Foreign Exchange Markets

1
Foreign Exchange Markets

• Chapter Four
• Eiteman, Stonehill, and Moffett

2
Efficiency of foreign exchange

• Thick (more than 1 billion US/day
• Many traders on both sides
• Opportunities for speculators (returns)
• Information incorporated into price more quickly
• Less opportunity to arbitrage
• Expected returns compensate for high risk taken
• Opportunities for hedgers (costs)
• More instruments
• Cost prices risks appropriately

3
Contract

• Quantity of goods
• Quality of goods
• Price of goods
• Denominated in which currency
• Time of delivery of goods to importer
• Time of payment by importer for goods

4
Who goes to the exchange market

• Contracts specify importers payment terms
• Denominated in the exporters currency
• Importer must go into exchange markets
• Denominated in the importers currency
• Exporter must go into exchange markets
• Denominated in a third-party currency
• Both parties must go into exchange markets

5
Source of exchange-rate exposure

• Lags
• Time lag between contract and production
• Variable on production schedule
• Time lag between production and delivery
• Variable relative to distance and mode of
  delivery
• Time lag between delivery and payment
• Variable on credit terms
• Exposure directly related to length of lag

6
Market participants

• Banks, dealers, brokers,exchanges (market makers)
• Central banks
• Foreign exchange liquidity demanders
• Exporters, importers,, investors, etc.
• Speculators
• Risk takers looking for high expected returns
• Arbitragers
• Exploiting price anomalies

7
More on market participants

• commercial banks
• market makers - hold positions
• make money on bid-ask spread
• foreign exchange brokers
• match buyers and sellers
• make money on commissions
• multinationals - reduce costs
• central banks treasuries

8
More on market participants

• arbitragers- exploit interest differentials
• hedge forward cash flow positions
• traders (hedgers) -
• exporting or importing goods
• (hedging balance sheet entries)
• speculators - exposed to exchange rate risk
• higher risk earns a higher expected return

9
Market thickness

• 1.5 trillion in usd per day
• Growing 11 per year
• Largest markets
• London (and United Kingdom) 32.3
• New York, Chicago (and U.S.) 17.8
• Tokyo (and Japan) 7.5

10
Contracts

• spot
• Delivery and payment on 2nd business day
• forwards
• Quotes for 1, 2, 3, 6, 12 month increments
• Contracts however are negotiable
• Non-deliverable forwards
• Settled only in dollars
• Priced in terms of other currencies

11
Swaps

• Simultaneously purchase and sale on two different
  value dates
• Spot-forward swap
• Buy (sell) spot, Sell (buy) forward
• Same counter party
• Borrowing a currency fully collateralized
• Reflects interest rate parity between the two
  currencies
• Essentially adjusts for relative inflation
• Forward-forward swaps
• Buy (sell) forward, sell (buy) further forward

12
Mechanics of exchange markets

• transactions confirmed by
• telephone
• telex
• SWIFT
• Society for Worldwide Interbank Financial
  Communications
• provides liquidity
• goods service flows - 5
• capital flows - 95

13
The clearing system

• clearing house interbank pymts sys (chips)
• fedwire
• electronic trading - direct trading
• EBS
• Telerate
• Quotron
• efficiency of the markets increasing
• more pricing information
• competition has brought transaction costs down

14
Spot market

• Globe Mail direct quotes
• European terms
• bid (buy) -ask (sell) spread
• higher (lower) in thin (thick) markets
• higher (lower) in riskier (less risky) markets
• higher (lower) for large (small) transactions

15
cross rates

• calculating the pound price of the usd going
  through the cd
• check for arbitrage possibilities
• arbitrage involves trading gains from a riskless
  series of instantaneous transactions

16
Arbitrage

• assume crcd. Usd gt ecd. Usd through the Euro
• buy US dollars
• sell US dollars for the Euro
• sell the Euro for Canadian dollars

17
Thickness of the market

• 1.19 trillion per day
• spot, forward, and swap transactions
• major centers
• London 30
• New York 16
• Japan 10
• major currency pairs
• usd/dm 22.3
• usd/yen 21.3

18
The Spot Exchange rate

• Price of one currency in terms of another
• For delivery today (four business days)
• Price fluctuates constantly to reflect market
  conditions

19
Change in the value of the CD
20
Forward contracts

• contract today for future delivery of exchange
• amount contracted, term contracted, rate
  contracted
• quotations in points basis
• points added to or subtracted from spot bid/ask
  spread
• if bid points larger than ask points, subtract
• trading at discount
• if bid points smaller than ask points, add
• trading at premium