The Foreign Exchange Market

1
The Foreign Exchange Market

• International Corporate Finance
• P.V. Viswanath

2
Market Organization

• The forex market is an electronically linked
  network of banks, forex brokers and dealers.
• Trading is done by phone, telex or SWIFT (Society
  for Worldwide Interbank Financial
  Telecommunications), an international
  bank-communications network.
• The purpose of the market is to permit transfers
  of purchasing power denominated in one currency
  to another.

3
Market Organization

• The interbank market is a wholesale market in
  which major banks trade with each other.
• In the spot market, currencies trade for
  immediately delivery (within 2 business days).
• In the forward market, contracts are made to buy
  and sell for future delivery.
• The swap market involves packages of spot and
  forward contracts.

4
Participants

• Foreign Exchange Brokers specialists in
  matching net supplier and demander banks.
• Arbitrageurs seek to earn risk-free profits by
  taking advantage of differences in interest rates
  among countries
• Traders use forward contracts to eliminate or
  cover the risk of loss on export or import orders
  denominated in foreign currencies.
• Hedgers (mostly multinationals) engage in forward
  contracts to protect the home currency value of
  various foreign currency-denominated assets and
  liabilities
• Speculators expose themselves to currency risk in
  order to profit from exchange rate fluctuations.

5
Clearing System

• Most electronic funds transfers involving
  international transactions take place through the
  Clearing House Interbank Payments System (CHIPS),
  a computerized network developed by the New York
  Clearing House Association. Most large US banks
  and US branches of foreign banks are members of
  CHIPS.
• At the beginning of the day, each bank puts in a
  security deposit into (prefunds) its CHIPS
  account.
• Interbank transfers during the day are processed
  electronically through CHIPS.
• At the end of the day, all CHIPS member bank
  balances are netted out and their balances
  remitted back to them using Fedwire.

6
How Fedwire Works

• The Fedwire system is used by the Feds member
  banks to make interbank transactions. CHIPS is a
  clearing system, while Fedwire is a mechanism to
  accomplish any interbank transaction.
• In a typical funds transfer, an individual or a
  business instructs its bank to send a funds
  transfer.
• The sending bank debits the sender's account and
  initiates a fedwire funds transfer.
• The Federal Reserve, in turn, debits the account
  of the sending bank and credits the account of
  the receiving bank the Fed notifies the
  receiving bank about the transfer.
• The receiving bank credits the recipient's
  account and notifies the recipient of the receipt
  of the funds. The transfer is final when the
  funds are received. Funds can be used by the
  recipient immediately thereafter.

7
How CHIPS Works
8
Spot Quotations Direct and Indirect

• Direct quotation home currency price of the
  foreign currency quoted. In the US, this would
  be equivalent to quoting in
• American terms (no. of US per unit of foreign
  currency). e.g. on 6/2/04, 1.2216 per . This
  would be an indirect quote in Europe.
• Indirect quotation foreign currency price of
  the home currency. In the US, this would be
  equivalent to quoting in
• European terms (no. of units of foreign currency
  per ). e.g. on 6/2/04, 0.8186 per . This
  would be a direct quote in Europe.

9
Bid-ask spread

• The bid price of a security is the price which
  the person quoting (e.g. a dealer) is willing to
  pay for it the price at which anybody can sell
  it.
• The ask price is the price at which the dealer is
  willing to sell it the price at which anybody
  can buy it.
• The bid-ask spread is the difference.
• The direct (American) quote for the euro on
  6/2/04 was 1.2262 -67, i.e. you could buy a for
  1.2267 (ask), but if you wanted to sell it, you
  could get only 1.2262.
• The spread is 0.0005 per .
• The percentage spread is 100(Ask-Bid)/Ask
  100(0.0005)/1.2267 0.04

10
Cross rates

• Most currencies are quoted against the dollar
  hence it may be necessary to work out the cross
  rates for currencies other than the dollar.
• For example, the euro was quoted on 6/2/04 at
  1.2208 -12 (direct), while the yen was quoted at
  109.99 -04 (indirect).
• A Japanese trader who wants to buy the euro
  would, implicitly be buying the dollar for yen
  and then trading the dollar for euros.
• 100 yen would buy (100/110.04) or 0.9088 this
  could be used to buy 0.9088/1.2212 0.7442
• 1 would buy 1.2208, which would buy
  1.2208(109.99) 134.28 yen to buy 100 yen, you
  would need 100/134.28 0.7447.
• Hence the (indirect) cross quote in Japan would
  be 0.7442 -7.

11
Currency Arbitrage

• If traders quote currencies in terms of more than
  one base currency, the possibility exists that
  the different quotes may be inconsistent.
• Thus, if one dealer quotes the dollar against the
  and the same or another dealer quotes against
  the yen, and there is also a dollar quote against
  the yen, then consistency requires that the cross
  dollar-yen quote equal the direct dollar-yen
  quote.
• If it doesnt, the possibility of making money by
  trading against these dealers exists, assuming
  that the discrepancy is sufficiently large to
  outweigh the bid-ask spreads in the two
  transactions.

12
Currency Arbitrage

• Suppose the pound is bid at 1.5422 in New York
  and the euro is offered at 0.9251 in Frankfurt
  and simultaneously, the pound is quoted at
  1.6650, ask, in London.
• An arbitrageur can sell 1 for 1.5422 in New
  York, buy 1.5422/0.9251 1.6671 with the
  dollars in Frankfurt, and finally buy
  1.6671/1.6650 1.0012391 with the euros, in
  London for a profit of 0.124.

13
Currency Arbitrage
14
Settlement risk

• Settlement risk is the risk that a settlement in
  a transfer system does not take place as
  expected.
• This can happen if one party defaults on its
  clearing obligations to one or more
  counterparties.
• Settlement risk comprises both credit and
  liquidity risks. The former arises when a
  counterparty cannot meet an obligation for full
  value on due date and thereafter because it is
  insolvent.
• Liquidity risk refers to the risk that a
  counterparty will not settle for full value at
  due date but could do so at some unspecified time
  thereafter, causing the party which did not
  receive its expected payment to have to finance
  the shortfall at short notice.

15
The Case of Bankhaus Herstatt

• On 26th June 1974 the Bundesaufsichtsamt für das
  Kreditwesen withdrew the banking licence of
  Bankhaus Herstatt, a small bank in Cologne active
  in the FX market, and ordered it into liquidation
  during the banking day but after the close of the
  interbank payments system in Germany.
• Prior to the announcement of Herstatt's closure,
  several of its counterparties had, through their
  branches or correspondents, irrevocably paid
  Deutsche Mark to Herstatt on that day through the
  German payments system against anticipated
  receipts of US dollars later the same day in New
  York in respect of maturing spot and forward
  transactions.

16
The Case of Bankhaus Herstatt

• Upon the termination of Herstatt's business at
  10.30 a.m. New York time on 26th June (3.30 p.m.
  in Frankfurt), Herstatt's New York correspondent
  bank suspended outgoing US dollar payments from
  Herstatt's account.
• This action left Herstatt's counterparty banks
  exposed for the full value of the Deutsche Mark
  deliveries made (credit risk and liquidity risk).
  
• Moreover, banks which had entered into forward
  trades with Herstatt not yet due for settlement
  lost money in replacing the contracts in the
  market (replacement risk), and others had
  deposits with Herstatt (traditional counterparty
  credit risk). (Source http//riskinstitute.ch/140
  960.htm)

17
The BCCI case, 1991

• An institution in London was due to settle on 5th
  July 1991 a dollar/sterling foreign exchange
  transaction into which it had entered two days
  previously with BCCI SA, London.
• The sterling payment was duly made in London on
  5th July. BCCI had sent a message to its New York
  correspondent on 4th July (a public holiday in
  the United States) to make the corresponding US
  dollar payment for value on 5th July. The payment
  message was delayed beyond the time of the
  correspondent bank's initial release of payments
  (at 7 a.m.) by the operation of a bilateral
  credit limit placed on BCCI's correspondent by
  the recipient CHIPS member.

18
The BCCI case, 1991

• The payment remained in the queue until shortly
  before 4 p.m. (New York time), when it was
  cancelled by BCCI's correspondent, shortly after
  the correspondent had received a message from
  BCCI's provisional liquidators in London on the
  subject of the action it should take with regard
  to payment instructions from BCCI London. In this
  way, BCCI's counterparty lost the principal
  amount of the contract.
• A major Japanese bank also suffered a principal
  loss in respect of a dollar/yen deal due for
  settlement on 5th July, since yen had been paid
  to BCCI SA Tokyo that day, through the Foreign
  Exchange Yen Clearing System, and the assets of
  BCCI SA in New York State were frozen before
  settlement of the US dollar leg of the
  transaction took place.

19
The BCCI case, 1991

• The UK institution's loss illustrates a
  particular aspect of the difficulties which face
  the private sector under current circumstances in
  any attempt to coordinate the timing of payments
  in this instance, the loss would almost certainly
  not have occurred but for the measures in place
  to reduce risk domestically within CHIPS (the
  bilateral credit limit).
• Moreover, the closure of BCCI by the banking
  supervisors illustrates that it is generally not
  possible to close a bank which is active in the
  foreign exchange market at a time when all the
  relevant payments systems have settled all its
  transactions due on a given day. In this case,
  the closure required the Luxembourg Court to
  appoint a liquidator, an action which under
  Luxembourg law can take place only within the
  normal business day of the Court.

20
Forward Exchange Rates

• The forward exchange rate is the rate that is
  contracted today for the exchange of currencies
  at a specified rate in the future.
• A contract for such a simple exchange is an
  outright forward contract.
• A swap contract is a combination of a spot
  contract and a forward contract
• A swap-in Canadian is an agreement to buy
  Canadian dollars spot and sell Canadian dollars
  forward.
• A swap-out is the reverse.
• A forward-forward involves two forward contracts
  of different maturities.

21
Hedging with Forwards

• The forward market can be used to hedge foreign
  exchange risk.
• Suppose a US company buys textiles from England
  with payment of 1 m. due in 90 days. The
  importer is implicitly short pounds. If the
  pound were to rally during the next 90 days, the
  importer would lose out he would have to pay a
  larger amount in dollars.
• He could go long in the forward market, i.e., buy
  pounds for forward delivery in 90 days.
• Suppose he can negotiate a forward rate of 1.72
  per 1. In 90 days, the bank will give him 1m.
  and he will give the bank 1.72m., irrespective
  of how the exchange rate changes.
• Implicitly, his loss/gain in the forward market
  is offset by his gain/loss in the spot market.

22
Hedging with Forwards
23
Forward Market Transactions

• If the actual price is quoted, its called an
  outright quote.
• In the interbank market, the forward rate is
  quoted as a discount/premium from the spot. This
  is called the swap rate. The difference is known
  as points.
• On 6/2/04, the spot GBP/USD quote was 1.8350/
  1.8355 on Moneyline.
• The one-year forward rate was quoted as
  -536.25/-533.25
• This implies an outright quote of
  (1.8350-.053625)/ (1.8355-.053325) or 1.781375/
  1.782175.

24
Forward rates
On June 2, 2004, the GBP/USD spot rate was
1.8302/1.8323 and the forward rates on
www.ozforex.com.au were
We can compute the implied forward discount as
(forward spot)/spot x (360/days).Hence the
3-month pound bid is quoted at a discount of
3.33, since (1.81509-1.8302)/ 1.8302x(360/90)
-0.033