The Structure of the ForeignExchange Market

1
The Structure of the Foreign-Exchange Market

• Because the dollar is used to facilitate most
  currency exchange, it is known as the primary
  transaction currency for the foreign-exchange
  market.
• The foreign-exchange departments of large
  international banks play a dominant role in the
  foreign-exchange market. These banks stand ready
  to buy or sell the major traded currencies.

2
The Structure of the Foreign-Exchange Market
(cont.)

• International banks also play a key role in the
  retail market for foreign exchange, dealing with
  individual customers who want to buy or sell
  foreign currencies in large or small amounts.
• The clients of the foreign-exchange departments
  of banks fall into several categories
• Commercial customers
• Speculators
• Arbitrageurs

3
The Structure of the Foreign-Exchange Market
(conc.)

• Domestic laws may constrain the ability to trade
  a currency in the foreign-exchange market.
  Currencies that are freely tradable are called
  convertible currencies. Also called hard
  currencies, these include the various EU
  currencies, the Canadian dollar, the Japanese
  yen, and the U.S. dollar. Currencies that are not
  freely tradable because of domestic laws or the
  unwillingness of foreigners to hold them are
  called inconvertible currencies, or soft
  currencies.

4
Supply and Demand

• Pricing of currency
• How to translate (page 191)
• example

5
Spot and Forward Markets

• The spot market consists of foreign-exchange
  transactions that are to be consummated
  immediately (usually within two days of the trade
  date).
• The forward market consists of foreign-exchange
  transactions that are to occur some time in the
  future. Prices are often published for foreign
  exchange that will be delivered 30 days, 90 days,
  and 180 days in the future.

6
Currency Future
Publicly traded on many exchanges worldwide, a
currency future is a contract that resembles a
forward contract. The currency future is for a
standard amount on a standard delivery date.
7
Currency Option
The currency option allows, but does not require,
a firm to buy or sell a specified amount of
foreign currency at a specified price at any time
up to a specified date. A call option grants the
right to buy the foreign currency in question a
put option grants the right to sell the foreign
currency.
8
Arbitrage and the Currency Market

• Arbitrage is the riskless purchase of a product
  in one market for immediate resale in a second
  market in order to profit from a price
  discrepancy.
• There are two types of arbitrage activities that
  affect the foreign-exchange market
• Arbitrage of goods
• Arbitrage of money (Three or more currencies)

9
Arbitrage of GoodsPurchasing Power Parity

• The arbitrage of goods across national boundaries
  is represented by the theory of purchasing power
  parity (PPP). This theory states that the prices
  of tradable goods, when expressed in a common
  currency, will tend to equalize across countries
  as a result of exchange-rate changes. Hat costs
  10 or 136 yen.

10
International Fisher Effect

• Yale economist Irving Fisher demonstrated that a
  countrys nominal interest rate reflects the real
  interest rate plus expected inflation in that
  country. National differences in expected
  inflation rates thus yield differences in nominal
  interest rates among countries, a phenomenon
  known as the international Fisher effect.

11
The International Capital Market

• Not only are international banks important in the
  functioning of the foreign-exchange market and
  arbitrage transactions, but they also play a
  critical role in financing the operations of
  international businesses, acting as both
  commercial bankers and investment bankers.

12
LIBR

• London Interbank Offer Rate
• IBF (International Banking Facility)

13
Major International Banks

• A correspondent relationship is an agent
  relationship whereby one bank acts as a
  correspondent, or agent, for another bank in the
  first banks home country and vice versa.
• As the larger banks have internationalized their
  operations, they have increasingly provided their
  own overseas operations, rather than utilizing
  correspondent banks, in order to improve their
  ability to compete internationally.

14
The Eurocurrency Market

• Today a Eurocurrency is defined as a currency on
  deposit outside its country of issue. Some 6
  trillion worth of Eurocurrencies are on deposit
  in banks worldwide roughly two thirds of these
  deposits are in the form of Eurodollars.

15
Foreign Bonds
Foreign bonds are bonds issued by a resident of
country A but sold to residents of country B and
denominated in the currency of country B.
16
Eurobonds
A Eurobond is a bond issued in the currency of
one country but sold to residents of other
countries.