324_foreign exchange market-forex

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

Chapter 5

The Foreign

Exchange

Market


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1. Definition and Organization of the Foreign Exchange Markets

2. Foreign Exchange Market Functions

3. Foreign Exchange Market Participants

4. Size and Structure of Foreign Exchange Market Transactions5. Types of Foreign Exchange Market Transactions

6. Quotations of Currencies on Foreign Exchange Markets

CONTENTS AND PURPOSE

Purpose: Enhance theoretical knowledge from the first two chapters with practicalissues of foreign exchange markets functioning

Principles for the analysis of the international business finance problems


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Foreign Exchange Markets

The FOREX market provides the physical andinstitutional structure through which The money of one country is exchanged for that of another

country The rate of exchangebetween currencies is determined

Foreign exchange transactions are physically completed

A foreign exchange transaction is an agreement

between a buyer and a seller that a fixed amount of onecurrency will be delivered for some other currency at aspecified rate


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Definition and Organization of the Foreign

Exchange Markets

Foreign Exchange Markets are markets on whichindividuals, fi rms and banks buy and sell foreign

currencies: foreign exchange trading occurs with the help of the

telecommunication net between buyers and sellers offoreign exchange that are located all over the world

can actually talk about a singleinternational foreign

exchange market for every single currency

foreign exchange trading takes place at least in some ofthe world financial centers in every moment

interbank-markets client markets


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Clearing of currencies:

service of exchanging one currency for another

Provision of Credit:

trader that bought a certain good from themanufacturer, needs time to sell this good to thefinal customer and to pay the manufacturer with themoney he received from the customer

Foreign Exchange Market Functions

Clearing of Currencies and Provision of Credit


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There are six main character istics of the FOREX

markets which will be discussed

The geographic extent

The three main functions

The markets participants

Its daily transaction volume

Types of transactionsincluding spot, forward and swaps Methods of stating exchange rates, quotations, and changes

in exchange rates


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Geographic Extent of the Market

Geographically, the FOREX market spans theglobe with prices moving and currencies tradingevery hour of every business day

Major world trading starts each morning inSydney and Tokyo

Then moveswest to Hong Kong and Singapore

Continuingto Europe and finishing on the WestCoast of the U.S.


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Exhibit 5.1 Measuring Foreign

Exchange Market Activity: Average

Electronic Conversions per Hour


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Foreign Exchange Market and Insurance Against

Foreign Exchange Risk

hedging:activities with which the foreign exchange market

participants avoid exchange rate risk or activities withwhich they are closing their open foreign exchange

positionclosed foreign exchange position: size of the assets in a certain currency is equal to the size of the

liabilities in the same currency full insurance against exchange rate risk with respect to this

currency

open foreign exchange position: long: net assets in a certain currency short: net liabilities in a certain currency

in the spot or forward foreign exchange marketstandardized forward contracts and options


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Market Participants

The FOREX market consists of two tiers, the interbank or

wholesalemarket, and the client or retail market.

Five broad categories of participants operate within these two

tiers Bank and non bank foreign exchange dealers

Individuals and firms conducting commercial or investment transactions

Speculators and arbitragers

Central banks and treasuries Foreign exchange brokers


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Foreign Exchange Market Participants

Economic Agents and Types of Activities on

Foreign Exchange MarketsClient buys $

with

Local bank

Main banks

interbank market

Local bank

Client buys with $

Purchases and sales

of big multinational

companiesBrokers


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Economic Agents and Types of

Activities on Foreign Exchange Markets

Brokers:

agents that connects dealers interested in buyingand selling foreign exchange, but does not become

an active client in the transactionthey provide their client, the bank, with the

information about the exchange rates at whichbanks are willing to buy or sell a particular currency

Central banks: foreign exchange market interventions are meant to influence the exchange rate of the domestic

currency in a way that is beneficial for the domestic economy and, consequently, for the country

it does not necessarily have a profit, it can also have a loss


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Economic Agents and Motivation for the

Foreign Exchange Market Participation

Arbitragers:

they want to earn a profit without taking any kind ofrisk (usually commercial banks):

try to profit from simultaneous exchange rate differences indifferent markets

making use of the interest rate differences that exist innational financial markets of two countries along withtransactions on spot and forward foreign exchange marketat the same time (covered interest parity)


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Economic Agents and Motivation for the

Foreign Exchange Market Participation

Hedgers and Speculators:

Hedgers do not want to take risk while participating in the market, they want toinsure themselves against the exchange rate changes

Speculators think they know what the future exchange rate of a particularcurrency will be, and they are willing to accept exchange rate risk with the goal ofmaking profit

Every foreign exchange market participant can behave either as a hedger or as aspeculator in the context of a particular transaction


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Bank and Non-bank Dealers

These participants profit from buying currencies at a bid price

and then reselling them at an off er or askprice

Competition among dealers narrows the spread between the bidand offer rate contributing to the marketsefficiency

Dealers on behalf of large international banks often act as

market makers, often willing to stand in and buy or sell thesecurrencies without having a counterpart with which to unload the

inventory


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Bank and Non-bank Dealers

They trade amongst other banks and dealers in order to

keep their inventory levels at manageable levels

Currency trading is profitable and often contributesbetween 10% - 20% of abanksaverage net income

Small- to medium-sized banks rarely act as marketmakers yet still participate in the interbank market


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Individuals and Firms Conducting

Commercial/Investment Transactions

Importers, exporters, portfolio investors, MNEs,

tourists and others use the FOREX market to

facilitate execution of commercial or investment

transactions

Some of these participants use the market to

hedge foreign exchange rate risk


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Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading in the

market itself

They operate for their own interest, without need or obligation to

serve clients or ensure a continuous market

Speculatorsseek all their profit from exchange rate changes

Arbitragerstry to profit from simultaneous differences in

exchange rates in different markets

A large proportion of speculation and arbitrage is conducted onbehalf of major banks by traders employed by those banks


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Central Banks and Treasuries

Central banks and treasuries use the market to acquireor spend their countryscur rency reserves as well as toinfluence the price at which their own currency trades

They may act to support the value of their cur rencybecause of their governmentspolicies or obligations orbecause of commitments entered through joint floatagreements such as the European Monetary System(EMS)

Consequently their motive is not to profi t but ratherinf luence the foreign exchange value of their currencyin a manner that will benefit their interests


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Continuous Linked Settlement

Continuous Linked Settlement (CLS) system (since

2002) eliminates losses if either party unable to settle

CLS links with Real-Time Gross Settlement (RTGS)

systems in seven major currencies

Eventually we expect same-day settlement instead of

the current lag of two days

The U.S. Commodity Futures Trading Commission(CFTC) regulates foreign exchange trading


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Transactions in the Interbank Market

Transactions within this market can be executed

on a spot, forward, or swapbasis

A spottransaction requires almost immediatedelivery of foreign exchange

Aforwardtransaction requires delivery of foreign

exchange at some future date

Aswaptransaction is the simultaneous exchange of

one foreign currency for another


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Spot Transactions

A spot transaction in the interbank market is thepurchase of foreign exchange, with delivery andpayment between banks to take place, normally,

on the second following business dayThe settlement date is often referred to as the value

date

This is the date when most dollar transactions aresettled through the computerized Clearing HouseInterbank Payment Systems (CHIPS) in New York


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Outright Forward Transactions

This transaction requires delivery at a future value dateof 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 Terminology typically used is buying or selling forward

A contract to deliver dollars for euros in six months is bothbuying euros forward for dollarsandselling dollars forward

for euros


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Types of Foreign Exchange Market Transactions

Spot Foreign Exchange Transactions

almost immediate delivery of foreign exchange

buyer and seller establish the exchange rate at the time ofthe agreement, payment and delivery are not required untilmaturity

forward exchange rates: 1, 3, 6, 9 months, one year

Outright Forward Transactions


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Swap Transactions

A swap transaction in the interbank market is thesimultaneous purchase and sale of a given amount offoreign exchange for two different value dates

Both purchase and sale are conducted with the samecounterpart

A common type of swap is aspot against forward The dealer buys a currency in the spot market and

simultaneously sells the same amount back to the same bankin the forward market

Since this transaction occurs at the same time and with thesame counterpart, the dealer incurs no exchange rate exposure


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Swap Transactions

simultaneous purchase and sale of a given

amount of foreign exchange for two

different value dates:

spot against forward swaps: dc

ba *

aannual swap rate (%),

bpremium/discount during the time of the currency swap,

cspot exchange rate, and

d- 1/part of the year, for which the currency swap is agreed upon

(if the contract is valid for a three-month period, then this is one

quarter of a year)

forward-forward swaps


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Swap Transactions

Forward-forward swapsA dealer sells 20,000

forward for dollars for delivery in two months at

$1.8420/ and simultaneously buys 20,000 forward

for delivery in three months at $1.8400/ The difference between the buying and selling price is

equivalent to the interest rate differential

Thus a swap can be viewed as a technique for borrowing

another currency on a fully collateralized basis


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Swap Transactions

Non-deliverable forwards (NDFs)NDFs possess the

same characteristics as traditional forward contracts

except that they are settled only in US dollars and the

foreign currency being sold or bought forward is notdelivered

The dollar-settlement feature reflects the fact that NDFs are

contracted offshore and are beyond the reach and regulatory

frameworks of the home country governments

Pricing of NDFs reflects basic interest rate differentials


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Futures

basic characteristics of futures:

the amount of the currency that is being traded

type of currency quotation

contract expiration

last day of trading with the contract settlement day

margin requirements

information about futures trading

futures usage:

arbitrage between outright forward contract and futures

rarely used as an insurance instrument (rigidity!)

Similarities and differences between outright forward contract and


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Similarities and differences between outright forward contract and

futures:

both need to be executed unconditionally

they are usually established for at most one year

Characteristic Futures Outright Forward Contract

Size of the contracts standardized for a given currency depends on the individual needs of the

clientLocation and trade

activity

at the stock exchange or at a given

location; actively traded in an

organized market

with the provision of agents, connected

among each other with the help of

telecommunications; not traded in anorganized market

Duration of the

contract

standardized, but at most a year depends on the individual needs of the

client , but not more than a yearContr act has to be

executed

yes yes

I nsurance and

Securi ty of doi ng

Business wi th the

Instrument

insurance explicitly required (marg inrequirements); high security of doing

business with the ins trument

insurance not required explicitly(implicit insurance are affiliat ions oftwo partners up till now); lower

security than futuresTrade regulati on regulated with the stock exchange

rules

regulation not exp licitly determined



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Contract partners not in direct contact in direct contact

Pri ce determination based on supply and demand based on quotationsDetermination of the

dayof the sett lement

standardized depends on the individual needs of theclient

Accesibi li ty of thecontract for non-

bank agents

accessible to anyone in practice accessible to big clientswith good ratings

Li quidity of the

instrument and the

contract amounts

high liqu idity; small contract amountsand small size of transactions

low liquidity; high contract amountsand large size of transactions compared

to the size of futuresCosts of the

instrument

based on costs that the broker zaraunafor the purchase of the instrument andits sale later on

higher than for futures; based on thedifference in offer and bid price of thecurrency that the bank offers the client

Currency quotati on number of units of $ for one unit of aforeign currency (American quotation)

number of domestic currency units forone unit of a foreign currency

(European quotation)Riskiness of the

instrument

very limited; stock exchange enters thecontract, explicitly required insurance

higher than for futures; for this reason,business is done only with crediblepartners

Profi t yield/loss

payment

daily once; at contract execution or when the

contract expires


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Options

basic characteristics of options: financial instrument that gives the buyer the right, but not the obligation, to

buy or sell a standardized amount of a foreign currency, that is traded, at a

fixed price at a particular time, or until a particular time in the future

call option and put option

American and European options

three different prices:

exercise/strike price

cost, price or value of the option underlying or actual spot exchange rate

at-the-money

in-the-money

out-of-money


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Options

types of options trading:

in organized markets:

standardized contracts with given strike prices, standardized

durations (1, 3, 6, 9, 12 months) and expirations

only certain currencies, contract amounts are standardized over-the-counter trading:

expiration date, strike price and contract amount depend on the

individual needs of the client

counterparty risk!

retail and interbank market

informationabout options trading
http://www.phlx.com/http://www.phlx.com/


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Usage of options:

when the economic agent expects that the

exchange rate trend of a particular currency

could change drasticallywhen the economic agent does not know for

sure that a certain foreign exchange flow will

occur in the future

advantages:

fixed option costs

options do not need to be executed

Options


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Profit/

loss

Limited

loss

Unlimited

profit

A. Buyer of a calloption

Profit/

loss

Limited

loss

Unlimited

profit

C. Buyer of a putoption

Profit/

loss

Limited

profit

Unlimited

loss

B. Seller of a calloption

Profit/

loss

Unlimitedloss

Limitedprofit

D. Seller of a putoption


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Size of the FOREX Market

The Bank for International Settlements (BIS)

estimates that daily global net turnover in

traditional FOREX market activity to be US$3.2trillion in April 2007

Spot transactions at $1,005 billion/day

Outright forward transactions at $363 billion/day

Swap transactions at $1,714 billion/day

Exhibit 5 2 Global Foreign Exchange


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Exhibit 5.2 Global Foreign Exchange

Market Turnover, 1989-2007 (daily

averages in April, billions of U.S. dollars)


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Size of the FOREX Market

The United Kingdom (London) and the United States

(New York) make up roughly 50% of the foreign

exchange market

The London trade alone makes up 34.1% of daily

transactions in the foreign exchange market

Switzerland has grown in recent years and is now the

third largest market with 6.1% of world trading

Exhibit 5 3 Top 10 Geographic Trading Centers


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Exhibit 5.3 Top 10 Geographic Trading Centers

in the Foreign Exchange Market, 1992-2007

(daily averages in April, billions of U.S. dollars)

Exhibit 5.4 Foreign Exchange Market


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Exhibit 5.4 Foreign Exchange Market

Turnover by Currency Pair (Daily

averages in April)

F i E h R t &


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Foreign Exchange Rates &

Quotations

A foreign exchange quote is a statement of willingnessto buy or sell at an announced rate

In the retail market (newspapers and exchange booths), quotesare often given as the home currency price of the foreign

currency Interbank quotesprofessional dealers or brokers may

state quotes in one of two ways The foreign currency price of one dollar

Sfr1.6000/$, read as 1.600 Swiss francs per dollar

The dollar price of a unit of foreign currency $0.6250/Sfr, read as 0.625 dollars per Swiss franc

F i E h R t &


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Quotations

The former quote is considered to be inEuropean termsand the latter is considered tobe American terms

European Terms: express the rate as the foreigncurrency price of one U.S, dollar

SF 1.6000/$ (1.6000 SF per dollar)

Almost all European currencies, except two, are quoted the European way

The Pound Ster ling and the Euro are the exceptions

Additionally, Australian and New Zealand dollars are also quoted inAmerican terms



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Quotations

Direct and Indirect Quotes

A direct quote is a home currency price of a unit of aforeign currency

Sfr1.6000/$ is a direct quote in Switzerland Sfr1.6000/$ is a indirect quote when used in the US

Anindirectquote is a foreign currency price in a

unit of the home currency Sfr1.600/$ is an indirect quote in the US,

$0.6250/Sfr is a direct quote in the US and an indirectquote in Switzerland



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Quotations

Interbank quotes are given as a bidand ask

The bidis the price at which a dealer will buy

another currency

The askor offeris the price at which a dealer will

sell another currency Example: 118.27 - 118.37/$ is the bid/ask for Japanese yen

The bank will buy yen at 118.27 per dollar and sell yen at118.37 per dollar making profit on the spread


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Quotations of Currencies on Foreign

Exchange Markets

quotation of a currency tells us at what price

is a financial mediator willing to buy or sell

a certain currency

Currency Quotations in Spot Foreign Exchange

Markets

European and American quotation

direct and indirect quotation (which currency is regardedas a domestic/basis currency)

100*0

0

s

sss

t

100*0

t

t

s

sss


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Exhibit 5.5 Spot and Forward Quotations

for the Euro and Japanese Yen

Currency Quotations in Spot Foreign


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Exchange Markets

American quotation European quotation

Definition:

number of units of $ needed to buy a unit of a

foreign currency

Definition:

number of units of a foreign currency needed to buy

$1

Di rect quotation in the USA:

number of units of a domestic currency ($) needed

to buy a unit of foreign currency

Di rect quotation outside the USA:

number of units of a domestic currency needed to

buy a unit of a foreign currency ($)

I ndir ect quotation outside the USA:

number of units of a foreign currency ($) needed to

buy a unit of a domestic currency

I ndir ect quotation in the USA :

number of units of a foreign currency needed to buy

a unit of a domestic currency ($)



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Exchange Markets

bid price and offer/sell price quotation:

bid price is the exchange rate at which a bank is

willing to buy another currency

offer/sell price is the exchange rate at which the

same bank is willing to sell the currency in question

transaction costs:

banks usually do not charge provision

difference between the bid and offer/sell price

represents the banks profit and is called a margin or

spread

priceoffer/sell

pricebid-priceoffer/sellmargin



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Exchange Markets

cross exchange rate:

can be calculated with the help of the relationship of

two currencies with a third currency

tr iangular cur rency arbitrage:

it enables profit earning because of inconsistency

between currency quotations in different financial

centersbuying a particular currency in one financial center

and selling it in another financial center

Currency Quotations in Forward


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Currency Quotations in Forward


outright quotation

tokovna quotation, forward premium/discount:

forward discount:

when a currency is worth less (is cheaper relative to another currency) in theforward foreign exchange market than in the spot foreign exchange market

forward premium:

when a currency is worth more (is more expensive relative to another

currency) in the forward foreign exchange rate market than in the spot foreign

exchange market

annual forward premium and discount

100*360

*ns

sffUSD

100*360

*nf

fsfUSD

Publishing the Currency Quotations


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Financial Times

Wall Street Journal

g y Qin the Leading World Financial

Newspapers



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Quotations

Expressing Forward Quotations on a Points Basis

The previously mentioned rates for yen were considered

outright quotes

Forward quotes are different and typically quoted in terms ofpoints

Apointis the last digit of a quotation, with convention

dictating the number of digits to the right of the decimal

Hence a point is equal to 0.0001 of most currencies



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Bid Ask

Outright spot: 118.27 118.37

Outright forward: 116.84 116.97

Plus points (3 months) -1.43 -1.40


Quotations

Expressing Forward Quotations on a Points Basis

The yen is quoted only to two decimal points

A forward quotation is not a foreign exchange rate, rather the

differencebetween the spot and forward rates Example:



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100xdays

360x

Foward

Foward-SpotfFC


Quotations

Forward Quotations in Percentage Terms Forward quotations may also be expressed as the percent-per-

annum deviation from the spot rate This is similar to the forward discount or premium calculated earlier

The important thing to remember is which currency is beingused as the home or base currency

For indi rect quotes (i.e. quote expressed in foreign currency terms),the formula is



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100xdays

360x

Spot

Spot-ForwardfH


Quotations

Forward Quotations in Percentage Terms

For direct quotes (i.e. quote expressed in home

currency terms), the formula is



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p.a.2.32%100x90

360x105.04

105.04-105.65f

p.a.2.32%100x90

360x

50.00946521

50.00946521-30.00952018f$


Quotations

Forward Quotations in Percentage Terms

Example: I ndirect quote

Example: Direct quote

Exhibit 5.6 Foreign Exchange Rate


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Quotations on the U.S. Dollar/British Pound in

the Financial Press



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Japanese yen 110.73/$

Mexican peso MXP 11.4456/$


Quotations

Cross Rates

Many currencies pairs are inactively traded, so their exchange

rate is determined through their relationship to a widely

traded third currency Example: A Mexican importer needs Japanese yen to pay for

purchases in Tokyo. Both the Mexican peso (MXP) and

Japanese yen () are quoted in US dollars

Assume the following quotes:



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9.6745/MXP

MXP11.4456/$

110.73/$

dollarpesos/USMexican

dollaryen/USJapanese


Quotations

Cross Rates

The Mexican importer can buy one US dollar for

11.4456 Mexican pesos and with that dollar buy

110.73; the cross rate would be



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Citibank $1.2223/

Barclays Bank $1.8410/

Dresdner Bank 1.5100/


Quotations

I ntermarket Arbitrage

Cross rates can be used to check on opportunities for

intermarket arbitrage

Example: Assume the following exchange rates are

quoted



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1.5062/

$1.2223/

$1.8410/


Quotations

Intermarket Arbitrage The cross rate between Citibank and Barclays is

This cross rate is not the same as Dresdners rate quote of

1.5100/ Therefore, an opportunity exists for risk-less profit or

arbitrage


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Exhibit 5.8A Triangular Arbitrage

8


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Exhibit 5.8B Triangular Arbitrage

S f L i Obj ti


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Summary of Learning Objectives

The three functions of the foreign exchange market(FOREX) are to transfer purchasing power, providecredit, and minimize foreign exchange rate risk

The FOREX is composed of two tiers: the interbankmarket and the client market. Participants within thesetiers include bank and nonbank foreign exchangedealers, individuals and firms conducting commercial

and investment functions, speculators and arbitragers,central banks and treasuries and foreign exchangebrokers

S f L i Obj ti


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Geographically, the FOREX market spans the globe, with prices

moving and currencies traded every hour of every business day

A foreign exchange rateis the price of one currency expressed in

terms of another currency A foreign exchange quotation is a statement of willingness to

buy or sell currency at an announced price

Transactions within the FOREX market are executed either on a

spot basis requiring delivery two days after the transaction or ona forward basis requiring settlement at some designated future

date

S f L i Obj ti


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European terms quotations are the foreign currency

price of one US dollar. American termsare the dollar

price of a foreign currency

Quotations can also be direct or indirect. A directquote is the home currency price of a unit of foreign

currency, while an indirect quote is the foreign

currency price of a unit of the home currency

Direct and indirect are not synonymous for American

and European terms, because the home currency will

change for calculation purposes

S f L i Obj ti


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A cross rate is an exchange rate between two

currencies, calculated from their common

relationships with a third currency

When cross rates differ from the direct rates

between two currencies, intermarket arbitrage is

possible


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S l ti A ti i t d E h R t


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Exchange at $0.52/NZ$

4. Holds $20,912,320

2. Holds NZ$40 million


Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of$0.50 to $0.52 in 30 days.

1. Borrows $20 million

Borrows at 7.20% for 30 days

Lends at 6.48% for 30 days

3. Receives NZ$40,216,000

Returns $20,120,000Profit of $792,320



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Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of

$0.50 to $0.48 in 30 days.


4. Holds NZ$41,900,000

2. Holds $20 million


1. Borrows NZ$40 million

Borrows at 6.96% for 30 days

Lends at 6.72% for 30 days

3. Receives $20,112,000

Returns NZ$40,232,000Profit of NZ$1,668,000

or $800,640

324_foreign exchange market-forex

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