1. Chapter 6 The Foreign Exchange Market

2. OVERVIEW 2

3. The Foreign Exchange Market The Foreign Exchange Market provides: –the physical and institutional structure through which the money of one country is exchanged for that of another country; –the determination rate of exchange between currencies, and –is where foreign exchange transactions are physically completed. Foreign exchange means the money of a foreign country; that is, foreign currency bank balances, banknotes, checks and drafts. 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 date. 3

4. Functions of the Foreign Exchange Market The foreign exchange market is the mechanism by which participants: –transfer purchasing power between countries; –obtain or provide credit for international trade transactions, and –minimize exposure to the risks of exchange rate changes (e.g., hedging with forward contracts). To be discussed in more detail later. 4

5. The Top 20 Dealers in the Foreign Exchange Market 5

6. Geography The FX market spans the globe, with prices moving and currencies trading somewhere every hour of every business day - the major currency trading centers open and close throughout the day. 6 Measuring Foreign Exchange Market Activity: Average Electronic Conversions Per Hour

7. Global Currency Trading: The Trading Day 7

8. Global Foreign Exchange Market Turnover, 1989-2010 (average daily turnover in April, billions of U.S. dollars) 8

9. Top 10 Geographic Trading Centers in the FX Market, 1991-2010 (average daily turnover in April) 9

10. Foreign Exchange Market Turnover by Currency Pair (daily average in April) 10

11. FX Quotes Tuesday, December 21, 2010 11

12. WSJ Quotes, January 16, 2012 12

13. MARKET PARTICIPANTS 13

14. Market Participants The foreign exchange market consists of two tiers: –the interbank or wholesale market (multiples of $1MM US or equivalent in transaction size), and –the client or retail market (specific, smaller amounts). Four broad categories of participants operate within these two tiers; –bank and nonbank foreign exchange dealers, –individuals and firms conducting commercial or investment transactions, –speculators and arbitragers, and –central banks and treasuries. 14

15. Market Participants: Bank and Nonbank Foreign Exchange Dealers Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets. The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price. Dealers in the foreign exchange department of large international banks often function as “market makers.” These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. Currency trading is profitable sources of income for major banks, collecting 10%-20% on average of their annual income. 15

16. Market Participants: Individuals and Firms Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose. Some of the participants use the market to “hedge” foreign exchange risk. 16

17. A Simple Currency Hedging Example: Forward Contract Currency forwards may be purchased (sold) by MNCs to hedge foreign currency payables (receivables). 1.Expect to receive 500,000 pesos from a foreign buyer. Contract to sell 500,000 pesos @ $.09/peso on June 17. April 4 2.Receive 500,000 pesos as expected. June 17 3.Sell the pesos at the locked-in rate. 17

18. Market Participants: Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. –Do not need to maintain inventories of foreign currencies. –They simply take long or short potions. While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets. 18

19. Arbitrage In finance, arbitrage opportunity means a riskless profit. Example of arbitrage: –Agricultural goods traded in two different regions (e.g., OJ harvested in CA and FL) –Dual-listed companies in two different exchanges –Triangle arbitrage with foreign currencies –to name a few… However, arbitrage is a misnomer in some cases where a significant risk can be involved such as execution risk. 19

20. Triangle Arbitrage Suppose that the exchange rates in two markets are as follows: –in London £5 = $10 = ¥1,000 –in Tokyo £6 = $12 = ¥1,000 Arbitrage profit –Converting ¥1000 to $12 in Tokyo and –converting that $12 into ¥1,200 (=12/10*1,000) in London, for a profit of ¥200, would be arbitrage. 20

21. Market Participants: Central Banks and Treasuries Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System. The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens. As willing loss takers, central banks and treasuries differ in motive from all other market participants. 21

22. Central Bank Interventions The policy problem concerns the art of intervening in the foreign exchange market in order to influence the exchange rate in desirable directions. When, for instance, a nation’s currency gets over- valued because of some shock, it may want to devalue the currency in order to dampen the fluctuation. Some developing economies have followed the policy of deliberately keeping its currency a little under-valued so as to boost exports. In India, when the Reserve Bank of India (RBI) wants to devalue the rupee, it typically does so by using rupees to buy up foreign currency from the market. –This strengthens the foreign currency and weakens the rupee. 22

23. Top 10 Largest Countries by Foreign Exchange Reserves 23

24. TYPES OF FX TRANSACTIONS 24

25. Types of Foreign Exchange Transactions Spot Transaction Outright Forward Transaction Foreign Exchange Market Swap 25

26. Spot Transaction Spot transaction - Single transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) within two business days. –one day in the case of North American currencies –The date of settlement is referred to as the value date. Example: On Tuesday, September 5, 2006, Megasouth Bank sells USD 10,000,000 for Japanese yen at the spot rate of JPY 110.32/USD. –No money changes hands on September 5, 2006. –On Thursday, September 7, 2006, Megasouth pays USD 10,000,000 (transfer in US) and Megasouth receives JPY 1,103,200,000 at its branch in Tokyo (transfer in Japan). 26

27. Forward Contract An outright forward transaction (usually called just forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for foreign exchange to be delivered at value dates of one, two, three, six and twelve months. Buying forward and selling forward describe the same transaction (the only difference is the order in which currencies are referenced.) –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”. 27

28. Forward Contract Transaction involving the exchange of two currencies at a rate agreed on the date of the contract for value or delivery (cash settlement) at some time in the future (more than two business days later). ALTERNATE DEFINITION: A foreign exchange transaction whose value date is later than the value date for a spot transaction. A forward contract is basically a contract to buy or sell a fixed amount of foreign currency at a specific date in the future at a price (forward rate) agreed upon now and not changed, regardless of the spot exchange rate at the time the contract is executed. 28

29. Forward Contract: Example On Tuesday, September 5, 2006, –the spot Japanese yen was JPY110.32/USD; –the six month forward yen was quoted JPY108.00/USD. –The spot value date is Thursday, September 7, 2006. –The six-month value date is the same day of the month as the spot value date, six months later, or Wednesday, March 7, 2007. Suppose on September 5, 2006, Megasouth buys USD 10,000,000 for JPY six months forward at the forward rate of JPY 108.00/USD. –No money changes hands September 5, 2006. –No money changes hands September 7, 2006. –On March 7, 2007, Megasouth pays JPY 1,080,000,000 from its Tokyo branch and receives USD 10,000,000 in the US. 29

30. Swap Transaction 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 counterparty. Some different types of swaps are: –spot against forward, –forward-forward, –nondeliverable forwards (NDF). 30

31. Foreign Exchange Market Swap Transaction that involves the actual exchange of two currencies (principal amount only) on a specific date at a rate agreed at the time of conclusion of the contract (the short leg), and a reverse exchange of the same two currencies at a date further in the future at a rate (generally different from the rate applied to the short leg) agreed at the time of the contract (the long leg). 31

32. Swap Transaction: Example On Tuesday, September 5, 2006, Megasouth Bank enters a foreign exchange market swap: –Short Leg – Megasouth buys USD 10,000,000 for Japanese yen at the spot rate of JPY110.32/USD –Long Leg - Megasouth sells USD 10,000,000 for Japanese yen six months forward at the forward rate of JPY108.00/USD. 32

33. Swap Transaction (contd) On Tuesday, September 5, 2006, no money changes hands. On Thursday, September 7, 2006, Megasouth receives USD 10,000,000 (transfer in US) and Megasouth pays JPY 1,103,200,000 from its branch in Tokyo (transfer in Japan). On Wednesday, March 7, 2007, Megasouth receives JPY 1,080,000,000 at its Tokyo branch (transfer in Japan) and pays USD 10,000,000 in the US (transfer in US). A foreign exchange market swap includes two transactions. What the parties agree on is the difference between the spot rate and the rate to be applied to the forward transaction. Here, that difference is 110.32 – 108.00 = JPY2.32/USD. 33

34. FX RATES AND QUOTATIONS 34

35. Exchange Rates: New York Closing January 3, 2012 35

36. Exchange Rates: New York Closing Snapshot (cont.) 36

37. FX Rates and Quotations A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate. 37

38. FX Rates and Quotations Most foreign exchange transactions involve the US dollar. Professional dealers and brokers may state foreign exchange quotations in one of two ways: –European terms: the foreign currency price of one dollar, or –American terms: the dollar price of a unit of foreign currency. Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar. 38

39. FX Rates and Quotations For example, the exchange rate between US dollars and the Swiss franc is normally stated: –SF 1.6000/$ (European terms) However, this rate can also be stated as: –$0.6250/SF (American terms) Excluding two important exceptions, most interbank quotations around the world are stated in European terms. –The two most important are quotes for the euro and U.K. pound sterling which are both normally quoted in American terms. –American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with tourists. 39

40. FX Rates and Quotations Foreign exchange quotes are at times described as either direct or indirect. In this pair of definitions, the home or base country of the currencies being discussed is critical. A direct quote is a home currency price of a unit of foreign currency. An indirect quote is a foreign currency price of a unit of home currency. The form of the quote depends on what the speaker regard as “home.” 40

41. Direct Exchange Quotes A direct exchange rate is the domestic price of foreign currency. For example, an American investor seeing a direct quote $1.34/€ knows she will pay $1.34 for one euro. To a European investor, the direct quote is €0.74627/$ which says that 1 dollar (foreign currency) is worth 0.74627 euro. An appreciation of the foreign currency causes an increase in the direct quote. 41

42. Indirect FX Quotations An indirect exchange rate is the amount of foreign currency that one unit of domestic currency will purchase. For an American investor, the indirect quote €0.74627/$ says that 1 dollar will purchase 0.74627 euro. Direct quotes and indirect quotes are reciprocals of each other. An appreciation of the foreign currency causes a decrease in the indirect quote. 42

43. Conversion b/w Direct and Indirect Quotes For example, a direct quote of $1.5200/ £ can be converted into a indirect quote as follows: Indirect = 1 / 1.5200 =.6579 And then switch currency symbols Indirect Quote = £ 0.6579/$ Indirect = 1 / Direct 43

44. Foreign Currency Quotations 44

45. Example: Direct and Indirect Exchange Rates Question: On July 1, the British pound (£) is quoted as $1.80/£. –Is this a direct or indirect quote from the viewpoint of an American and a British investor? –A month later, the exchange rate moved to $1.90/£. Which currencies appreciated or depreciated? Answer: The pound is quoted in terms of dollars. This quote is a direct quote from the American viewpoint and an indirect quote from the British viewpoint. –The pound is the quoted currency. Over a month, the pound’s price increased from $1.80 to $1.90, so the pound appreciated and the dollar depreciated. 45

46. Currency Movements and Exchange Rate Quotations 46

47. Understanding FX Quotes: Helpful Rules Rule 1: If an exchange rate quote, “Currency A/Currency B” RISES, the currency B appreciates and the currency A depreciates. FOCUS ON THE CURRENCY IN THE DENOMINATOR! Rule 2: Keep track of your units. Notice that Direct Quote = 1/ Indirect Quote Rule 3: Always buy or sell the currency in the denominator of a foreign exchange quote. Rule 4: A dealer bank buys foreign currencies at a lower rate and sells at a higher rate. Remember “Buy low and sell high.” Rule 5: Bid price Direct = 1/Ask price Indirect, Ask price Direct = 1/Bid price Indirect Rule 6: Buying dollars = Selling yens, or selling dollars = buying yens 47

48. Bid, Ask Interbank quotations are given as a bid and ask (also referred to as offer). A bid is the price (i.e. exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i.e. exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices. A bid for one currency is also the offer for the opposite currency. 48

49. Stock Market Quote: NYSE Bid Ask IBM$160.25$160.75 Specialist buys low, sells high. Specialists buys at $160.25, so you sell at $160.25. Specialist sells at $160.75, so you buy at $160.75 $160.75 - $160.25 = $0.50 = “spread” 49

50. Bid and Offer Bid Rate – the rate at which a foreign exchange dealer is willing to buy a currency Offer Rate – the rate at which a foreign exchange dealer is willing to sell a currency Example: Megasouth quotes the GBP against the USD as USD1.9630-35/GBP 1.What is the Megasouth’s Bid Rate for the pound? 2.Which currency is Megasouth buying at this rate? 3.If you needed GBP10,000,000, how much would you pay in dollars? 50

51. Bid and Offer for Indirect Rates Suppose Megasouth Bank quotes the Japanese yen at JPY 110.21-32 / USD 1.What is the bid rate? What currency is being bought at this rate by Megasouth bank? 2.What is the offer rate? What currency is being sold at this rate by Megasouth bank? 3.If you needed Japanese yen and you wanted to get them from Megasouth, at what rate would you transact this deal? 4.If you had USD 10,000,000, and you exchanged them with Megasouth for Japanese yen, how many yen would you get? 5.If you had JPY 10,000,000,000 and you want to exchange them for dollars, how many dollars would you get? Megasouth is willing to buy dollars for yen at 110.21 and sell dollars for yen at 110.32. Tip: Imagine you want to buy one Big Mac for $2. The exchange rate between dollar and Big Mac is $2/BM. When you buy a Big Mac, you sell dollars. Again, the key is to focus on the denominator. 51

52. Bid, Ask, and Mid-Point Quotation 52

53. How Banks Make Profits in FX Market From the Bid-offer Spread –Simultaneous sale and purchase of foreign currency. By Taking a Speculative Position –Going long - buying more foreign currency than you sell in hopes that the value of the currency will go up (the foreign currency appreciates). –Going short - selling more foreign currency than you buy in hopes that the value of the currency will go down (the foreign currency depreciates). 53

54. Speculation: Example 1.On the morning of Tuesday, September 5, 2006, Megasouth Bank sells GBP50,000,000 at USD1.8000 (total value USD90,000,000). Megasouth has opened a short position. 2.That afternoon, after the pound has depreciated to USD1.7900, Megasouth closes its short position by buying GBP50,000,000 (total cost USD89,500,000). 3.Megasouth has made USD500,000. 4.If Megasouth had bought in the morning (opened a long position) and sold in the afternoon, it would have lost money. 54

55. Spot and Forward Quotations for the Euro and Japanese Yen 55

56. FX Rates and Quotes: Points Forward rates are typically quoted in terms of points. A forward quotation is expressed in points is not a foreign exchange rate as such. Rather, it is the difference between the forward rate and the spot rate. 56

57. Forward Premium or Discount Premium: a currency is at a premium in the forward market if it’s worth more in the forward market than it is in the spot market. Discount: a currency is at a discount in the forward market if it’s worth less in the forward market than it is in the spot market. 57

58. Forward Premium / Discount For quotations expressed in foreign currency terms (Indirect quotations) the formula becomes: f ¥ = Spot – Forward 360 For quotations expressed in home currency terms (Direct quotations) the formula becomes: f ¥ = Forward – Spot 360 100 nForward xx 100 n Spot xx 58

59. Example: Forward Premium/Discount 59

60. Clearly the market participants expect that the pound will be worth less in dollars in six months. 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry Spot Rates vs. Forward Rates 60

61. Currency Appreciation/Depreciation Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations): %∆ = Ending rate – Beginning Rate Quotations expressed in foreign currency terms (indirect quotations): %∆ = Beginning Rate – Ending Rate A positive %  represents appreciation of the foreign currency, while a negative %  represents depreciation. Beginning Rate x 100 Ending Rate x 100 61

62. Example Given a quote of SF1.6351/$ (or, $0.61158/SF) and later strengthens to SF1.5000/$ (or, $0.6667/SF). 62

63. ARBITRAGE IN FX MARKET 63

64. Arbitrage Arbitrage involves the simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk free profit on the price differential. Arbitrage keeps exchange rates in line with each other and with risk free interest rates. –For example, the €/$ rate must be the same, at a given instant, in Frankfurt, Paris and New York. An arbitrage could be created if it were profitable to buy from one bank and sell to another bank. When describing arbitrage, we are usually discussing a riskless transaction that does not require any invested capital. 64

65. Arbitrage Example Consider the following three banks each providing a ¥/$ quote: Bank ABank BBank C 122.25-35122.40-45122.25-45 –Does an arbitrage opportunity exist? 65

66. Cross Rates Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate). Cross rates can be used to check on opportunities for intermarket arbitrage. This situation arose because one bank’s (Dresdner) quotation on €/£ is not the same a calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank). 66

67. Key Currency Cross Rates January 3, 2012 67

68. Triangular Arbitrage B Citibank quote - $/€$1.2223/€ Barclays quote - $/£ $1.8410/£ Dresdner quote - €/£€1.5100/£ Cross rate calculation: $1.8410/£ $1.2223/€ = € 1.5062/£ = 68

69. Triangular Arbitrage 69

70. Triangular Arbitrage 70

71. Triangular Arbitrage A Compute profit given the following exchange rates $/£ in New York = $1.9724 $/€ in Frankfurt= $1.3450 €/£ in London= €1.4655 Cross rate calculation: $1.9724/ £ $1.3450/ € New York Frankfurt London Sell $1,000,000 in Frankfurt for euros: $1,000,000/($1.3450) = €743,494 Sell euros in London for pounds: €743,494/€1.4655 = £507,332 Sell pounds in New York for dollars: £507,332/(1/$1.9724) = $1,000,661 Profit = $661 €1.4665/£ 71

72. Currency Arbitrage, continued Results of triangular currency arbitrage New York Frankfurt London Selling dollars for euros, the euro will appreciate against the dollar in Frankfurt Selling euros for pounds, the euro will depreciate against the pound in London Selling pounds for dollars, the pound will depreciate against the dollar in New York 72

73. Example: Compute direct bid and ask cross rates for the pound in Zurich Direct quote for pound sterling = $1.9719-36/£ Direct quote for SFr = $0.8130-47/SFr Thus, the direct quote for the pound in Zurich is SFr2.4204-27/£. = Bid cross rate = Bid rate for £ in $ Ask rate for SFr in $ $1.9719 $0.8147 =SFr2.4204 Ask cross rate = Ask rate for £ in $ Bid rate for SFr in $ $1.9736 $0.8130 =SFr2.4227 = Finding Cross Rates: Bid and Ask 73