CHAPTER OVERVIEWI. INTRODUCTIONII. ORGANIZATION OF THE FOREIGN EXCHANGE MARKETIII. THE SPOT MARKETIV. THE FORWARD MARKETV. INTEREST RATE PARITY THEORY
PART I. INTRODUCTIONI. INTRODUCTION A. The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency.
INTRODUCTIONB. International Trade and Capital Transactions: - facilitated with the ability to transfer purchasing power between countries
INTRODUCTIONC. Location 1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications
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.
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day
ORGANIZATION OF THEFOREIGN EXCHANGE MARKET2. Forward Market: - transactions take place at a specified future date
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETC. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks
ORGANIZATION OF THEFOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETII. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. FedWire - operated by the Fed - used for domestic transfers
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETIII. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETIV. SIZE OF THE MARKET A. Largest in the world 1995: $1.2 trillion daily
ORGANIZATION OF THEFOREIGN EXCHANGE MARKETB. Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily
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
THE SPOT MARKETB. Method of Quotation 1. For interbank dollar trades: a. American terms example: $.5838/dm b. European terms example: dm1.713/$
THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. EXAMPLE: dm0.25/FF
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
THE SPOT MARKET4. Percent Spread Formula (PS): Ask − Bid PS = x100 Ask
THE SPOT MARKETD. Cross Rates 1. The exchange rate between 2 non - US$ currencies.
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/
THE SPOT MARKETE. Currency Arbitrage 1. If cross rates differ from one financial center to another, and profit opportunities exist.
THE SPOT MARKET2. Buy cheap in one int’l market, sell at a higher price in another3. Role of Available Information
THE SPOT MARKETF. Settlement Date Value Date: 1. Date monies are due 2. 2nd Working day after date of original transaction.
THE SPOT MARKETG. Exchange Risk 1. Bankers = middlemen a. Incurring risk of adverse exchange rate moves. b. Increased uncertainty about future exchange rate requires
THE SPOT MARKET 1.) Demand for higher risk premium 2.) Bankers widen bid-ask spread
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)
MECHANICS OF SPOTTRANSACTIONS Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1.
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.
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.
THE FORWARD MARKET2. Purpose of a Forward: Hedging the act of reducing exchange rate risk.
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.
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
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
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.
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
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
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.
INTEREST RATE PARITYTHEORY3. Market pressures develop: a. As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates.
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.