Foreign Exchange Markets

1
Foreign Exchange Markets

• Market makers,
• Market participants

2
Foreign exchange risk

• liquidity in terms of a different currency for
  international transactions
• lags involved (credit transactions)
• exposure from a position in a currency
• an importer holding a payable denominated in a
  different currency
• an exporter holding a receivable denominated in a
  different currency
• http//www.oanda.com/convert/fxhistory

3
Market Participants

• market makers
• banks, foreign exchange dealers, foreign exchange
  brokers
• firms
• exporters, importers
• individuals (investors)
• speculators and arbitragers
• central banks treasuries

4
Market Makers

• Chartered banks the main market
• Hold positions in foreign exchange
• Buy and sell spot and forward
• Sell over-the-counter options
• Hedge open positions buy buying and selling
• Exchange traded options and futures
• Make money on the bid-ask spread
• Exchange dealers
• Hold positions specialize in specific currencies
• Make money on the bid-ask spread
• Exchange brokers
• Broker deals paid commissions

5
Demanders and suppliers of foreign exchange

• Firms (primary demanders)
• Exporters paid in foreign currency want home
  currency
• When you buy foreign, sellers usually demand
  payment in their own currency
• Some exceptions (all oil transactions denominated
  in us dollars)
• Buying home currency both spot and forward
• Individuals (travelers)
• Buying foreign currency spot or forward
  (travelers checks)
• Individuals (investors)
• Buying foreign currency spot

6
Wild Cards in the Market

• Speculators - create volatility?
• Trying to profit from a perceived miss-valuation
  of a currency
• If currency is perceived overvalued
• More of it will be needed in the future to buy
  another currency
• It will be shorted (puts for example)
• Arbitrageurs - create stability?
• Profiting from a riskless arbitrage
• Triangular arbitrage
• Direct price different than price through another
  currency

7
Wild Cards in the Market

• Central banks
• May try to influence the trend of the value of a
  currency
• Buying foreign exchange to prevent depreciation
• Selling foreign exchange to prevent appreciation
• Trying to prevent appreciation or depreciation of
  the currency
• May try to reduce volatility in the markets
• The direction of the trend line is not important
• But the volatility around the trend line is
  important
• Reduce the costs of hedging to exporters and
  importers

8
Thickness of the market

• 1.19 trillion per day (2004)
• spot, forward, and swap transactions
• major centers
• London 700 billion/day
• New York 450 billion/day
• Japan 200 billion/day
• major currencies
• usd 45
• Euro 20
• yen 10

9
Contracts

• spot
• Delivery and payment on 2nd business day
• forwards
• Quotes for 1, 2, 3, 6, 12 month increments
• Contracts however are negotiable

10
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

11
Spot rate

• e0 , cd, terms cd/usd 1.1522
• cd cost of the usd
• Canadian terms, European terms, direct
• interbank quotes usually in European terms
• e0 , usd terms usd/cd 0.8679
• usd cost of the cd
• American terms, indirect

http//www.x-rates.com/htmlgraphs/CAD30.html
12
Bid/ask (Offer) quotations

• bid - what the dealer will buy for
• ask (offer) - what the dealer will sell for
• spread
• a function of increased volatility (risk)
• Individual firm risk
• Increased market risk
• Forward exchange rates far into the future
• dealers and banks generate revenues from the
  spread

13
Example - spot rates
Canadian terms, European terms, direct terms
American terms, indirect terms
14
Equilibrium Spot Rate determinants

• Demand for CD by holders of foreign currency
• foreigners want to buy something Canadian
• goods, services, securities, etc.
• Supply from Canadians holding CD demanding
  foreign exchange
• Canadians want to buy something foreign
• goods, services, securities, etc

15
Equilibrium Spot Rate
Supply of cd - Canadians buying foreign
usd/cd
e0
Demand for cd - foreigners buying Canadian
Qcd
Q0
16
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

17
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

18
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

19
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

20
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

21
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

22
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

23
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

24
Change in the value of the CD
25
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

26
Factors affecting money exchange rates

• 1. economic growth
• economic growth increases demand for base
• 2. inflation
• CB controls the supply of base money
• 3. interest rates
• CB controls the bank rate directly
• CB influences term structure of interest rates
  indirectly
• 4. political risk