a guide to foreign exchange markets...a guide to foreign exchange markets k. alec chrystal he...

A Guide to Foreign ExchangeMarketsK. Alec Chrystal

HE economies of the free world are becomingincreasingly interdependent. U.S. exports now amountto almost 10 percent of Gross National Product. Forboth Britain and Canada, the figure currently exceeds

25 percent. Imports are about the same size. Trade ofthis magnitude would not be possible without theability to buy and sell currencies. Currencies must bebought and sold because the acceptable means of pay-ment in other countries is not the U.S. dollar. As aresult, importers, exporters, travel agents, tourists andmany others with overseas business must change dol-

lars into foreign currency and/or the reverse.

The trading of currencies takes place in foreign ex-change markets whose major function is to facilitateinternational trade and investment. Foreign exchangemarkets, however, are shrouded in mystery. One

reason for this is that a considerable amount of foreignexchange market activity does not appear to be relateddirectly to the needs of international trade and invest-

ment.

The purpose of this paper is to explain how thesemarkets work.1 The basics of foreign exchange will first

K. Alec Chrystal, professor of economics-elect, University ofSheffield, England, is a visiting scholar atthe Federal Reserve Bankof St. Louis. Leslie Bailis Koppel provided research assistance. Theauthor wishes to thank Joseph Hernpen, Centerre Bank, St. Louis, forhis advice on this paper.1For further discussion of foreign exchange markets in the UnitedStates, see Kubarych (1983). See also Dutey and Giddy (1978) andMcKinnon (1979).

be described. This will be followed by a discussion ofsome of the more important activities of market partici-pants. Finally, there will be an introduction to theanalysis of a new feature of exchange markets — cur-rency options. The concern of this paper is with the

structure and mechanics of foreign exchange markets,not with the detemiinants of exchange rates them-selves.

THE BASICS OF FOREIGN EXCHANGEMARKETS

There is an almost bewildering variety of foreignexchange markets. Spot markets and forward marketsabound in a number of currencies. tn addition, thereare diverse prices quoted for these currencies. Thissection attempts to bring order to this seeming dis-array.

Spot) Forward, Bid, Ask

Virtually every major newspaper, such as the WallStreet Journal or the London Financial Times, prints adaily list of exchange rates. These are expressed eitheras the number of units of a particular currency thatexchange for one U.S. dollar or as the number of U.S.dollars that exchange for one unit of a particular cur-

rency. Sometimes both are listed side by side seetable Il.

For major currencies, up to four different prices

typically will be quoted. One is the “spot” price. Theothers may be ‘30 days forward,” 90 days forward,”

5

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and “180 days forward.” These may be expressed eitherin “European Terms” (such as number of $ per LI or in“American Terms” (such as number oIL per $1. (See theglossary for further explanation .1

The spot price is what you must pay to buy curren-

cies for immediate delivery (two working days in theinterbank market; over the counter, if you buy banknotes or travelers checks). The forward prices for eachcurrency are what you will have to pay if you sign a

contract today to buy that currency on a specific futuredate (30 days from now, etc.). In this market, you pay forthe currency when the contract matures.

Why would anyone buy and sell foreign currencyforward? There are some major advantages from hav-ing such opportunities available. For example, an ex-porter who has receipts of foreign currency due at

some future date can sell those funds forward now,thereby avoiding all risks associated with subsequentadverse exchange rate changes. Similarly, an importerwho will have to pay for a shipment ofgoods in foreigncurrency in, say, three months can buy the foreignexchange forward and, again, avoid having to bear the

exchange rate risk.

The exchange rates quoted in the financial press (forexample, those in table 1) are not the ones individualswould get at a local bank. Unless otherwise specified,the published prices refer to those quoted by banks to

other banks for currency deals in excess of $1 million.Even these prices will vary somewhat depending uponwhether the bank buys or sells. The difference betweenthe buying and selling price is sometimes known as thebid-ask spread.” The spread partly reflects the banks’

costs and profit margins in transactions; however, ma-jor banks make their profits more from capital gainsthan from the spread.2

‘rhe market for bank notes arid travelers checks isquite separate from the interbank foreign exchangemarket. For smaller currency exchanges, such as an

individual going on vacation abroad might make, thespread is greater than in the interbank market. ‘Ibis

presumably reflects the larger average costs — includ-ing the exchange rate risks that banks face by holdingbanknotes in denominations too small to be sold in theinterbank market — associated with these smaller ex-changes. Asa result, individuals generally pay a higherprice for foreign exchange than those quoted in thenewspapers.

tNotice the Wall Street Journal quotes only a bank selling price at aparticular time. The Financial Times quotes the bid-ask spread andthe range over the day.

\ii ix~ttiipIrtil tlit’ iirigr ol 51)01 V\rllZIilizi’ rates a%ailable is presented ui table Z. which .sIiow% prires orcli’iitsrhic’iiuiiLs and St(i’liIiL4 (ILIOttLI ~~ithin a one—Iii,tir

iit’iiiitl cii) \c,\c’n)l,i’r-25 1983 I lien’ are t~~(i ii1,cii’tant

h)OiiitS 1(1 t’iijti(i’. I ii’,! all c’’~ec’pltlici,,c’ iii tin’ lirsi lie‘‘I’ I~ir’sqtiott’cI iii the interhank 1)1 ~vhioles~iIi’. iii~ii

Let tor li-ansac—tion,. in ewess ol S L niihlioit. I he .‘,ti’rlingprices have a hid-ask spread ol cinI~0 I ccitt ~vhiich i’.

oiiI~ahlotil 0.07 percent cit the price or 57 on S 10.000On Ifli. the ~pic’~id per dollar-s norih ~~oiks out 1cr hi’abont hall that on sterling ‘54 on .410.000

Sc.’c’oi)(l. tIt’ ~Ilces c1iiciti’d I,,’ local hank,. lorsriiall. n’

ct’tzul. ti-arisat-ticins which ‘,er~eonly as a uuiclr and doriot rierev,arl\ nrpiesciit prices on actual clc’als. iii—

‘. oItc’ a iiiiic1 I.ii-ger- h,icl—~tsL spi’t’.ttl I hic’se rtails1,rvzccls ,.ar; tc-c,r)) Ii;,iik Ic, bank. but are i elated to ‘and

larger than the inlethztnk iate’,. Iii sonic cases. thin

In practice, the spread w I va~during Inc day depending uponmarket corrditiops Fnr example the slorl,np spread may he as litheas 001 cents at ti~iesana or averages about 0.05 cents Spreadsqenert-;yw,’i h~arger on ‘ess wioeiy traded cijrrcnc es

7


may be of the order of4 cents orless on sterling, thoughthe prices quoted in St. Louis involved average spreadsof 8 cents on sterling. The latter represents a spread ofabout 5½percent (about $530 per $10,000 transaction).‘rhe equivalent spread for DM was 7 percent ($700 per$10,000 transaction).

The spread on forward transactions will usually bewider than on spot, especially for longer maturities.For interbank trade, the closing spread on one andthree months forward sterling on September 8, 1983,was .15 cents, while the spot spread was .10 cents. Thisis shown in the top line of the Financial Times report intable 1. Of course, like the spot spread, the forwardspread varies with time of day and market conditions.At times it may be as low as .02 cents. No information isavailable for the size of spread on the forward pricestypically offered on small transactions, since the retailmarket on forward transactions is very small.

HOW DOES “THE” FOREIGNEXCHANGE MARKET OPERATE?

It is generally not possible to go to a specific buildingand “see” the market where prices of foreign exchangeare determined. With few exceptions, the vast bulk offoreign exchange business is done over the telephonebetween specialist divisions of major banks. Foreignexchange dealers in each bank usually operate fromone room; each dealer has several telephones and issurrounded by video screens and news tapes. Typical-ly, each dealer specializes in one ot’ a small number ofmarkets (such as sterling/dollar or deutschemark/dol-lar). Trades are conducted with other dealers whorepresent banks around the world. These dealers tvpi-cally deal regularly with one another and are thus able

to make firm commitments by word of mouth.

Only the head or regional offices of the larger banksactively deal in foreign exchange. The largest of thesebanks are known as “market makers” since they standready to buy or sell any of the major currencies on amore orless continuous basis.Unusuallylarge transac-tions, however, will only be accommodated by market

maket’s on more favorable terms. In such cases, foreignexchange brokers may be used as middlemen to find ataker or takers for the deal. Brokers (of which there are

four major firms and a handful of smaller ones) do nottrade on their own account, but specialize in setting up

large foreign exchange transactions in return for acommission (typically 0.03 cents or less on the sterlingspread). In April 1983, 56 percent of spot transactions

by value involving banks in the United States were

channeled through brokers.4 If all interbank transac-tions at-c included, the figure rises to 59 percent.

Most small banks and local offices of major banks donot deal directly in the interbank foreign exchangemarket. Rather they typically will have a credit line witha large bank or their head office. Transactions will thusinvolve an extra step (see figure IL The customer dealswith a local bank, which in turn deals with a majorbank or head office. The interbank foreign exchangemarket exists between the major banks either directlyor indirectly via a broker.

FUTURES AND OPTION MARKETSFOR FOREIGN EXCHANGE

Until very recently, the interbank market was theonly channel through which foreign exchange transac-tions took place. The past decade has produced major

innovations in foreign exchange trading. On May 16,1972, the International Money Market (1MM) opened

under the auspices of the Chicago Mercantile Ex-change. One novel feature of the 1MM is that it providesa trading floor on which deals are struck by brokers

face to face, rather than over telephone lines. The mostsignificant difference between the 1MM and the inter-bank market, however, is that trading on the 1MM is infutures contracts forforeign exchange, the wpical busi-ness being contracts for delivery on the third Wednes-day of March, June, September or December. Activity atthe 1MM has expanded greatly since its opening. Forexample, during 1972, 144,336 contracts were traded;the figure for 1981 was 6,121,932.

There is an important distinction between “forward”transactions and “futures” contracts. The former areindividual agreements between two parties, say, abankand customer’. The latter’ is a contract traded on anorganized market of a standard size and settlementdate, which is resalable at the market price up to theclose of trading in the contract. These organized mar-kets are discussed more fully below.

While the major banks conduct foreign exchangedeals in large denominations, the 1MM trading is done

in contracts of standard size which are fairly small.Examples of the standard contracts at present areL25,000; DM125,000; Canadian $100,000. These areactually smaller today than in the early days of the

1MM.

Further, unlike prices on the interbank market, price

movements in any single day are subject to specific

4See Federal Reserve Bank of New York (1983).

8


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limits at the 1MM. For- example, for sterling futures,

prices are not allowed to vary more than $0500 awayfrom the previous day’s settlement price; this limit isexpanded if it is reached in the same direction for two

successive days. The limit does not apply on the lastday a contract is traded.

Unlike the interbank market, parties to a foreign ex-

change contract at the 1MM typically do not know eachother. Default risk, however, is minor because con-

tracts are guaranteed by the exchange itself. To mini-mize the cost of this guarantee, the exchange insistsupon “margin requirements” to cover fluctuations inthe value of a contract. This means that an individual orfirm buying a futures contract would, in effect, place a

deposit equal to about 4 percent of the value of thecontract.5

Perhaps the major limitation of the 1MM from thepoint of view of importers or exporters is that contractscover only eight currencies—those of Britain, Canada,West Germany, Switzerland, Japan, Mexico, Franceand the Netherlands — and they are specified in stan-dard sizes for particular dates. Only by chance willthese conform exactly to the needs of importers andexporters. Large firms and financial institutions willfind the market useful, however, if they have a fairlycontinuous stream of payments and receipts in thetraded foreign currencies. Although contracts have aspecified standard date, they offer a fairly flexiblemethod of avoiding exchange rate risk because they aremarketable continuously.

A major economic advantage of the 1MM for non-bank customers is its low transaction cost. Though thebrokerage cost of a contract will vary, a ‘round trip”(that is, one buy and one sell) costs as little as $15. Thisis only .04 percent ofthe value of a sterling contract andless for some of the lat-ger contracts. Of course, suchcosts are high compared with the interbank market,where the brokerage cost on DM 1 million would beabout $6.25 (the equivalent-valued eight futures con-tracts would cost $60 in brokerage, taking $7.50 per

single dealt. They are low, however, compared withthose in the retail market, where the spread may in-

volve a cost of up to 2.5 percent or 3 percent pertransaction.

A market similat to the 1MM, the London Interna-tional Financial Futures Exchange (LIFFE(, opened inSeptember 1982. On LIFFE, futures are traded in ster-

5A bank may also insist upon some minimum deposit to cover aforward contract, though there is no firm rule.

ling, deutschemarks, Swiss francs and yen in identicalbundles to those sold on the 1MM. In its first year, theforeign exchange business of L1FFE did not take off in abig way. The majot provider of exchange rate risk cov-erage for business continues to be the bank network.Less than 5 percent of such cover is provided by mar-kets such as 1MM and LIFFE at present.

An entirely new feature of foreign exchange marketsthat has arisen in the 1980s is the existence of optionmarkets.” The Philadelphia Exchange was the first tointroduce foreign exchange options. ‘Fhese are in fivecurrencies (deutschemark, sterling, Swiss franc, yenand Canadian dollar). Trades are conducted in stan-dard bundles half the size of the 1MM futures con-tracts. The 1MM introduced an options market in Ger-man marks on January 24, 1984; this market tradesoptions on futures conti-acts whereas the Philadelphiaoptions are for spot currencies.

Futures and options prices for foreign exchange arepublished daily in the financial press. Table 3 showsprices for February 14, 1984, as displayed in the WallStreet Journal on the following day. Futures prices onthe 1MM are presented for five currencies (left-handcolumn(. There are five contracts quoted for each cur-rency: March, June, September, December and March1985. For each contr’act, opening and last settlement(settle( prices, the range over the day, the change fromthe previous day, the range over the lifeof the contractand the number of contracts outstanding with theexchange (open interest( are listed.

Consider the March and June DM futures. March

futures opened at $3653 per mark and closed at $3706per’ mark; June opened at $3698 per mark and closed at$3746 pet’ mark. Turn now to the Chicago MercantileExchange (1MM) futures options (center columnLThese are options on the futur-es contracts just dis-cussed (see inset for explanation of options). Thus, theline labeled “Futures” lists the settle prices of theMarch and June futures as above.

Let us look at the call options. These are rights to buyDM futures at specified prices — the strike price. Forexample, take the call option at strike price 35. Thismeans that one can purchase an option to buy DM125,000 March futures up to the March settlement datefor 5.3500 per mark. This option will cost 2.05 cents permark, or $2,562.50, plus brokerage fees. The June op-tion to buyJune futures DM at 5.3500 per’ mark will cost

2.46 cents pet- mat-k, or $3,075.00, plus brokerage fees.

“For a discussion of options in commodities, see Belongia (1983).

10


‘l’he March call option at strike price 5.3900 per markcosts only 0.01 cents per mark or $12.50. These pr’icedifferences indicate that the market expects the dollar’price of the mark to exceed 5.3500, but not to risesubstantially above 5.3900.

Notice that when you exercise a futures call optionyou buy the relevant futures contract but onE’ fulfillthat futures contract at maturity. In contrast, the Phil-

adelphia foreign currency options (right column( areoptions to buy foreign exchange (spot) itself iatherthan futures. So, when a call option is exercised, for-

eign curr’eticy is obtained immediately.

The only difference in presentation of the currency

option prices as compared with the futures options isthat. in the lormei-, the spot exchange r-ate is listed forcomparison rather than the futures price. ‘I’hus, on thePhiladelphia exchange, call options on March DM

62,500at strike price 5.3500 per mar-k cost 1.99 cents perrnar’k or $1,243.75, plus brokerage. Brokerage fees herewould be ofthe same or-der as on thc 1MM, about $16PeA- transaction round trip, per contr’act.

We have seen that there are sevei-al different maikets

for foreign exchange — spot, fijrward, futures, options

on spot, options on futures. The channels throughwhich these markets are formed are, however, fairly

straightforward (see figur-e IL The main channel is theinter1jank network, though for lar-ge interbank transac-

tions, foreign exchange brokers may be used asmiddlemen.

FOREIGN EXCHANGE MARKETACTIVITIES

Much foreign exchange market trading does notappear to be related to the simple basic purpose ofallowing businesses to buy or sell foreign cuxrency inorder, say, to sell or- purchase goods overseas. It iscertainly easy to see the usefulness ofthe large range offoreign exchange transacrions available through theinterhank and organized markets (spot. forward, in-tures, options) to facilitate trade between nations. It isalso clearthat there is a useful role forforeign exchangebroker’s in helping to “make” the interbank rnar’ket.‘l’here are several other activities, however, iii foreignexchange markets that are less well understood andwhose relevance is less obvious to people interested inunderstanding what these mat-kets accomplish.

11


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Two major classes of activity will be discussed. First,the existence of a large number of foreign exchange

markets in many locations creates opportunities toprofit from ‘arbitrage.’ Second, there is implicitly amarket in (foreign exchange) risk bearing. Those whowish to avoid foreign exchange risk (at a price) may doso. Those who accept ;he risk in expectation of profits

are known as speculators.”

Triangular Arbitrage

Triangular arbitrage is the process that ensures that

all exchange rates are mutually consistent. IL for exam-ple, one U.S. dollar exchanges for one Canadian dollar,and one Canadian dollar- exchanges for one Britishpound, then the U.S. dollar-pound exchange rateshould be one pound for one dollar. If it differs, thenthere is an opportunity for profit making. To see why

this is so, suppose that you could purchase two U.S.dollars with one British pound. By first buying C$1 withU.5.51, then purchasing £1 with C$1, and finally buyingUS$2 with £1, you could double your money im-mediately. Clearly this opportunity will not last for- long

since it involves making large profits with certainty.The process of triangular arbitrage is exactly that offinding and exploiting ptofitable opportunities in such

exchange rate inconsistencies. As a result of triangulararbitrage, such inconsistencies will be eliminatedrapidly. Cross rates, however, will only be roughly con-sistent given the bid-ask spread associated with trans-

action costs.

In the past. the possibility of making profits fromtriangular arbitrage was greater as a result of the prac-

tice of expressing exchange rates in American terms inthe United States and in European terms elsewhere.The adoption of standard practice has reduced thelikelihood of inconsistencies.’ Also, in recent years,such opportunities for profit making have been greatlyreduced by high-speed, computerized infonnationsystems and the increased sophistication of the banksoperating in the market.

Arbitrage of a slightly different kind results fromprice differences in different locations. This is ‘space”arbitrage. For example, if sterling were cheaper in Lon-don than in New York, it would be profitable to buy inLondon and sell in New York. Similarly, if prices in theinterbank market differed from those at the 1MM, itwould be profitable to arbitrage between them. As aresult of this activity, prices in different locations will

be brought broadly into line.

Interest Arbitrage

Interest arbitrage is slightly different in nature fromtriangular or space arbitrage; however, the basic motiveof finding and exploiting profitable opportunities stillapplies. There is no reason why interest r-ates denomi-nated in different currencies should be equal. Interestrates are the cost of borrowing or the return to lendingfot a specific period of time. The relative price (ex-change rate of money may change over time so thatthe comparison of, say, a U.S. and a British interest raterequires some allowance for expected exchange ratechanges. Thus, it will be not at all unusual to find

‘All except U.K. and Irish exchange rates are expressed in Americanterms. Futures and options contracts are expressed in Europeanterms.

13


interest rates denominated in dollars and interest ratesdenominated in, say, pounds being somewhat differ-ent. However, real returns on assets of similar qualityshould be the same if the exchange rate r-isk is coveredor’ hedged in the forward market. Wet’e this not true, itwould be possible to borrow in one cur-i-ency and lendin another at a profit with no exchange risk.

Suppose we lend one dollar for a year in the UnitedStates at an interest rate of r,,~.The amount accumu-lated at the end of the year per dollar lent will be I + r~,8(capital plus interest) - If, instead of making dollar loans,we converted them into pounds and lent them in theUnited Kingdom at the rate r~4k,the amount of poundswe would have for each original dollar at the end of theyear would be Sf1 + r~k(,where S is the spot exchangerate (in pounds per dollar( at the beginning of theperiod. At the outset, it is not known if 1 + r~,5dollars isgoing to be worth more than 5(1 + r~k(pounds in ayear’s time because the spot exchange rate in a year’s

time is unknown. This uncertainty can be avoided byselling the pounds forward into dollar’s. ‘[hen the rela-tive value of the two loans would no longer depend onwhat subsequently happens to the spot exchange rate.By doing this, we end up with (1 + r~,k(dollars peroriginal dollar invested. This is known as the ‘cov-ered,’ or hedged, return on pounds.

Since the covered return in our example is denomi-nated in dollars, it can reasonably be compared withthe U.S. interest rate. If these returns are very different,investors will move funds where the retur-n is higheston acovered basis. This process is interest arbitrage. Itis assumed that the assets involved are equally safeand, because the returns are covered, all exchange riskis avoided. Of course, if funds do move in large volumebetween assets or between financial centers, then in-terest rates and the exchange rates (spot and forwardiwill change in predictable ways. Funds will continue toflow between countries until there is no extra profit tobe made from interest arbitr-age. This will occur whenthe returns on both dollar-- and sterling-denominated

assets are equal, that is, when

If (1+r~8) = n+r~kL

Speculation

Arbitrage in the foreign exchange markets involveslittle or- no risk since transactions can be completedrapidly. An alternative source of profit is available fromourguessing other market participants as to what fu-ture exchange rates will be. This is called speculation.Although any foreign exchange transaction that is notentirely hedged forward has a speculative element,only deliberate speculation for’ profit is discussed here.

Until recently, the main foreign exchange specula-tors were the foreign exchange departments of banks,with a lesser role being played by portfolio managers ofother financial institutions and international corpora-tions. The 1MM, however, has made it much easier’ for’individuals and smaller businesses to speculate. A high

proportion of 1MM transactions appears to be specula-tive in the sense that only about 5 percent of contractslead to ultimate delivery of foreign exchange. This

means that most of the activity involves the buying andselling of a contract at d~ffcrenttimes and possiblydifferent prices prior to maturity. It is possible, how-ever, that buying and selling of contracts before matu-

rity would arise out of a str-ate~’to reduce risk. So it isnot possible to say that all such activity is speculative.

Speculation is important for the efficient working offoreign exchange markets. It is a form of arbitrage that

occurs across time rather than across space or be-tween markets at the same time. Just as arbitrage in-creases the efficiency of markets by keeping pricesconsistent, so speculation increases the efficiency offorward, futures and options markets by keeping those

markets liquid. Those who wish to avoid foreign ex-change risk may thereby do so in a well-developedmarket. Without speculators~,r’iskavoidance in foreign

exchange markets would be more difficult and, inmany cases, impossible.”

Risk Reduction

Speculation clearly involves a shifting of risk fromone party to another. For example, if a bank buys for-

This result is known as covered interest parity. It holdsmore or less exactly, subject only to a margin due totransaction costs, so long as the appropriate dollar’ andsterling interest rates are compared.8

8Since there aremanydifferent interest rates, it obviously cannot holdfor allot them. Where (1) does hold is if the interest rates chosenareeurocurrency deposit ratesof thesame duration. In otherwords, itfor

r~,we take, say, the three-month eurodollar deposit rate in Paris andfor rUk we take the three-montheurosterling deposit rate in Paris, then(1) will hold lust about exactly. Indeed, if we took the interest rate andexchange rate quotes all from the same bank, it would be remarkableif (I) did not hold. Otherwise the bank would be offering to pay you toborrow from it and lend straight backl That is, the price of borrowingwould be less than the covered return on lending. A margin betweenborrowing and lending rates, of course, will make thiseven less likelyso that in reality you would lose.

9This is not to say that all speculative activity is necessarilybeneficial.

14

FEGE~ALRESERVE BANK OF ST. ~OU~S MAROH 1984

Covered Interest Parity: An Example

11w lotion rig iflti-nst ate anti n_change -alt- hid- ask spii’ad tin tin’ loin aid tate ~\otilII lii—iIliiltatinns ale laken rum the London 1-iciniujal 1-1927 1 41)42.I lOWS ol Si’pti9TthlT 8, 1 9M3 litHe 1-. -

\o~~let us see it nf’ nouilrl do hettei- to irv,.vst in a( losing three—month eiiilister ing deposit iw a three—mouthi,~change Hate Sj_n 3\tp~lil_ L12.1~%.~.1:iJ c-iir-tirlollai’ tte})t)sit t~lien! the (lOhlairs to he iTht9~’i’dili,llai-s pt-c- I-PUll- I 11)20 IT-- 22 discount war-i sold Ion~aitIinto stl’i log I hi’ ii’ttun F~~~-t100

potlIlCi iirtestitt ill (or SteIIiIl!4 is 2 369 annual iilti’i’r’stiatt (II !P ti,.’ \\Iil,iiZls the iettii’n oil a eo~’eu’e.dcoin—

inti’wst Rates. ltiix;stui ici~ I lilOdt)ilai -—-—-— —- clolIztide1iosit is

1 -\liiiilll ( )ilei- 9’’i,.Rati’ i.-49t0

2.25I - tOO ‘~ - -- 1 i12 17 — mu1 hi, uitei-est i-aU’ on the tIli’I!t’-illIJntii i’uiIltlollzii I I11~I2

(lepllsit is a lii tie hcghei- 7 pecrent than that on an- - liii is wi- could 1101 niakt’ a piulit out ol i:ovei’erl

eurusteruig dV1)OsIt II hit’ c—.u’harige rule rt-malns . . -

- - Hltt’ti’st .trInii’age l)i~spite tile tail that dollar jji -

unchanged. it nould hi’ Imliet- to hold dollais, it the -

- tni’t’st rates art’ higher- till! iliscotirit till ton~ai-ddot—c!\tliatIgl’ i-ate tails, the t’oi’o-.teruig deposit would -

lw’s ill the lr,i’n art o1,Eiikeh 111(51115 they buy teweihi- pr-Ierahle SIi~}lose von decide to cm ti the e~- . . _ -

- - . Iornanl jiouncis Asaiesolt. till-il! us no bent-lit to‘-hange rsk in sellicig the dollars tornarl into . - . . -

the opi~iation I i-an-,aclion costs toi’ iiinst 111111—piJililds. let its I lltliifltl’e liii’ i-ettii-ii to IIIJI(IIIlg Li

- - . - viduals ~~otitd hi, i~\cii greater 111811 those ahtj~e ar~sic-i-hog deposit vt Itil the return ti) holiling a cloliw - -

- . thi’\. noi,ild hire a lie-get- hId ask spli-ati 111,11) thattIi’posil sold lornard into step mg !asstiiliit’ig that

i1

tiotid (ill ihi’ nitt’ihank market‘ on stat I xviih sterling-.

- - cotist-i~tientI~- hi-ti’ is 10 ht’i’ielit lot tht~tvpi’aII ‘Vu unpor;int points i iced to lit, tlai lied atjr,tit - - - -

- en t-stoi- from nlakmg a i-ut eI’NI ui hedged etirlirLir-—till ahote data I- i-st 11111 interest iati~sart- arinrial— - . -

- ltlll\ deposit. tile rvttiiii ~tilt lit’ at least as high On aI/eli SI) the~alt, not t~hdinould actually In- eai-iit-d . -

- iit’I)Osit iii tht’ t’iiiii’iit’v inn 111th tOil starl and n-ishour a three-month pei-u;d liii- ri;implc. the tiuli!— - .. - -

III (‘11(1 u~i that is. ii oil ilat-li dollars aunt wish toinhiilth i-ate equivalent to au ajintiat -alt- ul 1W - - -

- - — (‘11(1 ti}i ‘‘ ith dollars. niakt’ a enu-ollollar deposil - Iipt~ier1t t~2-Is pei-~i-nt. - - -

ton hate stei’luig am! ttisii to (lId IiJ) t-t-nh stel-Ictlg.~‘econd, till’ Ii itt aid exehiangi’ rates need 501111 naki- a etiiister ing deposit ttvt;ti han, sti-ili ig arId

n_pianauioul I lit- dollLo- is at a discount against stir— ttisl) to thu till ill thillai’s lilt-i-i’ IS likely to lie 19th’ or1mg Ibis ineatm the lijinac (I ilcihlin hovs 1155 stei— miii ditiereni-v hetnei-n holding a eiuiiisit-rhing up—hug. So tte han- to mid the tlisroiiiit onto the spo

tposil sold toi-nai-d into dtihliii’s In liuivirig diillais

pi~-~-to r41’t the torn-aid pun- heraose till- pu-ire is spoi nOd lioldi ig a t-tirodohlar deposit. ( )l clitilse iithe iltilllIfl’l ut doilztis per

1iotind. not the -eu’i st’ you hold ad tilIl’rrtl!rtl (leplJSit 81111 i-tc-haiigt’

\otuce also tint the llisl-IJtlrlt is tiit-asur’d iii tiiu-— i-aU’s sohisequemlv change, tin- irstilt will lie ten’lions ol a ll’ilt 1101 ti-actions ol a (1()llai~So the dilli-it-ut

nar d lot eign i’srhange horn a i-usurullcr it 1111 cases its muumive tlu risk ul losses tile to une’tpertcll I’’

t’\pOsl.lI-c lii risk tthili till- rtcstomer reduces his I ton— rhunge I ate i-han~es ( )ne si uple wat to ito this is to

ncr lhc-c-e is 111)1 .1 ti\r-d amount ot risk that ills to hi’ eflsnr-e that assets and liatiitrties dcnurni sited in each‘shai-ed (lilt Some siraleLies niat molt i-a net ‘cdiii’ operating riurrcnrt are equal. this is kulo\t las 11181111

tool lit risk all around iui,~. loi sample 1 hank that sells sterling lounard liii1-ristorner- ni_n sonuitanrotrslv tim sterin~ Iou’nard In

general rote liriauicial inslituterns -or other this i-u-nt. the tlank is n_posed to I_eu-u e’¼1-hangi-rate

liinis:. ir1

Ierati ig n—i tar-il-It cii rio-rent es. ttill Ii to risk.


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Banks often use ‘swaps to close gaps in the matu-rity structure of their assets and liabilities in a cur-r’ency. This involves the simultaneous purchase andsale of a currency for ditferent maturity dates. In April1983, 33 percent of U.S. banks’ foreign exchange turn-over involved swaps as compared with 63 percent spotcontracts and only 4 percent outright forwardcontracts.1°

Suppose a bank has sold DM to a customer threemonths forward and bought the same amount of DMfrom a different customer six months forward. There

are two ways in which the bank could achieve zeroforeign exchange risk exposure. It could either under-

take two separate offsetting forward transactions, or itcould set up a single swap with another bank that hasthe opposite mismatch of dollar-DM flows whereby itteceives DM in exchange for dollars in three monthsand receives back dollars in exchange for DM in six

‘°SeeFederal Reserve Bank of New York (1983).

months. Once the swap is set up, the bank’s net profitsare protected against subsequent changes in spot ex-

change rates during the next six months.

Within the limits imposed by the nature of the con-

tracts, a similar effect can be achieved by an appropri-ate portfolio of futuies contracts on the 1MM. Thus, abank would buy and sell futures contracts so as to

match closely its forward commitments to customers.In reality, banks will use a combination of methods toreduce foreign exchange risk.

Markets that permit banks, firms and individuals tohedge foreign exchange risk are essential in times of

fluctuating exchange rates. This is especially impor-tant for banks if they are to be able to provide efficientforeign exchange services for their customers. In theabsence of markets that permit foreign exchange riskhedging, the cost and uncertainty of internationaltransactions would be greatly increased, and interna-tional specialization and trade would be greatly re-duced.

16

FEDERAL RESERVE BANK OF ST LOUIS MARCH 1984

CONCLUStON

The foreign exchange markets are complex and, for

the outsider, hard to comprehend. The primacy func-tion of these markets is straightforward. It is to facilitateinternational transactions related to trade, travel orinvestment. Foreign exchange markets can now

accommodate a large range of current and forwardtransactions -

Given the variability ofexchange rates, it is importantfor banks and firms operating in foreign currencies to

be able to reduce exchange rate risk whenever possi-ble, Some risk reduction is achieved by interbankswaps, but some is also taken up by speculation Arbi-

trage and speculation both increase the efficiency ofspot and forward foreign exchange markets and haveenabled foreign exchange markets to achieve a highlevel of efficiency. Without the successful operation ofthese markets, the obstacles to international trade andinvestment would be substantial and the world wouldbe a poorer place

17


REFERENCES Federal Reserve Bank of New York. “Summary of Results of US,Foreign Exchange Market Turnover Survey Conducted in April

Belongia, Michael T. “Commodity Options: A New Risk Manage- 1983” (September 8, 1983).ment Toot for Agricultural Markets,” this Review (June/July 1983), Garman, Mark B., and Steven W. Kohlhagen. “Foreign Currencypp. 5—15. Option Values,” Journal of International Money and Finance (De-

cember 1983), pp. 231—37.Black, Fisher, and Myron Scholes. “The Pricing of Options andCorporate Liabilities,” Journal of Political Economy (May/June Giddy, tan H. “Foreign Exchange Options,” Journalof Futures Mar-1973), pp. 637—54. kets (Summer 1983), pp. 143—66,

Chrystal, K. Alec. “On the Theory of International Money” (paper Krugman, Paul, “Vehicle Currencies and the Structure of Intemna-presented to UK. International Economics Study Group Confer- tional Exchange,” Journal of Money, Credit and Banking (Augustence, September1982, Sussex, England). Forthcoming in J. Black 1980), pp. 513-26.and C, S. Dorrance, eds., Problems of International Finance (Lon- Kubarych, Roger M. Foreign Exchange Markets in the Uniteddon: Macmillan, 1984). States. (Federal Reserve Bank of New York, 1983).

Dufey, Gunter, and Ian H. Giddy. The International Money Market McKinnon, Ronald I, Money in International Exchange: The Con-(Prentice-Hall, 1978). vertible Currency System (Oxford University Press, 1979),

18

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