The Foreign Exchange Market

1
The Foreign Exchange Market

• Chapter 7

2
The Foreign Exchange Markets

• I. INTRODUCTION
• A. The Market
• the place where money denominated in one
  currency is bought and sold with money
  denominated in another currency.

3
INTRODUCTION

• B. International Trade and Capital
  Transactions
• - facilitated with the ability to
  transfer purchasing power
• between countries

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INTRODUCTION

• C. Location
• 1. OTC-type no specific location
• 2. Most trades by phone or SWIFT
• SWIFT Society for Worldwide Interbank
  Financial Telecommunications

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PART II. ORGANIZATION OF THE FOREIGN EXCHANGE
MARKET

• I . PARTICIPANTS IN THE FOREIGN EXCHANGE
  MARKET
• A. Participants at 2 Levels
• 1. Wholesale Level (95)
• - major commercial banks
• 2. Retail Level
• - banks dealing for business
  customers.

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• B. Two Types of Currency Markets
• 1. Spot Market
• - immediate transaction
• - recorded by 2nd business day
• 2. Forward Market
• - transactions take place at a specified
  future date

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• C. Participants by Market
• 1. Spot Market
• a. Commercial banks
• b. Brokers
• c. Customers of commercial banks
• d. Central banks

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• 2. Forward Market
• a. Arbitrageurs
• (holds currency)
• b. Speculators
• c. Hedgers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• II. SIZE OF THE CURRENCY MARKET
• A. Largest in the world (1999)
• 1.5 trillion daily
• B. Market Centers (1998)
• London 637 billion daily
• New York 351 billion daily
• Tokyo 149 billion daily
• C. Benchmark
• 1999 USGDP 9.1 trillion

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PART III. THE SPOT MARKET

• I. 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

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THE SPOT MARKET

• B. For nonbank customers
• Direct quote
• gives the home currency price of one unit
  of foreign currency.
• EXAMPLE in France .80/US
• Indirect quote is the reciprocal

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THE SPOT MARKET

• C. Transactions Costs
• 1. Bid-Ask Spread
• used to calculate the fee
• charged by the bank
• 2. Bid the price at which the bank is
  willing to buy 3. Ask the price it will
  sell the currency

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THE SPOT MARKET

• 4. Percent Spread Formula
• Percent Spread (Ask-Bid)/Ask x 100

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Sample Problem

• Suppose the spot quote for the Swedish Krona is
  .1395-99, what is the percent spread?
• PS Ask Bid x 100
• Ask
• .1399 - .1395 x 100
• .1399
• .29 or 29 basis points

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THE SPOT MARKET

• D. Cross Rates
• 1. The exchange rate between 2 non-US
  currencies.
• 2. Purpose to identify arbitrage
  opportunities

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Sample Problem

• Suppose the spot quote for the Swedish
• Krona and the French franc are .1395/kr and
  .1133/FF, what is the quote for the krona in
  Paris?
• .1133
• FF _FF_ 8.826 x US 8.826
• kr .1395 US 7.168 7.168
• kr
• FF1.23/kr

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THE SPOT MARKET

• E. Currency Arbitrage
• 1. When cross rates differ from
• one financial center to another,
• profit opportunities exist.
• 2. Buy cheap in one intl market,
• sell at a higher price in another
• 3. Importance of Arbitrage

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Sample Problem

• Suppose the euro is quoted in London at
  .6064-80 and the is quoted in Frankfurt at
  1.6244-59. Is there a profitable arbitrage
  situation?

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Sample Problem

• London Frankfurt
• .6064-80/ 1.6244-59/
• Bid Ask Bid Ask
• .6064 .6080 .6150 .6156

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Sample Problem

• 1. Buy euros for .6080 / in London.
• Use them in Frankfurt to buy pounds at 1.6259
  (same as selling euros at .6150).
• This is a net profit is
• .6150-.6080 .0070 per euros
• 4. A yield of 1.16 (.0070/.6080)

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Compute the percent spread

• Pound spread (1.6259-1.6244)/1.6259 .09
• Euro spread (.6080-.6064)/.6080 .26

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CURRENCY ARBITRAGE

• What is The Critical Role of Arbitrage in the
  Global Financial Markets?

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PART III. THE FORWARD MARKET

• I. 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.

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THE FORWARD MARKET

• 2. Purpose of a Forward
• Hedging
• the act of reducing exchange rate risk.

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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
• 3. Require performance

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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

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Sample Problem

• What is the forward discount or premium if the
  30 day forward rate is 1.4498/ and the spot is
  1.4487?

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Sample Problem

• What is the forward discount or premium if the 3
  month forward rate is 1.4511/ and the spot is
  1.4487?