Transcript Chapter 1

Chapter 6 Outline
A. Foreign Exchange Market
B. Spot Market
C. Forward Market
Chapter 6: The Foreign Exchange Market
0
6.A Foreign Exchange Market (1)

Foreign exchange market permits transfers of purchasing power
denominated in one currency to another.

Interbank market – wholesale market in which major banks trade
with one another. Accounts for ~95% of foreign exchange
transactions.
Spot market – where currencies are traded for immediate
delivery 35%
Forward market – where contracts are made to buy or sell
currencies for future delivery 12%
Swap transactions – involve a package of a spot and a
forward contract 53%
Chapter 6: The Foreign Exchange Market
1
6.A Foreign Exchange Market (2)

Methods of trading
– Telephone still predominant
– Telex (dead)
– SWIFT (Society for Worldwide Interbank Financial Telecommunications)
system
– Internet-based systems

Market participants
– Large commercial banks
– Foreign exchange brokers in the interbank market
– Commercial customers (primarily MNCs)
– Central banks

The role of human brokers has declined as electronic brokers have
significantly increased their share of the foreign exchange market.
Chapter 6: The Foreign Exchange Market
2
6.A Foreign Exchange Market (3)

Quotations
– Up to four different foreign exchange quotes are displayed in major
newspapers.
• Spot rate
• Forward rates, including 30-, 90-, and 180-day forward
– Quotes are for dealers in the interbank market for >$1m in a
single transaction. Your rate will suck unless using credit cards (with
small fees).
– When interbank trades involve dollars, rates are expressed in
American/Direct terms ($/foreign currency) or European/Indirect terms
(foreign currency/$).
Chapter 6: The Foreign Exchange Market
3
6.A Foreign Exchange Market (4)

Forward market participants
– Arbitrageurs – seek to earn risk-free profits by taking advantage of
interest rates differentials among countries. Use forward contracts to
eliminate the exchange rate risk involved in transferring their funds
between countries.
– Traders – use forward contracts to eliminate or cover the risk on export
or import orders denominated in foreign currencies.
– Hedgers – use forward contracts to protect the home currency value of
various foreign currency-denominated assets and liabilities.
– Speculators – actively expose themselves to exchange risk by buying
or selling currencies forward to profit from exchange rate fluctuations.
– Thus, arbitrageurs, traders, and hedgers seek to eliminate or
minimize exchange risk while speculators expose themselves to
risk through forward market transactions.
Chapter 6: The Foreign Exchange Market
4
6.A Foreign Exchange Market (5)

Clearing System
– In the U.S., where all foreign exchange transactions involving dollars
are cleared, electronic funds transfers between banks are processed
through the Clearing House Interbank Payments System (CHIPS).
– Settlement payments are debited from and credited to a settlement
account established by the New York Federal Reserve Bank for
member banks.
– Member banks with debit positions deposit funds into their settlement
accounts through FedWire to cover their part of a transaction.
Chapter 6: The Foreign Exchange Market
5
6.A Foreign Exchange Market (6)

Example of CHIPS process: Fuji Bank sells $15 million to Citibank
for ¥1.5 billion.
Fuji Bank
Enters transaction
into CHIPS system
Approves and
releases
transaction
Fuji Bank
CHIPS
1
2
3
+
Stores transaction
Makes appropriate
debits and credits to
Fuji and Citibank
settlement accounts
5
-
¥1.5 bil. $15 mil.
4
Citibank
+
$15 mil. ¥1.5 bil.
Makes permanent
record of transaction
6
Issues a settlement
report to each
member bank
Chapter 6: The Foreign Exchange Market
6
6.A Foreign Exchange Market (7)

Electronic trading systems
– First created in 1992
– Enable automatic matching and execution of foreign exchange
transactions
– Reduce cost of trading by eliminating brokers and reducing the number
of transactions traders had to engage in to obtain market prices
– Gather and publish information on prices and quantities of currencies
as they are traded
– FXall largest electronic trading system
Chapter 6: The Foreign Exchange Market
7
6.B Spot Market (2)

Spot Quotations, continued
– Quotes are given in pairs that reflect the bid-ask price.
• E.g., pound sterling is quoted at $1.9719-28.
• $1.9719 is the (bid) rate at which banks will buy pounds
• $1.9728 is the (ask) rate at which banks will sell pounds
• The spread equals the dealer’s profit
• The bid-ask spread is often quoted by the last two numbers; e.g., 19-28.
– Bid-ask quote expressed in American and European terms and as
direct and indirect quotes:
American Terms
Direct in U.S.
European Terms*
Direct outside U.S.
$1.9719-28
Indirect outside U.S.
Indirect in U.S.
(1/$1.9728)-(1/$1.9719)
=£0.5069-71
*Note that the bid and ask prices are reversed in quoting in European terms.
Chapter 6: The Foreign Exchange Market
8
6.B Spot Market (3)

Spot quotations, continued
– Bid-ask spreads are expressed as a percentage cost of transacting in
the foreign exchange market as follows:
Percent Spread =

Ask price – Bid price
x 100
Ask price
Cross rates
– Most currencies are quoted against the dollar.
– A cross rate is the exchange rate between two non-dollar currencies
Chapter 6: The Foreign Exchange Market
9
6.B Spot Market (4)

Cross rates, continued
– Example: Compute direct bid and ask cross rates for the pound in
Zurich
– Direct quote for pound sterling = $1.9719-36
– Direct quote for SFr = $0.8130-47
Bid cross rate =
Ask cross rate =
Bid rate for £ in $
Ask rate for SFr in $
Ask rate for £ in $
Bid rate for SFr in $
=
=
$1.9719
$0.8147
$1.9736
$0.8130
= SFr2.4204
= SFr2.4227
– Thus, the direct quote for the pound in Zurich is SFr2.4204-27.
Chapter 6: The Foreign Exchange Market
10
6.B Spot Market (5)

Currency arbitrage
– Triangular currency arbitrage – traders take advantage of exchange
rate inconsistencies in different money markets by buying a currency
in one market and simultaneously selling it in another.
– E.g., compute profit given the following exchange rates, FYI
• $/£ = $1.9724 in New York
• $/€ = $1.3450 in Frankfurt
• €/£= €1.4655 in London
New York
Sell pounds in New York for dollars:
£507,332/(1/$1.9724) = $1,000,661
Sell $1,000,000 in Frankfurt for euros:
$1,000,000/($1.3450) = €743,494
Profit = $661
London
Frankfurt
Sell euros in London for pounds:
€743,494/€1.4655 = £507,332
Chapter 6: The Foreign Exchange Market
11
6.B Spot Market (7)

Exchange risk
– Bank losses and gains from exchange rate transactions result from the
immediate adjustment of quotes in response to new political and
economic information affecting exchange rates.
– E.g., given a $/£ exchange rate of $1.9712, a bank buys $985,600 for
£500,000 (£500,000/(1/$1.9712) = $985,600) in the foreign exchange
market.
– If no offsetting transaction to cover its position is made simultaneously,
it is exposed to exchange rate risk.
– If the bank then decides to cover its position in the interbank market,
increases or decreases in the exchange rate will affect its exchange
loss/gain.
• If the exchange rate increases to $1.9801 before the bank completes its
transaction, the bank will pay $990,050 to buy £500,000, thus incurring a
loss of $990,050 - $985,600 = $4,450.
• If the exchange rate increases, the bank will realize an exchange gain.
Chapter 6: The Foreign Exchange Market
12
6.C Forward Market (1)

A forward contract between a bank and a customer calls for
delivery on a fixed future date of a specified amount of one
currency against dollar payment at a fixed exchange rate.

Negotiating a forward contract for payment of a future liability
eliminates exchange risk by locking in a known future exchange rate.

E.g., a U.S. company buys textiles from England, with payment of
£1 million due in 90 days.
Day
0
e0 = $1.97
90
e90 > $1.98
Exchange risk:
If e90 > f90, cost of
payable will increase

f90 =
$1.98
No exchange risk:
£1,000,000 = $1,980,000
Implicit gains/losses on forward positions are related to the difference
between ft and et at the forward contract’s maturity.
Chapter 6: The Foreign Exchange Market
13
6.C Forward Market (2)

Forward rate quotations
– Actual price of f1 is the outright rate
– Swap rate – quoted as the premium on or discount from eo, e.g.:
•
eo for yen = $0.008225, f1 for yen = $0.008421
•
Swap rate is 0.008421-0.008225 = 196
– Determining whether swap rate is a premium or discount on f1
•
When forward bid < ask rate, f1 is at a premium.
•
When forward bid > ask rate, f1 is at a discount.
– Converting swap rate to outright rate – add the premium to or
subtract the discount from eo
Chapter 6: The Foreign Exchange Market
14
6.C Forward Market (3)

Forward cross rates
– Computed in the same way as spot cross rates
– Example: Compute the forward cross rates for yen in terms of euros*
– f30 for €/$ = €0.81070 - €0.81243
– f30 for ¥/$ = ¥107.347 - ¥107.442
Bid cross rate =
Ask cross rate =
Ask rate for €
Bid rate for ¥
=
Bid rate for €
Ask rate for ¥
=
€0.81243
¥107.347
€0.81170
¥107.442
= €0.0075683
= €0.0075548
– Forward cross rates for yen in terms of euros are €0.0075683 - €0.0075548.
*Note that this example is in European terms, as opposed to previous example
computing bid/ask cross rates for pounds in Zurich, which was in American terms. Thus,
ask and bid rates are reversed in the cross rate formulas.
Chapter 6: The Foreign Exchange Market
15