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Ch07 2
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Ch07 2


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  • 3. PART I. INTRODUCTIONI. INTRODUCTION A. The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency.
  • 4. INTRODUCTIONB. International Trade and Capital Transactions: - facilitated with the ability to transfer purchasing power between countries
  • 5. INTRODUCTIONC. Location 1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications
  • 6. PART II.ORGANIZATION OF THE FOREIGNEXCHANGE MARKET I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET A. Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level - business customers.
  • 7. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day
  • 8. ORGANIZATION OF THEFOREIGN EXCHANGE MARKET2. Forward Market: - transactions take place at a specified future date
  • 9. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETC. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks
  • 10. ORGANIZATION OF THEFOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators
  • 11. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETII. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.
  • 12. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. FedWire - operated by the Fed - used for domestic transfers
  • 13. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETIII. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market
  • 14. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity
  • 15. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETIV. SIZE OF THE MARKET A. Largest in the world 1995: $1.2 trillion daily
  • 16. ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily
  • 17. PART III.THE SPOT MARKETI. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes: a. spot price b. 30-day c. 90-day d. 180-day
  • 18. THE SPOT MARKETB. Method of Quotation 1. For interbank dollar trades: a. American terms example: $.5838/dm b. European terms example: dm1.713/$
  • 19. THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. EXAMPLE: dm0.25/FF
  • 20. THE SPOT MARKETC. Transactions Costs 1. Bid-Ask Spread used to calculate the fee charged by the bank Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency
  • 21. THE SPOT MARKET4. Percent Spread Formula (PS): Ask − Bid PS = x100 Ask
  • 22. THE SPOT MARKETD. Cross Rates 1. The exchange rate between 2 non - US$ currencies.
  • 23. THE SPOT MARKET2. Calculating Cross Rates When you want to know what the dm/ cross rate is, and you know dm2/US$ and .55/US$ then dm/ = dm2/US$ ÷ .55/US$ = dm3.636/ 
  • 24. THE SPOT MARKETE. Currency Arbitrage 1. If cross rates differ from one financial center to another, and profit opportunities exist.
  • 25. THE SPOT MARKET2. Buy cheap in one int’l market, sell at a higher price in another3. Role of Available Information
  • 26. THE SPOT MARKETF. Settlement Date Value Date: 1. Date monies are due 2. 2nd Working day after date of original transaction.
  • 27. THE SPOT MARKETG. Exchange Risk 1. Bankers = middlemen a. Incurring risk of adverse exchange rate moves. b. Increased uncertainty about future exchange rate requires
  • 28. THE SPOT MARKET 1.) Demand for higher risk premium 2.) Bankers widen bid-ask spread
  • 29. MECHANICS OF SPOTTRANSACTIONSSPOT TRANSACTIONS: An ExampleStep 1. Currency transaction: verbal agreement, U.S. importer specifies: a. Account to debit (his acct) b. Account to credit (exporter)
  • 30. MECHANICS OF SPOTTRANSACTIONS Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1.
  • 31. MECHANICS OF SPOTTRANSACTIONSStep 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date. U.S. bank debits importer’s account.
  • 32. PART III.THE FORWARD MARKETI. INTRODUCTION A. Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.
  • 33. THE FORWARD MARKET2. Purpose of a Forward: Hedging the act of reducing exchange rate risk.
  • 34. THE FORWARD MARKETB. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market as a discount or premium.
  • 35. THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract
  • 36. THE FORWARD MARKET C. Forward Contract Maturities 1. Contract Terms a. 30-day b. 90-day c. 180-day d. 360-day 2. Longer-term Contracts
  • 37. PART IV.INTEREST RATE PARITY THEORYI. INTRODUCTION A. The Theory states: the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.
  • 38. INTEREST RATE PARITYTHEORY2. The forward premium or discount equals the interest rate differential. (F - S)/S = (rh - rf) where rh = the home rate rf = the foreign rate
  • 39. INTEREST RATE PARITYTHEORY3. In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S
  • 40. INTEREST RATE PARITYTHEORYB. Covered Interest Arbitrage 1. Conditions required: interest rate differential does not equal the forward premium or discount. 2. Funds will move to a country with a more attractive rate.
  • 41. INTEREST RATE PARITYTHEORY3. Market pressures develop: a. As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates.
  • 42. INTEREST RATE PARITYTHEORYC. Summary: Interest Rate Parity states: 1. Higher interest rates on a currency offset by forward discounts. 2. Lower interest rates are offset by forward premiums.