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International Financial Markets – 05/08/2015
TABLE OF CONTENTS
The FX market
Exchange rates
Exchange rates regimes
Financial balances
Coopeland – ch. 1, 2 and 8
International Financial Markets – Lecture IV: Forex 05/08/2015
The FX market
As every markets, the market for foreign currency can be
viewed as the place where supply and demand of foreign
currency meet.
International Financial Markets – Lecture IV: Forex 05/08/2015
The FX market
The foreign exchange market, or simply Forex or FX, is a
global decentralize.
The FX market is the place where people exchange
currencies.
The FX market operates on several levels:
The Interbank FX market;
The Corporate and retail FX market.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX market structure
Traders as well as market makers are geographically
dispersed.
They are linked by:
Voice brokers;
Direct dealing through telephone conversations.
Quotations are distributed over proprietary systems and
typically for indications.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX market structure
General Motors Microsoft
Chase Bank
Dealer
Deutsche Bank
Dealer
Broker
Barclay’s Bank Credit Suisse Bank of Tokyo
Bank of
America
Motorola
International Financial Markets – Lecture IV: Forex 05/08/2015
FX market structure
It is geographically dispersed
It is a dealer market
Open 24 hours a day
There is price dispersion
Highly customized products
International Financial Markets – Lecture IV: Forex 05/08/2015
FX market size
590 820
1190 1490
1200
1880
3300
3980
0
500
1000
1500
2000
2500
3000
3500
4000
4500
1989 1992 1995 1998 2001 2004 2007 2010
Daily
ave
rag
e in
bill
ion
US$
International Financial Markets – Lecture IV: Forex 05/08/2015
Daily volumes by location
UK 37%
US 18%
Japan 06%
Singapore 05%
Switzerland 05%
Hong Kong 05%
Australia 04%
France 03%
Denmark 02%
Germany 02% Others 13%
International Financial Markets – Lecture IV: Forex 05/08/2015
Daily volumes by location
1854
904
312 266 263 238 192 152 120 109
646
0
200
400
600
800
1000
1200
1400
1600
1800
2000
International Financial Markets – Lecture IV: Forex 05/08/2015
Daily volumes by currency
84.9
39.1
19 12.9
7.6 6.4 5.3 2.4 2.2
20.2
0
10
20
30
40
50
60
70
80
90
100
200420072010
Perc
enta
ge s
hare
s of
ave
rage d
aily
turn
ove
r
International Financial Markets – Lecture IV: Forex 05/08/2015
Turnover by currency pair
14.3%
9.0%
6.3% 4.2% 4.6%
18.8%
27.7%
2.8% 2.7% 1.8% 4.1% 3.7%
0
200
400
600
800
1000
1200$ pairs
84.9%
€ pairs
39.1%
International Financial Markets – Lecture IV: Forex 05/08/2015
Main roles of the FX market
Medium of exchange
The foreign exchange market facilitates trades in goods and
services;
Medium of exchange
It facilitates purchase and sale of securities.
Medium of risk management
It helps to redenominate and manage currency risk in asset
stock or liability positions.
International Financial Markets – Lecture IV: Forex 05/08/2015
Main roles of the FX market
Who are the suppliers or demanders of the foreign
currency?
1. Exporters: they are paid with the foreign currency and
therefore the need to convert it.
2. Foreign investors: British investors exchange pounds for
dollars so as to buy shares in Apple.
3. Speculators: they operate in the FX markets aiming to
obtain profit from the trading activity.
International Financial Markets – Lecture IV: Forex 05/08/2015
What is an exchange rate?
The first thing to understand about an exchange rate is
that it is simply a price.
While it is normal to talk of the price of books rather than
the price of money, there is no normal way to express an
exchange rate.
Indeed, the same exchange rate can be expressed in the
following way:
EUR/USD=1.0758, that is 1EUR=1.0758USD
USD/EUR=0.9295, that is 1USD=0.9295EUR
International Financial Markets – Lecture IV: Forex 05/08/2015
What is an exchange rate?
The bilateral exchange rate is defined as the price of the
foreign currency in units of the domestic currency.
In other words, the exchange rates defines the number of
foreign currency units purchasable with one domestic
currency unit.
The bilateral exchange rate between, say, the UK and the
USA, is the price of dollars in terms of pounds.
International Financial Markets – Lecture IV: Forex 05/08/2015
What is an exchange rate?
Suppose that the EUR/USD=1.0758
How many dollars can you buy with 100 euros?
How many euros can you buy with 100 dollars?
What if the exchange rate rises to 1.11?
What if the exchange rate decline to 1?
International Financial Markets – Lecture IV: Forex 05/08/2015
What is an exchange rate?
The cross exchange rate is an exchange rate between the
two currencies A and B, computed through the currency C.
It can be computed as the ratio of the exchange rate of A
to C, divided by the exchange rate of B to C.
A
B=A/C
B/C
International Financial Markets – Lecture IV: Forex 05/08/2015
What is an exchange rate?
Suppose that:
€/$=1.0796, that is 1€=1.0796$
£/$=1.5044, that is 1£=1.5044$
The exchange rate €/£ equals…
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Floating rates:
A completely flexible (or floating rates) is the one whose
level is solely determined by the market demand and
supply. Therefore, there is not any outside intervention.
Example.
As the import grows, the demand (supply) of foreign
(domestic) currency increases too.
All else equal the greater the demand the greater will be
the clearing market exchange rate.
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Floating rates – The EUR/USD example
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Fixed rates
The excessive volatility of the exchange rate may be
hurtful.
For this reason sometimes governments want the exchange
rates not to vary.
They can do this imposing restrictions on dealing, or
intervening directly on the market
Fixing the interest rate implies surrendering control of the
domestic money stock.
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Fixed rates – The USD/CNY example
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Managed exchange rates
Between the two boundaries represented by the freely
and the fixed rate, there is the compromise of the
managed floating exchange rates.
This time the authorities sometimes intervene on the
market, fixing the exchange rate, sometimes decide to
remain on the sideline.
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Managed rates – example
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
In general the regimes can be classified on the basis of the
foreign currency reserves.
Under a pure float regimes, reserves are constant.
Under a managed regimes, reserves vary on a constant
basis but remain constantly around a broad level.
Under a fixed regimes, reserves must carry the burden of
the exchange rate fluctuations. Therefore, the reserves
probably exhibit swings up or down.
International Financial Markets – Lecture IV: Forex 05/08/2015
Types of exchange rates
Fixed exchange rate and foreign currency reserves.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX vocabulary
Appreciation vs Depreciation
Because every exchange rate involves two currencies
Appreciation of currency A against B
Depreciation of currency B against A
International Financial Markets – Lecture IV: Forex 05/08/2015
FX vocaabulary
Appreciation vs Depreciation – Example
Change from €/$=1.30 to €/$=1.00
(alternatively expressed as change from 0.7692€=1$ to
1€=1$)
Appreciation of dollar against euro or, alternatively,
depreciation of euro against dollar.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX vocabulary
Appreciation vs Depreciation
Exact percentage measures depend on the base rate.
x% depreciation of the Mexican peso means x% more
pesos to buy 1$
y% appreciation of the US$ means y% fewer dollars to
buy 1 peso.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX vocabulary
Sometimes exchange rates are indicated as follow:
4𝑀𝑃/$ , that is 1dollar for 4 Mexican pesos.
Therefore change from 4MP/$ to 8 MP/$ means an
appreciation (depreciation) of dollar (Mexican peso)
against Mexican peso (dollar).
From 4MP/$ to 8 MP/$ means a 100% depreciation of
the Mexican peso, that is a 50% appreciation the US
dollar.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX contracts
Spot exchange rates
It is an exchange of two currencies for immediate
delivery.
They involve the delivery of currency immediately after
the bargain is struck.
In other words, it is the rate figuring in agreements to
exchange one currency for another more or less
immediately.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX contracts
Forward exchange rates
It is the exchange rate agreed today for obligatory
delivery at a specified time in the future.
No exchange of funds on agreement day, or at any time
until the settlement date.
Quoting conventions:
Outright
% premium or discount relative to spot
International Financial Markets – Lecture IV: Forex 05/08/2015
FX contracts
Forward exchange rate – example
On 05/08/15 buy £1,000,000 1-month forward at
$1.60/£.
On 06/08/15 (settlement date) when spot pound is
$1.55:
Take delivery of £1,000,000, pay out $1,600,000;
“Cash settle”, pay $50,000 to cancel the obligation
International Financial Markets – Lecture IV: Forex 05/08/2015
Covered interest rate parity
Spot and forward exchange rates are linked by a “no-
arbitrage” relation.
The forward exchange rate depends on three known
variables:
The spot exchange rate (S);
The domestic interest rate (r);
The foreign interest rate (r*);
International Financial Markets – Lecture IV: Forex 05/08/2015
Covered interest rate parity
In order to avoid risk-free arbitrage opportunity the
following relation must hold:
1 + 𝑟 =𝐹
𝑆(1 + 𝑟∗)
The following allows for no-arbitrage opportunities since
the return in domestic deposits equals the return in foreign
deposits.
International Financial Markets – Lecture IV: Forex 05/08/2015
Covered interest rate parity
… 1 + 𝑟 =𝐹
𝑆(1 + 𝑟∗).
Reorganizing…
1 + 𝑟 = 1 + 𝑓 ∗ (1 + 𝑟∗)
Where 1 + 𝑓 =𝐹
𝑆 is known as the “forward premium
(discount)” that is the proportion by which a country’s
forward exchange rate exceeds its spot rate.
International Financial Markets – Lecture IV: Forex 05/08/2015
FX vocabulary
Direct quotations: the exchange rate expresses the
number of domestic currency units purchasable with a
foreign currency unit.
(In US the direct quote for Euro is $1.0796=€1)
Indirect quotations: the exchange rate expresses the
number of foreign currency units purchasable with a
domestic currency unit.
(In US the indirect quote for Euro is $1=€0.9263)
International Financial Markets – Lecture IV: Forex 05/08/2015
Exercise
Fill in the blank based on the following quotes:
Currency US $
Equivalent Currency per $
Equivalent of
$4,000
$Equivalent of
6,000 units of
foreign currency
Yen 85.2350
Euro (€) 1.3517
Canadian $ 1.0129
GB pounds (£) $9,633,91
Swiss Franc 1.0324
Chinese Yuan 6.61594
Indian Rupee 181,405.90
International Financial Markets – Lecture IV: Forex 05/08/2015
Exercise
Based on the quotes around a one year interval, determine
the extent to which USD and the foreign currency
appreciated or depreciated during the period
Currency 5/8/201X 5/8/20X+1
% appreciation/
depreciation of
USD
% appreciation/
depreciation of
foreign currency
USD/JPY 90.00 85.2350
EUR/USD 1.3329 1.3517
USD/CNY 6.8348 6.1659
AUD/USD 0.89087 1.0047
International Financial Markets – Lecture IV: Forex 05/08/2015
FX dealers behavior
Quoting behavior
There is little evidence of “quote shading” as a tool for
inventory control in interbank trades;
Quote shading: raising quotes when dealer is below the
desired inventory level and lowering quotes when above;
Dealer does not want to give away information about his
position to other interbank dealers.
Inventory controls
Dealers regains desired inventory level quickly (5/6
minutes) by actively initiating trades at other dealers quotes.
International Financial Markets – Lecture IV: Forex 05/08/2015
Exchange rate - focus
Since the FX market is a dealer market we have:
Bid rate (Price). It is the price of currency A in terms of
currency B at which dealers buy currency A (or sell the
currency B).
Ask rate (Price). It is the price of currency A in terms of
currency B at which dealers sell currency A (or buy
currency B).
The difference between the bid and ask rate is the so
called bid-ask spread.
International Financial Markets – Lecture IV: Forex 05/08/2015
Exchange rate - focus
The bid-ask spread measures the cost of liquidity services
The bid-ask spread can varies on a constant basis
The bid-ask spread increases when the volatility in the
spot rate increases too, and decreases when more dealers
are in the market.
The bid ask spread increases at the start of the trading
day (due to the investors “feelings”)
The bid-ask spread increases at the end of the trading
day (due to the inventory adjustment)
International Financial Markets – Lecture IV: Forex 05/08/2015
Exchange rate - focus
Since one can buy one currency by simultaneously selling
one another, the ask price of currency A in terms of
currency B is the reciprocal of the bid price of currency B
in terms of currency A and vice versa.
In formula:
𝑺𝒂 𝑨 𝑩 = 𝟏 𝑺𝒃 (𝑩 𝑨 )
where:
S(A/B) the price of B in terms of A
Sa and Sb, respectively, the ask and bid rates