Foreign Exchange Markets (or chapter 6)

Agenda Description of foreign exchange market Size? Functions? Participants? Transactions? Rates & Quotations? Inter-market Arbitrage?

Average Electronic Conversations Per Hour Geographic Extent Singapore, Hong Kong, Tokyo, Bahrain, London, New York, San Fran, & Sydney. Average Electronic Conversations Per Hour Greenwich Mean Time Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London 6 pm In NY Americas open Europe opening Lunch

Functions of FOREX Market Transfer purchasing power between countries. Obtain/ provide credit for international trade. Minimize exposure to exchange rate risk.

Size, Structure, & Participants Daily global net turnover in forex US$1.21 trn (April’01), data by Bank for Int’l Settlements - Switzerland FOREX market has two tiers interbank (wholesale) market. client (retail) market. Five categories participants: Bank & non-bank forex dealers. Individuals & firms. Speculators & arbitragers. Central banks & treasuries. Forex brokers.

Transactions in the Interbank Market Transactions: spot, forward, or swap basis Spot transaction requires almost immediate delivery of foreign exchange Forward transaction requires delivery of foreign exchange at some future date Swap transaction is the simultaneous exchange of one foreign currency for another

Spot & Outright Forward Transactions Spot: Purchase of forex, w/ delivery & payment b/n banks to take place on 2nd following business day. Settlement date referred as value date Settlement through computerized Clearing House Interbank Payment Systems (CHIPS), New York () Forward: Requires delivery @ a future value date Exchange rate is agreed upon at the time of the transaction, payment & delivery are delayed Quoted for value dates of 1-, 2-, 3-, 6-, 9- & 12-months

Swap Transactions Simultaneous purchase & sale of of foreign exchange for two different value dates Both purchase & sale w/ same counterparty Common types of swaps Spot against forward: buy currency in spot market & simultaneously sells same amount back to same bank in forward market Forward-forward swaps: Dealer sells £20,000 forward for $, delivery in 2 months @ $1.687/£ & simultaneously buys £20,000 forward for delivery in 3 months @ $1.682/£ Difference b/n buying and selling price is interest rate differential. Can be viewed as way for collateralized borrowing another currency. Non-deliverable forwards (NDF): same as traditional forward contracts except they are settled only in US$. Foreign currency sold/ bought forward not delivered. NDF contracted offshore & are beyond reach & regulation of home governments Pricing NDF reflects basic interest rate differentials.

Rates & Quotes What is a quote? Inter-bank Quotes Foreign currency for a dollar (SF1.60/$). European quote Dollar for unit foreign currency ($0.625/SF). American quote All European currencies quoted in European way, except: Pound Sterling, Euro, Australian, & New Zealand $. Direct & Indirect Quotes Direct: home currency per unit of foreign Indirect: foreign currency per unit home currency SF1.60/$ indirect quote in US, $0.625/SF is direct quote in US Bid & Ask Quotes Interbank quotes given as bid & ask (offer) Bid is the price at which a dealer will buy another currency Ask or offer is the price at which a dealer will sell another currency E.g.: ¥118.27 - ¥118.37/$ is the bid/ask for Japanese yen Bank will buy yen @ ¥118.27 per US$ & sell yen @ ¥118.37 per US$ making profit on spread.

Rates & Quotes Forward Quotations on a Points Basis Outright quotes. Forward quotes different & usually quoted in points A point: last digit of quote, w/ convention dictating number of digits to the right of decimal. => a point = 0.0001 most currencies

Rates & Quotes Expressing Forward Quotations on Points Basis Yen quoted only to 2 decimal points Forward quote is not forex rate, but difference b/n spot & forward. Example: Bid Ask Outright spot: ¥118.27 ¥118.37 Plus points (3 months) -1.43 -1.40 Outright forward: ¥116.84 ¥116.97

Rates & Quotes Can have forward quotes as % p.a. deviation from spot. Important: which currency is home currency? Indirect quotes (i.e. foreign per domestic) Direct quotes (i.e. domestic per foreign currency) For example: S = Yen 105.65/$, F30 = Yen 105.04/$ ¥

Cross Rates & Intermarket Arbitrage Japanese yen ¥121.13/$. Mexican peso Ps9.190/$. Suppose Cross rate is: Assume Cross rate Citibank & Barclays: Cross rate =/= Dresdner rate €1.62/£. ¥ Citibank $0.9045/€. Barclays Bank $1.4443/£. Dresdner Bank €1.6200/£. £ €

Intermarket Arbitrage Citibank $0.9045/€. Barclays $1.4443/£. Dresdner €1.6200/£. Intermarket Arbitrage Citibank Dresdner Bank Barclays Bank End with $1,014,533 Start with $1,000,000 Sell €1,121,651 to Citibank at $0.9045/€ (6) Receive $1,014,533 Sell $1,000,000 to Barclays Bank at $1.4443/£ (2) Receive £692,377 Sell £692,377 to Dresdner Bank at €1.6200/£ (4) Receive €1,121,651

Things to remember Market Participants Transaction types Quotations Inter-market arbitrage