THE FOREX MARKET

1
CHAPTER 7

• THE FOREX MARKET

2
CHAPTER OVERVIEW

• INTRODUCTION
• THE SPOT MARKET
• THE FORWARD MARKET

3
INTRODUCTION

• Interbank Market
• the wholesale market for foreign currencies in
  which the major banks trade.
• Accounts for 95 of all currency transactions.

4
INTRODUCTION

• In the Interbank Market
• Spot Market where currencies are traded for
  immediate delivery (40).
• Forward Market where currencies are traded for
  future delivery (9).
• Swap Market a bundle of a spot and forward
  contract (51).

5
INTRODUCTION

• FX Market a network of banks, currency brokers,
  and dealers linked by computer terminal of phone.
• Commercial Banks
• Commercial Customers
• FX Brokers
• Central Banks

6
INTRODUCTION

• Transactions clear through the Clearing House
  Interbank Payments System.
• CHIPS handles an average of 105,000 transfers per
  day worth 350 billion.
• 90 of all interbank transactions in U.S.

7
INTRODUCTION

• Largest financial market in the world
• In 1999 US1.5 trillion daily
• or
• US375 trillion a year
• By comparison, in 1999 the US GDP was US9.1
  trillion

8
INTRODUCTION

• Market Centers (1998)
• 1 London 637 billion daily
• 2 New York 351 billion daily
• 3 Tokyo 149 billion daily

9
THE SPOT MARKET
Suppose you owned the local Range Rover
dealership and had a 500,000 shipment of
vehicles to pay for. How much in ? Suppose you
received a 500,000 bonus check from Range Rover.
How much in ? How do the amounts
compare? http//www.forex-markets.com/quotes.htm
10
THE SPOT MARKET
Suppose you owned the local Toyota dealership and
had a 18,000,000 shipment of vehicles to pay
for. How much in ? Suppose you received a
18,000,000 bonus check from Toyota. How much in
? How do the amounts compare? http//www.forex-ma
rkets.com/quotes.htm
11
THE SPOT MARKET

• Do banks and dealers trade for free?
• Bid-Ask Spread is how they make their money.
• Bid the price at which the bank is
  willing to buy
• Ask the price at which it will sell the
  currency

12
THE SPOT MARKET

• Percent Spread Formula (PS)

13
THE SPOT MARKET

• Cross Rates
• The exchange rate between 2 non - US currencies.
• Calculating Cross Rates
• Easy when ignore bid-ask spread
• Yen / pound ?

14
THE SPOT MARKET

• Calculating Cross Rates
• Suppose Bid Ask
• 110.86 110.92 per
• 1.6661 1.6668 per
• Write full units of currency.
• Perform necessary math functions.

15
THE SPOT MARKET

• Currency Arbitrage
• purchase in one market at low price and
  immediate sale in another at higher price.
• Triangular Arbitrage
• simultaneous buying and selling in three
  different markets to take advantage of price
  discrepancies.

16
THE SPOT MARKET

• Suppose dealer in Japan quotes
• Bid Ask
• 184.23 184.40 per
• 184.74 184.91 per

17
THE FORWARD MARKET

• Forward Contract
• an agreement between a bank and a customer to
  exchange predetermined amounts of currency at a
  specified future date thus locking in a future
  exchange rate.
• Purpose of Forward Contract
• To hedge against future losses due to changes in
  exchange rates.

18
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