THE FOREIGN BANKNOTE MARKET

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THE FOREIGN BANK-NOTE MARKET

• Market for exchange of bank notes and
  foreign-currency-denominated travelers checks
• Rates quoted to travelers are the most expensive
  spread is more than 6 due to absence of
  economies of scale
• Bank-note wholesale market available to banks
  spread usually less than 2

2
SPOT FOREIGN EXCHANGE MARKET

• The spot FX market determines the spot exchange
  rate through demand and supply
• Participants commercial banks and FX brokers
• Market participants are connected through SWIFT
  (Society for Worldwide Intl Financial
  Telecommunications)

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• Spreads are very low delivery is immediate
• Spot market organized at two levels
• ? Interbank level
• ? Indirect level via brokers
• At the interbank level, banks deal and trade
  directly with each other

4

• At the indirect level, banks place limit orders
  with brokers
• Example of indirect market bank places an order
  to purchase DM1m at DM1.6/
• Interbank market is decentralized, continuous,
  open-bid, double-auction
• Indirect market is quasi-centralized, continuous,
  limit-book, single-auction

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HOW DO TRANSACTIONS TAKE PLACE?

• In the interbank market, transactions take place
  through SWIFT by use of electronic messages
• Delivery takes place 1 or 2 days after the
  initial transaction
• Delivery date or settlement date or value date is
  determined by the business days of the bank that
  is being contacted

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EXAMPLE OF TRANSACTION VIA SWIFT

• Corp A needs 100m to pay Corp B (Japanese
  supplier)
• ? Step 1 Corp A agrees on a rate to buy with
  Bank A
• ? Step 2 Bank A gets information to make
  payment in Japan (routing number for Bank B and
  Corp Bs account number)

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• ? Step 3 Bank A sends message to Bank B via
  SWIFT on day order is placed rate is the one
  agreed with Corp A and cannot change (assume
  100/)
• ? Step 4 On settlement date, Bank A debits Corp
  As account by 1m and Bank B credits Corp Bs
  account by 100m

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• ? Step 5 Payment takes place through CHIPS
  (Clearing House Interbank Payments System)
• After agreeing to sell to Corp A, Bank A will
  enter the interbank market to look for the lowest
  rate
• Bank A may buy from Bank C and transfer them to
  Bank B

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SPOT-RATE QUOTATION

• Two ways to quote rates
• ? American terms (e.g. 0.5/DM)
• ? European terms (e.g. DM2/)
• All rates are given in European terms, except for
  
• Two rates for each currency buying or bid rate
  and selling or ask rate

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• Rates quoted in European terms are bid and ask
  rates for
• E.g. Suppose rates for Mexican peso are quoted
  as
• Bid 100pesos/
• Ask 110pesos/

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• First rate is bid rate for , second is ask rate
  for difference is banks spread
• Rates in interbank market are quoted as
• FF5.832/5.841 per
• Dealers may assume 5.8 and quote 32/41 last
  digit quoted is called a point
• Difference between bid and ask rates gives
  bid-ask spread

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CROSS EXCHANGE RATES

• If there are no transaction costs (no bid-ask
  spread), then cross exchange rates can be
  obtained through the
• Triangular arbitrage assuming no transaction
  costs, the cross rate must be equal to the
  indirect rate via the , meaning there should be
  zero arbitrage profits

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CROSS RATES WITH ZERO TRANSACTION COSTS

• E.g. Exchange pts for FF directly or through
  direct rate is pts/FF
• Alternatively
• ? Exchange pts for (/pts)
• ? Exchange for FF (FF/)
• ? We get (/pts) ? (FF/)

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• For a bank to offer to exchange pts for FF
  directly, it must quote a rate (FF/pts) such that
• (FF/pts) ? (/pts) ? (FF/) (1)
• Similarly, to exchange FF for pts, the bank must
  quote a rate (pts/FF) such that
• (pts/FF) ? (/FF) ? (pts/) (2)

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• By definition (FF/pts) 1/(pts/FF), etc.
• Substitute into (1) to obtain
• (pts/FF) ? (/FF) ? (pts/) (3)
• For (2) and (3) to be consistent, it must be that
• (pts/FF) (pts/S) ? (/FF)

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CROSS RATES WITH NONZERO TRANSACTION COSTS

• Define
• ? i/ask(j) price to buy one unit of currency j
  with currency i
• ? i/bid(j) number of units of currency i from
  selling one unit of currency j
• Note i/ask(j) 1/(j/bid(i)) and i/bid(j)
  1/(j/ask(i))

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• E.g. DM/ask() is the price to buy one with DM
  DM/bid() is the number of DM received from
  selling one
• ? DM1.7295/ is DM/ask()
• ? 0.5794/DM is /bid(DM)
• How are cross rates determined if there exist
  transaction costs?

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• E.g. To exchange pts for FF directly, the rate
  would be pts/ask(FF) (number of pts to buy one
  FF)
• If the exchange is via the , then
• ? obtain /bid(pts) dollars for each peseta
• ? obtain FF/bid() francs for each dollar
• ? FF/bid(pts) (/bid(pts)) ? (FF/bid())

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• For a bank to exchange pts for FF directly, it
  must offer a rate FF/bid(pts) such that
• FF/bid(pts) ? (/bid(pts)) ? (FF/bid())
• Using the result that FF/bid(pts)
  1/(pts/ask(FF)) we write
• (pts/ask(FF)) ? (pts/ask()) ? (/ask(FF))

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• This is the highest price at which a bank will
  sell a FF for pesetas
• For a bank to exchange FF for pts directly, it
  must offer a rate pts/bid(FF) such that
• (pts/bid(FF)) ? (/bid(FF)) ? (pts/bid())
• This is the lowest price that a bank will offer
  to buy a FF

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• The actual cross exchange rate will be somewhere
  in between and it depends on the competition
  between banks for direct exchange between
  currencies
• Practical implication it pays to call a number
  of banks when going directly from one currency to
  another