The Foreign Exchange Market CHAPTER 7 The Foreign Exchange Market

PART I. INTRODUCTION I. INTRODUCTION A. The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency.

INTRODUCTION B. International Trade and Capital Transactions: facilitated with the ability to transfer purchasing power between countries

INTRODUCTION C. Location 1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications

PART II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET A. Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level - business customers

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market: - transactions take place at a specified future date

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. FedWire - operated by the Fed - used for domestic transfers

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE MARKET A. Largest in the world 2004: US$1.9 trillion daily or US$475 trillion a year In 1999 the US GDP was US$9.1 trillion

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market Centers (2004): #1: London = $753 billion daily #2: New York= $461 billion daily #3: Tokyo = $199 billion daily

PART III. THE SPOT MARKET I. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes: a. spot price b. 30-day c. 90-day d. 180-day

THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades: a. American terms example: $1.21/€ b. European terms example: Peso1.713/$

2. For nonbank customers: THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price (always in the numerator) of one unit of foreign currency. EXAMPLE: $1.81/£ Since this is a direct quote, we know that in the U.S., one pound transacted at $1.81.

used to calculate the fee THE SPOT MARKET C. Transactions Costs 1. Bid-Ask Spread used to calculate the fee charged by the bank Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency

THE SPOT MARKET 4. Percent Spread Formula (PS):

THE SPOT MARKET D. Cross Rates 1. The exchange rate between 2 non - US$ currencies.

2. Calculating Cross Rates THE SPOT MARKET 2. Calculating Cross Rates Suppose you want to calculate the £/€ cross rate. You know £.5556/US$ and €.8334/US$ then £/ € = £.5556/US$  €.8334/US$ = £.6667/ €

2. Buy cheap in one int’l market, THE SPOT MARKET E. Currency Arbitrage 1. If cross rates differ from one financial center to another, and profit opportunities exist. 2. Buy cheap in one int’l market, sell at a higher price in another 3. The Critical Role of Available Information

F. Settlement Date Value Date: THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due 2. 2nd Working day after date of original transaction.

THE SPOT MARKET G. Exchange Risk 1. Bankers = middlemen a. Incurring risk of adverse exchange rate moves. b. Increased uncertainty about future exchange rate requires 1.) Demand for higher risk premium 2.) Bankers widen bid-ask spread

MECHANICS OF SPOT TRANSACTIONS SPOT TRANSACTIONS: Example Step 1. Currency transaction: verbal agreement, U.S. importer specifies: a. Account to debit (his acct) b. Account to credit (exporter)

MECHANICS OF SPOT TRANSACTIONS Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1.

MECHANICS OF SPOT TRANSACTIONS Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date. U.S. bank debits importer’s account.

PART IV. THE FORWARD MARKET I. INTRODUCTION A. Definition of a Forward Contract: an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk.

B. Forward Rate Quotations THE FORWARD MARKET B. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market as a discount or premium.

CALCULATING THE FORWARD PREMIUM OR DISCOUNT THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract