1. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Chapter 6 The Foreign Exchange Market and Derivatives

2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-2 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.

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-3 The Foreign Exchange Market 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.

4. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-4 Geography The foreign exchange market spans the globe, with prices moving and currencies trading somewhere every hour of every business day. As the next exhibit will illustrate, the volume of currency transactions ebbs and flows across the globe as the major currency trading centers open and close throughout the day.

5. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-5 Greenwich Mean Time Tokyo opens Asia closing 10 AM In Tokyo Afternoon in America London closing 6 pm In NY Americas open Europe opening Lunch In Tokyo Source: Federal Reserve Bank of New York, “The Foreign Exchange Market in the United States,” 2001, www.ny.frb.org. Exhibit 6.1 Measuring Foreign Exchange Market: Average Electronic Conversations Per Hour

6. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-6 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.

7. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-7 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). Five broad categories of participants operate within these two tiers; bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers.

8. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-8 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.

9. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-9 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.

10. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-10 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. 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.

11. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-11 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.

12. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-12 Transactions in the Interbank Market A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. The date of settlement is referred to as the value date.

13. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-13 Transactions in the Interbank Market 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 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.)

14. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-14 Transactions in the Interbank Market 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).

15. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-15 Market Size In April 2004, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1.9 trillion. This most recent period showed dramatic growth in foreign exchange trading over that seen in April 2001.

16. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-16 Exhibit 6.3 1000 900 800 700 600 500 400 300 200 100 0 1992 1989 1995 1998 2001 Spot Forwards Swaps 2004 Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 9.

17. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-17 Exhibit 6.4 800 700 600 500 400 300 200 100 0 United States United Kingdom Japan Singapore Germany 1992 1989 1995 1998 20012004 Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 13.

18. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-18 Exhibit 6.5 90 80 70 60 50 40 30 20 10 0 1992 1989 Because all exchange transactions involve two currencies, percentage shares total 200% 1995 1998 20012004 US Dollar Euro Deutschemark French Franc EMS Currencies JapaneseYen Pound Sterling Swiss Franc Source: Bank for International Settlements, “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2004,” September 2004, p. 11.

19. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-19 Foreign Exchange 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.

20. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-20 Foreign Exchange 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: –the foreign currency price of one dollar, or –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.

21. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-21 Foreign Exchange 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.

22. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-22 Foreign Exchange Rates and Quotations As mentioned, several exceptions exist to the use of European terms quotes. 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.

23. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-23 Foreign Exchange 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.”

24. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-24 Foreign Exchange Rates and Quotations 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.

25. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-25 Foreign Exchange Rates and Quotes 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.

26. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-26 Foreign Exchange Rates and Quotes Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate. This method of quotation facilitates comparing premiums or discounts in the forward market with interest rate differentials.

27. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-27 Foreign Exchange Rates and Quotes 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

28. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-28 Foreign Exchange Rates and Quotes 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).

29. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-29 Foreign Exchange Rates and Quotes Citibank quote - $/€$1.2223/€ Barclays quote - $/£ $1.8410/£ Dresdner quote - €/£€1.5100/£ Cross rate calculation: $1.8410/£ $1.2223/€ = € 1.5062/£ =

30. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-30 $1,000,000 x $1.8410/£ = £543,183 Exchange £543,183 with Dresdner for euros at €1.5100/£ Citibank, New York Dresdner Bank, Frankfurt Barclays Bank, London £543,183 x €1.5100/£ = €820,206 €820,206 x $1.2223/€ = $1,002,538 End with $1,002,538Start with $1,000,000 Exchange $1,000,000 with Barclays Bank for pounds at $1.8410/£ Sell €1,121,651 to Citibank at $0.9045/€ (1) (2) (3) (4) (5) (6) Exhibit 6.9A Triangular Arbitrage

31. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-31 Foreign Exchange Rates and Quotes 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 Beginning Rate x 100 Ending Rate x 100

32. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-32 Mini-Case Questions: The Venezuelan Bolivar Why does a country like Venezuela impose capital controls? In the case of Venezuela, what is the difference between the gray market and the black market? Create a financial analysis of Santiago’s choices and use it to recommend a solution to his problem.