Forex markets

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Forex markets

  1. 1. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICSInternational CONTENTS END Page 1
  2. 2. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS CONTENTS AND PURPOSE1. Definition and Organization of the Foreign Exchange Markets2. Foreign Exchange Market Functions3. Foreign Exchange Market Participants4. Size and Structure of Foreign Exchange Market Transactions5. Types of Foreign Exchange Market Transactions6. Quotations of Currencies on Foreign Exchange Markets purpose:  enhance theoretical knowledge from the first two chapters with practical issues of foreign exchange markets functioning  principles for the analysis of the international business finance problemsInternational CONTENTS END Page 2
  3. 3. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 1. Definition and Organization of the Foreign Exchange Markets foreign exchange markets are markets on which individuals, firms and banks buy and sell foreign currencies:  foreign exchange trading occurs with the help of the telecommunication net between buyers and sellers of foreign exchange that are located all over the world  can actually talk about a single international foreign exchange market for every single currency  foreign exchange trading takes place at least in some of the world financial centers in every moment interbank-markets client marketsInternational CONTENTS END Page 3
  4. 4. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 2. Foreign Exchange Market Functions Clearing 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 the manufacturer, needs time to sell this good to the final customer and to pay the manufacturer with the money he received from the customerInternational CONTENTS END Page 4
  5. 5. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICSForeign Exchange Market and Insurance Against Foreign Exchange Risk hedging:  activities with which the foreign exchange market participants avoid exchange rate risk or activities with which they are closing their open foreign exchange position  closed foreign exchange position:  size of the assets in a certain currency is equal to the size of the liabilities in the same currency  full insurance against exchange rate risk with respect to this currency  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 optionsInternational CONTENTS END Page 5
  6. 6. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICSForeign Exchange Markets and Conscious Foreign Exchange Risk Acceptance activities in which economic agents consciously open their foreign exchange positions – long or short – hoping to get profits in all foreign exchange market segmentsInternational CONTENTS END Page 6
  7. 7. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 3. Foreign Exchange Market Participants Economic Agents and Types of Activities on Foreign Exchange Markets Client buys $ with € Local bank Purchases and sales Main banks’ of big mu ltinational Bro kers interbank market companies Local bank Client buys € with $International CONTENTS END Page 7
  8. 8. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Economic Agents and Types of Activities on Foreign Exchange Markets bank clients (individuals, firms, non-banking financial institutions):  all those groups of legal and physical persons that need foreign currency in doing their commercial or investment business commercial banks:  the most important group of foreign exchange market participants  they buy and sell foreign currencies for their clients and trade for themselvesInternational CONTENTS END Page 8
  9. 9. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Economic Agents and Types of Activities on Foreign Exchange Markets brokers:  agents that connects dealers interested in buying and selling foreign exchange, but does not become an active client in the transaction  they provide their client, the bank, with the information about the exchange rates at which banks are willing to buy or sell a particular currency central banks:  foreign exchange market interventions are meant to influence the exchange rate of the domestic currency in a way that is beneficial for the domestic economy and, consequently, for the country  it does not necessarily have a profit, it can also have a lossInternational CONTENTS END Page 9
  10. 10. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Economic Agents and Motivation for the Foreign Exchange Market Participation arbitragers:  they want to earn a profit without taking any kind of risk (usually commercial banks):  try to profit from simultaneous exchange rate differences in different markets  making use of the interest rate differences that exist in national financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)International CONTENTS END Page 10
  11. 11. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Economic Agents and Motivation for the Foreign Exchange Market Participation hedgers and speculators:  hedgers do not want to take risk while participating in the market, they want to insure themselves against the exchange rate changes  speculators think they know what the future exchange rate of a particular currency will be, and they are willing to accept exchange rate risk with the goal of making profit  every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transactionInternational CONTENTS END Page 11
  12. 12. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 4. Size and Structure of Foreign Exchange Market Transactions  the biggest share of all financial markets in the world Currency Percentage $ 87 DEM 30 ¥ 21 £ 11 FRF 5Table 4.1: Size and Structure of Transactions in the Foreign Exchange Markets, CHF 7 1989 – 1998 (mia $) Other 39 All currencies 200,00 1989 1992 1995 1998 Traditional fore ign e xchange 590 820 1190 1490 transactions • Spot market transactions 350 400 520 590 • Forward market 240 420 670 900 transactions Untraditional foreign exchange - - 45 97 transactionsSource: Roberts, 1999, p. 33. International CONTENTS END Page 12
  13. 13. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 5. Types of Foreign Exchange Market Transactions Spot Foreign Exchange Transactions almost immediate delivery of foreign exchange Outright Forward Transactions buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity forward exchange rates:  1, 3, 6, 9 months, one yearInternational CONTENTS END Page 13
  14. 14. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Swap Transactions simultaneous purchase and sale of a given amount of foreign exchange for two different value dates:  “spot against forward” swaps: b a = *d c a – annual swap rate (%), b – premium/discount during the time of the currency swap, c – spot exchange rate, and d - 1/part of the year, for which the currency swap is agreed upon (if the contract is valid for a three-month period, then this is one quarter of a year)  “forward-forward” swapsInternational CONTENTS END Page 14
  15. 15. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 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 and futures  rarely used as an insurance instrument (rigidity!)International CONTENTS END Page 15
  16. 16. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS  similarities and differences between outright forward contract and futures:  both need to be executed unconditionally  they are usually established for at most one year Charac teristic Futures Outright Forwar d ContractSize of the contracts standardized for a given currency depends on the individual needs of the clientLocation and trade at the stock exchange or at a given with the provision of agents, connectedactivity location; actively traded in an among each other with the help of organized market telecommun ications; not traded in an organized marketDuration of the standardized, but at most a year depends on the individual needs of thecontract client , but not more than a yearContract has to be yes yesexecutedInsurance and insurance explicitly required (marg in insurance not required exp licitlySecurity of doing requirements); high security of doing (imp licit insurance are affiliat ions ofBusiness with the business with the instrument two partners up till now); lowerInstrument security than futuresTrade regulation regulated with the stock exchange regulation not exp lic it ly determined rules International CONTENTS END Page 16
  17. 17. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Characteristic Futures Outright Forward ContractContract partners not in direct contact in direct contactPrice determination based on supply and demand based on quotationsDetermination of the standardized depends on the individual needs of thedayof the settlement clientAccesibility of the accessible to anyone in practice accessible to big clientscontract for non- with good ratingsbank agentsLiquidity of the high liqu idity; small contract amounts low liquidity; high contract amountsinstrument and the and small size of t ransactions and large size of transactions comparedcontract amounts to the size of futuresCosts of the based on costs that the broker zaračuna higher than for futures; based on theinstrument for the purchase of the instrument and difference in offer and bid price of the its sale later on currency that the bank offers the clientCurrency quotation number of units of $ for one unit of a number of domestic currency units for foreign currency (A merican quotation) one unit of a foreign currency (European quotation)Riskiness of the very limited; stock exchange enters the higher than for futures; for this reason,instrument contract, exp lic itly required insurance business is done only with credible partnersProfit yield/loss daily once; at contract execution or when thepayment contract expires International CONTENTS END Page 17
  18. 18. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Options basic characteristics of options:  financial instrument that gives the buyer the right, but not the obligation, to buy or sell a standardized amount of a foreign currency, that is traded, at a fixed price at a particular time, or until a particular time in the future “at-the-  call option and put option money”  American and European options “in-the-  three different prices: money”  exercise/strike price “out-of- money”  cost, price or value of the option  underlying or actual spot exchange rateInternational CONTENTS END Page 18
  19. 19. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Options types of options trading:  in organized markets:  standardized contracts with given strike prices, standardized durations (1, 3, 6, 9, 12 months) and expirations  only certain currencies, contract amounts are standardized  over-the-counter trading:  expiration date, strike price and contract amount depend on the individual needs of the client  counterparty risk!  retail and interbank market information about options tradingInternational CONTENTS END Page 19
  20. 20. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Options Usage of options:  when the economic agent expects that the exchange rate trend of a particular currency could change drastically  when the economic agent does not know for sure that a certain foreign exchange flow will occur in the future  advantages:  fixed option costs  options do not need to be executedInternational CONTENTS END Page 20
  21. 21. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICSProfit/ A. Buyer of a call Profit/ C. Buyer of a put loss option loss option Unlimited Unlimited profit profit Limited Limited loss loss Profit/ B. Seller of a c all Profit/ D. Seller of a put loss option loss option Limited Limited profit profit Unlimited Unlimited loss lossInternational CONTENTS END Page 21
  22. 22. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS 6. Quotations of Currencies on Foreign Exchange Markets quotation of a currency tells us at what price is a financial mediator willing to buy or sell a certain currency Currency Quotations in Spot Foreign Exchange Markets European and American quotation direct and indirect quotation (which currency is regarded as a domestic/basis currency) st − s 0 s0 − st ∆s = * 100 ∆s = * 100 s0 stInternational CONTENTS END Page 22
  23. 23. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Currency Quotations in Spot Foreign Exchange MarketsAmerican quotation European quotationDefinition: Definition:number of units of $ needed to buy a unit of number of units of a foreign currency neededa foreign currency to buy $1Direct quotation in the USA: Direct quotation outside the USA:number of units of a domestic currency ($) number of units of a domestic currencyneeded to buy a unit of foreign currency needed to buy a unit of a foreign currency ($)Indirect quotation outside the USA: Indirect quotation in the USA :number of units of a foreign currency ($) number of units of a foreign currency neededneeded to buy a unit of a domestic currency to buy a unit of a domestic currency ($)International CONTENTS END Page 23
  24. 24. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Currency Quotations in Spot Foreign Exchange Markets bid price and offer/sell price quotation:  bid price is the exchange rate at which a bank is willing to buy another currency  offer/sell price is the exchange rate at which the same bank is willing to sell the currency in question transaction costs:  banks usually do not charge provision  difference between the bid and offer/sell price represents the bank’s profit and is called a margin or spread offer/sell price - bid price margin = offer/sell priceInternational CONTENTS END Page 24
  25. 25. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Currency Quotations in Spot Foreign Exchange Markets cross exchange rate:  can be calculated with the help of the relationship of two currencies with a third currency triangular currency arbitrage:  it enables profit earning because of inconsistency between currency quotations in different financial centers  buying a particular currency in one financial center and selling it in another financial centerInternational CONTENTS END Page 25
  26. 26. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS Currency Quotations in Forward Foreign Exchange Markets outright quotation točkovna quotation, forward premium/discount:  forward discount:  when a currency is worth less (is cheaper relative to another currency) in the forward foreign exchange market than in the spot foreign exchange market  forward premium:  when a currency is worth more (is more expensive relative to another currency) in the forward foreign exchange rate market than in the spot foreign exchange market annual forward premium and discount f − s 360 s − f 360f USD = * *100 f USD = * *100 s n f nInternational CONTENTS END Page 26
  27. 27. UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICSPublishing the Currency Quotations in the Leading World Financial Newspapers Financial Times Wall Street JournalInternational CONTENTS END Page 27

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