The Foreign Exchange Market (Part I)

Overview of the Lecture Description of the foreign exchange market Rates and quotations Currency arbitrage © 2002 by Stefano Mazzotta

1. Description of the Foreign Exchange Market

What is the foreign exchange market? It is a set of banks, brokerage firms, and dealers that brings buyers and sellers of foreign exchange together. It is a system which allows institutions and individuals to transfer purchasing power from one currency to another, to engage in international transactions, to manage their exchange rate risk exposure. © 2002 by Stefano Mazzotta

Major markets United Kingdom, United States, Japan, Germany, Switzerland, Singapore, Honk Kong, France... All the time-zones are covered, from Tokyo to San Francisco, through London and New York. © 2002 by Stefano Mazzotta

Size of the market Average Daily volume in is about $1,500,000,000,000 Compare: NYSE - $30,000,000,000 NASDAQ - $23,000,000,000 TSE - $1,400,000,000 Canada’s GDP - $605,000,000,000 © 2002 by Stefano Mazzotta

Major participants Large commercial banks Foreign exchange brokers continuously making the market, receive compensation by making the “bid-ask” spread. Foreign exchange brokers facilitate trading between dealers, keep list of suppliers and demanders of different currencies. © 2002 by Stefano Mazzotta

Other participants Central banks Commercial entities conduct intervention. Commercial entities regular but not continuous participants of the market. Speculators and arbitrageurs trade to profit from the market itself. © 2002 by Stefano Mazzotta

Interbank market A highly liquid interbank market is formed by an informal arrangement of large commercial banks and foreign exchange brokers. Day-to-day exchange rate day movements is mainly the result of the activity of interbank trades. © 2002 by Stefano Mazzotta

Interbank market transactions Spot transaction requires almost immediate delivery of foreign exchange. Forward transaction requires delivery of foreign exchange at some future date. Currency Swap transaction is the simultaneous purchase and sale of a foreign currency . © 2002 by Stefano Mazzotta

Efficiency The foreign exchange market is very efficient due to its 24-hour trading schedule extensive telecommunication network shear size of the market computerized quotation system © 2002 by Stefano Mazzotta

2. Rates and Quotations

Price quotes The prices are quoted in pairs: Bid - price at which the bank buys the currency Ask - price at which the bank sells the currency The spread, i.e. | bid – ask |, is the profit of the bank (dealer) Home country based quotes: direct quote - a home currency price of a foreign currency, e. g., EUR/USD in France indirect quote - a foreign currency price of home currency, e. g., USD/EUR in France © 2002 by Stefano Mazzotta

Example The pound sterling is quoted at $1.6618-35. (This notation is a shorthand for 1.6618-1.6635 USD/GBP) What is the “bid-ask” spread? 1.6635 - 1.6618 = $0.0017 What is the spread in percentage points? © 2002 by Stefano Mazzotta

Example The pound sterling is quoted in New York at $1.6618-35. This is a direct quote. What is the indirect quote? Therefore, the indirect quote is: 0.6011-18. What is the direct quote of a dollar in London? © 2002 by Stefano Mazzotta

Bid and ask quotes relation Suppose, there are 2 currencies: A and B. Then: And: © 2002 by Stefano Mazzotta

Example The bank quote for is 1.6050-72 SF/$ What is the SF/$ exchange rate for a customer who wants to exchange $ for SF? What is the $/SF exchange rate for a customer who wants to exchange SF for $? © 2002 by Stefano Mazzotta

The U.S. dollar based quotations If currencies are quoted against USD, they can be quoted in American terms: $ per unit of foreign currency European terms: units of foreign currency per 1$ Nowadays, almost all except U.K. and Euro exchange rates are expressed in European terms. © 2002 by Stefano Mazzotta

Example EXCHANGE RATES Tuesday, February 6, 1990 The New York foreign exchange selling rates below apply to trading among banks in amounts of $1 million and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co. Retail transactions provide fewer units of foreign currency per dollar. Currency U.S. $ equiv. per U.S. $ Country Tues. Mon. Tues. Mon. Britain (Pound) ...... 1.7015 1.7000 .5877 .5882 Canada (Dollar) ..... .8405 .8421 1.1897 1.1875 France (Franc) ...... .17709 .17718 5.6470 5.6440 Source: The Wall Street Journal © 2002 by Stefano Mazzotta

Cross rates Definition: Reason: Result: Exchange rate between two foreign currencies. Reason: Most currencies are quoted against the U.S. $ and not against each other. Result: The U.S. $ rate can be used to compute a cross rate. © 2002 by Stefano Mazzotta

Example of cross rate quotation See http://money.cnn/markets/currencies See also http://www.bloomberg.com/markets/fxc.html © 2002 by Stefano Mazzotta

Cross Rates 23 Dec 2002 USD GBP CHF JPY CAD AUD EUR NZD DKK SEK 8.8943 14.18 6.2715 7.3879 5.7331 4.9990 9.1318 4.5917 1.2295   7.2342 11.53 5.1010 6.0090 4.6630 4.0660 7.4274 3.7347 0.8134 1.9371 3.0879 1.3659 1.6090 1.2486 1.0887 1.9888 0.2678 0.2178 0.9740 1.5526 0.6868 0.8090 0.6278 0.5474 0.5028 0.1346 0.1095 1.7792 2.8362 1.2546 1.4779 1.1468 1.8267 0.9185 0.2459 0.2000 1.5514 2.4731 1.0939 1.2887 0.8720 1.5928 0.8009 0.2145 0.1744 120.39 191.91 84.89 77.60 67.67 123.60 62.15 16.64 13.54 1.4182 2.2608 1.1780 0.9141 0.7971 1.4561 0.7322 0.1960 0.1595 0.6273 0.4423 0.5211 0.4044 0.3526 0.6441 0.3239 0.0867 0.0705 1.5941 0.7051 0.8306 0.6446 0.5621 1.0267 0.5163 0.1382 0.1124 © 2002 by Stefano Mazzotta

Example Let e(USD/EUR) = 0.97 Let e(USD/CAD) = 0.63 What is the EUR/CAD cross-rate? So, 1 Canadian dollar can buy 0.65 euros. © 2002 by Stefano Mazzotta

The general rule for cross rates Suppose, there are 3 currencies: A, B, and C. Suppose, the spot exchange rates e(A/B) and e(B/C) are known. What is the cross exchange rate e(A/C)? © 2002 by Stefano Mazzotta

Cross rates and bid-ask spreads With bid-ask spreads, the general rule to compute cross rates is: © 2002 by Stefano Mazzotta

Example: Question The spot quote for CHF/USD is 1.5150-72 The spot quote for CAD/USD is 1.5810-56 What is the direct spot quote for CHF/CAD? © 2002 by Stefano Mazzotta

Example: Solution (part I) © 2002 by Stefano Mazzotta

Example: Solution (part II) So, the direct spot CHF/CAD quote is 0.9555-96. © 2002 by Stefano Mazzotta

3. Currency Arbitrage

Currency arbitrage Definition: Cause: Realization of a riskless profit by simultaneous buying a currency in one market and selling it in another market. Cause: Exchange rate quote inconsistencies across different money centers. © 2002 by Stefano Mazzotta

Example Bank of America’s quote of $1C is $0.7056-76. Royal Bank’s quote of $1C is $0.7038-52. How to make easy money? Buy $C from Royal Bank by paying $ and sell $C to BoA receiving $. Make about $0.0004 per $ or $40 per $100,000. © 2002 by Stefano Mazzotta

Arbitrage exclusion condition In the absence of taxes, etc., the arbitrage exclusion condition is to have overlapping bid-ask quotes. Bid1 Ask1 Bid2 Ask2 © 2002 by Stefano Mazzotta

Triangular arbitrage The essence: 1 unit of currency A buys currency B Currency B buys currency C Currency C buys more than 1 unit of currency A A A B C © 2002 by Stefano Mazzotta

Example: part 1 - the set up The GBP is bid at 1.9809 in New York: e(USD/GBP) = 1.9809 Swiss franc is offered at $0.6251 in Zurich: e(USD/CHF) = 0.6251 London offers pounds sterling at CHF 3.1650: e(CHF/GBP) = 3.1650 Amount of money: $1,000,000 © 2002 by Stefano Mazzotta

Example: part 2 - the strategy Sell $1,000,000 in Zurich at e(USD/CHF) and receive CHF 1,599,744.04. Sell these Swiss francs in London at e(CHF/GBP) and receive GBP505,448.35. Sell the pounds sterling in New York at e(USD/GBP) and receive $1,001,242.64. Net profit: $1,242.64 © 2002 by Stefano Mazzotta

Example: part 3 - market adjustment mechanism Large number of arbitrage transactions will cause: Swiss franc to appreciate with respect to U.S. dollar in Zurich Swiss franc to depreciate against the pound sterling in London Sterling will fall in New York Markets adjust quickly and eliminate arbitrage opportunities © 2002 by Stefano Mazzotta

Triangular arbitrage condition For triangular arbitrage to exist, the following must hold: Or, equivalently: © 2002 by Stefano Mazzotta

Exercise To familiarize yourself with the currency spot market sign up to: http://fxgame.oanda.com/ Take a position of your choice in ONE currency. Individually. Take note of anything that you find interesting, related or unrelated to what we discussed In one week we will have a class discussion of your findings © 2002 by Stefano Mazzotta