The Market for Foreign Exchange

A summary

Objective

Getting acquainted with the environment in which currencies are traded world-wide

• Definitions • The players • The mechanisms • The functions • Types of quotations

Outline

Foreign exchange rate

The price of one currency expressed in terms of another currency

Foreign exchange: Glossary of terms

• • • • • • •

convertibility

= exchanging paper money for gold

fixed exchange rate system

= a system in which governments maintain a fixed exchange rate for long periods of time

floating exchange rate system

= a system in which exchange rates are determined by the market

devaluation

= decrease in the price of a currency under a fixed exchange rate system

revaluation

= increase in the price of a currency under a fixed exchange rate system

weakening (depreciation)

= decrease in the price of a currency under a floating exchange rate system

strengthening (appreciation)

= increase in the price of a currency under a floating exchange rate system

Current Currency Arrangements

• Pegged to another currency

to the US$:

Argentina, Bahamas, Barbados, etc. • • Pegged to a basket of currencies

to the SDR

: Libya, Rwanda

to other baskets

: Algeria, Burundi, Morocco, etc .

• Managed float (dirty float) China, Egypt, Indonesia, Israel, Tunisia, etc.

Independently floating • New Zealand, S. Africa, Australia, Canada, India, Japan, Switzerland, Russia, US

Change is relative

s 0 = C$ 1.35/US$ s 1 = C$ 1.37/US$ The US$ appreciated by (1.37-1.35)/1.35 = 1.48 % against the C$ (the price of US$ in terms of C$ increased by 1.48%) Conversely, the C$ depreciated by (1/s 1 -1/s 0 )/(1/s 0 ) = (s 0 - s 1 )/s 1 = 1.46 % against the US$

Participants

• Central banks • Commercial banks • MNC • Foreign exchange brokers • Dealers • Speculators (arbitrageurs)

Size of the Forex

Over US $1,600 billion/day worldwide (late 1990s) About $ 1.2 trillion (today)

Top foreign exchanges

London New York Tokyo

Functions

Transfer of purchasing power Minimizing foreign exchange risk

Clearing systems

The Clearing House Interbank Payments System (CHIPS) The Society for Worldwide Interbank Financial Telecommunications (SWIFT) Continuing Link Settlement Services (CLSS)

Types of transactions

Spot Forward

Spot transactions

Immediate purchase or sale of foreign exchange Cash settlement is made two days after the transaction (one day for North American currencies).

Spot rates: Quotations

Direct vs. Indirect and American vs. European

Spot rates: Direct quotation

The price of foreign currency in terms of domestic currency If you are in Paris, the Swiss franc is at: s = € 1.51

If you are in Frankfurt, the Euro is at: s = Chf 0.66

Spot rates: Indirect quotation

The price domestic currency in terms of foreign currency In Toronto, the US$ is at: s = US$ 0.65

In New York, the C$ is at: s = C$ 1.538

Spot rates: European terms

For US$ only, the dollar is at: s = € 1.1 (indirect from US perspective)

Spot rates: American terms

For US$ only, the Euro is at: s = US$ 0.909 (direct from US perspective)

Bid-ask spread

The form in which foreign exchange prices are quoted by dealers and market-makers.

C$ 1.5321 - 1.5332

It shows the price at which the dealer is willing to buy and sell foreign currency Big figure: it is assumed known by all traders C$

1.53

21 -

1.53

32 Small figure: the one that is referred to when quoting and negotiating: 21 - 32

How to convert a direct into an indirect quote In Montreal: C$1.5555 - 60 In Miami: US$0.6427 - 29

Cross-rates

Some currency pairs are rarely traded Ex: A$ and Dkr Their exchange rate is determined through a widely traded third currency: s(1) = A$1.3806/US$ s(2)= Dkr6.468/US$ cross rate: A$0.2135/DKr or Dkr4.685/A$

Triangular Currency Arbitrage

Taking advantage of exchange rate "inconsistencies" Quoted exchange rates: Frankfurt: s = € 1.1/US$ London: s = € 1.5/£ New-York: s = US$ 1.7

/£ The cross rate between the US$ and the British pound is USD 1.37 or £ 0.73

The arbitrage (1)

Start in Frankfurt with $1 Buy 1.1 Euros in Frankfurt With 1.1 Euros buy £ 0.73 in London With £ 0.73 buy US$1.24 in New York

The arbitrage (2)

Start in London with E1 Buy £0.667 in London With £0.667 buy US$1.13 in NY With US$1.13 buy E1.24 in Frankfurt

The arbitrage (3)

ETC.

Shortcut to assessing a triangular arbitrage opportunity

(1.1) € /US$ x (0.667

) £ / € x (1.7

)US$/ £ = 1.24

Since 1.24 > 1, there is an arbitrage opportunity.

Arbitrage: Question

What if instead of making money you are loosing money?

Maybe transactions costs more than offset any gains or Maybe you ’re going the wrong way….

Transaction costs

Bid-ask spread Commissions and fees

Forward exchange rates

Forward contract A contract between a bank and a customer calling for the delivery of a foreign currency at a fixed future date and at

an agreed-upon rate

.

Quotation of forward rates

Explicit Forward point quotation

Explicit quotation

spot 30 day 90-day 180-day US$ C$ 1.5450 - 54 C$ 1.5465 - 74 C$ 1.5469 - 80 C$ 1.5477 - 82

Forward point quotation

Points are added to or subtracted from the last two digits of the spot bid-ask quotation spot 30 day 90-day 180-day US$ C$ 1.5450 - 54 15 - 20 19 - 26 27 - 28

Forward contract: What for?

Hedging

Reducing the foreign exchange risk of doing business

Speculating

Betting on foreign exchange fluctuations in the hope of making a profit

Hedging using forward contracts

Assume Corel sells US$25 m worth of WordPerfect to Stack-Rack, a Roanoke Va. based company. Shipment of the software and payment will take place in one month. Corel has two options: It can wait until payment date, receive US$ 25 m from Stack-Rack, and buy C$ in the spot market (go unhedged) It can lock in a forward rate of C$1.5465, and receive C$38.66 m, regardless of the spot rate one month from now (hedge)

Speculating using forward contracts

Assume an American trader buys C$10 m three-month forward in the hope that the US$ will weaken against the C$.

US$ spot 30 day 90-day C$ 1.5450 - 54 15 - 20 19 - 26 180-day 27 - 28

In three months, the spot rate turns to be: s = C$1.5325 - 43. Our trader delivers on the C$10 m forward contract and immediately sells the C$10 m on the spot

US$profit = 10 m

/

1.5343 - 10 m

/

1.5469