2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-0 INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fourth Edition Chapter Objectives: This chapter introduces you to the institutional framework within which exchange rates are determined. It also lays the foundation for much of the discussion throughout the remainder of the text. 5 Chapter Five The Market for Foreign Exchange

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-1 Function and Structure of the FX Market The Spot Market The Forward Market Function and Structure of the FX Market FX Market Participants Correspondent Banking Relationships The Spot Market The Forward Market Function and Structure of the FX Market The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Triangular Arbitrage Spot Foreign Exchange Market Microstructure The Forward Market Function and Structure of the FX Market The Spot Market The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross-Exchange Rates Swap Transactions Forward Premium Function and Structure of the FX Market FX market participants Correspondent banking relationships The Spot Market The Forward Market Chapter Outline

4. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-2 FX Market Participants The FX market is a two-tier market: 1) Interbank Market (Wholesale) 2) Client Market (Retail) Market participants include: International banks— “make a market” Bank customers—eg. MNCs, money managers, private speculators Nonbank dealers—eg. investment banks, mutual funds, pension funds, hedge funds FX brokers—match buy/sell orders for a fee Central banks—intervention

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-3 Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market.

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-4 Correspondent Banking Relationships Bank A is in London, Bank B is in New York. The current exchange rate is £1.00 = $2.00. A currency trader employed at Bank A buys £100m from a currency trader at Bank B for $200m settled using its correspondent relationship. Bank A London Bank B NYC $200£100

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-5 Correspondent Banking Relationships AssetsLiabilities £ deposit at B£300m Other Assets£600m B’s Deposit$1,000m Other L&E£600m Total Assets£1,300mTotal L&E£1,300m AssetsLiabilities $ deposit at A$1000m Other Assets$800m A’s Deposit£300m Other L&E$800m Total Assets$2,200mTotal L&E$2,200m £400m$1,200m$1200m£400m$600m B’s Deposit£200m $600m £ deposit at A£200m £100m A’s Deposit$800m Bank A London Bank B NYC $200£100 $ deposit at B$800m £100m

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-6 Correspondent Banking Relationships International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO: Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions.

9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-7 The Spot Market Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-8 Spot Rate Quotations Direct quotation The price of one unit of the foreign currency in domestic currency. From the Thai perspective, a US dollar is worth about 34 baht. Indirect Quotation the price of one unit of domestic currency in the foreign currency From the Thai perspective, one baht is about 0.03 USD.

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-9 FX Rate Quotations Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso)0.33090.32923.02213.0377 Australia (Dollar)0.78300.78361.27711.2762 Brazil (Real)0.37350.37912.67742.6378 Britain (Pound)1.90771.91350.52420.5226 1 Month Forward1.90441.91010.52510.5235 3 Months Forward1.89831.90380.52680.5253 6 Months Forward1.89041.89590.52900.5275 Canada (Dollar)0.80370.80681.24421.2395 1 Month Forward0.80370.80691.24421.2393 3 Months Forward0.80430.80741.24331.2385 6 Months Forward0.80570.80881.24121.2364

12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-10 The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask (offer) price is the amount the dealer wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices.

13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-11 The Bid-Ask Spread A dealer could offer bid price of $1.25 per € ask price of $1.26 per € The bid-ask spread represents the dealer’s expected profit. In the interbank market, the standard size trade is about U.S. $10 million.

14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-12 The Bid-Ask Spread A dealer would likely quote these prices as 72-77. It is presumed that anyone trading $10m already knows the “big figure”. BidAsk 1.9072.5242 S($/£) S(£/$) 1.9077.5243 big figure small figure

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-13 Cross Rates Suppose that S($/€) = 1.50 i.e. $1.50 = €1.00 and that S(¥/€) = 50 i.e. €1.00 = ¥50 What must the $/¥ cross rate be? $1.50 ¥50 = $1.50€1.00 ¥50 × $1.00 = ¥33.33 $0.0300 = ¥1

16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-14 Triangular Arbitrage $ £ ¥ Bank B S(£/$)=1.50 Bank C S(¥/£)=85 Bank A S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate any implied cross rate to see if an arbitrage exists. £1.00 ¥80 = £1.50$1.00 ¥120 ×

17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-15 Triangular Arbitrage $ Bank B S(£/$)=1.50 Bank C S(¥/£)=85 Bank A S(¥/$)=120 The implied S(¥/£) cross rate is Bank C has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? ¥ £ £1.00 ¥80 = £1.50$1.00 ¥120 × Then trade yen for your preferred currency. Buy the £ @ ¥80; sell @ ¥85.

18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-16 Triangular Arbitrage $ Bank B S(£/$)=1.50 Bank C S(¥/£)=85 Bank A S(¥/$)=120 Strategy: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. ¥ £ 1 2 3 $

19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-17 Triangular Arbitrage 1. Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 2. Sell our £150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 3. Sell ¥12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $106,250 – $100,000 = $6,250

20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-18 Triangular Arbitrage $ Bank B S(£/$)=1.50 Bank C S(¥/£)=85 Bank A S(¥/$)=120 Here we have to go “clockwise” to make money—but it doesn’t matter where we start. ¥ £ 1 23 $ If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient!

21. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-19 Spot Foreign Exchange Microstructure Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market:  increase with FX exchange rate volatility and  decrease with dealer competition. Private information is an important determinant of spot exchange rates.

22. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-20 The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

23. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-21 The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. Exporters sell foreign currency forward. Importers buy foreign currency forward. Forward contracts are traded over the counter (OTC) and can be tailored-made to meet the customer’s need. Forward rates can be different across banks.

24. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-22 Forward Rate Quotations Example: for British pounds, the spot rate is $1.9077 = £1.00 While the 180-day forward rate is $1.8904 = £1.00 What does this imply about market expectation?

25. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-23 FX Rate Quotations Clearly the market participants expect that the pound will be ____ __________ ________in six months. Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso)0.33090.32923.02213.0377 Australia (Dollar)0.78300.78361.27711.2762 Brazil (Real)0.37350.37912.67742.6378 Britain (Pound)1.90771.91350.52420.5226 1 Month Forward1.90441.91010.52510.5235 3 Months Forward1.89831.90380.52680.5253 6 Months Forward1.89041.89590.52900.5275 Canada (Dollar)0.80370.80681.24421.2395 1 Month Forward0.80370.80691.24421.2393 3 Months Forward0.80430.80741.24331.2385 6 Months Forward0.80570.80881.24121.2364

26. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-24 Forward Rate Quotations Consider the (dollar) holding period return of a dollar-based investor who buys £1 million at the spot and sells them forward: $HPR= gain pain $1,890,400 – $1,907,700 $1,907,700 = –$17,300 $1,907,700 = $HPR = –0.0091 Annualized dollar HPR = –1.81% = –0.91% × 2

27. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-25 Forward Premium The interest rate differential implied by forward premium or discount. For example, suppose the € is appreciating from S($/€) = 1.25 to F 180 ($/€) = 1.30 The 180-day forward premium is given by: = 0.08 1.30 – 1.25 1.25 × 2=f 180,€v$ F 180 ($/€) – S($/€) S($/€) =× 360 180

28. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-26 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 FX forward, you are short. If you have agreed to buy FX forward, you are long.

29. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-27 Payoff Profiles 0 S 180 ($/¥) F 180 ($/¥) =.009524 Short positionloss profit If you agree to sell anything in the future at a set price, and the spot price later falls, then you gain. If you agree to sell anything in the future at a set price and the spot price later rises then you lose.

30. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-28 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F 180 (¥/$) = 105 profit short position

31. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-29 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 -F 180 (¥/$) 120 If, in 180 days, S 180 (¥/$) = 120, the short will make a profit by buying ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 15¥ profit short position

32. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-30 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position-F 180 (¥/$) F 180 (¥/$) short position profit Since this is a zero-sum game, the long position payoff is the opposite of the short.

33. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-31 Payoff Profiles loss 0 S 180 (¥/$) F 180 (¥/$) = 105 Long position -F 180 (¥/$) profit The long in this forward contract agreed to BUY ¥ in 180 days at F 180 (¥/$) = 105 If, in 180 days, S 180 (¥/$) = 120, the long will lose by having to buy ¥ at S 180 (¥/$) = 120 and delivering ¥ at F 180 (¥/$) = 105. 120 –15¥

34. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-32 Forward Cross Exchange Rates In generic terms

35. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-33 Country USD equiv Friday USD equiv Thursday Currency per USD Friday Argentina (Peso)0.33090.32923.0221 Australia (Dollar)0.78300.78361.2771 Brazil (Real)0.37350.37912.6774 Britain (Pound)1.90771.91350.5242 1 Month Forward1.90441.91010.5251 3 Months Forward1.89831.90380.5268 6 Months Forward1.89041.89590.5290 Canada (Dollar)0.80370.80681.2442 1 Month Forward0.80370.80691.2442 3 Months Forward0.80430.80741.2433 6 Months Forward0.80570.80881.2412 Forward Cross Exchange Rates GBP1.00 CAD2.3464 = GBP1.00USD1.00 USD1.8904CAD1.2412 × pound-Canadian dollar cross rate The forward

36. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-34 Forward premium/discount If the forward price of a currency is higher than the spot price  at a premium (expected to appreciate) If the forward price of a currency is lower than the spot price  at a discount (expected to depreciate) Britain ($/Pound) spot1.9077 1 Month Forward1.9044 3 Months Forward1.8983 6 Months Forward1.8904 £ can buy fewer $ at forward rates  £ is trading at a forward discount to $

37. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-35 Baht/USD Forward Rates Forward rate = Spot rate + Swap points*0.01 Source: BOT website For this specific case, $ forward is traded at a premium to ฿

38. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-36 Baht/USD Forward Rates Forward rate = Spot rate +/- Swap points*0.01 + if trading “at premium” - if trading “at discount” In general, If given the spot rate and swap points, how to figure out whether to add or to subtract the swap points from the spot to get forward rates? Step 1: See whether, for a pair of swap points, the second (ask price) number is greater or smaller than the first (bid price) number. Step 2: If greater (smaller), then the currency is expected to appreciate (depreciate) i.e. traded at a premium (at a discount). Step 3: Thus, “add” (“subtract”).

39. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-37 Notes All bid prices, including those of forward rates, must be less than the corresponding ask prices (for traders to be willing to make a market). The bid-ask spread increases in time to maturity (due to greater uncertainty/risk into the future). Forward points may remain constant for long periods of time, even if the spot rates fluctuate frequently.

40. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-38 Thailand’s FX regulations on FX Forward In general, the Exchange Controls Act of Thailand requires that all FX forward transactions must have underlying future oligations to pay or receive foreign currency from cross-border trade or investment. Banks are required to check the customer’s documents showing clear underlying (eg. invoice, buy/sell contract, purchase order). Forward amount cannot exceed the total value of the underlying oligations.

41. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-39 Currency Symbols In addition to the familiar currency symbols (e.g. £, ¥, €, $) there are three-letter codes for all currencies. It is a long list, but selected codes include: CHFSwiss francs GBPBritish pound ZARSouth African rand CADCanadian dollar JPYJapanese yen

42. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-40 SWAPS A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Often on a recurring basis—e.g. every six months for five years. Swap transactions account for approximately 56 percent of interbank FX trading in international markets, whereas outright trades are 11 percent. Swaps are covered fully in chapter 14.

43. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-41 Practice Problem The current spot exchange rate is $1.55/£ and the three- month forward rate is $1.50/£. Based on your analysis of the exchange rate, you are confident that the spot exchange rate will be $1.52/£ in three months. Assume that you would like to buy or sell £1,000,000. a. What actions do you need to take to make profit in the forward market? What is the expected dollar profit from this activity? b. What would be your profit in dollar terms if the spot exchange rate actually turns out to be $1.46/£? c. Graph your results.

44. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-42 Solution a.If you believe the spot exchange rate will be $1.52/£ in three months, you should buy £1,000,000 forward for $1.50/£. Your expected profit will be: $20,000 = £1,000,000 × ($1.52 – $1.50) b.If the spot exchange rate actually turns out to be $1.46/£ in three months, your loss from the long position will be: –$40,000 = £1,000,000 × ($1.46 – $1.50)

45. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5-43 Solution loss 0 S 180 (£/$) F 180 (£/$) = 1.50 –$ 40k 1.52 $20k profit 1.46