1. Definition and Organization of theForeign Exchange Markets• foreign exchange markets are markets on whichindividuals, firms and banks buy and sell foreigncurrencies:– foreign exchange trading occurs with the help of thetelecommunication net between buyers and sellers offoreign exchange that are located all over the world– a single international foreign exchange market forevery single currency– foreign exchange trading takes place at least in someof the world financial centers in every moment
The Currency MarketWhere money denominated in one currency isbought and sold with money denominated inanother currency.International Trade and Capital Transactions:• facilitated with the ability to transferpurchasing power between countries.
Location1. OTC-type: no specific location2. Most trades by phone, telex, or SWIFTSWIFT: Society for Worldwide InterbankFinancial Telecommunications
Participants in the foreign exchangemarketParticipants at 2 Levels1. Wholesale Level (95%) - major banks2. Retail Level (business customers)Two Types of Currency Markets1. Spot Market:- immediate transaction- recorded by 2nd business day2. Forward Market:- transactions take place at a specified future date
Participants by Market• Spot Marketa. commercial banksb. Brokersc. customers of commercial and central banks• Forward Marketa. arbitrageursb. tradersc. hedgersd. speculators
CLEARING SYSTEMSA. Clearing House Interbank Payments System(CHIPS)- used in U.S. for electronic fund transfers.B.FedWire- operated by the Fed- used for domestic transfers
ELECTRONIC TRADINGA. Automated Trading- genuine screen-based marketB.Results:1. Reduces cost of trading2. Threatens traders’ oligopoly of information3. Provides liquidity
2. Foreign Exchange Market FunctionsClearing of Currencies and Provision of Credit• Clearing of currencies:– service of exchanging one currency for another• Provision of Credit:– trader that bought a certain good from themanufacturer, needs time to sell this good to thefinal customer and to pay the manufacturer withthe money he received from the customer
Foreign Exchange Market and InsuranceAgainst Foreign Exchange Risk–activities with which the foreign exchangemarket participants avoid exchange rate riskor activities with which they are closingtheir open foreign exchange position–closed foreign exchange position:• size of the assets in a certain currency is equalto the size of the liabilities in the same currency• full insurance against exchange rate risk withrespect to this currency
Foreign Exchange Market and InsuranceAgainst Foreign Exchange Risk– open foreign exchange position:• long: net assets in a certain currency• short: net liabilities in a certain currency– in the spot or forward foreign exchange market– standardized forward contracts and options
Foreign Exchange Markets and ConsciousForeign Exchange Risk Acceptance• activities in which economic agentsconsciously open their foreign exchangepositions – long or short – hoping to getprofits in all foreign exchange marketsegments
3. Foreign Exchange Market ParticipantsEconomic Agents and Types of Activities on ForeignExchange MarketsClient buys $with €Local bankMain banks’interbank marketLocal bankClient buys €with $Purchases and salesof big multinationalcompaniesBrokers
Economic Agents and Types of Activitieson Foreign Exchange Markets• bank clients (individuals, firms, non-bankingfinancial institutions):– all those groups of legal and physical persons thatneed foreign currency in doing their commercialor investment business• commercial banks:the most important group of foreign exchangemarket participantsthey buy and sell foreign currencies for theirclients and trade for themselves
• brokers:– agents that connects dealers interested inbuying and selling foreign exchange, but doesnot become an active client in the transaction– they provide their client, the bank, with theinformation about the exchange rates at whichbanks are willing to buy or sell a particularcurrencyEconomic Agents and Types of Activitieson Foreign Exchange Markets
• central banks:foreign exchange market interventions are meantto influence the exchange rate of the domesticcurrency in a way that is beneficial for thedomestic economy and, consequently, for thecountryit does not necessarily have a profit, it can alsohave a lossEconomic Agents and Types of Activitieson Foreign Exchange Markets
Economic Agents and Motivation for theForeign Exchange Market Participation• arbitragers:–they want to earn a profit without takingany kind of risk (usually commercial banks):• try to profit from simultaneous exchange ratedifferences in different markets• making use of the interest rate differences thatexist in national financial markets of twocountries along with transactions on spot andforward foreign exchange market at the sametime (covered interest parity)
Economic Agents and Motivation for theForeign Exchange Market Participation• hedgers and speculators:hedgers do not want to take risk whileparticipating in the market, they want to insurethemselves against the exchange rate changesspeculators think they know what the futureexchange rate of a particular currency will be, andthey are willing to accept exchange rate risk withthe goal of making profitevery foreign exchange market participant canbehave either as a hedger or as a speculator in thecontext of a particular transaction
4. Size and Structure of ForeignExchange Market Transactions• the biggest share of all financial markets in the world
5. Types of Foreign Exchange MarketTransactions Spot Foreign ExchangeTransactions• almost immediate delivery of foreignexchangeOutright Forward Transactions buyer and seller establish the exchange rate at the time ofthe agreement, payment and delivery are not required untilmaturity forward exchange rates: 1, 3, 6, 9 months, one year
Swap Transactions• simultaneous purchase and sale of a givenamount of foreign exchange for two differentvalue dates:– “spot against forward” swaps:
Hedging• the act of reducing exchange rate riskForward Rate QuotationsTwo Methods:a) Outright Rate: quoted tocommercial customers.b) Swap Rate: quoted in the interbankmarket as a discount or premium.
Futures positions• Futures are similar to forwards• First, futures positions require a margin deposit to beposted and maintained daily.• If a loss is taken on the contract, the amount is debitedfrom the margin account after the close of trading.• In other words, these futures are cash settled and nounderlying instruments or principals are exchanged.• Secondly, all contract specifications such as expirationtime, face amount, and margins are determined by theexchange instead of by the individual trading parties.
Futures• basic characteristics of futures:– the amount of the currency that is being traded– type of currency quotation– contract expiration– last day of trading with the contract– settlement day– margin requirements• information about futures trading• futures usage:– arbitrage between outright forward contract andfutures– rarely used as an insurance instrument (rigidity!)
• similarities and differences between outright forwardcontract and futures:– both need to be executed unconditionally– they are usually established for at most one yearCharacteristic Futures Outright Forward ContractSize of the contracts standardized for a given currency depends on the individual needs of theclientLocation and tradeactivityat the stock exchange or at a givenlocation; actively traded in anorganized marketwith the provision of agents, connectedamong each other with the help oftelecommunications; not traded in anorganized marketDuration of thecontractstandardized, but at most a year depends on the individual needs of theclient , but not more than a yearContract has to beexecutedyes yesInsurance andSecurity of doingBusiness with theInstrumentinsurance explicitly required (marginrequirements); high security of doingbusiness with the instrumentinsurance not required explicitly(implicit insurance are affiliations oftwo partners up till now); lowersecurity than futuresTrade regulation regulated with the stock exchangerulesregulation not explicitly determined
Options• Options are a way of buying or selling a currencyat a certain point in the future.• An option is a contract which specifies the priceat which an amount of currency can be bought ata date in the future called the expiration date.• Unlike forwards and futures, the owner of anoption does not have to go through with thetransaction if he or she does not wish to do so.
Types of options• The buyer of a call has the right but not the obligation to buy theunderlying asset at the strike price on or before a specified date inthe future.• However, the seller has a potential obligation to sell the underlyingasset at the strike price on or before a specified date in the future ifthe holder of the option exercises his or her right.• The buyer of a put has the right but not the obligation to sell theunderlying asset at the strike price on or before a specified date inthe future.• On the other hand, the seller of a put has a potential obligation tobuy the underlying asset at the strike price on or before a specifieddate in the future if the holder of the option exercises his/her right.
Options• basic characteristics of options:– financial instrument that gives the buyer theright, but not the obligation, to buy or sell astandardized amount of a foreign currency, thatis traded, at a fixed price at a particular time, oruntil a particular time in the future– call option and put option– American and European options– three different prices:• exercise/strike price• cost, price or value of the option• underlying or actual spot exchange rate
Options• types of options trading:– in organized markets:• standardized contracts with given strike prices,standardized durations (1, 3, 6, 9, 12 months) andexpirations• only certain currencies, contract amounts arestandardized– over-the-counter trading:• expiration date, strike price and contract amountdepend on the individual needs of the client• counterparty risk!• retail and interbank market
• Usage of options:– when the economic agent expects that theexchange rate trend of a particular currencycould change drastically– when the economic agent does not know forsure that a certain foreign exchange flow willoccur in the future– advantages:• fixed option costs• options do not need to be executedOptions
6. Quotations of Currencies on ForeignExchange Markets• quotation of a currency tells us at what price is afinancial mediator willing to buy or sell a certaincurrencyCurrency Quotations in Spot Foreign ExchangeMarkets European and American quotation direct and indirect quotation (which currency is regardedas a domestic/basis currency)
Forward Contract• an agreement between a bank and a customerto deliver a specified amount of currencyagainst another currency at a specified futuredate and at a fixed exchange rate.