1. Foreign Exchange Markets
(or chapter 6)

2. Agenda Description of foreign exchange market Size? Functions?
Participants?
Transactions?
Rates & Quotations?
Inter-market Arbitrage?

3. Average Electronic Conversations Per Hour
Geographic Extent
Singapore, Hong Kong, Tokyo, Bahrain, London, New York, San Fran, & Sydney.
Average Electronic Conversations Per Hour
Greenwich Mean Time
Tokyo
opens
Asia
closing
10 AM
In Tokyo
Afternoon
in America
London
6 pm
In NY
Americas
open
Europe
opening
Lunch

4. Functions of FOREX Market
Transfer purchasing power between countries.
Obtain/ provide credit for international trade.
Minimize exposure to exchange rate risk.

5. Size, Structure, & Participants
Daily global net turnover in forex US$1.21 trn (April’01), data by Bank for Int’l Settlements - Switzerland
FOREX market has two tiers
interbank (wholesale) market.
client (retail) market.
Five categories participants:
Bank & non-bank forex dealers.
Individuals & firms.
Speculators & arbitragers.
Central banks & treasuries.
Forex brokers.

6. Transactions in the Interbank Market
Transactions: spot, forward, or swap basis
Spot transaction requires almost immediate delivery of foreign exchange
Forward transaction requires delivery of foreign exchange at some future date
Swap transaction is the simultaneous exchange of one foreign currency for another

7. Spot & Outright Forward Transactions
Spot: Purchase of forex, w/ delivery & payment b/n banks to take place on 2nd following business day.
Settlement date referred as value date
Settlement through computerized Clearing House Interbank Payment Systems (CHIPS), New York ()
Forward: Requires a future value date
Exchange rate is agreed upon at the time of the transaction, payment & delivery are delayed
Quoted for value dates of 1-, 2-, 3-, 6-, 9- & 12-months

8. Swap Transactions
Simultaneous purchase & sale of of foreign exchange for two different value dates
Both purchase & sale w/ same counterparty
Common types of swaps
Spot against forward: buy currency in spot market & simultaneously sells same amount back to same bank in forward market
Forward-forward swaps: Dealer sells £20,000 forward for $, delivery in 2 $1.687/£ & simultaneously buys £20,000 forward for delivery in 3 $1.682/£
Difference b/n buying and selling price is interest rate differential.
Can be viewed as way for collateralized borrowing another currency.
Non-deliverable forwards (NDF): same as traditional forward contracts except they are settled only in US$. Foreign currency sold/ bought forward not delivered.
NDF contracted offshore & are beyond reach & regulation of home governments
Pricing NDF reflects basic interest rate differentials.

9. Rates & Quotes What is a quote? Inter-bank Quotes
Foreign currency for a dollar (SF1.60/$). European quote
Dollar for unit foreign currency ($0.625/SF). American quote
All European currencies quoted in European way, except:
Pound Sterling, Euro, Australian, & New Zealand $.
Direct & Indirect Quotes
Direct: home currency per unit of foreign
Indirect: foreign currency per unit home currency
SF1.60/$ indirect quote in US, $0.625/SF is direct quote in US
Bid & Ask Quotes
Interbank quotes given as bid & ask (offer)
Bid is the price at which a dealer will buy another currency
Ask or offer is the price at which a dealer will sell another currency
E.g.: ¥ ¥118.37/$ is the bid/ask for Japanese yen
Bank will buy ¥ per US$ & sell ¥ per US$ making profit on spread.

10. Rates & Quotes Forward Quotations on a Points Basis Outright quotes.
Forward quotes different & usually quoted in points
A point: last digit of quote, w/ convention dictating number of digits to the right of decimal.
=> a point = most currencies

11. Rates & Quotes Expressing Forward Quotations on Points Basis
Yen quoted only to 2 decimal points
Forward quote is not forex rate, but difference b/n spot & forward.
Example:
Bid Ask
Outright spot: ¥ ¥118.37
Plus points (3 months)
Outright forward: ¥ ¥116.97

12. Rates & Quotes Can have forward quotes as % p.a. deviation from spot.
Important: which currency is home currency?
Indirect quotes (i.e. foreign per domestic)
Direct quotes (i.e. domestic per foreign currency)
For example: S = Yen /$, F30 = Yen /$

13. Cross Rates & Intermarket Arbitrage
Japanese yen ¥121.13/$.
Mexican peso Ps9.190/$.
Suppose
Cross rate is:
Assume
Cross rate Citibank & Barclays:
Cross rate =/= Dresdner rate €1.62/£.
Citibank $0.9045/€.
Barclays Bank $1.4443/£.
Dresdner Bank €1.6200/£. €

14. Intermarket Arbitrage
Citibank $0.9045/€.
Barclays $1.4443/£.
Dresdner €1.6200/£.
Intermarket Arbitrage
Citibank
Dresdner Bank
Barclays Bank
End with $1,014,533
Start with $1,000,000
Sell €1,121,651 to Citibank
at $0.9045/€
(6) Receive $1,014,533
Sell $1,000,000 to Barclays
Bank at $1.4443/£
(2) Receive £692,377
Sell £692,377 to Dresdner Bank
at €1.6200/£
(4) Receive €1,121,651

15. Things to remember Market Participants Transaction types Quotations
Inter-market arbitrage