1. The Market for
Foreign Exchange 4
Chapter Four
INTERNATIONAL
Chapter Objectives: FINANCIAL
MANAGEMENT
This chapter serves to introduce the student to the
institutional framework within which exchange
Third Edition
rates are determined.
This chapter lays the foundation for EUN / RESNICK
much of the
discussion throughout the remainder of the text,
thus it deserves your careful attention.
3. Chapter Outline
• Function and Structure of the FOREX
Market
– FX Market Participants
– Correspondent Banking Relationships
• The Spot Market
• The Forward Market
4. Chapter Outline
• Function and Structure of the FOREX
Market
• The Spot Market
– Spot Rate Quotations
– The Bid-Ask Spread
– Spot FX Trading
– Cross Exchange Rate Quotations
– Triangular Arbitrage
– Spot Foreign Exchange Market Microstructure
5. Chapter Outline
• Function and Structure of the FOREX
Market
• The Spot Market
• The Forward Market
– Forward Rate Quotations
– Long and Short Forward Positions
– Forward Cross-Exchange Rates
– Swap Transactions
– Forward Premium
6. The Function and Structure of the
FOREX Market
• FOREX Market Participants
• Correspondent Banking Relationships
7. FOREX Market Participants
• The FOREX market is a two-tiered market:
– Interbank Market (Wholesale)
• About 700 banks worldwide stand ready to make a
market in Foreign exchange.
• Nonbank dealers account for about 20% of the
market.
• There are FX brokers who match buy and sell orders
but do not carry inventory and FX specialists.
– Client Market (Retail)
• Market participants include international
banks, their customers, nonbank dealers,
8. Correspondent Banking
Relationships
• Large commercial banks maintain demand deposit
accounts with one another which facilitates the
efficient functioning of the forex market.
• International commercial banks communicate with
one another with:
– SWIFT: The Society for Worldwide Interbank Financial
Telecommunications.
– CHIPS: Clearing House Interbank Payments System
– ECHO Exchange Clearing House Limited, the first
global clearinghouse for settling interbank FOREX
transactions.
9. The Spot Market
• Spot Rate Quotations
• The Bid-Ask Spread
• Spot FX trading
• Cross Rates
10. Spot Rate Quotations
• Direct quotation
– the U.S. dollar equivalent
– e.g. “a Japanese Yen is worth about a penny”
• Indirect Quotation
– the price of a U.S. dollar in the foreign currency
– e.g. “you get 100 yen to the dollar”
• See the insert card from your textbook.
11. Spot Rate Quotations
USD equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia
(Dollar) 0.5906 0.5934 1.6932 1.6852 The direct
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
quote for
Britain (Pound) 1.5627 1.566 0.6399 0.6386
1 Month Forward 1.5596 1.5629 0.6412 0.6398
British pound
3 Months is:
Forward 1.5535 1.5568 0.6437 0.6423
6 Months
Forward 1.5445 1.5477 0.6475 0.6461
£1 = $1.5627
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months
Forward 0.6658 0.6717 1.502 1.4888
13. Spot Rate Quotations
Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
Note that
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 the direct
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 quote is the
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
Britain (Pound) 1.5627 1.566 0.6399 0.6386
reciprocal
1 Month Forward 1.5596 1.5629 0.6412 0.6398 of the
3 Months Forward 1.5535 1.5568 0.6437 0.6423 indirect
6 Months Forward 1.5445 1.5477 0.6475 0.6461
quote: 1
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1.5627
1 Month Forward 0.6681 0.6741 1.4968 1.4835 .6399
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975
14. The Bid-Ask Spread
• The bid price is the price a dealer is willing
to pay you for something.
• The ask price is the amount the dealer wants
you to pay for the thing.
• The bid-ask spread is the difference between
the bid and ask prices.
15. Spot FX trading
• In the interbank market, the standard size
trade is about U.S. $10 million.
• A bank trading room is a noisy, active place.
• The stakes are high.
• The “long term” is about 10 minutes.
16. Cross Rates
• Suppose that S($/€) = .50
– i.e. $1 = 2 €
• and that S(¥/€) = 50
– i.e. €1 = ¥50
• What must the $/¥ cross rate be?
$ $ €
since ,
¥ € ¥
$1 €1 $1
S ($ / ¥) .01or $1 ¥100
€2 ¥50 ¥100
17. Triangular Arbitrage
Suppose we
$
observe these
banks posting Barclays
Credit
these exchange S(¥/$)=120 Lyonnais
rates.
S(£/$)=1.50
¥ Credit Agricole
First calculate the £
implied cross S(¥/£)=85
rates to see if an
arbitrage exists.
18. Triangular Arbitrage
The implied S(¥/£) cross $
rate is S(¥/£) = 80 Barclays
Credit
S(¥/$)=120 Lyonnais
Credit Agricole has S(£/$)=1.50
posted a quote of Credit Agricole
S(¥/£)=85 so there is an ¥ £
arbitrage opportunity. S(¥/£)=85
£1.50 $1 £1
So, how can we make money?
$1 ¥120 ¥80
Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.
19. Triangular Arbitrage
As easy as 1 – 2 – 3:
$
1. Sell our $ for £, Barclays
Credit
2. Sell our £ for ¥, S(¥/$)=120 Lyonnais
3 1
3. Sell those ¥ for $. S(£/$)=1.50
2
¥ Credit Agricole
£
S(¥/£)=85
20. Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
21. Spot Foreign Exchange
Microstructure
• Market Microstructure refers to the
mechanics of how a marketplace operates.
• Bid-Ask spreads in the spot FX market:
– increase with FX exchange rate volatility and
– decrease with dealer competition.
• Private information is an important
determinant of spot exchange rates.
22. The Forward Market
• Forward Rate Quotations
• Long and Short Forward Positions
• Forward Cross Exchange Rates
• Swap Transactions
• Forward Premium
23. The Forward Market
• A forward contract is an agreement to buy
or sell an asset in the future at prices agreed
upon today.
• If you have ever had to order an out-of-
stock textbook, then you have entered into a
forward contract.
24. Forward Rate Quotations
• The forward market for FOREX involves
agreements to buy and sell foreign
currencies in the future at prices agreed
upon today.
• Bank quotes for 1, 3, 6, 9, and 12 month
maturities are readily available for forward
contracts.
• Longer-term swaps are available.
25. Forward Rate Quotations
• Consider the example from above:
for Japanese yen, the spot rate is
$1.5627 = £1.00
While the 180-day forward rate is
$1.5445 = £1.00
• What’s up with that?
26. Spot Rate Quotations
Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
Clearly the
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 market
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 participants
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
Britain (Pound) 1.5627 1.566 0.6399 0.6386
expect that
1 Month Forward 1.5596 1.5629 0.6412 0.6398 the pound
3 Months Forward 1.5535 1.5568 0.6437 0.6423 will be
6 Months Forward 1.5445 1.5477 0.6475 0.6461
worth less
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
in dollars in
3 Months Forward 0.6658 0.6717 1.502 1.4888 six months.
6 Months Forward 0.662 0.6678 1.5106 1.4975
27. Long and Short Forward
Positions
• If you have agreed to sell anything (spot or
forward), you are “short”.
• If you have agreed to buy anything (forward
or spot), you are “long”.
• If you have agreed to sell forex forward, you
are short.
• If you have agreed to buy forex forward,
you are long.
28. Payoff Profiles
profit
If you agree to sell anything in the
future at a set price and the spot
price later falls then you gain.
S180($/¥)
0
F180($/¥) = .009524
If you agree to sell anything in the
future at a set price and the spot
loss price later rises then you lose. Short position
29. Payoff Profiles
profit
short position
Whether the
payoff profile
slopes up or
down depends
0 S180(¥/$) upon whether
F180(¥/$) = 105
you use the
direct or indirect
quote:
-F180(¥/$) F180(¥/$) = 105 or
loss
F180($/¥) =
30. Payoff Profiles
profit
short position
S180(¥/$)
0
F180(¥/$) = 105
When the short entered into this forward contract,
he agreed to sell ¥ in 180 days at F180(¥/$) = 105
-F180(¥/$)
loss
31. Payoff Profiles
profit
short position
15¥
S180(¥/$)
0
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will
make a profit by buying ¥ at S180(¥/$) = 120 and
-F180(¥/$)
loss delivering ¥ at F180(¥/$) = 105.
32. Payoff Profiles
profit
F180(¥/$)
Since this is a zero-sum game, short position
the long position payoff is the
opposite of the short.
S180(¥/$)
0
F180(¥/$) = 105
-F180(¥/$) Long position
loss
33. Payoff Profiles
profit
The long in this forward contract agreed to BUY
-F180(¥/$)
¥ in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at S180(¥/$) = 120
and delivering ¥ at F180(¥/$) = 105.
S180(¥/$)
0
120
F180(¥/$) = 105
–15¥
Long position
loss
34. Forward Cross Exchange Rates
• It’s just an “delayed” example of the spot
cross rate discussed above.
• In generic terms
FN ($ / k )
FN ( j / k )
FN ($ / j )
and
FN ($ / j )
FN (k / j )
FN ($ / k )
35. SWAPS
• A swap is an agreement to provide a
counterparty with something he wants in
exchange for something that you want.
• Swap transactions account for
approximately 56 percent of interbank FX
trading, whereas outright trades are 11
percent.
36. Forward Premium
• It’s just the interest rate differential implied
by forward premium or discount.
• For example, suppose the € is appreciating
from S($/€) = .5235 to F180($/€) = .5307
• The forward premium is given by:
F180 ($ / €) S ($ / €) 360 .5307 .5235
f180,€ v $ .01375
S ($ / €) 180 .5235
37. Currency Market
• Where currencies are bought and sold
against each other.
• OTC market.
• Quite decentralized and operates
through an electronic network that
links various market participants.
39. Global Currency Markets
• A 24 hours market
• Spreads geographically across all the time
zones
• No physical presence
• Through dealing rooms of commercial banks
• Sleek, being screen based
• Deep, highly liquid, efficient and “fairest”
• Highly volatile
• High potential for profits/loss
43. Indian Currency Market
Consists of
• Authorized Dealers
• Full-fledged Money Changers
• Restricted Money Changers
44. Dealing Room
• A centralised establishment, usually
of a commercial bank, which is
willing to make/offer a two way
dealing price for different currencies
at all times even when they may not
wish to deal, but all during
prescribed business hours.
46. Currency Dealers
• Primary price makers or professional
dealers make a two-way market to
each other and to their clients
• Foreign currency brokers act as
middlemen between two market
makers.
• Corporations usually are price takers.
47. Exchange Quotes
• Direct Quote/Home Currency Quote:
– Unit of foreign currency is kept constant against the
amount of home currency to be exchanged for it.
Example: US $ 1 = INR 43.60
• Indirect Quote/Foreign Currency Quote:
– Indicates the number of units of foreign currency which
will be exchanged for a fixed number of home currency
units.
Example: INR 100 = US $ 2.16
48. Exchange Rates
Exchange of currencies on the very date of Cash/Ready
deal. Rate
Exchange of currencies on the next working Tom Rate
day i.e. tomorrow
Exchange of currencies on the second Spot Rate
working day after the date of deal.
Exchange of currencies after a period of spot Forward Rate
date.
Simultaneous purchase and sale of identical Swap
amounts of a currency for different value
dates.
49. Spot Quotes
• USD/CHF SPOT: 1.4575/1.4580
Bid Offer
• Bank will buy 1 USD and give CHF 1.4575
• Bank will sell 1 USD and want to be paid
CHF 1.4580.
• Shortened to 1.4575/80 or even 75/80
between dealers. “1.45” is the “big figure”
50. Spot Rates
• A spot GBP/USD deal on Friday Dec 8 : Value date
Tuesday Dec 11
• If Dec 11 holiday in NY/London, value date 12 Dec.
• A 2-month forward deal USD/CHF on Monday Dec
11: Value date Feb 13 2001. If holiday in NY/Zurich,
Feb 14.
• A 2-month forward USD/JPY on Dec 26. Value date
Feb 28. If holiday Tokyo/NY, push forward? NO.
Pushing forward must not carry to next calendar month.
Push back to Feb 27.
• Spot deals in some currency pairs such as US dollar-
Canadian dollar settled in one business day
51. Spot Rates
• Base Currency/Quoted Currency Bid Rate/Offer
Rate
– USD/CHF : USD base, CHF quoted
– GBP/USD : GBP base, USD quoted
• Most currencies quoted with USD as base.
Exceptions are EUR, GBP, AUD, NZD
• Quotation given as no. of units of quoted
currency per unit of base currency, bid rate/offer
rate.
• Bid rate applies to market maker buying base
currency. Offer rate applies to market maker
selling base currency.
52. Interbank Spot Dealing
• Monday September 21, 10.45 am
BANK A: "Bank A calling. DLR-FRF 25
please.
• BANK B: "Forty -Fifty two”
(Bank B is specifying a two-way price.
Knowing that the caller is also a forex
dealer, the dealer in Bank B quotes only the
last two decimals of the full quotation. For
instance the full quotation might be
4.1540/4.1552.)
• BANK A: “Mine”
53. Forward Rates
Spot rate interest rate differential forward period
100 × No. of days in the year (usually 360)
54. Forward Rates
t
Where, S 1 iT
F
F = Forward exchange rate
t
1 ic
S = Spot exchange rate
iT = Interest rate in the country of the terms
currency
ic = Interest rate in the country of the
commodity
currency
t = Time period
56. Euro Markets
• International money and capital markets on
which currencies held outside their countries of
origin are traded
• Dollar is the predominant currency
• Tokyo, Singapore, London, Frankfurt,
Bahamas, Bermuda, Cayman Islands, Panama
• Euro money market
• Euro credit market
• Euro capital market
