The Foreign Exchange Market Chapter 06 The Foreign Exchange Market

The Foreign Exchange Market Characteristics of the FOREX market Geographic extent of the foreign exchange (FOREX) market Functions of the FOREX market Market participants Foreign exchange transactions – spot, forward, and swaps Review of currency quotations used by currency dealers, financial institutions, and agents Cross exchange rates and opportunities arising from inter-market arbitrage

Characteristics of the FOREX Market The FOREX market provides the physical and institutional structure through which currencies are exchanged A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate

Geographic Extent of the Market Geographically, the FOREX market spans the globe with prices moving and currencies trading on a 24 hour basis Major exchanges are located in Singapore, Hong Kong, and Tokyo in the East Then it moves to Bahrain, and London for the European area And on to New York, San Francisco, and Sydney

Geographic Extent of the Market Greenwich Mean Time Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London 6 pm In NY Americas open Europe opening Lunch Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org.

Functions of the FOREX Market The FOREX market functions to transfer purchasing power between countries, obtain or provide credit for international trade, and manage the exchange rate risk Transferring purchasing power – allow trade partners to convert foreign currency revenues into their own currency Credit for trade – the movement of goods between countries takes time which requires financing for products in transit (letters of credit) Managing FX exposure – the FOREX market provides “hedging” instruments to transfer exchange rate risk to someone else who is more willing to take that risk

Market Participants The FOREX market has two parts, the interbank or wholesale market, and the client or retail market Five broad categories of participants operate within these two parts Bank and non-bank foreign exchange dealers Individuals and firms Speculators and arbitragers Central banks and treasuries

Market Participants: Bank and Non-bank Dealers These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price Competition among dealers narrows the spread between the bid and offer rate contributing to the market’s efficiency – lower the spread lower the costs of trading Dealers at large international banks often act as market makers – willing to buy or sell these currencies without having a counterpart with which to unload the “inventory” Dealers trade to keep their inventory levels at manageable levels providing liquidity Currency trading is profitable and often contributes between 10% – 20% of a banks’ average net income

Market Participants: Individuals and Firms Conducting Commercial/Investment Transactions Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions Some of these participants use the market to hedge foreign exchange rate risk

Market Participants: Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market itself They operate for their own interest Speculators seek all their profit from favorable exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets – without risk A large proportion of speculation and arbitrage is executed by traders employed by large banks

Market Participants: Central Banks and Treasuries Central banks and treasuries use FOREX to influence the value of their own currency – this is the mechanism in which reserves balances are placed at work Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests

Transactions in the Interbank Market Transactions in FOREX: spot, forward, and swap A spot transaction requires almost immediate delivery of foreign exchange A forward transaction requires delivery of foreign exchange at some future date A swap transaction is the simultaneous exchange of one foreign currency for another

Transactions in the Interbank Market A spot transaction in the interbank market is the purchase of foreign exchange with delivery and payment between banks to take place on the second following business day The settlement date is often referred to as the value date This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York

Transactions in the Interbank Market Outright forward transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros

Transactions in the Interbank Market A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counter party A common type of swap is a spot against forward The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market. Why a dealer would do this? The dealer incurs no exchange rate exposure

Transactions in the Interbank Market Forward-forward swaps – A dealer sells £20,000 forward for dollars for delivery in two months at $1.6400/£ and simultaneously buys £20,000 forward for delivery in three months at $1.6350/£ The dealer’s motive is to take advantage of the interest rate differentials Non-deliverable forwards (NDFs) – NDFs have the same characteristics as traditional forward contracts except that they are settled only in US dollars at maturity (dollars change hands, the amount is determined by the difference between agreed upon forward rate and actual spot rate at maturity) The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments Pricing of NDFs reflects basic interest rate differentials

Size of the FOREX Market Global Foreign Exchange Market Turnover, 1989-2007 (daily averages in April, billions of US$)

Size of the FOREX Market Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1992–2007 (daily averages in April, billions of U.S. dollars)

Size of the FOREX Market Foreign Exchange Market Turnover by Currency Pair (Daily averages in April)

Foreign Exchange Rates & Quotations A foreign exchange quote is a statement of willingness to buy or sell at an announced rate In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency Interbank quotes – professionals state forex quotes in one of two ways The foreign currency price of one dollar (European Quote) Sfr1.6000/$, read as 1.600 Swiss francs per dollar The dollar price of a unit of foreign currency (American Quote) $0.6250/Sfr, read as 0.6250 dollars per Swiss franc

Foreign Exchange Rates & Quotations Direct and Indirect Quotes A direct quote is a home currency price of a unit of a foreign currency Sfr1.6000/$ is a direct quote in Switzerland An indirect quote is a foreign currency price of a unit of the home currency Sfr1.6000/$ is an indirect quote in the US, $0.6250/Sfr is a direct quote in the US and an indirect quote in Switzerland

Foreign Exchange Rates & Quotations AUD/USD bid quote should be read as 1 AUD is 0.7740 USD ($0.7740/AUD) In the FX markets, the US Dollar is normally considered to be the “base” currency (the currency in which an investor or issuer maintains its book of accounts) for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair (European). The primary exceptions to this rule are the British Pound, the Euro and the Australian Dollar (American) (indicated by *) Rates USD/CHF show the number of Swiss franks to be paid for one US dollar, but rates GBP/USD show the number of US dollars having to be paid for one British pound If you wanted to buy USD you would pay CHF 1.2371 per USD If you wanted to sell USD you would get CHF 1.2366 per USD If you wanted to buy Swiss Franc you would pay USD 0.80867 per CHF If you wanted to sell Swiss Franc you would get USD 0.80834 per CHF

Foreign Exchange Rates & Quotations Expressing Forward Quotations on a Points Basis The previously mentioned rates for yen were considered outright quotes Forward quotes are different and typically quoted in terms of points A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal Hence a point is equal to 0.0001 for most currencies => point(s) / 10,000 will convert points into decimal form For Japanese Yen one point is 0.01 => point(s) / 100 will convert points into decimal form

Foreign Exchange Rates & Quotations Expressing Forward Quotations on a Points Basis A forward quotation on a point basis is not a foreign exchange rate, rather the difference between the spot and forward rates Example:

Foreign Exchange Rates & Quotations Forward Quotations in Percentage Terms Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate The important thing to remember is which currency is being used as the home or base currency For direct quotes (i.e. quote expressed in home currency terms), the formula is For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is

Foreign Exchange Rates & Quotations Cross Rates Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and Japanese yen (¥) are quoted in US dollars Assume the following quotes: Japanese yen ¥121.13/$ and Mexican peso Ps9.190/$ The Mexican importer can buy one US dollar for Ps9.190 and with that dollar buy ¥121.13; the cross rate would be

Cross Currency Arbitrage Intermarket Arbitrage Cross rates can be used to check on opportunities for intermarket arbitrage Example: Assume the following exchange rates are quoted Citibank $0.9045/€ Barclays Bank $1.4443/£ Dresdner Bank €1.6200/£ The cross rate between Citibank and Barclays is This cross rate is not the same as Dresdner’s rate quote of €1.6200/£, so an opportunity exists for risk-less profit What is the cross rate between Citibank and Dresdner?

Cross Currency Arbitrage Intermarket Arbitrage Citibank $0.9045/€ Barclays Bank $1.4443/£ Dresdner Bank €1.6200/£ What is the cross rate between Barclays and Dresdner? If you have $ at the start then the order of currency conversions (locations) is: $ => £ (Barclays) => € (Dresdner) => $ (Citibank)

Cross Currency 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

Foreign Exchange Rates & Quotations Direct and Indirect Quotes A direct quote is a home currency price of a unit of a foreign currency Sfr1.6000/$ is a direct quote in Switzerland An indirect quote is a foreign currency price of a unit of the home currency Sfr1.6000/$ is an indirect quote in the US, $0.6250/Sfr is a direct quote in the US and an indirect quote in Switzerland

Measuring a Change in Spot Rates Assume that Swiss franc is quoted at Sfr1.6000/$ (same as $0.6250/Sfr). Suddenly it strengthens to Sfr1.2800/$ (same as $0.78125/$). What is the percentage change in the dollar value of the franc? (Home currency is dollar) Using Direct Quotes: Using Indirect Quotes: What if Home Currency is Sfr in this example. (What is the percentage change in the Sfr value of the dollar?) Direct Quote %Δ = [ (Sfr1.2800/$ – Sfr1.6000/$) / Sfr1.6000/$ ] x 100 = –20% Indirect Quote %Δ = [ ($0.6250/Sfr – $0.78125/Sfr) / $0.78125/Sfr ] x 100 = –20% SAME