1. The Foreign Exchange Market
CHAPTER 7
The Foreign Exchange Market

2. PART I. INTRODUCTION I. INTRODUCTION A. The Currency Market:
where money denominated in one currency is bought and sold with money denominated in another currency.

3. INTRODUCTION B. International Trade and Capital Transactions:
facilitated with the ability
to transfer purchasing power
between countries

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

5. PART II. 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

6. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Two Types of Currency Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business day

7. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
2. Forward Market:
- transactions take place at a specified future date

8. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial and central banks

9. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators

10. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
II. CLEARING SYSTEMS
A. Clearing House Interbank Payments System (CHIPS)
- used in U.S. for electronic
fund transfers.

11. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic transfers

12. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
III. ELECTRONIC TRADING
A. Automated Trading
- genuine screen-based market

13. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Results:
1. Reduces cost of trading
2. Threatens traders’ oligopoly of information
3. Provides liquidity

14. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
IV. SIZE OF THE MARKET
A. Largest in the world
2004: US$1.9 trillion daily or
US$475 trillion a year
In 1999 the US GDP was US$9.1 trillion

15. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Market Centers (2004):
#1: London = $753 billion daily
#2: New York= $461 billion daily
#3: Tokyo = $199 billion daily

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

17. THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades:
a. American terms
example: $1.21/€
b. European terms
example: Peso1.713/$

18. 2. For nonbank customers:
THE SPOT MARKET
2. For nonbank 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.

19. used to calculate the fee
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 sell the currency

20. THE SPOT MARKET
4. Percent Spread Formula (PS):

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

22. 2. Calculating Cross Rates
THE SPOT MARKET
2. Calculating Cross Rates
Suppose you want to calculate the £/€ cross rate.
You know £.5556/US$ and €.8334/US$
then
£/ € = £.5556/US$  €.8334/US$
= £.6667/ €

23. 2. Buy cheap in one int’l market,
THE SPOT MARKET
E. Currency Arbitrage
1. If cross rates differ from one financial center to another, and profit opportunities exist.
2. Buy cheap in one int’l market,
sell at a higher price in another
3. The Critical Role of Available Information

24. F. Settlement Date Value Date:
THE SPOT MARKET
F. Settlement Date Value Date:
1. Date monies are due
2. 2nd Working day after date of original transaction.

25. THE SPOT MARKET G. Exchange Risk 1. 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

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

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

28. MECHANICS OF SPOT TRANSACTIONS
Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporter’s.
Value Date.
U.S. bank debits importer’s
account.

29. PART IV. THE FORWARD MARKET
I. INTRODUCTION
A. 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.

30. THE FORWARD MARKET 2. Purpose of a Forward: Hedging
the act of reducing exchange
rate risk.

31. B. Forward Rate Quotations
THE FORWARD MARKET
B. Forward Rate Quotations
1. Two Methods:
a. Outright Rate: quoted to commercial customers.
b. Swap Rate: quoted in the
interbank market as a discount or premium.

32. CALCULATING THE FORWARD PREMIUM OR DISCOUNT
THE FORWARD MARKET
CALCULATING THE FORWARD PREMIUM OR DISCOUNT
= F-S x x 100
S n
where F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the
forward contract