon Moulton

Cross-rates with Bid-ask spreads 𝑆 𝑏 € £ = 𝑆 𝑏 € $ × 𝑆 𝑏 $ £ 𝑆 𝑎 € £ = 𝑆 𝑎 € $ × 𝑆 𝑎 $ £ Given the Bid/Ask table, compute €/£ rates .. 𝑆 𝑏 € £ = 𝑆 𝑎 € £ =

Example Using the sample quotations, compute the AUD/CHF rate..

Cross-Rate Arbitrage Cross rate can be used to check on opportunities for intermarket arbitrage. Suppose the following exchange rates are available: The cross rate between Citibank and Barclays is 𝑆 𝐸𝑈𝑅 𝐺𝐵𝑃 =𝑆 𝐸𝑈𝑅 𝑈𝑆𝐷 ×𝑆 𝑈𝑆𝐷 𝐺𝐵𝑃 = 1 𝑆 𝑈𝑆𝐷 𝐸𝑈𝑅 ×𝑆 𝑈𝑆𝐷 𝐺𝐵𝑃 = 1 $1.2223/€ × $1.8410 £ = €1.5062 £ You get more € from HSBC! Citibank USD/EUR $1.2223/€ Barclays Bank USD/GBP $1.8410/£ HSBC EUR/GBP €1.5100/£ © Prof. Jon Moulton

Cross-Rate Arbitrage The implicit cross rate is not the same as HSBC’s quote of €1.5100/£ An opportunity for profit from arbitrage between these three markets exists (TRIANGLUAR ARBITRAGE). If we start with US dollars: Buy £ from Barclays @ $1.8410/£ Sell £ to HSBC for € @ €1.5100/£ Sell € to Citibank for $ @ $1.2223/€ © Prof. Jon Moulton

Triangular arbitrage Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross- exchange rate.

Cross-Rate Triangular Arbitrage Given that we are starting with USD, you have two routes: One gives a loss and one gives a profit. If you choose the wrong path you will get a loss. $ € £ $ £ € or

Cross-Rate Triangular Arbitrage Calculate the arbitrage profit if you were to start with $1,000,000…

Cross-Rate Triangular Arbitrage Find the arbitrage opportunity if you start with $1,000,000 Bank of America BRe/USD BRe2.0273/$ Chase Bank C$/USD C$0.9922/$ US Bank BRe/C$ BRe2.0602/C$ © Prof. Jon Moulton

The Forward Market A Spot transaction requires almost immediate delivery of foreign exchange. A Forward transaction requires future delivery and payment of foreign exchange at a rate agreed upon today. Bank quotes for maturities of 1, 3, 6, 9,and 12 months are readily available. Maturities extending beyond one year are becoming more frequent. © Prof. Jon Moulton

Spot vs. Forward Exchange Rates Currencies which are more expensive to buy forward (relative to the spot price) are at a premium. For the denominator currency, Forward>Spot implies a forward premium. E.g. S(USD/CHF)=1.0420, F6(USD/CHF)=1.0466 The Swiss franc CHF is more expensive to buy forward. Therefore, the forward Swiss franc is trading at a premium to the spot Swiss franc (relative to USD). © Prof. Jon Moulton

Forward premium/discount Given S(USD/CHF)=1.0420, F6(USD/CHF)=1.0466, is the USD trading at a forward premium or discount? We want the denominator currency to be in USD to answer this question, then we can apply the rule. S(CHF/USD)=1/1.0420= 0.9597, F6(CHF/USD)=1/1.0466= 0.9554 The USD (denominator currency) is less expensive to buy forward. Therefore, the forward USD is trading at a discount to the spot USD (relative to the CHF). © Prof. Jon Moulton

Annualized % Forward Premium or Discount Annualized Forward Premium or Discount of the denominator currency is always: 𝑓 𝑡 = 𝐹𝑜𝑟𝑤𝑎𝑟𝑑−𝑆𝑝𝑜𝑡 𝑆𝑝𝑜𝑡 × 360 𝑑𝑎𝑦𝑠 If the answer if positive: denominator currency is trading at a forward premium. If the answer if negative: denominator currency is trading at a forward discount. © Prof. Jon Moulton

Annualized % Forward Premium or Discount Suppose you are given the following quotes: S($/£)=1.5810 F1($/£)=1.5809 F3($/£)=1.5807 Calculate the £ annualized forward premium/discount for the one month and three months contracts. 𝑓 𝑡 = 𝐹𝑜𝑟𝑤𝑎𝑟𝑑−𝑆𝑝𝑜𝑡 𝑆𝑝𝑜𝑡 × 360 𝑑𝑎𝑦𝑠 𝑓 1 = 1.5809−1.5810 1.810 × 360 30 =−0.00076=−0.076% 𝑓 3 = 1.5807−1.5810 1.810 × 360 90 =−0.00076=−0.076% © Prof. Jon Moulton

Example Using the June, 5th, 2013 quotation table, calculate the Japanese Yen annualized forward premium/discount for the 3 months and 6 months contracts.

Forward cross-exchange rates Calculated similar to the spot cross-rates. Fn(€/£)= Fn(€/$) x Fn($/£) Example: F3(£/¥)= F6(£/¥)= F3 (€/£)=