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Foreign Exchange Market

Reading: Chapter 6
Lecture Outline
 Describe the FX market
 Identify participants and currencies
 Understand spot and forward rates
 Calculate & use cross and forward rates
 Triangular arbitrage
 Changes in exchange rates

2
Functions of FX Market
The foreign exchange market is the mechanism by
which participants:
– transfer purchasing power between countries;
– obtain or provide credit for international trade
transactions, and
– minimize exposure to the risks of exchange rate
changes.

3
Characteristics of FX Market
 Largest of all financial markets with average daily
turnover of over $2 trillion!
 66% of all foreign exchange transactions involve
cross-border counterparties.
 Only ≈11% of daily spot transactions involve nonfinancial customers.
 London is the largest FX market.
 US dollar involved in 87% of all transactions.

4
Market Activity – 24hrs

5
Increasing Turnover

Daily foreign exchange market turnover in billions of US
dollars
(Bank for International Settlements Triennial Central Bank Survey 2004)

6
Important Currencies

7
Types of Transactions
A Spot transaction in the interbank market
is the purchase of foreign exchange, with
delivery and payment between banks to
take place, normally, on the second
following business day.
The date of settlement is referred to as the
value date.

8
Types of Transactions
 An outright forward transaction (usually called just
“forward”) requires delivery at a future value date of a
specified amount of one currency for a specified amount of
another currency.
 The exchange rate is established at the time of the
agreement, but payment and delivery are not required until
maturity.
 Forward exchange rates are usually quoted for value dates of
one, two, three, six and twelve months.
 Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which
currencies are referenced.)

9
Types of Transactions
 A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates.
 Both purchase and sale are conducted with the
same counterparty.
 Some different types of swaps are:
– spot against forward,
– forward-forward,
– nondeliverable forwards (NDF).
10
Types of Transactions

11
Market Participants
 The foreign exchange market consists of two tiers:
– the interbank or wholesale market (multiples of $1M US or
equivalent in transaction size), and
– the client or retail market (specific, smaller amounts).

 Five broad categories of participants operate within
these two tiers: bank and nonbank foreign exchange
dealers, individuals and firms, speculators and
arbitragers, central banks and treasuries, and foreign
exchange brokers.
12
Market Participants
 Banks and a few nonbank foreign exchange dealers
operate in both the interbank and client markets.
 They profit from buying foreign exchange at a “bid”
price and reselling it at a slightly higher “offer” or
“ask” price.
 Dealers in the foreign exchange department of large
international banks often function as “market makers.”
 These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an “inventory” position in those currencies.
13
Market Participants
 Individuals (such as tourists) and firms (such as
importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
market.
 Their use of the foreign exchange market is necessary
but nevertheless incidental to their underlying
commercial or investment purpose.
 Some of the participants use the market to “hedge”
their foreign exchange risk.
14
Market Participants
 Speculators and arbitragers seek to profit from
trading in the market itself.
 They operate in their own interest, without a need
or obligation to serve clients or ensure a
continuous market.
 While dealers seek the bid/ask spread, speculators
seek all the profit from exchange rate changes and
arbitragers try to profit from simultaneous
exchange rate differences in different markets.
15
Market Participants
 Central banks and treasuries use the market to acquire or
spend their country’s foreign exchange reserves as well as
to influence the price at which their own currency is traded.
 They may act to support the value of their own currency
because of policies adopted at the national level or because
of commitments entered into through membership in joint
agreements such as the European Monetary System.
 The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
 As willing loss takers, central banks and treasuries differ in
motive from all other market participants.

16
Types of Activities
 Speculation
 An activity that leaves one open to exchange rate
fluctuations where one aims to make a profit.

 Hedging
 Allows the firm to transfer exchange rate risk inherent in
foreign currency transactions or positions.

 Arbitrage – take advantage of inconsistent prices to
make risk-free profits. These profits are unlikely to last
long.
 Spatial (or Locational) Arbitrage
 Triangular Arbitrage
 Covered Interest Arbitrage – Lecture 3
17
Foreign Exchange Rates & Quotations
 A foreign exchange rate is the price of one currency
expressed in terms of another currency.
 A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.

 http://finance.yahoo.com/currency
18
Bid & Ask Quotes
 Foreign currency dealers provide two quotes:
Bid Price: Price at which the dealer is willing to buy
foreign currency from you.
Ask Price: Price at which the dealer is willing to sell
foreign currency to you.
 It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread.
 The less traded and more volatile a currency, the greater
is the spread.
19
Direct & Indirect Quotes
 Direct Quote: Home currency per unit of Foreign currency
(FC) - e.g. AUD/€ quote is 1.6003 – 1.6499
 Indirect Quote: Foreign currency per unit of Home currency
- e.g. €/AUD quote of 0.6061 – 0.6249
 Note that in all cases, the reciprocal of a direct quote is an
indirect quote:
AUD
1
=
EUR
EUR
AUD

 Also, you might encounter an exchange rate quotation in
American terms (US$/FC) or European terms (FC/US$).
20
Example
Bid
$/£

Ask

1.4482

1.4484

Bid: Dealer buys £ for $ at the Bid, Client
sells £ for $ (i.e., dealer will buy £1,000,000
for $1,448,200).
Ask: Dealer sells £ for $ at the Ask, Client
buys £ with $ (i.e., dealer will sell £1,000,000
for $1,448,400).
21
Bid – Ask Spread
 Banks act as market makers and realise their profits
from the spread:
Bid-Ask Spread = (Ask-Bid)/Ask

 Consider the DIRECT quote of $ 1.4482 – 1.4484/£

(1.4484 − 1.4482) × 100 = 1.38%
% spread =
1.4484

22
Forward Quotes
 Forward rates can be quoted as either as an outright quote,
points or as an annualised % forward premium or discount.

23
Forward Quotes – Points
 A forward quotation expressed in points is not a foreign
exchange rate as such. It is the difference between the
forward rate and the spot rate.
 When the Bid Points > Ask Points, you subtract the
points from the spot rate to get the outright forward
quote.
 If the Bid Points < Ask Points, you add the points to
the spot rate to get the outright forward quote

24
Forward Quotes – Percentage
 For quotations expressed in foreign currency terms
(Indirect quotations) the formula becomes:
f ¥ = Spot – Forward 360
x n x 100
Forward

 For quotations expressed in home currency terms
(Direct quotations) the formula becomes:
f ¥ = Forward – Spot 360
x n x 100
Spot

25
Cross Rates
 Many currency pairs are inactively traded, so their exchange
rate is determined through their relationship to a widely
traded third currency.
 For example, an Australian importer needs Danish currency
to pay for purchases in Copenhagen.
 The Australian dollar (symbol A$) is not widely quoted
against the Danish kroner (symbol DKr).
 However, both currencies are quoted against the U.S. dollar.
Assume the following quotes:
Australian dollar
Danish kroner

A$1.5431/US$
DKr7.0575/US$

26
Cross Rates
 The Australian importer can buy one U.S. dollar
for A$1.5431 and with that dollar buy
DKr7.0575. The cross-rate calculation would
be:
Australian dollar/U.S. dollar A$1.5431/US$
=
= 0.2186 A$/DKr
Danish kroner/U.S. dollar
DKr7.0575/US$

 However, calculating cross-rates is usually
not as easy as this!

27
Cross Rates – Example
We have the following rates:
US$1.4419 – 36 / GBP
US$0.6250 – 67 / CHF
Calculate the CHF / GBP rate!
= CHF 2.3008 – 98 / GBP.
28
Cross Rates – Example
First: How do I get CHF/GBP from the two rates?
CHF/GBP = (US$/GBP)/(US$/CHF)
Second: Bid = go from bottom (GBP) to top (CHF) (use
GBP to buy US$, then US$ to buy CHF)
Third: Ask = go from top (CHF) to bottom (GBP) (use CHF
to buy US$, then US$ to buy GBP)
Fourth: Apply rule from part one to currency rate pairs.
Therefore, CHF 2.3008 – 98 / GBP.
29
Cross Rates – Tips
 As you do more cross rate questions you
will start to see patterns emerging.
 For example if both rates are something
per USD or USD per something then you
will have to divide the rates somehow and
you will be matching bids with asks.
 Or if the rates are in different forms (USD
is in different places) then you will be
multiplying and you will match bid with
bid and ask with ask.
30
Triangular Arbitrage
 Cross rates can be used to check on opportunities for
inter-market arbitrage. Suppose the following exchange
rates are available:
Bank of America:

Dutch guilders (fl) per U.S. $

fl1.9025/U.S.$

Dominion Bank:
ABN Amro Bank:

Canadian dollars per U.S. $
Dutch guilders per Canadian $

C$1.2646/U.S.$
fl1.5214/C$

 The synthetic cross rate between Dutch
guilders and Canadian dollars is:

You get more
guilders from
ABN Amro

Dutch guilders/U.S. dollar
fl1.9025/US$
=
= 1.5044fl/C$
Canadian dollars/U.S. dollar C$1.2646/US$

31
Triangular Arbitrage – Example
Netherlands
fl1,011,281
(End)

fl1,000,000
(Start)

Profit = fl 11,281
Multiplied by
1.5214 fl/C$

C$664,704

Canada

Divided by
1.9025 fl/US$

Multiplied by
1.2646 C$/US$

US$525,624

United States

32
Measuring a Change in the Spot Rate
• Measuring a change in the foreign currency for
quotations expressed in home currency terms
(direct):
%∆ = Ending rate – Beginning Rate
Beginning Rate

x 100

• Quotations expressed in foreign currency terms
(indirect):
%∆ = Beginning Rate – Ending Rate
x 100
Ending Rate
33
Example
 The Australian dollar was quoted at A$1.8445/US$ on
Aug 19, 2002, while on March 2, 2004 it was quoted at
A$1.335/US$.

What is the appreciation/depreciation of the US$?

34
Example
 Thus, the appreciation/depreciation of the US$, relative
to the A$ from t-1 to t is:
Rt −1,t

St − St −1 A$1.335/$ − A$1.8445 /$
=
=
= −27.6%
St −1
A$1.8445 /$
Thus, the U.S.$ has depreciated
relative to the A$ by 27.6%

35
Example
 To calculate the appreciation/depreciation of the
Australian dollar, relative to the US dollar, we want the
denominator currency to be the A$:



At t-1: A$1.8445/US$ = US$0.5422/A$
At t: A$1.335/US$ = US$0.7491/A$

Rt −1,t

St − St −1 $0.7491 − $0.5422 / A$
=
=
= 38.2%
St −1
$0.5422 / A$
Thus, the A$ has appreciated
relative to the US $ by 38.2%
36
$ depreciation, A$ appreciation not equal
 In general, the percentage appreciation in one currency
is not equal to the percentage depreciation in the other
currency. Instead…
1
________________________

1 + RA$ =

(1 + RUS$)

37

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fims

  • 2. Lecture Outline  Describe the FX market  Identify participants and currencies  Understand spot and forward rates  Calculate & use cross and forward rates  Triangular arbitrage  Changes in exchange rates 2
  • 3. Functions of FX Market The foreign exchange market is the mechanism by which participants: – transfer purchasing power between countries; – obtain or provide credit for international trade transactions, and – minimize exposure to the risks of exchange rate changes. 3
  • 4. Characteristics of FX Market  Largest of all financial markets with average daily turnover of over $2 trillion!  66% of all foreign exchange transactions involve cross-border counterparties.  Only ≈11% of daily spot transactions involve nonfinancial customers.  London is the largest FX market.  US dollar involved in 87% of all transactions. 4
  • 6. Increasing Turnover Daily foreign exchange market turnover in billions of US dollars (Bank for International Settlements Triennial Central Bank Survey 2004) 6
  • 8. Types of Transactions A Spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day. The date of settlement is referred to as the value date. 8
  • 9. Types of Transactions  An outright forward transaction (usually called just “forward”) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.  The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.  Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.  Buying Forward and Selling Forward describe the same transaction (the only difference is the order in which currencies are referenced.) 9
  • 10. Types of Transactions  A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.  Both purchase and sale are conducted with the same counterparty.  Some different types of swaps are: – spot against forward, – forward-forward, – nondeliverable forwards (NDF). 10
  • 12. Market Participants  The foreign exchange market consists of two tiers: – the interbank or wholesale market (multiples of $1M US or equivalent in transaction size), and – the client or retail market (specific, smaller amounts).  Five broad categories of participants operate within these two tiers: bank and nonbank foreign exchange dealers, individuals and firms, speculators and arbitragers, central banks and treasuries, and foreign exchange brokers. 12
  • 13. Market Participants  Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.  They profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.  Dealers in the foreign exchange department of large international banks often function as “market makers.”  These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. 13
  • 14. Market Participants  Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.  Their use of the foreign exchange market is necessary but nevertheless incidental to their underlying commercial or investment purpose.  Some of the participants use the market to “hedge” their foreign exchange risk. 14
  • 15. Market Participants  Speculators and arbitragers seek to profit from trading in the market itself.  They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.  While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets. 15
  • 16. Market Participants  Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.  They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.  The motive is not to earn a profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.  As willing loss takers, central banks and treasuries differ in motive from all other market participants. 16
  • 17. Types of Activities  Speculation  An activity that leaves one open to exchange rate fluctuations where one aims to make a profit.  Hedging  Allows the firm to transfer exchange rate risk inherent in foreign currency transactions or positions.  Arbitrage – take advantage of inconsistent prices to make risk-free profits. These profits are unlikely to last long.  Spatial (or Locational) Arbitrage  Triangular Arbitrage  Covered Interest Arbitrage – Lecture 3 17
  • 18. Foreign Exchange Rates & Quotations  A foreign exchange rate is the price of one currency expressed in terms of another currency.  A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.  http://finance.yahoo.com/currency 18
  • 19. Bid & Ask Quotes  Foreign currency dealers provide two quotes: Bid Price: Price at which the dealer is willing to buy foreign currency from you. Ask Price: Price at which the dealer is willing to sell foreign currency to you.  It is always the case that the Ask Price > Bid Price. The difference is the Bid-Ask spread.  The less traded and more volatile a currency, the greater is the spread. 19
  • 20. Direct & Indirect Quotes  Direct Quote: Home currency per unit of Foreign currency (FC) - e.g. AUD/€ quote is 1.6003 – 1.6499  Indirect Quote: Foreign currency per unit of Home currency - e.g. €/AUD quote of 0.6061 – 0.6249  Note that in all cases, the reciprocal of a direct quote is an indirect quote: AUD 1 = EUR EUR AUD  Also, you might encounter an exchange rate quotation in American terms (US$/FC) or European terms (FC/US$). 20
  • 21. Example Bid $/£ Ask 1.4482 1.4484 Bid: Dealer buys £ for $ at the Bid, Client sells £ for $ (i.e., dealer will buy £1,000,000 for $1,448,200). Ask: Dealer sells £ for $ at the Ask, Client buys £ with $ (i.e., dealer will sell £1,000,000 for $1,448,400). 21
  • 22. Bid – Ask Spread  Banks act as market makers and realise their profits from the spread: Bid-Ask Spread = (Ask-Bid)/Ask  Consider the DIRECT quote of $ 1.4482 – 1.4484/£ (1.4484 − 1.4482) × 100 = 1.38% % spread = 1.4484 22
  • 23. Forward Quotes  Forward rates can be quoted as either as an outright quote, points or as an annualised % forward premium or discount. 23
  • 24. Forward Quotes – Points  A forward quotation expressed in points is not a foreign exchange rate as such. It is the difference between the forward rate and the spot rate.  When the Bid Points > Ask Points, you subtract the points from the spot rate to get the outright forward quote.  If the Bid Points < Ask Points, you add the points to the spot rate to get the outright forward quote 24
  • 25. Forward Quotes – Percentage  For quotations expressed in foreign currency terms (Indirect quotations) the formula becomes: f ¥ = Spot – Forward 360 x n x 100 Forward  For quotations expressed in home currency terms (Direct quotations) the formula becomes: f ¥ = Forward – Spot 360 x n x 100 Spot 25
  • 26. Cross Rates  Many currency pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency.  For example, an Australian importer needs Danish currency to pay for purchases in Copenhagen.  The Australian dollar (symbol A$) is not widely quoted against the Danish kroner (symbol DKr).  However, both currencies are quoted against the U.S. dollar. Assume the following quotes: Australian dollar Danish kroner A$1.5431/US$ DKr7.0575/US$ 26
  • 27. Cross Rates  The Australian importer can buy one U.S. dollar for A$1.5431 and with that dollar buy DKr7.0575. The cross-rate calculation would be: Australian dollar/U.S. dollar A$1.5431/US$ = = 0.2186 A$/DKr Danish kroner/U.S. dollar DKr7.0575/US$  However, calculating cross-rates is usually not as easy as this! 27
  • 28. Cross Rates – Example We have the following rates: US$1.4419 – 36 / GBP US$0.6250 – 67 / CHF Calculate the CHF / GBP rate! = CHF 2.3008 – 98 / GBP. 28
  • 29. Cross Rates – Example First: How do I get CHF/GBP from the two rates? CHF/GBP = (US$/GBP)/(US$/CHF) Second: Bid = go from bottom (GBP) to top (CHF) (use GBP to buy US$, then US$ to buy CHF) Third: Ask = go from top (CHF) to bottom (GBP) (use CHF to buy US$, then US$ to buy GBP) Fourth: Apply rule from part one to currency rate pairs. Therefore, CHF 2.3008 – 98 / GBP. 29
  • 30. Cross Rates – Tips  As you do more cross rate questions you will start to see patterns emerging.  For example if both rates are something per USD or USD per something then you will have to divide the rates somehow and you will be matching bids with asks.  Or if the rates are in different forms (USD is in different places) then you will be multiplying and you will match bid with bid and ask with ask. 30
  • 31. Triangular Arbitrage  Cross rates can be used to check on opportunities for inter-market arbitrage. Suppose the following exchange rates are available: Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025/U.S.$ Dominion Bank: ABN Amro Bank: Canadian dollars per U.S. $ Dutch guilders per Canadian $ C$1.2646/U.S.$ fl1.5214/C$  The synthetic cross rate between Dutch guilders and Canadian dollars is: You get more guilders from ABN Amro Dutch guilders/U.S. dollar fl1.9025/US$ = = 1.5044fl/C$ Canadian dollars/U.S. dollar C$1.2646/US$ 31
  • 32. Triangular Arbitrage – Example Netherlands fl1,011,281 (End) fl1,000,000 (Start) Profit = fl 11,281 Multiplied by 1.5214 fl/C$ C$664,704 Canada Divided by 1.9025 fl/US$ Multiplied by 1.2646 C$/US$ US$525,624 United States 32
  • 33. Measuring a Change in the Spot Rate • Measuring a change in the foreign currency for quotations expressed in home currency terms (direct): %∆ = Ending rate – Beginning Rate Beginning Rate x 100 • Quotations expressed in foreign currency terms (indirect): %∆ = Beginning Rate – Ending Rate x 100 Ending Rate 33
  • 34. Example  The Australian dollar was quoted at A$1.8445/US$ on Aug 19, 2002, while on March 2, 2004 it was quoted at A$1.335/US$. What is the appreciation/depreciation of the US$? 34
  • 35. Example  Thus, the appreciation/depreciation of the US$, relative to the A$ from t-1 to t is: Rt −1,t St − St −1 A$1.335/$ − A$1.8445 /$ = = = −27.6% St −1 A$1.8445 /$ Thus, the U.S.$ has depreciated relative to the A$ by 27.6% 35
  • 36. Example  To calculate the appreciation/depreciation of the Australian dollar, relative to the US dollar, we want the denominator currency to be the A$:   At t-1: A$1.8445/US$ = US$0.5422/A$ At t: A$1.335/US$ = US$0.7491/A$ Rt −1,t St − St −1 $0.7491 − $0.5422 / A$ = = = 38.2% St −1 $0.5422 / A$ Thus, the A$ has appreciated relative to the US $ by 38.2% 36
  • 37. $ depreciation, A$ appreciation not equal  In general, the percentage appreciation in one currency is not equal to the percentage depreciation in the other currency. Instead… 1 ________________________ 1 + RA$ = (1 + RUS$) 37

Editor's Notes

  1. Swap point/rate (also known as the FORWARD DIFFERENTIAL) – as is the convention with the “Financial Review” is the difference between the OUTRIGHT Forward rate and the spot rate.
  2. C stronger than should be, DG weaker than should be.