1. 1 CHAPTER 6 Foreign Exchange Market (Textbook Chapter 7)

2. 2 INTRODUCTION I. INTRODUCTION A.The Foreign Exchange Market Definition: a place where money denominated in one currency is bought and sold with money denominated in another currency – that is, to trade one currency for another currency. 2

3. 3 INTRODUCTION B. Location 1.OTC-type: no specific location 2.Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications 3

4. INTRODUCTION 4

5. 5 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 5

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7. 7 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.Two Types of Currency Markets 1.Spot Market: - immediate delivery - within 2nd business day after transactions concluded 2. Forward Market: - contracts are made to buy or sell currencies for future delivery 7

8. 8 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. commercial banks b. brokers: specialists in matching net supplier and demander banks c. customers of commercial and central banks 8

9. 9 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2.Forward Market a. Arbitrageurs: seek to earn risk-free profits by taking advantage of differences in interest rates among countries b. Traders: use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies c. Hedgers: engage in forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities 9

10. 10 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2.Forward Market (con’t) d. Speculators: actively expose themselves to currency risk by buying or selling currencies forward in order to profit from exchange rate fluctuations 10

11. 11 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II.CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) – used in U.S. for electronic fund transfers. B. FedWire - operated by the Fed - used for domestic transfers 11

12. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET Eurozone TARGET used for all settlements. Run by European Central Bank. TARGET: Trans-European Automated Real-time Gross settlement Express Transfer 12

13. 13 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market B. Results: 1.Reduces cost of trading 2.Threatens traders’ oligopoly of information 3.Provides liquidity 13

14. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE CURRENCY MARKET A. Largest financial market in the world. 2013: US$5.3 trillion daily or US$1,272 trillion a year. 14

15. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market centers by size (2013): – daily turnover: #1: London = $2.726 billion. #2: New York = $1.263 billion. #3: Singapore = $383 billion. 15

16. 16 THE SPOT MARKET I.SPOT QUOTATIONS A. Sources 1. Major newspapers 2. Major currencies have four different quotes: a.spot price b.30-day c.90-day d.180-day 16

17. 17 THE SPOT MARKET B.Method of Quotation 1.For inter-bank dollar trades: a. American terms example: $1.21/€ b. European terms example: Peso1.713/$ Nowadays, in trades involving the euro and U.S. dollars, their exchange rates are normally expressed in European terms. The exception for the U.S. dollars is British pounds, which is traditionally expressed in American terms. 17

18. 18 THE SPOT MARKET 2.For non-bank 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 18

19. THE SPOT MARKET 2.For non-bank customers: (con’t) Indirect quote gives the foreign currency price of one unit of home currency. Banks in Great Britain usually use this method. 19 American termsEuropean terms U.S. dollar price per unit of foreign currency ($0.009251/¥) Foreign currency units per dollar (¥108.10/$) A direct quote in the U.S.A direct quote outside the U.S. An indirect quote outside the U.S.An indirect quote in the U.S.

20. 20 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 sellthe currency Suppose theBritish pound is quoted at $1.8419 - 28 20

21. 21 THE SPOT MARKET Percent Spread Formula (PS): 21

22. 22 THE SPOT MARKET D. Cross Rates 1.The exchange rate between 2 non - US$ currencies 22

23. 23 THE SPOT MARKET D. Cross Rates (con’t) 2.Calculating Cross Rates (example) Suppose you want to calculate the £/€ cross rate. You know £.5556/US$ and €.8334/US$ then £/ € = £.5556/US$  €.8334/US$ = £.6667/ € 23

24. THE SPOT MARKET D. Cross Rates (con’t) 3. Examples (i) Suppose sterling is quoted at $1.9519-36, and the Swiss franc is quoted at $0.9250-67. What is the direct quote for the pound in Zurich? (ii) Suppose that the Brazilian real is quoted at R 0.9955-1.0076/U.S.$ and the Thai baht is quoted at B 25.2513-3986. What is the direct quote for the real in Bangkok? 24

25. 25 THE SPOT MARKET E. Currency Arbitrage 1.If cross rates differ from one financial center to another, profit opportunities exist. 2.Buy cheap in one int’l market, sell at a higher price in another 25

26. THE SPOT MARKET E. Currency Arbitrage 3. Examples (i) Suppose the British pound is bid at $1.9422 in New York and the euro is offered at $1.4925 in Frankfurt. London banks are offering the British pounds euro cross rate at €1.2998. Do any arbitrage opportunities exist? (ii) If the direct quote for the dollar is €0.65 in Frankfurt, and transaction costs are 0.3%, what are the minimum and maximum possible direct quotes for the euro in New York? 26

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28. 28 THE SPOT MARKET F. Settlement Date Value Date: 1.Date on which monies are due 2.2nd working day after date of original transaction. 28

29. 29 THE SPOT MARKET G.Exchange Risk 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 29

30. 30 MECHANICS OF SPOT TRANSACTIONS H. SPOT TRANSACTIONS: Example Step 1.Currency transaction: verbal agreement, U.S. importer specifies: a. Account to debit (his acct) b. Account to credit (exporter) 30

31. 31 MECHANICS OF SPOT TRANSACTIONS Step 2.Bank sends importer contract note including: - amount of foreigncurrency - agreed exchange rate - confirmation of Step 1. 31

32. 32 MECHANICS OF SPOT TRANSACTIONS Step 3.Settlement Correspondent bank in Hong Kong is informed to transfer HK$ from nostro account to exporter’s. Value Date. U.S. bank debits importer’s account. Exporter has his account credited by Hong Kong correspondent bank. 32

33. 33 THE FORWARD MARKET I.INTRODUCTION A. 3 Part 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 33

34. 34 THE FORWARD MARKET B. Purpose of a Forward : Hedging the act of reducing exchange rate risk. For example, a U.S. company buys textiles from England with payment £1 million due in 90 days. During this period, the pound might rise against the dollar. The importer can guard against this exchange risk by immediately negotiating a 90-day forward contract with a bank at a price, say, £1 = $1.98. 34

35. THE FORWARD MARKET 35 The forward contract allows the importer to convert an unknown dollar cost into a known dollar cost, thereby eliminating all exchange risk on this transaction.

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37. 37 THE FORWARD MARKET C.Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to commercial customers b.Swap Rate: quoted in the inter-bank market as a discount or premium 37

38. 38 THE FORWARD MARKET CALCULATING THE FORWARDPREMIUM OR DISCOUNT 38

39. THE FORWARD MARKET C. Forward Rate Quotations (con’t) 2. swap rate converted to outright rate adding the premium (in points) to, or subtracting the discount (in points) from spot rate 39

40. THE FORWARD MARKET 40

41. THE FORWARD MARKET D. Cross Rates Forward cross rates are figured in much the same way as spot cross rates. For example, a customer wants to sell 30- day forward euros against yen delivery. 41

42. THE FORWARD MARKET E. Example Given the following information, can you find an arbitrage opportunity? What is the profit per ₤1,000,000 arbitraged? 42