The Foreign Exchange Market Chapter 7 The Foreign

The Foreign Exchange Market Chapter 7

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. 2

INTRODUCTION B. International Trade and Capital Transactions: - facilitated with the ability to transfer purchasing power between countries 3

INTRODUCTION C. Location 1. 2. OTC-type: no specific location Most trades by phone or SWIFT* *SWIFT: Society for Worldwide Interbank Financial Telecommunications 4

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. 6

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2 nd business day 2. Forward Market: - transactions take place at a specified future date 7

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. b. c. d. Commercial banks Brokers Customers of commercial banks Central banks 8

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market a. Arbitrageurs (holds currency) b. Speculators c. Hedgers 9

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 11

PART III. THE SPOT MARKET I. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes: a. b. c. d. spot price 30 -day 90 -day 180 -day 13

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 14

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 18

THE SPOT MARKET 4. Percent Spread Formula: Percent Spread = (Ask-Bid)/Ask x 100 21

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 22

THE SPOT MARKET D. Cross Rates 1. The exchange rate between 2 non-US$ currencies. 2. Purpose: to identify arbitrage opportunities 23

圖表 7. 7 三角套匯(triangular currency arbitrage) 25

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 kr = FF 1. 23/kr 26

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 int’l market, sell at a higher price in another 3. Importance of Arbitrage 27

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? 28

Sample Problem London £. 6064 -80/€ Bid Ask. 6064 . 6080 Frankfurt € 1. 6244 -59/£ Bid Ask . 6150 . 6156 29

Sample Problem 1. Buy euros for £. 6080 / € in London. 2. Use them in Frankfurt to buy pounds at € 1. 6259 (same as selling euros at £. 6150). 3. This is a net profit is 4. . 6150 -. 6080= £. 0070 per euros 4. A yield of 1. 16% (. 0070/. 6080) 30

Compute the percent spread Pound spread = (1. 6259 -1. 6244)/1. 6259 =. 09% Euro spread = (. 6080 -. 6064)/. 6080 =. 26% 31

CURRENCY ARBITRAGE What is The Critical Role of Arbitrage in the Global Financial Markets? 32

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. 33

THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk. 34

THE FORWARD MARKET C. Forward Contract Maturities 1. Contract Terms a. b. c. d. 2. 3. 30 -day 90 -day 180 -day 360 -day Longer-term Contracts Require performance 35

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 36

Sample Problem What is the forward discount or premium if the 30 day forward rate is $1. 4498/£ and the spot is $1. 4487? 37

Sample Problem What is the forward discount or premium if the 3 month forward rate is $1. 4511/£ and the spot is $1. 4487? 38