chapter 4 the market for foreign exchange management 3460 institutions and practices in...

Chapter 4 The Market for Foreign

Exchange

Management 3460 Institutions and Practices in

International Finance

Fall 2003Greg Flanagan

Oct 2, 2003 2

Chapter Objectives The student will be able to:

Explain the Function and Structure of the FOREX MarketFX Market ParticipantsCorrespondent Banking RelationshipsWholesale/retailDirect and indirect

Oct 2, 2003 3


Explain the Spot market Spot Rate Quotations S(j/k)The Bid-Ask SpreadSpot FX TradingCross Exchange Rate QuotationsTriangular Arbitrage

Oct 2, 2003 4


Explain the Forward market

Forward Rate Quotations FN(j/k)

Long and Short Forward Positions

Forward Cross-Exchange Rates

Swap Transactions

Forward Premium

Oct 2, 2003 5

FOREX Market Participants

The FOREX market is a two-tiered market: Interbank Market (Wholesale)

• About 700 banks worldwide stand ready to make a market in Foreign exchange.

• Nonbank dealers account for about 20% 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.

Oct 2, 2003 6

Correspondent Banking Relationships

Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market.

International commercial banks communicate with one another with: 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—in cooperation with fedwire (The US Fed reserve system).

Oct 2, 2003 7

Spot Rate Quotations

The direct quote for British pound is:

£1 = $1.5627

CountryUSD equiv Friday

USD equiv Thursday

Currency per USD Friday

Currency per USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.5906 0.5934 1.6932 1.6852

Brazil (Real) 0.2939 0.2879 3.4025 3.4734

Britain (Pound) 1.5627 1.566 0.6399 0.6386

1 Month Forward 1.5596 1.5629 0.6412 0.6398

3 Months Forward 1.5535 1.5568 0.6437 0.6423

6 Months Forward 1.5445 1.5477 0.6475 0.6461

Canada (Dollar) 0.6692 0.6751 1.4943 1.4813

1 Month Forward 0.6681 0.6741 1.4968 1.4835

3 Months Forward 0.6658 0.6717 1.502 1.4888

6 Months Forward 0.662 0.6678 1.5106 1.4975

Oct 2, 2003 8


The indirect quote for British pound is:

£.6399 = $1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)

1.68521.69320.59340.5906Australia (Dollar)

3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday

USD equiv FridayCountry

Oct 2, 2003 9


Note that the direct quote is the reciprocal of the indirect quote:

6399.

15627.1

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)


3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday


Oct 2, 2003 10

Reciprocal FX Markets

BR Direct BR Indirect

1.5627

£

QUS$

D

US$

Q£

S

D

S

US Indirect US Direct

.6399

Oct 2, 2003 11

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 the dealer wants you to pay for the thing.

The bid-ask spread is the difference between the bid and ask prices.

Oct 2, 2003 12

Cross Rates Suppose that S($/€) = .50

i.e. $1 = 2 € and that S(¥/€) = 50

i.e. €1 = ¥50 What must the $/¥ cross rate be?

,¥

€

€

$

¥

$ since

¥100 $1or .01 ¥)/($¥100

1$

¥50

1€

2€

1$ S

Oct 2, 2003 13

Triangular Arbitrage

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

$

£¥

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.

Oct 2, 2003 14


80¥

1£

120¥

1$

1$

50.1£

The implied S(¥/£) cross rate is S(¥/£) = 80

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

So, how can we make money?

Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

$

£¥

Oct 2, 2003 15


As easy as 1 – 2 – 3: Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

$

£¥

1. Sell our $ for £, 1

22. Sell our £ for ¥,

3

3. Sell those ¥ for $.

Oct 2, 2003 16


Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000

Sell our £ 150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000Sell ¥ 12,750,000 for $ at S(¥/$) = 120

receive $106,250

profit per round trip = $ 106,250- $100,000 = $6,250

Oct 2, 2003 17

Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics of how a marketplace operates.

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.

Oct 2, 2003 18

The Forward Market

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

Oct 2, 2003 19

Forward Rate Quotations

The forward market for FOREX 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.

Oct 2, 2003 20

Forward Rate Quotations

Consider the example :

for Japanese yen, the spot rate is

$1.5627 = £1.00

While the 180-day forward rate is

$1.5445 = £1.00 What’s up with that?

Oct 2, 2003 21


The market participants expect that the pound will be worth less in dollars in six months.

1.49751.51060.66780.6626 Months Forward

1.48881.5020.67170.66583 Months Forward

1.48351.49680.67410.66811 Month Forward

1.48131.49430.67510.6692Canada (Dollar)

0.64610.64751.54771.54456 Months Forward

0.64230.64371.55681.55353 Months Forward

0.63980.64121.56291.55961 Month Forward

0.63860.63991.5661.5627Britain (Pound)

3.47343.40250.28790.2939Brazil (Real)


3.03773.02210.32920.3309Argentina (Peso)



USD equiv Thursday


Oct 2, 2003 22

Long and Short Forward Positions

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”.

If you have agreed to sell FX forward, you are short.

If you have agreed to buy forex forward, you are long.

Oct 2, 2003 23

Payoff Profiles

S180($/¥)

F180($/¥) = .009524

Short position

0

loss

profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain.

F180($/¥) = .0095

.0024

Oct 2, 2003 24

Payoff Profiles

S180($/¥)

F180($/¥) = .009524

Short position

0

loss

profitIf you agree to sell in the future at a set price and the spot price later rises then you lose.

F180($/¥) = .0096

-.0076

Oct 2, 2003 25

Payoff Profiles

loss

0 S180($/¥)

Short position-F180($/¥)

F180($/¥)Long position

profitSince this is a zero-sum game, the long position payoff is the

opposite of the short.

F180($/¥) = .009524

Oct 2, 2003 26

Forward Cross Exchange Rates

It’s just an “delayed” example of the spot cross rate discussed above.

In generic terms

)/($

)/($)/(

and

)/($

)/($)/(

kF

jFjkF

jF

kFkjF

N

NN

N

NN

Oct 2, 2003 27

SWAPS A swap is an agreement to provide a

counterparty with something he wants in exchange for something that you want.

Swap transactions are a simultaneous sale of spot FX and a forward purchase of an equal amount (or vice versus)

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

Oct 2, 2003 28

Forward Premium

It’s just the interest rate differential implied by forward premium or discount.

For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307

The forward premium is given by:

01375.5235.

5235.5307.

180

360

€)/($

€)/($€)/($180$,€180

S

SFf v

chapter 4 the market for foreign exchange management 3460 institutions and practices in...

Documents

tiered market

forex market participants

indirect slide

interbank market wholesale

usd equiv fridaycountry

premium slide

months forward1

months forward0