CHAPTER 7CHAPTER 7
THE FOREIGNTHE FOREIGN
EXCHANGEEXCHANGE
MARKETMARKET
CHAPTER OVERVIEWCHAPTER OVERVIEW
I.I. INTRODUCTIONINTRODUCTION
II.II. ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHA...
PART I. INTRODUCTIONPART I. INTRODUCTION
I.I. INTRODUCTIONINTRODUCTION
A.A. The Currency Market:The Currency Market:
where...
INTRODUCTIONINTRODUCTION
B. International Trade andB. International Trade and
Capital Transactions:Capital Transactions:
-...
INTRODUCTIONINTRODUCTION
C.C. LocationLocation
1.1. OTC-type: no specificOTC-type: no specific
locationlocation
2.2. Most ...
PART II.PART II.
ORGANIZATION OF THE FOREIGNORGANIZATION OF THE FOREIGN
EXCHANGE MARKETEXCHANGE MARKET
II .. PARTICIPANTS ...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. Two Types of CurrencyTwo Types ...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
2.2. Forward Market:Forward Market:
...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
C.C. Participants by MarketParticipa...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
2.2. Forward MarketForward Market
a....
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
II.II. CLEARING SYSTEMSCLEARING SYST...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. FedWireFedWire
- operated by th...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
III.III. ELECTRONIC TRADINGELECTRONI...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. Results:Results:
1.1. Reduces c...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
IV.IV. SIZE OF THE MARKETSIZE OF THE...
ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. Market Centers (1995):Market Ce...
PART III.PART III.
THE SPOT MARKETTHE SPOT MARKET
I.I. SPOT QUOTATIONSSPOT QUOTATIONS
A.A. SourcesSources
1.1. All major n...
THE SPOT MARKETTHE SPOT MARKET
B.B. Method of QuotationMethod of Quotation
1.1. For interbank dollarFor interbank dollar
t...
THE SPOT MARKETTHE SPOT MARKET
2.2. For nonbank customers:For nonbank customers:
Direct quoteDirect quote
gives the home c...
THE SPOT MARKETTHE SPOT MARKET
C.C. Transactions CostsTransactions Costs
1.1. Bid-Ask SpreadBid-Ask Spread
used to calcula...
THE SPOT MARKETTHE SPOT MARKET
4.4. Percent Spread Formula (PS):Percent Spread Formula (PS):
100x
Ask
BidAsk
PS
−
=
THE SPOT MARKETTHE SPOT MARKET
D.D. Cross RatesCross Rates
1.1. The exchange rateThe exchange rate
between 2 non - US$betw...
THE SPOT MARKETTHE SPOT MARKET
2.2. Calculating Cross RatesCalculating Cross Rates
When you want to knowWhen you want to k...
THE SPOT MARKETTHE SPOT MARKET
E.E. Currency ArbitrageCurrency Arbitrage
1.1. If cross rates differ fromIf cross rates dif...
THE SPOT MARKETTHE SPOT MARKET
2.2. Buy cheap in one int’l market,Buy cheap in one int’l market,
sell at a higher price in...
THE SPOT MARKETTHE SPOT MARKET
F.F. Settlement Date Value Date:Settlement Date Value Date:
1.1. Date monies are dueDate mo...
THE SPOT MARKETTHE SPOT MARKET
G.G. Exchange RiskExchange Risk
1.1. Bankers = middlemenBankers = middlemen
a.a. Incurring ...
THE SPOT MARKETTHE SPOT MARKET
1.)1.) Demand for higher riskDemand for higher risk
premiumpremium
2.)2.) Bankers widen bid...
MECHANICS OF SPOTMECHANICS OF SPOT
TRANSACTIONSTRANSACTIONS
SPOT TRANSACTIONS: AnSPOT TRANSACTIONS: An
ExampleExample
Step...
MECHANICS OF SPOTMECHANICS OF SPOT
TRANSACTIONSTRANSACTIONS
Step 2.Step 2. Bank sends importerBank sends importer
contract...
MECHANICS OF SPOTMECHANICS OF SPOT
TRANSACTIONSTRANSACTIONS
Step 3.Step 3. SettlementSettlement
Correspondent bank in Hong...
PART III.PART III.
THE FORWARD MARKETTHE FORWARD MARKET
I.I. INTRODUCTIONINTRODUCTION
A. Definition of a ForwardA. Definit...
THE FORWARD MARKETTHE FORWARD MARKET
2. Purpose of a Forward:2. Purpose of a Forward:
HedgingHedging
the act of reducing e...
THE FORWARD MARKETTHE FORWARD MARKET
B.B. Forward Rate QuotationsForward Rate Quotations
1.1. Two Methods:Two Methods:
a.a...
THE FORWARD MARKETTHE FORWARD MARKET
CALCULATING THE FORWARDCALCULATING THE FORWARD
PREMIUM OR DISCOUNTPREMIUM OR DISCOUNT...
THE FORWARD MARKETTHE FORWARD MARKET
C.C. Forward Contract MaturitiesForward Contract Maturities
1.1. Contract TermsContra...
PART IV.PART IV.
INTEREST RATE PARITY THEORYINTEREST RATE PARITY THEORY
I.I. INTRODUCTIONINTRODUCTION
A. The Theory states...
INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORY
2.2. The forward premium orThe forward premium or
discount equals th...
INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORY
3.3. In equilibrium, returns onIn equilibrium, returns on
currencies...
INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORY
B.B. Covered Interest ArbitrageCovered Interest Arbitrage
1. Conditi...
INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORY
3.3. Market pressures develop:Market pressures develop:
a.a. As one ...
INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORY
C.C. Summary:Summary:
Interest Rate Parity states:Interest Rate Pari...
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Forign exchange market

  1. 1. CHAPTER 7CHAPTER 7 THE FOREIGNTHE FOREIGN EXCHANGEEXCHANGE MARKETMARKET
  2. 2. CHAPTER OVERVIEWCHAPTER OVERVIEW I.I. INTRODUCTIONINTRODUCTION II.II. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGEFOREIGN EXCHANGE MARKETMARKET III.III. THE SPOT MARKETTHE SPOT MARKET IV.IV. THE FORWARD MARKETTHE FORWARD MARKET V.V. INTEREST RATE PARITYINTEREST RATE PARITY THEORYTHEORY
  3. 3. PART I. INTRODUCTIONPART I. INTRODUCTION I.I. INTRODUCTIONINTRODUCTION A.A. The Currency Market:The Currency Market: where moneywhere money denominated in onedenominated in one currency is bought andcurrency is bought and sold with moneysold with money denominated in anotherdenominated in another currency.currency.
  4. 4. INTRODUCTIONINTRODUCTION B. International Trade andB. International Trade and Capital Transactions:Capital Transactions: - facilitated with the ability- facilitated with the ability to transfer purchasing powerto transfer purchasing power between countriesbetween countries
  5. 5. INTRODUCTIONINTRODUCTION C.C. LocationLocation 1.1. OTC-type: no specificOTC-type: no specific locationlocation 2.2. Most trades by phone,Most trades by phone, telex, or SWIFTtelex, or SWIFT SWIFT:SWIFT: Society for WorldwideSociety for Worldwide Interbank FinancialInterbank Financial TelecommunicationsTelecommunications
  6. 6. PART II.PART II. ORGANIZATION OF THE FOREIGNORGANIZATION OF THE FOREIGN EXCHANGE MARKETEXCHANGE MARKET II .. PARTICIPANTS IN THEPARTICIPANTS IN THE FOREIGN EXCHANGEFOREIGN EXCHANGE MARKETMARKET A.A. Participants at 2 LevelsParticipants at 2 Levels 1.1. Wholesale Level (95%)Wholesale Level (95%) - major banks- major banks 2.2. Retail LevelRetail Level - business- business customers.customers.
  7. 7. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET B.B. Two Types of CurrencyTwo Types of Currency MarketsMarkets 1.1. Spot Market:Spot Market: - immediate transaction- immediate transaction - recorded by 2nd- recorded by 2nd business daybusiness day
  8. 8. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET 2.2. Forward Market:Forward Market: - transactions take place at a- transactions take place at a specified future datespecified future date
  9. 9. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET C.C. Participants by MarketParticipants by Market 1.1. Spot MarketSpot Market a.a. commercial bankscommercial banks b.b. brokersbrokers c.c. customers of commercialcustomers of commercial and central banksand central banks
  10. 10. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET 2.2. Forward MarketForward Market a.a. arbitrageursarbitrageurs b.b. traderstraders c.c. hedgershedgers d.d. speculatorsspeculators
  11. 11. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET II.II. CLEARING SYSTEMSCLEARING SYSTEMS A. Clearing House InterbankA. Clearing House Interbank Payments SystemPayments System (CHIPS)(CHIPS) - used in U.S. for electronic- used in U.S. for electronic fund transfers.fund transfers.
  12. 12. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET B.B. FedWireFedWire - operated by the Fed- operated by the Fed - used for domestic transfers- used for domestic transfers
  13. 13. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET III.III. ELECTRONIC TRADINGELECTRONIC TRADING A.A. Automated TradingAutomated Trading - genuine screen-based- genuine screen-based marketmarket
  14. 14. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET B.B. Results:Results: 1.1. Reduces cost of tradingReduces cost of trading 2.2. Threatens traders’Threatens traders’ oligopoly of informationoligopoly of information 3.3. Provides liquidityProvides liquidity
  15. 15. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET IV.IV. SIZE OF THE MARKETSIZE OF THE MARKET A.A. Largest in the worldLargest in the world 1995: $1.2 trillion daily1995: $1.2 trillion daily
  16. 16. ORGANIZATION OF THEORGANIZATION OF THE FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET B.B. Market Centers (1995):Market Centers (1995): London =London = $464 billion$464 billion dailydaily New York= $244 billionNew York= $244 billion dailydaily Tokyo = $161 billionTokyo = $161 billion dailydaily
  17. 17. PART III.PART III. THE SPOT MARKETTHE SPOT MARKET I.I. SPOT QUOTATIONSSPOT QUOTATIONS A.A. SourcesSources 1.1. All major newspapersAll major newspapers 2.2. Major currencies haveMajor currencies have four different quotes:four different quotes: a.a. spot pricespot price b.b. 30-day30-day c.c. 90-day90-day d.d. 180-day180-day
  18. 18. THE SPOT MARKETTHE SPOT MARKET B.B. Method of QuotationMethod of Quotation 1.1. For interbank dollarFor interbank dollar trades:trades: a.a. American termsAmerican terms example: $.5838/dmexample: $.5838/dm b.b. European termsEuropean terms example: dm1.713/$example: dm1.713/$
  19. 19. THE SPOT MARKETTHE SPOT MARKET 2.2. For nonbank customers:For nonbank customers: Direct quoteDirect quote gives the home currencygives the home currency price of one unit of foreignprice of one unit of foreign currency.currency. EXAMPLE:EXAMPLE: dm0.25/FFdm0.25/FF
  20. 20. THE SPOT MARKETTHE SPOT MARKET C.C. Transactions CostsTransactions Costs 1.1. Bid-Ask SpreadBid-Ask Spread used to calculate the feeused to calculate the fee charged by the bankcharged by the bank Bid = the price at whichBid = the price at which the bank is willing to buythe bank is willing to buy Ask = the price it will sellAsk = the price it will sell the currencythe currency
  21. 21. THE SPOT MARKETTHE SPOT MARKET 4.4. Percent Spread Formula (PS):Percent Spread Formula (PS): 100x Ask BidAsk PS − =
  22. 22. THE SPOT MARKETTHE SPOT MARKET D.D. Cross RatesCross Rates 1.1. The exchange rateThe exchange rate between 2 non - US$between 2 non - US$ currencies.currencies.
  23. 23. THE SPOT MARKETTHE SPOT MARKET 2.2. Calculating Cross RatesCalculating Cross Rates When you want to knowWhen you want to know what the dm/what the dm/ cross ratecross rate is, and you knowis, and you know dm2/US$ anddm2/US$ and .55/US$.55/US$ then dm/then dm/ = dm2/US$= dm2/US$ ÷÷ .55/US$.55/US$ = dm3.636/= dm3.636/ 
  24. 24. THE SPOT MARKETTHE SPOT MARKET E.E. Currency ArbitrageCurrency Arbitrage 1.1. If cross rates differ fromIf cross rates differ from one financial center toone financial center to another, and profitanother, and profit opportunities exist.opportunities exist.
  25. 25. THE SPOT MARKETTHE SPOT MARKET 2.2. Buy cheap in one int’l market,Buy cheap in one int’l market, sell at a higher price insell at a higher price in anotheranother 3.3. Role of Available InformationRole of Available Information
  26. 26. THE SPOT MARKETTHE SPOT MARKET F.F. Settlement Date Value Date:Settlement Date Value Date: 1.1. Date monies are dueDate monies are due 2.2. 2nd Working day after date of2nd Working day after date of original transaction.original transaction.
  27. 27. THE SPOT MARKETTHE SPOT MARKET G.G. Exchange RiskExchange Risk 1.1. Bankers = middlemenBankers = middlemen a.a. Incurring risk of adverseIncurring risk of adverse exchange rate moves.exchange rate moves. b.b. Increased uncertaintyIncreased uncertainty about future exchangeabout future exchange rate requiresrate requires
  28. 28. THE SPOT MARKETTHE SPOT MARKET 1.)1.) Demand for higher riskDemand for higher risk premiumpremium 2.)2.) Bankers widen bid-askBankers widen bid-ask spreadspread
  29. 29. MECHANICS OF SPOTMECHANICS OF SPOT TRANSACTIONSTRANSACTIONS SPOT TRANSACTIONS: AnSPOT TRANSACTIONS: An ExampleExample Step 1.Step 1. Currency transaction:Currency transaction: verbal agreement, U.S.verbal agreement, U.S. importer specifies:importer specifies: a. Account to debit (his acct)a. Account to debit (his acct) b. Account to creditb. Account to credit (exporter)(exporter)
  30. 30. MECHANICS OF SPOTMECHANICS OF SPOT TRANSACTIONSTRANSACTIONS Step 2.Step 2. Bank sends importerBank sends importer contract note including:contract note including: - amount of foreign- amount of foreign currencycurrency - agreed exchange rate- agreed exchange rate - confirmation of Step 1.- confirmation of Step 1.
  31. 31. MECHANICS OF SPOTMECHANICS OF SPOT TRANSACTIONSTRANSACTIONS Step 3.Step 3. SettlementSettlement Correspondent bank in HongCorrespondent bank in Hong Kong transfers HK$ fromKong transfers HK$ from nostro account to exporter’s.nostro account to exporter’s. Value Date.Value Date. U.S. bank debits importer’sU.S. bank debits importer’s account.account.
  32. 32. PART III.PART III. THE FORWARD MARKETTHE FORWARD MARKET I.I. INTRODUCTIONINTRODUCTION A. Definition of a ForwardA. Definition of a Forward ContractContract an agreement between a bank andan agreement between a bank and a customer to deliver a specifieda customer to deliver a specified amount of currency againstamount of currency against another currency at a specifiedanother currency at a specified future date and at a fixed exchangefuture date and at a fixed exchange rate.rate.
  33. 33. THE FORWARD MARKETTHE FORWARD MARKET 2. Purpose of a Forward:2. Purpose of a Forward: HedgingHedging the act of reducing exchangethe act of reducing exchange rate risk.rate risk.
  34. 34. THE FORWARD MARKETTHE FORWARD MARKET B.B. Forward Rate QuotationsForward Rate Quotations 1.1. Two Methods:Two Methods: a.a. Outright Rate:Outright Rate: quoted toquoted to commercial customers.commercial customers. b.b. Swap Rate:Swap Rate: quoted in thequoted in the interbank market as ainterbank market as a discount or premium.discount or premium.
  35. 35. THE FORWARD MARKETTHE FORWARD MARKET CALCULATING THE FORWARDCALCULATING THE FORWARD PREMIUM OR DISCOUNTPREMIUM OR DISCOUNT == F-SF-S xx 1212 x 100x 100 SS nn where F = the forward rate of exchangewhere F = the forward rate of exchange S = the spot rate of exchangeS = the spot rate of exchange n = the number of months in then = the number of months in the forward contractforward contract
  36. 36. THE FORWARD MARKETTHE FORWARD MARKET C.C. Forward Contract MaturitiesForward Contract Maturities 1.1. Contract TermsContract Terms a.a. 30-day30-day b.b. 90-day90-day c.c. 180-day180-day d.d. 360-day360-day 2.2. Longer-term ContractsLonger-term Contracts
  37. 37. PART IV.PART IV. INTEREST RATE PARITY THEORYINTEREST RATE PARITY THEORY I.I. INTRODUCTIONINTRODUCTION A. The Theory states:A. The Theory states: the forward rate (F) differsthe forward rate (F) differs from the spot rate (S) atfrom the spot rate (S) at equilibrium by an amountequilibrium by an amount equal to the interestequal to the interest differential (rdifferential (rhh - r- rff) between) between two countries.two countries.
  38. 38. INTEREST RATE PARITYINTEREST RATE PARITY THEORYTHEORY 2.2. The forward premium orThe forward premium or discount equals the interestdiscount equals the interest rate differential.rate differential. (F - S)/S = (r(F - S)/S = (rhh - r- rff)) wherewhere rrhh = the home rate= the home rate rrff = the foreign rate= the foreign rate
  39. 39. INTEREST RATE PARITYINTEREST RATE PARITY THEORYTHEORY 3.3. In equilibrium, returns onIn equilibrium, returns on currencies will be the samecurrencies will be the same i. e. No profit will be realizedi. e. No profit will be realized and interest parity existsand interest parity exists which can be writtenwhich can be written (1 + r(1 + rhh)) == FF (1 + r(1 + rff) S) S
  40. 40. INTEREST RATE PARITYINTEREST RATE PARITY THEORYTHEORY B.B. Covered Interest ArbitrageCovered Interest Arbitrage 1. Conditions required:1. Conditions required: interest rate differential doesinterest rate differential does not equal the forwardnot equal the forward premium or discount.premium or discount. 2.2. Funds will move to a countryFunds will move to a country with a more attractive rate.with a more attractive rate.
  41. 41. INTEREST RATE PARITYINTEREST RATE PARITY THEORYTHEORY 3.3. Market pressures develop:Market pressures develop: a.a. As one currency is moreAs one currency is more demanded spot and solddemanded spot and sold forward.forward. b. Inflow of fund depressesb. Inflow of fund depresses interest rates.interest rates.
  42. 42. INTEREST RATE PARITYINTEREST RATE PARITY THEORYTHEORY C.C. Summary:Summary: Interest Rate Parity states:Interest Rate Parity states: 1.1. Higher interest rates on aHigher interest rates on a currency offset bycurrency offset by forwardforward discounts.discounts. 2.2. Lower interest rates areLower interest rates are offset by forwardoffset by forward premiums.premiums.

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