International Finance FINA 5331 Lecture 7: The market for foreign exchange Read: Chapters 5 Aaron Smallwood Ph.D.

Official reserves The official settlements balance, sometimes referred to as the overall balance, is the total balance on the current account plus the balance on all NON-OFFICIAL reserve transactions. It must be exactly offset by the balance on official reserves transactions

Official reserves When a country buys foreign reserves (for example, if the People’s Bank of China acquires dollars): –China’s assets increase: Debit entries in official reserves (a deficit) –Offset by an official settlements surplus If a country must sell official reserves (Thailand in 1997 because of speculative attacks): –The country’s reserve assets decrease: Credit entries in official reserves (a surplus) –Offset by an official settlements deficit.

Foreign Exchange Market Products and Activities A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

Foreign Exchange Market Products and Activities Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery. Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

Foreign Exchange Market Products and Activities Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation. Arbitrage is the simultaneous, or nearly simultaneous, purchase of asset in one market for sale in another market with (for our purposes) the expectation of a risk-free profit.

FOREX Players Broadly speaking the FX market consists of 5 groups –International banks –Bank customers –Non-bank dealers Include investment banks, mutual funds, and hedge funds. –FX brokers –Central banks

FX Market Participants The FX market is a two-tiered market: –Interbank market (wholesale) About banks worldwide stand ready to make a market in foreign exchange. Other financial institutions account for about 53% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. –Client market (retail) Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

Size of the FOREX market (billions of US $) Daily Average ALL 1,5271,2391,9343,3243,9715,345 SPOT ,0051,4882,046 OUTRIGHT FORWARD FOREX SWAPS ,7141,7592,228 CURRENCY SWAPS OPTIONS SOURCE: Bank for International Settlements

Currency shares CURRENCY USD EURN/A JPY GBP AUD CHF CAD MXN CNY

Trends in CNY

Recent changes In 2010, PBOC establishes a target value against the dollar. The actual value of the exchange rate was maintained within bands of +/-0.50%. –Daily parity value is changed everyday, creating a “crawling peg” system In April 2012, the band was widened to +/- 1% creating more flexibility. In March of this year, the band was again increased to +/- 2%, again creating more flexibility.

Another example According to an article published in Bloomberg on June 6, 2014: “China’s yuan strengthened as the central bank raised the currency’s daily fixing rate by the most in five months following an overnight slide in the dollar…. The currency posted the biggest gain in a week in onshore and offshore trading as the People’s Bank of China raised its reference rate by 0.14 percent to per dollar.”

Example, continued Knowing what we know about China’s exchange rate system, how high could the yuan price of the dollar go? In actual markets, could have gone as high as RMB *1.02 = RMB How low could we go? In actual markets, could have gone as low as RMB6.1623*0.98 = RMB

What happened According to the article: “The yuan advanced … to close at per dollar in Shanghai, its biggest gain since May 29… The onshore rate was 1.4% weaker than the fixing, within the 2% limit.”

Spot Rate Quotations A direct quotation for the US is: –The U.S. dollar equivalent. –E.g., “a Japanese Yen is worth about a penny.” For China: direct quote for the dollar is about RMB An indirect quotation is: –The price of a U.S. dollar in the foreign currency. –E.g., “you get 100 yen to the dollar.

Spot rate quotations Currencies U.S.-dollar foreign-exchange rates in late New York trading as of March 5, Friday Country/currencyin US$per US$Country/currencyin US$per US$ Swiss franc Euro area euro mos forward most forward China, RMB mos forward Japanese yen British pound mos forward mos forward most forward most forward mos forward mos forward

The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask price is the amount a dealer wants you to pay for something. It doesn’t matter if we’re talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices.

Use these quotes to find… The pound price of the euro. The SF price of the yuan.

The Bid-Ask Spread A dealer could offer: –A bid price of $ per €. –An ask price of $ per €. While there are a variety of ways to quote the above, the bid-ask spread represents the dealer’s expected profit. Percent spread =