2. International Finance FINA 5331 Lecture 5: Balance of Payments concluded. The market for foreign exchange Read: Chapters 5 Aaron Smallwood Ph.D.

3. Official reserves The official settlements balance, sometimes referred to as the overall balance, is the total balance on the current account plus the balance on all NON- OFFICIAL reserve transactions. It must be exactly offset by the balance on official reserves transactions

4. Official reserves When a country buys foreign reserves (for example, if the People’s Bank of China acquires dollars): –China’s assets increase: Debit entries in official reserves (a deficit) –Offset by an official settlements surplus If a country must sell official reserves (Thailand in 1997 because of speculative attacks): –The country’s reserve assets decrease: Credit entries in official reserves (a surplus) –Offset by an official settlements deficit.

5. Foreign Exchange Market Products and Activities A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

6. Foreign Exchange Market Products and Activities Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery. Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

7. Foreign Exchange Market Products and Activities Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation. Arbitrage is the simultaneous, or nearly simultaneous, purchase of securities in one market for sale in another market with the expectation of a risk-free profit.

8. FX Players Broadly speaking the FX market consists of 5 groups –International banks –Bank customers –Non-bank dealers Include investment banks, mutual funds, and hedge funds. –FX brokers –Central banks

9. The Market for Foreign Exchange The FOREX market is the largest market in the world. According to the BIS, in 2010, daily turnover in April in FOREX market hit almost $4 TRILLION dollars.

10. Table 1 Global foreign exchange market turnover by instrument1 Average daily turnover in April, in billions of US dollars Instrument19982001200420072010 Foreign exchange instruments1,5271,2391,9343,3243,981 Spot transactions²5683866311,0051,490 Outright forwards²128130209362475 Foreign exchange swaps²7346569541,7141,765 Currency swaps107213143 Options and other products³8760119212207 Memo: Turnover at April 2010 exchange rates Exchange-traded derivatives 5 4 1,705 111,505 122,040 263,370 803,981 166 1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 Previously classified as part of the so-called "Traditional FX market". 3 The category "other FX products" covers highly leveraged transactions and/or trades whose notional amount is variable and where a decomposition into individual plain vanilla components was impractical or impossible. 4 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2010 exchange rates. 5 Sources: FOW TRADEdata; Futures Industry Association; various futures and options exchanges. Reported monthly data were converted into daily averages of 20.5 days in 1998, 19.5 days in 2001, 20.5 in 2004, 20 in 2007 and 20 in 2010.

11. Daily Trading Volumes by Hour

12. Spot Exchange Rates

13. Spot Rate Quotations Indirect quotation –the price of a U.S. dollar in the foreign currency –e.g. the yuan price of the dollar = RMB 6.5605 on March 24. Direct Quotation –the price of a unit of foreign currency: given by 1/Indirect Quotation –e.g. $/Euro = 1/0.7055=$1.4174

14. The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. The ask 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.

15. Example: If the bid ask spread for RMB is: –$0.1600 -$0.1610: –How many RMB do we receive if we sell $10,000? $10,000/0.1610 = 6,211.18. –What is we wanted to sell RMB 10,000? RMB10,000 *.1600 = $1,600.

16. Cross Rates Suppose that S($/€) =.50 – i.e. $1 = 2 € and that S(¥/€) = 50 – i.e. €1 = ¥50 What must the $/¥ cross rate be?

17. Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

18. Triangular Arbitrage Barclays S(¥/$)=120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars. $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 ¥ £

19. Triangular Arbitrage Barclays S(¥/$)=120 As easy as 1 – 2 – 3: 1. Sell $ for £, 2. Sell £ for ¥, 3. Sell ¥ for $. $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 ¥ £ 1 2 3 $

20. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250

21. Cross Currency Exchange Rates with Bid- Ask Spreads Consider the example on page 122 –Suppose, relative to the US $, we are given the bid ask spread in the market for pounds (e.g. $/£). What then is the bid ask spread in the market for $? Bid price is the inverse of the ask price. If bid-ask spread in the market for pounds is: $1.9712-17, the bid price in the market for $= –Can show that the ask price is 0.5073

22. Triangular Arbitrage Previous triangular arbitrage is unrealistic since traders face no transactions costs. We want to consider examples with bid-ask spreads. See example on pages 122-123, with the following quotes: –Market for pounds: $1.9712-17 –Market for euros: $1.4739-44 –Market for pounds: €1.3305-10 Implied price in the third market is 1.3370-77. POUND UNDERVALED!

23. Exploit the arbitrage opportunity Suppose we start with $1,000,000 First, we need to get euros so we can buy pounds in the 3 rd market. –Start by selling dollars for euros: We receive: $1,000,000/1.4744 = €678,242.00 –Sell euros for pounds: We receive: €678,242.00/1.3310 = £509,573.25 –Finally, sell pounds for dollars We receive: £509,573.25*1.9712 = $1,004,470.79 PROFIT: $4,470.79.