The Foreign Exchange Market

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CHAPTER 7

• The Foreign Exchange Market

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PART I. INTRODUCTION

• I. INTRODUCTION
• A. The Currency Market
• where money denominated in one currency is
  bought and sold with money denominated
  in another currency.

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INTRODUCTION

• B. International Trade and Capital
  Transactions
• facilitated with the ability
• to transfer purchasing power
• between countries

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INTRODUCTION

• C. Location
• 1. OTC-type no specific location
• 2. Most trades by phone,
• telex, or SWIFT
• SWIFT Society for Worldwide Interbank
  Financial Telecommunications

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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 banks
• 2. Retail Level
• - business customers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• B. Two Types of Currency Markets
• 1. Spot Market
• - immediate transaction
• - recorded by 2nd business day

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• 2. Forward Market
• - transactions take place at a specified
  future date

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• C. Participants by Market
• 1. Spot Market
• a. commercial banks
• b. brokers
• c. customers of commercial and central banks

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• 2. Forward Market
• a. arbitrageurs
• b. traders
• c. hedgers
• d. speculators

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• II. CLEARING SYSTEMS
• A. Clearing House Interbank Payments System
  (CHIPS)
• - used in U.S. for electronic
• fund transfers.

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• B. FedWire
• - operated by the Fed
• - used for domestic transfers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• III. ELECTRONIC TRADING
• A. Automated Trading
• - genuine screen-based market

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• B. Results
• 1. Reduces cost of trading
• 2. Threatens traders oligopoly of
  information
• 3. Provides liquidity

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• IV. SIZE OF THE MARKET
• A. Largest in the world
• 2004 US1.9 trillion daily
• or
• US475 trillion a year
• In 1999 the US GDP was US9.1 trillion

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

• B. Market Centers (2004)
• 1 London 753 billion daily
• 2 New York 461 billion daily
• 3 Tokyo 199 billion daily

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PART III.THE SPOT MARKET

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

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THE SPOT MARKET

• B. Method of Quotation
• 1. For interbank dollar trades
• a. American terms
• example 1.21/
• b. European terms
• example Peso1.713/

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THE SPOT MARKET

• 2. For nonbank customers
• Direct quote gives the home currency price
  (always in the numerator) of one unit of
  foreign currency.
• EXAMPLE 1.81/
• Since this is a direct quote, we know that in
  the U.S., one pound transacted at 1.81.

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THE SPOT MARKET

• C. Transactions Costs
• 1. Bid-Ask Spread
• used to calculate the fee
• charged by the bank
• Bid the price at which the bank is willing
  to buy
• Ask the price it will sell the currency

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THE SPOT MARKET

• 4. Percent Spread Formula (PS)

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THE SPOT MARKET

• D. Cross Rates
• 1. The exchange rate between 2 non - US
  currencies.

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THE SPOT MARKET

• 2. Calculating Cross Rates
• Suppose you want to calculate the / cross
  rate.
• You know .5556/US and .8334/US
• then
• / .5556/US ? .8334/US
• .6667/

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THE SPOT MARKET

• E. Currency Arbitrage
• 1. If cross rates differ from one financial
  center to another, and profit opportunities
  exist.
• 2. Buy cheap in one intl market,
• sell at a higher price in another
• 3. The Critical Role of Available Information

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THE SPOT MARKET

• F. Settlement Date Value Date
• 1. Date monies are due
• 2. 2nd Working day after date of original
  transaction.

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THE SPOT MARKET

• G. Exchange Risk
• 1. Bankers middlemen
• a. Incurring risk of adverse
• exchange rate moves.
• b. Increased uncertainty about future
  exchange rate requires
• 1.) Demand for higher risk
• premium
• 2.) Bankers widen bid-ask spread

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MECHANICS OF SPOT TRANSACTIONS

• SPOT TRANSACTIONS Example
• Step 1. Currency transaction verbal
  agreement, U.S. importer specifies
• a. Account to debit (his acct)
• b. Account to credit (exporter)

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MECHANICS OF SPOT TRANSACTIONS

• Step 2. Bank sends importer
• contract note including
• - amount of foreign
• currency
• - agreed exchange rate
• - confirmation of Step 1.

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MECHANICS OF SPOT TRANSACTIONS

• Step 3. Settlement
• Correspondent bank in Hong
• Kong transfers HK from
• nostro account to exporters.
• Value Date.
• U.S. bank debits importers
• account.

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PART IV.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.

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THE FORWARD MARKET

• 2. Purpose of a Forward
• Hedging
• the act of reducing exchange
• rate risk.

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THE FORWARD MARKET

• B. Forward Rate Quotations
• 1. Two Methods
• a. Outright Rate quoted to commercial
  customers.
• b. Swap Rate quoted in the
• interbank market as a discount or
  premium.

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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