2. © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved PowerPoint® Presentation Prepared By Charles Schell The Market for Foreign Exchange Chapter 4

3. Slide 4-1 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Chapter Four Outline The structure and function of foreign exchange markets; Understanding the spot market (transaction now to trade currencies now) Quotations: direct versus indirect Trading Arbitrage opportunities. Forward market (transaction now to trade currencies later)

4. Slide 4-2 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 4.1The FOREX (also FX) Market

5. Slide 4-3 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 4.2Spot Rate Quotations: Perspective of a US investor Direct quotation: $/JY; / means per the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” Indirect quotation: JY/$ the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”

6. Slide 4-4 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Spot Rate Quotations: US investor’s perspective The direct quote for British pound is: £1=$1.5627 Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso)0.33090.32923.02213.0377 Australia (Dollar)0.59060.59341.69321.6852 Brazil (Real)0.29390.28793.40253.4734 Britain (Pound)1.56271.5660.63990.6386 1 Month Forward1.55961.56290.64120.6398 3 Months Forward1.55351.55680.64370.6423 6 Months Forward1.54451.54770.64750.6461 Canada (Dollar)0.66920.67511.49431.4813 1 Month Forward0.66810.67411.49681.4835 3 Months Forward0.66580.67171.5021.4888 6 Months Forward0.6620.66781.51061.4975

7. Slide 4-5 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Spot 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)0.59060.59341.69321.6852 Brazil (Real)0.29390.28793.40253.4734 Britain (Pound)1.56271.5660.63990.6386 1 Month Forward1.55961.56290.64120.6398 3 Months Forward1.55351.55680.64370.6423 6 Months Forward1.54451.54770.64750.6461 Canada (Dollar)0.66920.67511.49431.4813 1 Month Forward0.66810.67411.49681.4835 3 Months Forward0.66580.67171.5021.4888 6 Months Forward0.6620.66781.51061.4975 The indirect quote for British pound is: £.6399 = $1

8. Slide 4-6 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Spot 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)0.59060.59341.69321.6852 Brazil (Real)0.29390.28793.40253.4734 Britain (Pound)1.56271.5660.63990.6386 1 Month Forward1.55961.56290.64120.6398 3 Months Forward1.55351.55680.64370.6423 6 Months Forward1.54451.54770.64750.6461 Canada (Dollar)0.66920.67511.49431.4813 1 Month Forward0.66810.67411.49681.4835 3 Months Forward0.66580.67171.5021.4888 6 Months Forward0.6620.66781.51061.4975 Note that the direct quote is the reciprocal of the indirect quote:

9. Slide 4-7 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Bid-Ask Spread You versus the dealer (or bank). The bid price is the price a dealer is willing to pay you for something. You receive this lower price. The ask price is the amount the dealer wants you to pay for the thing. You pay this higher price. E.g. Bid = RMB 6.10/$; Ask = RMB 6.30/$ The bid-ask spread is the difference between the bid and ask prices.

10. Slide 4-8 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Spot FX trading In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes.

11. Slide 4-9 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Cross Rates

12. Slide 4-10 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Cross Rates 3 currencies, 2 exchange rates: what is the 3 rd exchange rate? Suppose that S($/€) =.50 i.e. $1 = 2 € and that S(¥/$) = 100 i.e. ¥1 = $0.01 What must the ¥/ € cross rate be?

13. Slide 4-11 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Triangular Arbitrage £ $ € Credit Lyonnais S ( € /$)=0.7720 BNP Paribas S ( € /£)=1.5100 Barclays S ($/£)=1.9589 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

14. Slide 4-12 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Triangular Arbitrage The implied S(€/£) cross rate is S(€/£) = 1.5123 Paribas has posted a quote of S a (€/£)=1.5100 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ €1.5100; sell @ €1.5123 £ $ € Credit Lyonnais S ( € /$)=0.7720 BNP Paribas S ( € /£)=1.5100 Barclays S ($/£)=1.9589

15. Slide 4-13 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Triangular Arbitrage As easy as 1 – 2 – 3: 1. Sell our $ for €, 2. Sell our € for £, 3. Sell those £ for $. 1 2 3 £ $ € Credit Lyonnais S ( € /$)=0.7720 BNP Paribas S ( € /£)=1.5100 Barclays S ($/£)=1.9589

16. Slide 4-14 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Triangular arbitrage: traverse the 3 currencies Only 2 paths: clockwise, counter-clockwise Path must be feasible: product of the 3 assembled FX rates must be dimensionless E.G. feasible path (clockwise): ($/₤)(€/$)(₤/€) = (1.9589)(0.772)(1/1.51)=1.0015 >1 Arbitrage! E.G. feasible path (counter-clockwise): (€/₤)($/€)(₤/$)=(1.51)(1/0.772)(1/1.9589)= 0.998<1 Loss! E.G. infeasible path: ($/₤)(€/$)(€/₤) is nonsense!

17. Slide 4-15 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Triangular Arbitrage Sell $5,000,000 for € at S(€/$) = 0.7720 receive €3,860,000 Sell our €3,860,000 for £ at S(€/£) = 1.5100 receive £2,556,291 Sell £2,556,291 for $ at S($/£) = 1.9589 receive $5,007,519 profit per round trip = $7,519

18. Slide 4-16 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 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.

19. Slide 4-17 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 4.3The Forward Market Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

20. Slide 4-18 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. The forward exchange rate, F, is quoted now. Buy forward: sign a contract with bank now to buy the FX later at contractual rate F. Sell forward: sign a contract with bank now to sell the FX later at contractual rate F.

21. Slide 4-19 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. 1-month F different from 3-month F, etc.

22. Slide 4-20 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Forward Rate Quotations Consider the example from above: for British pound, the spot rate is $1.5627 = £1.00 While the 180-day forward rate is $1.5445 = £1.00 What’s up with that?

23. Slide 4-21 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Spot Rate Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months. 1.49751.51060.66780.6626 Months Forward 1.4888 1.502 0.67170.66583 Months Forward 1.4835 1.4968 0.67410.66811 Month Forward 1.4813 1.4943 0.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.6423 0.6437 1.55681.55353 Months Forward 0.6398 0.6412 1.56291.55961 Month Forward 0.6386 0.6399 1.5661.5627Britain (Pound) 3.4734 3.4025 0.28790.2939Brazil (Real) 1.6852 1.6932 0.59340.5906Australia (Dollar) 3.0377 3.0221 0.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry

24. Slide 4-22 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved 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 forex forward, you are short. If you have agreed to buy forex forward, you are long.

25. Slide 4-23 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Payoff Profile: Sell Forward 0 S 180 ($/¥) F 180 ($/¥) =.009524 Short position loss 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.

26. Slide 4-24 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Payoff Profile: Buy Forward loss 0 S 180 ($/¥) F 180 ($/¥) =.009524 profit The long in this forward contract agreed to BUY ¥ in 180 days at F 180 ($/¥) =.009524 Long position

27. Slide 4-25 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Anticipatory Hedging Rule Hedge means protection. Situation of transactions (or contractual) exposure. Whatever you will do in the future spot market you should do now in the forward mark. Hedge a future spot sale of JPYs by selling JPYs forward. You, exporter to Japan, will receive JPY in future and want to protect yourself. Hedge a future spot purchase of JPYs by buying JPYs forward. You, importer from Japan, will pay JPY in future and want to protect yourself.

28. Slide 4-26 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Forward Cross Exchange Rates It’s just an “delayed” example of the spot cross rate discussed above. In generic terms

29. Slide 4-27 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved SWAPS A swap is a compound transaction comprised of a spot transaction combined with a reversing forward transaction. E.g., Buy greenback (USD) spot and sell greenback forward. Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

30. Slide 4-28 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Jargon: Forward Premium or Discount Forward Premium: F > S 0. For example, S($/€) =.5235 to F 360 ($/€) =.5307. The euro exhibits a forward premium. The market expects the euro to appreciate over the next year. Forward Discount: F < S 0. For example, S(€/$) = 1.91 to F 360 (€/$) = 1.884. The $ exhibits a forward discount. The market expects the $ to depreciate over the year.

31. Slide 4-29 © 2008 McGraw-Hill Ryerson Ltd., All Rights Reserved Summary Foreign exchange markets: Allow the conversion of purchasing power from one currency to another; Enables banking and credit across currencies, foreign trade financing and trading in foreign currency futures and options; Trading in the spot market involves immediate purchase and sale of currencies; In the forward market, buyers and sellers can enter into agreements to buy or sell currencies at a future date and a forward price quoted now.