The Market for Foreign Exchange (FX or FOREX) Chapter 5

Lecture Objectives Introduce the institutional framework within which exchange rates are determined Lay the foundation for much of the discussion throughout the course

Lecture Outline Structure of the FX Market The Spot Market The Forward Market

Structure of the FX Market Involves market participants buying and selling of different currencies all over the world. A worldwide network of traders, connected by telephone lines and computer screens – there is no central headquarters. Trading also occurs around the clock. Includes trading currencies spot and forward, bank deposits of foreign currencies, foreign trade financing, trading in currency options, futures and swaps.

Size of the FOREX Market Global Foreign Exchange Market Turnover (daily averages in April, billions of US dollars) 1992 1992 1998 2001 2004 2007 Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2007.

World FX transactions $1.9 trillion/day (2007) 55%

Distribution of FX Trading Centers Source: Triennial Central Bank Survey 2007

Major FX Trading Centers (Average daily volume ($b) during April of 1995-2007) Source: Bank for International Settlements triennial survey of central banks.

Top 5 Most Traded Currencies Rank Currency Code Symbol 1 United States USD $ 2 Eurozone EUR € 3 Japanese Yen Yen ¥ 4 British Pound Sterling GBP £ 5 Swiss Franc CHF -

World interbank FX transactions By currency pairs -- 2007

Top 10 currency traders % of overall volume, May 2009 Rank Name Market Share 1 Deutsche Bank 20.96% 2 UBS AG 14.58% 3 Barclays Capital 10.45% 4 Royal Bank of Scotland 8.19% 5 Citi 7.32% 6 JPMorgan 5.43% 7 HSBC 4.09% 8 Goldman Sachs 3.35% 9 Credit Suisse 3.05% 10 BNP Paribas 2.26%

The FX market in the U.S. is the most active market in the U.S. ($664 billion turnover per day, in April 2007) 1995 1998 2001 2004 2007

The FX market in the U.S. is the most active market in the U.S. $664 billion turnover per day, in April 2007 Comparisons with U.S. asset markets: 10 times the turnover of U.S. gov’t bonds 50 times the turnover of NYSE stocks Comparisons with real activity in U.S.: 10 times U.S. daily GDP 30 times U.S. daily exports + imports

Primary functions of FX Market Currency conversions associated with international payments process Provision of credit to clients (also part of international payments process) Managing exchange rate risk

Structure of the FX Market The FX market is a two-tiered market: Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in foreign exchange. Nonbank dealers account for about 40% of the market in 2007. There are FX brokers who match buy and sell orders but do not carry inventory. Client Market (Retail): central banks and companies; account about 17% in 2007. Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

Direct vs. brokered interbank trades Direct dealing banks face another bank’s bid-ask spread, at which they can transact immediately Brokered trades Get best price of all posted buys/sells If you post an order, may not get executed Electronic brokerage has become the primary method of trading interbank spot FX; drawback is that it covers only major currencies.

Much (56%) of FX trading is in the interbank (wholesale) market 56% of all dealers’ trades are with other dealers 31% are with other financial institutions (brokers, mutual funds, ...) 13% are with nonfinancial customers 66% of all trades are with foreign counterparties

However, the retail orders are the important ones that determine exchange rates Interbank traders are intermediaries (market makers) temporarily take positions intradaily, but work hard to zero out their positions regularly and by the end of the day

The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

Spot Rate Quotations “Spot” - settlement happens on the second working day after the deal is done. The exceptions are US dollar trades against the Canadian Dollar and Mexican Peso, which are settled next day. When looking at foreign exchange quotations, it is necessary to decide immediately which is the “home” currency and which the “foreign” currency. For the purposes of this class, the dollar will always be the “home” currency.

Spot Rate Quotations There are two ways of quoting spot rates: No of units of home currency per 1 unit of foreign currency No of units of foreign currency per 1 unit of home currency These are called, respectively, “Direct” and “Indirect” quotations. If the home currency is the dollar they are sometimes called “American” and “European” quotations, respectively. Direct quotation: the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” Indirect Quotation: the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”

Spot Rate Quotations For example: US$1 = S$1.789 is equivalent to S$1 = US$0.559 Note: No different from any other price. 10 US dollar/One umbrella 1/10 umbrella/$ We will use the notation, for example, S$/US$ as the numbers of Singapore dollars per 1 dollar - that is an indirect quotation from an American perspective. The Wall Street Journal gives both quotes.

Spot Rate Quotations The direct quote for British pound is: Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 Brazil (Real) 0.2939 0.2879 3.4025 3.4734 Britain (Pound) 1.5627 1.566 0.6399 0.6386 1 Month Forward 1.5596 1.5629 0.6412 0.6398 3 Months Forward 1.5535 1.5568 0.6437 0.6423 6 Months Forward 1.5445 1.5477 0.6475 0.6461 The direct quote for British pound is: £1 = $1.5627

Spot Rate Quotations The indirect quote for British pound is: 1.4975 1.5106 0.6678 0.662 6 Months Forward 1.4888 1.502 0.6717 0.6658 3 Months Forward 1.4835 1.4968 0.6741 0.6681 1 Month Forward 1.4813 1.4943 0.6751 0.6692 Canada (Dollar) 0.6461 0.6475 1.5477 1.5445 0.6423 0.6437 1.5568 1.5535 0.6398 0.6412 1.5629 1.5596 0.6386 0.6399 1.566 1.5627 Britain (Pound) 3.4734 3.4025 0.2879 0.2939 Brazil (Real) 1.6852 1.6932 0.5934 0.5906 Australia (Dollar) 3.0377 3.0221 0.3292 0.3309 Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv Friday Country The indirect quote for British pound is: £.6399 = $1

Spot Rate Quotations 1.4975 1.5106 0.6678 0.662 6 Months Forward 1.4888 1.502 0.6717 0.6658 3 Months Forward 1.4835 1.4968 0.6741 0.6681 1 Month Forward 1.4813 1.4943 0.6751 0.6692 Canada (Dollar) 0.6461 0.6475 1.5477 1.5445 0.6423 0.6437 1.5568 1.5535 0.6398 0.6412 1.5629 1.5596 0.6386 0.6399 1.566 1.5627 Britain (Pound) 3.4734 3.4025 0.2879 0.2939 Brazil (Real) 1.6852 1.6932 0.5934 0.5906 Australia (Dollar) 3.0377 3.0221 0.3292 0.3309 Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv Friday Country Note that the direct quote is the reciprocal of the indirect quote:

The Bid-Ask Spread In general, banks do not charge commissions on foreign currency transactions. They profit from bid-ask spread. The bid-ask spread is the difference between the bid and ask prices. The bid price is the price a dealer is willing to pay you for a foreign currency. The ask price is the amount the dealer wants you to pay for the foreign currency.

The Bid-Ask Spread Bank’s quote: US$/£ 1.794 - 1.796 1.794 is the “Bid” price. A bank will buy pounds for $1.794/pound; same as bank selling $1.794 for £1. 1.796 is the “Offer” price. A bank will sell pounds for $1.796; same as bank buying $1.796 for £1 pound. Bank’s profit = ASK-BID = “Bid-Ask Spread”.

The Bid-Ask Spread Bank’s quote: US$/£ 1.794 - 1.796 You pay US$1.796 for every pound you buy. You receive US$1.794 for every pound you sell. If you started with one million dollars and converted it into pounds, then back to dollars, how much would you have after the two conversions?

The Bid-Ask Spread Bank’s quote: €/US$ 1.0820 - 1.0826 What rate does the bank pay for every dollar you sell? What rate does the bank receive for every dollar you buy? What is the bank’s profit?

Cross Rates Suppose that S($/€) = .50 i.e. $1 = 2 € and that S(¥/€) = 50 i.e. €1 = ¥50 What must the $/¥ cross rate be? $1 €1 €2 ¥50 × $1 ¥100 =

Cross Rates Suppose that S($/€) = 1.082 i.e. €1 = $1.082 and that S(CHF/$) = 1.572 i.e. $1 = CHF 1.572 What must the €/CHF cross rate be?

Cross Rates Suppose that S($/€) = 1.20 and that S($/¥) = 0.009. What must the S(¥/€) cross rate be? Suppose that S(AUD/$) = 2. What must the S(AUD/€) cross rate be?

Triangular Arbitrage $ ¥ £ Suppose we observe these banks posting these exchange rates. $ Barclays S(¥/$)=120 Credit Lyonnais S($/£)=1.50 ¥ Credit Agricole S(¥/£)=185 £ First calculate the implied cross rates to see if an arbitrage exists.

Triangular Arbitrage $ ¥ £ The implied S(¥/£) cross rate is S(¥/£) = 180. $ Barclays S(¥/$)=120 Credit Lyonnais S($/£)=1.50 Credit Agricole has posted a quote of S(¥/£)=185 so there is an arbitrage opportunity. ¥ Credit Agricole S(¥/£)=185 £ So, how can we make money?

Cross Exchange Rate Equilibrium S(d/e)S(e/f)S(f/d) = 1 If S(d/e)S(e/f)S(f/d) < 1, then either S(d/e), S(e/f), or S(f/d) must rise. Þ Buy the currency in the denominator with the currency in the numerator of each spot rate. If S(d/e)S(e/f)S(f/d) > 1, then either S(d/e), S(e/f), or S(f/d) must fall. Þ Sell the currency in the denominator for the

Cross Exchange Rates and Triangular Arbitrage Calculate S(d/e)S(e/f)S(f/d). S(¥/$) = 120 S($/£)=1.50 S(¥/£)=185 Then S(¥/$) S($/£)[1/S(¥/£)] = 0.973. Þ Sell the currency in the numerator for the currency in the denominator of each spot rate.

Triangular Arbitrage $ $ ¥ £ As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. Barclays S(¥/$)=120 Credit Lyonnais S($/£)=1.50 3 1 2 ¥ Credit Agricole S(¥/£)=185 £

Triangular Arbitrage Sell $150,000 for £ at S($/£) = 1.50 receive £100,000 Sell our £ 100,000 for ¥ at S(¥/£) = 185 receive ¥18,500,000 Sell ¥ 18,500,000 for $ at S(¥/$) = 120 receive $154,167 profit per round trip = $ 154,167- $150,000 = $4,167

The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Premium

The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

Forward Rate Quotations Consider the example from above: for British pound, the spot rate is $1.5627 = £1.00 While the 180-day forward rate is $1.5445 = £1.00 What’s up with that?

Spot Rate Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months. 1.4975 1.5106 0.6678 0.662 6 Months Forward 1.4888 1.502 0.6717 0.6658 3 Months Forward 1.4835 1.4968 0.6741 0.6681 1 Month Forward 1.4813 1.4943 0.6751 0.6692 Canada (Dollar) 0.6461 0.6475 1.5477 1.5445 0.6423 0.6437 1.5568 1.5535 0.6398 0.6412 1.5629 1.5596 0.6386 0.6399 1.566 1.5627 Britain (Pound) 3.4734 3.4025 0.2879 0.2939 Brazil (Real) 1.6852 1.6932 0.5934 0.5906 Australia (Dollar) 3.0377 3.0221 0.3292 0.3309 Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv Friday Country

Forward Rate Quotations S(USD/CAD)= 0.6399 F30 (USD/CAD)= 0.6391 This is 1 month forward rate F90 (USD/CAD)= 0.6376 This is 3 month forward rate F180 (USD/CAD)= 0.6352 This is 6 month forward rate Market expects that USD will appreciate (CAD depreciate). A forward currency is at a forward discount if the forward rate expressed in USD is below the spot rate A forward currency is at a forward premium if the forward rate expressed in USD is above the spot rate

Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.

Forward Premium and Discount It’s just the interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307 The forward premium is given by: f180,€v$ F180($/€) – S($/€) S($/€) = × 360 180 .5307-.5235 .5235 × 2 = = 0.0275 € is traded at a premium of 2.75%. How about $?

Forward Premium and Discount Spot US$/£ 1.6000 6-mo Forward 1.5900 What is the forward premium/discount on the US$? What about £, is it trading at a premium or discount?

The following sections in chapter 5 are not required for the exam: Examples 5.2 and 5.3 Spot Foreign Exchange Microstructure Swap transactions

Learning outcomes Know the structure of the FX market Know the difference between wholesale (interbank) market and retail market Who are the participants in the FX market? Know how to read/use spot and forward quotes; direct and indirect method Know how to define and calculate the bid-ask spread Calculate currency cross-rates, with and without bid-ask quotes, when given two spot or forward FX quotations involving three currencies Calculate the profit/loss on a triangular arbitrage opportunity given three currency quotations, with and without bid-ask spread Calculate the profit or loss of short and long forward positions Define and calculate the forward discount or premium