ch 004 ppt_ge-session 1-2

The Market for

Foreign Exchange

Tolmas Wong, CFA

Outline

Function and Structure of the FX Market

FX Market Participants

Correspondent Banking Relationships

The Spot Market

Spot Rate Quotations

The Bid-Ask Spread

Spot FX Trading

Cross Exchange Rate Quotations

Triangular Arbitrage

Spot Foreign Exchange Market Microstructure

4-2

Outline Continued

The Forward Market

Forward Rate Quotations

Long and Short Forward Positions

Forward Cross-Exchange Rates

Swap Transactions

Forward Premium

Exchange-Traded Currency Funds

4-3

FX Market Participants

The FX market is a two-tiered market:

Interbank market (wholesale) About 100-200 banks worldwide stand ready to make a market in foreign

exchange.

Nonbank dealers account for about 40% of the market.

There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.

Client market (retail)

Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

4-4

Geographic Extent

0

5,000

10,000

15,000

20,000

25,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Average Electronic Conversations Per Hour

Greenwich Mean Time

Tokyo

opens

Asia

closing

10 AM

In Tokyo

Afternoon

in America

London

closing

6 pm

In NY

Americas

open

Europe

opening

Lunch

In Tokyo

Singapore, Hong Kong, Tokyo, Bahrain, London, New York, San Fran, & Sydney.


Large commercial banks maintain demand

deposit accounts with one another, which

facilitates the efficient functioning of the FX

market.

4-6


Bank A is in London. Bank B is in New York.

The current exchange rate is £1.00 = $2.00.

A currency trader employed at Bank A buys

£100m from a currency trader at Bank B for

$200m settled using its correspondent

relationship.

Bank A

London

Bank B

NYC

$200

£100

4-7

$600m

£400m $1200m

£100m £100m

$1,200m £400m

$600m

You can check your work: make sure that £1,300m = $1,200x(£1/$2) +£100 + £600

$200

£100

Bank A buys £100m from Bank B for $200m


Assets Liabilities

£ deposit at B £300m

Other Assets £600m

B’s Deposit $1,000m

Other L&E £600m

Total Assets £1,300m Total L&E £1,300m

Assets Liabilities

$ deposit at A $1000m

Other Assets $800m

A’s Deposit £300m

Other L&E $800m

Total Assets $2,200m Total L&E $2,200m

B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m

Bank A

London

Bank B

NYC

$ deposit at B $800m

4-8

Practice Problem

Bank X is in Milan. Bank Y is in London.

The current exchange rate is €1.10 = £1.00.

Show the correct balances in each account if a

currency trader employed at Bank X buys

£100,000,000 from a currency trader at Bank Y

for €110,000,000. (The balance sheets are

shown on the next slide.)

4-9

€110m

£100m

Check: £1,700m = €1,320m x +£100 + £400 £1.00 €1.10

Check: €2,020m = £400m x + € 770 + €810 € 1.10 £1.00

€770m

£400m

£100m

€1,320m

£100m

€1,320m

€770m

£400m

Bank X buys £100m from Y for €110m

Assets Liabilities

£ deposit at Y £300m

Other Assets £600m

Y’s deposit €1,210m

Other L&E £400m


Assets Liabilities

€ deposit at X €1,210m

Other Assets €590m

X’s deposit £300m

Other L&E €810m

Total Assets €2,020m Total L&E €2,020m

Y’s deposit £200m £ deposit at X £200m X’s deposit €880m

Bank X

Milano

Bank Y

London

€ deposit at Y €880m

Bank X Bank Y

€1.10 = £1.00

Assets Liabilities

£ deposit at Y £300m

Other Assets £600m

Y’s deposit

Other L&E £400m


Assets Liabilities

€ deposit at X €1,210m

Other Assets €590m

X’s deposit

Other L&E €810m

Total Assets €2,020m Total L&E €2,020m

Y’s deposit £200m £ deposit at X £200m X’s deposit

Bank X

Milano

Bank Y

London

€ deposit at Y €880m

Bank X Bank Y

€1,210m £300m

€880m

Practice Problem

4-10


International commercial banks communicate

with one another using:

SWIFT: The Society for Worldwide

Interbank Financial Telecommunications.

CHIPS: Clearing House Interbank Payments

System.

ECHO: Exchange Clearing House Limited,

the first global clearinghouse for settling

interbank FX transactions.

4-11


A direct quotation is:

The U.S. dollar equivalent.

E.g., “a Japanese Yen is worth about a

penny.”

An indirect quotation is:

The price of a U.S. dollar in the foreign

currency.

E.g., “you get 100 yen to the dollar.”

See Exhibit 4.4 in the textbook.

4-12

.5072 1

9717 . 1 =


Currencies

U.S.-dollar foreign-exchange rates in late New York trading.

--------Friday-------

Country/currency in US$ per US$

Euro area euro 1.4744 .6783

1-mos forward 1.4747 .6781

3-most forward 1.4744 .6782

6-mos forward 1.4726 .6791

British pound 1.9717 .5072

1-mos forward 1.9700 .5076


6-mos forward 1.9593 .5104

The direct quote for the

pound is: £1 = $1.9717

The indirect quote for the

pound is: £.5072 = $1

Note that the direct quote is

the reciprocal of the indirect

quote:

5072 .

1 9717 . 1 =

Currencies


--------Friday------- --------Friday-------

Country/currency in US$ per US$ Country/currency in US$ per US$

Canadian dollar .9984 1.0016 Euro area euro 1.4744 .6783

1-mos forward .9986 1.0014 1-mos forward 1.4747 .6781

3-most forward .9988 1.0012 3-most forward 1.4744 .6782


Japanese yen .009220 108.46 British pound 1.9717 .5072


3-most forward .009306 107.46 3-most forward 1.9663 .5086

6-mos forward .009378 106.63 6-mos forward 1.9593 .5104 4-13

The Bid-Ask Spread

The bid price is the price a dealer is willing

to pay you for something.

The ask price is the amount a dealer wants

you to pay for something.

It doesn’t matter if we’re talking used cars

or used currencies: the bid-ask spread is

the difference between the bid and ask

prices.

4-14

The Bid-Ask Spread

A dealer could offer:

A bid price of $1.4739 per €.

An ask price of $1.4744 per €.

While there are a variety of ways to

quote the above, the bid-ask spread

represents the dealer’s expected

profit.

Percent Spread = × 100 Ask Price – Bid Price

Ask Price

4-15

0.0339% = x 100 $1.4744 – $1.4739

$1.4744

The Bid-Ask Spread

A dealer pricing pounds in terms of dollars would likely

quote these prices as 12–17.

Anyone trading $10m knows the “big figure.”

USD Bank

Quotations

American Terms European Terms

Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

4-16

The Bid-Ask Spread

USD Bank

Quotations


Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Notice that the reciprocal

of the S($/£) bid is the

S(£/$) ask.

= £1.00

$1.9712

£.5073

$1.00

4-17

$10,000 × £1

$1.9720 = £5,071

Dealer will pay $1.9715 for 1 GBP; he is asking $1.9720.

He will pay £.5071 for $1 and will charge £.5072 for $1

Currency Conversion with

Bid-Ask Spreads

A speculator in New York wants to take a $10,000

position in the pound.

After his trade, what will be his position?

1.9715 – 20

.5071 – 72

S($/£)

S(£/$)

Bid Ask

4-18

He sells €250,000 at the dealer’s bid price: €250,000 x $1.4739

€1.00 =$368,475

He sells £500,000 at the dealer’s ask price:

£500,000 x $1.00 £.5076

=$985,027.58 $1,353,502.58

Sample Problem A businessman has just completed transactions in

Italy and England. He is now holding €250,000 and

£500,000 and wants to convert to U.S. dollars.

His currency dealer provides this quotation: GBP/USD 0.5025 – 76

USD/EUR 1.4739 – 44

What are his proceeds from conversion?

($985,027.58 + $100,000) x €1.00

$1.4744 = €735,911.27

£500,000 x $1.00

£.5076 $985,027.58 =

Another Sample Problem

An Italian has just completed transactions in

America and England. He is now holding $100,000 and £500,000, and wants to convert both amounts to the

euro.

His currency dealer provides this quotation: GBP/USD 0.5025 – 76

USD/EUR 1.4739 – 44

What are his proceeds from conversion?

4-20

Spot FX Trading

In the interbank market, the standard size

trade is about U.S. $10 million.

A bank trading room is a noisy, active

place.

The stakes are high.

The “long term” is about 10 minutes.

4-21

£0.75 €1.00

= $1.50 £1.00 €1.00 $2.00

×

€1.00 = £0.75

Pay attention to your “currency algebra”!

Cross Rates

Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and that

S($/£) = 2.00 (i.e., £1.00 = $2.00).

What must the €/£ cross rate be?

4-22

£10,000 sell £ at bid $19,712 buy € at ask €13,371

Cross Rates with Bid-Ask Spreads

To find the €/£ cross bid rate, consider a retail customer who:

USD Bank Quotations


Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Euros 1.4738 1.4742 .6783 .6785

£10,000 × $1.9712

£1.00

€.6783

$1.00 × = €13,370.65

Starts with £10,000, sells £ for $, and buys €:

He has effectively sold £ at a €/£ bid price of €1.3371/£.

4-23

£7,475 $14,738 buy £ at ask sell € at bid €10,000


To find the €/£ cross ask rate, consider a retail customer who starts with €10,000, sells € for $, and buys £:

€10,000 × $1.00

€.6785

£1.00

$1.9717 × = £7,474.97

He has effectively bought £ at a €/£ ask price of €1.3378/£.

USD Bank

Quotations


Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Euros 1.4738 1.4742 .6783 .6785

4-24


Bank

Quotations


Bid Ask Bid Ask

£:$ $1.9712 $1.9717 £.5072 £.5073

€:$ $1.4738 $1.4742 €.6783 €.6785

£:€ €1.3371 €1.3378 £0.7475 £0.7479

direct indirect

Recall that the reciprocal of the S(£/€) bid is the S(€/£) ask.

= £.7479

€1.00 €1.3371

£1.00

4-25


Bank Quotations Bid Ask

Deutsche Bank £:$ $1.9712 $1.9717

Credit Lyonnais €:$ $1.4738 $1.4742

Credit Agricole £:€ €1.3310 €1.3317

“No Arbitrage” £:€ €1.3371 €1.3378

Suppose we observe these banks posting these exchange rates. As we have calculated the “no arbitrage” £/€ cross bid and ask rates, we can see that there is an arbitrage opportunity:

£1 × $1.9712

£1.00

€1.00

$1.4742 × = €1.3371

4-26



Deutsche Bank £:$ $1.9712 $1.9717



“No Arbitrage” £:€ €1.3371 €1.3378

By going through Deutsche Bank and Credit Lyonnais, we can sell pounds for €1.3371.

The arbitrage is to buy the pounds from Credit Agricole for €1.3317.

£1 × $1.9712

£1.00

€1.00

$1.4742 × = €1.3371

4-27



Deutsche Bank £:$ $1.9712 $1.9717



Start with £1m. Sell £ to Deutsche Bank for $1,971,200:

Buy € from Credit Lyonnais, receive €1,337,132:

$1,971,200 × €1.00

$1.4742 = €1,337,132.

Buy £ from Credit Agricole, receive £1,004,078.89.

£10,000,000 × $1.9712 £1.00

= $1,971,200.

4-28

Spot Foreign Exchange Microstructure

Market microstructure refers to the

mechanics of how a marketplace

operates.

The bid-ask spreads in the spot FX

market:

Increase with FX exchange rate

volatility.

Decrease with dealer competition.

Private information is an important

determinant of spot exchange rates.

4-29

The Forward Market



Forward Cross Exchange Rates

Forward Premium

Swap Transactions

4-30


The forward market for FX involves

agreements to buy and sell foreign

currencies in the future at prices agreed

upon today.

Bank quotes for 1, 3, 6, 9, and 12 month

maturities are readily available for

forward contracts.

Longer-term swaps are available.

4-31


Consider the exchange

rates shown to the

right. For British

pounds, the spot

exchange rate is

$1.9717 = £1.00 while

the 180-day forward

rate is $1.9593 = £1.00

What’s up with that?


UK pound 1.9717 .5072

1-mos forward 1.9700 .5076


6-mos forward 1.9593 .5104

Clearly market participants

expect that the pound will be

worth less in dollars in six

months. 4-32


Consider the (dollar) holding period return of a

dollar-based investor who buys £1 million at the

spot exchange rate and sells them forward:

$HPR = gain

pain

$1,959,300 – $1,971,700

$1,971,700 =

–$12,400

$1,971,700 =

$HPR = –0.00629

Annualized dollar HPR = –1.26% = –0.629% × 2 4-33

Forward Premium

The interest rate differential implied by forward

premium or discount.

For example, suppose the € is appreciating from S($/€)

= 1.55 to F180($/€) = 1.60.

The 180-day forward premium is given by:

= 0.0645, or 6.45%

1.60 – 1.55

1.55 × 2 = f180,€v$

F180($/€) – S($/€)

S($/€) = ×

360

180

4-34


If you have agreed to sell anything (spot

or forward), you are “short.”

If you have agreed to buy anything

(forward or spot), you are “long.”

Sp, if you have agreed to sell an FX

forward, you are short, and if you have

agreed to buy an FX forward, you are

long.

4-35

Payoff Profiles pro

fit

loss

Spot exchange in 6 months $/£


UK pound 1.9717 .5072

1-mos forward 1.9700 .5076


6-mos forward 1.9593 .5104

$1.9593/£

$2.10/£

$1,407

$1.90/£

−$593

Consider the payoffs at

maturity to a long position

in a six month forward

contract on £10,000.

4-36

Forward Cross Rates

Currencies


--------Friday-------


Euro area euro 1.4744 .6783

1-mos forward 1.4747 .6781

3-mos forward 1.4744 .6782

6-mos forward 1.4726 .6791

UK pound 1.9717 .5072

1-mos forward 1.9700 .5076

3-mos forward 1.9663 .5086

6-mos forward 1.9593 .5104

The 3-month forward €/£

cross rate is:

£0.7498

€1.00 =

$1.4744 £1.00

€1.00 $1.9663 ×

4-37

Currency Symbols

In addition to the familiar currency symbols (£, ¥, €, $) there are three-letter codes for all currencies.

It is a long list, but selected codes include:

CHF Swiss francs

GBP British pound

ZAR South African rand

CAD Canadian dollar

JPY Japanese yen

4-38

Currency Market Basics:

Spot-Forward Arbitrage

ac_phil_05

Scenario: Today you have $1000, but you would like to have euros in a year and would like to ”lock in” today’s exchange rate

Option 1: Buy EUR, sell USD in the spot market, invest at EUR deposit rate

Option 2: Buy EUR, sell USD in the forward market, invest at USD deposit rate

Assumptions:

USD deposit rate = 2%

EUR deposit rate = 4%

Spot rate = 1.55 $/€

Questions:

1) How many euros would you have 1 year from now if you took the first option?

2) What is the arbitrage-free 1-year forward rate?

The relationship between spot and forward exchange rates is a function of the differential between the short term interest rates of the two currencies

Currency Market Basics:

Spot-Forward Arbitrage

ac_phil_05

Answers:

1) How many euros would you have 1 year from now if you took the first option?

Sell $1000, buy €645.16; Invest €645.16 at 4% for 1 year = €645.16 * 1.04 = €670.97

2) What is the arbitrage-free 1-year forward rate?

Invest $1000 at 2% for 1 year = $1000 * 1.02 = $1020; sell $1020, buy €670.97

Forward rate = $1020 / €670.97 = 1.5202 $/€

Alternatively, forward rate can be calculated as follows:

Forward rate = Spot rate * (1+ USD rate) / (1+EUR rate) = 1.55 * (1.02) / (1.04) = 1.5202

An arbitrage opportunity would exist if the spot/forward relationship differed from that implied by the short term rate differential.

A non-deliverable forward contract (NDF)

is a forward contract whereby there is no

actual exchange of currencies. Instead, a

net payment is made by one party to the

other based on the contracted rate and

the market rate on the day of settlement.

Although NDFs do not involve actual

delivery, they can effectively hedge

expected foreign currency cash flows.

Non-deliverable Forward Market

NDF Example

We need to hedge $ 10 million USD equivalent worth of risk on the

KRW out to a 1 month maturity. We know that the NDF market is

reasonably liquid out to a 1 year term and even further if needed.

Spot : 1120

1m NDF : 1145

As we have KRW we are going to sell the 1 month KRW NDF forward

@ 1145. So in effect we have bought $10 mn and sold KRW 11.45

billion.

In one months time we have some potential scenarios depending on

what the spot market did. The level at which the spot market ends up

on the maturity date of the contract is known as the fixing. The fixing is

usually a referenced level taken at a particular time of the day that will

be written into the Non Deliverable Forwards (NDF) contract :

NDF Example

- Scenario 1 Scenario 2 Scenario 3

Fixing 1120 1145 1165

USD Amount on

Fixing Day

KRW 11.45 bn @

1120 =

$10,223,214

KRW 11.45 bn @

1145 =

$10,000,000

KRW 11.45 bn @

1165 =

$9,828,326

Pay / Receive -$ 223,214 $0 +$171,674

Table : NDF Payoff

From the above it is now very clear that the net cashflow from the Non Deliverable

Forwards (NDF) will balance out with the spot transaction that the corporate will carry

out with their remittance. In effect they hedged their FX exposure at 1145.

One important aspect to note about Non Deliverable Forwards (NDF) is that the

forward points can be quite large, this is mainly due to the fact that the interest rate

differential between the USD and emerging market currencies tends to be quite high.

CNY-NDF market not important anymore since 2010 due to CNH market development

Evolution of Trading in Renminbi

The Gradual Revaluation of the RMB (1994–2010)

Managed float

Peg to dollar

One currency rate

The yuan is rapidly developing along the criteria for an international currency status

A Scoreboard of International

Currency Status

Swaps

A swap is an agreement to provide a counterparty with something he or she wants in exchange for something that you want.

Often on a recurring basis, e.g., every six months for five years.

Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

Swaps are covered fully in Chapter 10.

4-47


Individual shares are denominated in the U.S.

dollar and trade on the New York Stock Exchange.

Consider an ETF where each share represents 100 euros. The price of one share at any point in time will reflect the spot dollar value of 100 euros plus accumulated interest minus expenses.

Six additional currency trusts exist on the Australian dollar, British pound sterling, Canadian dollar, Mexican peso, Swedish krona, and the Swiss franc.

Currency is now recognized as a distinct asset class, like stocks and bonds. Currency ETFs facilitate investing in these currencies.

4-48


Single or a basket of currencies

Tracking error

Costs

Leverage

Liquidity

Trading flexibility (market hours,

short selling)

Summary

Spot rate quotations

Direct and indirect quotes

Bid and ask prices

Cross Rates

Triangular arbitrage


Forward premium (discount)

Forward points

4-50

ch 004 ppt_ge-session 1-2

Documents

total assets

xs deposit

ys deposit

bs deposit

london bank b nyc

tiered market

practice problem bank

demand deposit accounts