Transcript International Finance - Villanova University

The Foreign Exchange Market
International Finance
Dr. A. DeMaskey
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Learning Objectives
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What is the foreign exchange market, its function,
participants, size, geographic and currency composition?
What is the difference between spot, forward, and swap
transactions in the foreign exchange market?
What currency quotations are used by currency dealers and
financial institutions when conducting foreign exchange
transactions?
What currency arbitrage opportunities do exist in the
foreign exchange market, and how profitable are they?
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The Foreign Exchange
Market
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The FOREX market provides the physical and
institutional structure through which the money of
one country is exchanged for that of another
country.
A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount
of one currency will be delivered for some other
currency at a specified rate.
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Functions of the Foreign
Exchange Market
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Transfer of purchasing power
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Provision of credit
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Minimizing foreign exchange risk
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Structure of the Foreign
Exchange Market
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An over-the-counter market
– No centralized marketplace
– A network of telephones, telex machines,
computer terminals, and automated
dealing systems.
Not confined to any one country
 No fixed opening and closing times
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The World of Foreign
Exchange Dealing
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Size of the Market
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Worldwide daily trading volume
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Daily trading volume in the U.K.
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U.S. daily turnover
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Daily turnover in Tokyo
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Market Participants
Two Tier Market
International Banks
Central
Banks
FX
Broker
Bank Customers
Non-Bank
Dealers
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Transactions in the Interbank
Market
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Spot Transactions
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Outright Forward Transactions
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Swap Transactions
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Global Foreign Exchange
Market Turnover
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Two of the three categories fell between 1998 and 2001
with spot market daily turnover falling the most, from
$568 billion in 1998 to $387 billion in 2001.
Forward transactions increased slightly from $128 billion
in 1998 to $131 billion in 2001.
Swaps fell to $656 billion in 2001 from $734 billion in
1998.
– The BIS attributes the introduction of the Euro, the growing share
of electronic broking in the spot market and consolidation in
banking as explanations for the reduction
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Foreign Exchange Rate
Quotations
American Terms
 U.S. dollar price of
one unit of foreign
currency
 A direct quote in the
U.S.
 An indirect quote in
Europe
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European Terms
Foreign currency price
of one U.S. dollar
A direct quote in
Europe
An indirect quote in
the U.S.
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Bid and Ask Quotations
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Bid Rate and Offer/Ask Rate
– Outright quotations
– Abbreviation
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Reversing Bid and Offer Rate
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Bid-Ask Spread
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Cross Rates
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Exchange rate determined through the relationship
to a widely traded third currency.
Example:
– A Mexican importer needs Japanese yen to pay for
purchases in Tokyo. Both the Mexican peso (Ps) and
Japanese yen (¥) are quoted in US dollars
– Assume the following quotes:
Japanese yen
¥121.13/$
Mexican peso
Ps9.190/$
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Currency Arbitrage
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Capitalizing on the
discrepancy in quoted
prices.
– No investment
– No risk
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Locational Arbitrage
Triangular Arbitrage
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Locational Arbitrage
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When quoted exchange rates vary among locations,
participants in the foreign exchange market can capitalize
on the discrepancy.
Suppose the euro is quoted in London at 0.6064-80 and the
pound sterling is quoted in Frankfurt at 1.6244-59.
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Triangular Arbitrage
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Cross rates can be used to check on opportunities
for intermarket arbitrage.
Example: Assume the following exchange rates
are quoted in New York, Frankfurt, and London,
respectively:
– $1.4443/£
– $0.9045/€
– €1.6200/£
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Forward Transactions
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This transaction requires delivery at a future value
date of a specified amount of one currency for
another
The exchange rate is agreed upon at the time of
the transaction, but payment and delivery are
delayed
Forward rates are contracts quoted for value dates
of one, two, three, six, nine and twelve months
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Forward Market Participants
Trader
Ar bitr ager
Hedger
Speculator
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Forward Quotations
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Outright Rate
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Swap Rate
– Discount or Premium
– Annualized Percentage Discount or Premium
– Swap Rate Expressed in Points
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Swap Rate
Outright forward rate =
Spot rate ±Swap rate/point
 A point is the last digit of a quotation.
 Add points to spot rate if currency is
trading at a forward premium.
 Subtract points from spot rate if currency is
trading at a forward discount.
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Bid and Ask
Forward Quotations

If forward ask in points > forward bid in
points
forward premium

If forward ask in points < forward bid in
points
forward discount
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Bid-and-Ask Forward
Quotations in Points
Suppose you receive the following quotes for pound
sterling relative to the U.S. dollar for spot, 1-, 3-, and 6month forward:
“1.6075-85 10-15 14-22 20-30”
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