foreign exchange market notes

7/29/2019 Foreign Exchange Market Notes

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1. The Theory of Comparative Advantage Liberalization of international trade will enhance

the overall social welfare.

Trade liberalization (economic integration)

Review of Week 1

2-0

2Week Two


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Objective:

Todays class serves to introduce the institutional

framework within which exchange rates are

determined.

Todays class lays the foundation for much of the

discussion throughout the remainder of the

semester, thus it deserves your careful attention.

2Week TwoThe Market for

Foreign Exchange

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Foreign Exchange

1. Foreign exchanges are the institution or system

involved with changing one currency into

another.

2. Foreign exchange is used to refer toforeign

currency that is obtained through the foreign

exchange system.

source: Collins Cobuild Dictionary

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Function and Structure of the FX Market

The Spot Market

The Forward Market

Exchange-Traded Currency Funds


FX Market Participants

Correspondent Banking Relationships

The Spot Market

The Forward Market



The Spot Market

Spot Rate Quotations

The Bid-Ask Spread

Spot FX Trading

Cross Exchange Rate Quotations

Triangular Arbitrage Spot Foreign Exchange Market Microstructure

The Forward Market


The Spot Market

The Forward Market

Forward Rate Quotations

Long and Short Forward Positions

Forward Cross-Exchange Rates

Swap Transactions

Forward Premium



The Spot Market

The Forward Market

Topics

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Topics



The Spot Market

The Forward Market

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Topics


The Spot Market


The Bid-Ask Spread


Triangular Arbitrage

The Forward Market

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Topics


The Spot Market

The Forward Market



Forward Cross-Exchange Rates

Forward Premium

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Over-the-counter (OTC) markets

No central market place

via telephones, computer terminals, and automated

dealing systems.

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Circadian Rhythms of the FX Market

05000

100001500020000

2500030000350004000045000

1:00

10 am inTokyo

3:00

Lunchhour inTokyo

5:00

Europecoming in

07:00 9:00

Asia goingout

11:00

Lunchhour in

London

13:00

Americascoming in

15:00 17:00

Londongoing out

19:00 21:00

NewZealand

coming in

23:00

6 pm inNY

Electronic Conversations per Houraverage peak

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

Client Market (Retail)

Market participants include: International banks

Bank customers

Nonbank dealers FX brokers

Central banks.

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FX Market Participants (contd)

International banks The core of FX market

About 100-200 banks worldwide stand ready to make a

market in foreign exchange

Bank customers MNCs, money managers, and private speculators.

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Nonbank dealers Investment banks, mutual funds, pension funds, and

hedge funds, etc.

FX brokers Fulfill the role of financial intermediary.

Match dealers (buyers and sellers) for a fee, but do nottake a position themselves

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Central bank Intervenes in the foreign exchange market in an attempt

to influence the price of its currency

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Topics



The Spot Market

The Forward Market

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Topics


The Spot Market


The Bid-Ask Spread



The Forward Market

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(All the following definitions treat the U.S. as the

home country.)

Direct quotation (or American terms)

the price of one unit of the foreign currency in U.S.

dollars

e.g. a Japanese Yen is worth about a penny

Indirect Quotation (or European terms) the price of a U.S. dollar in the foreign currency

e.g. you get 100 yen to the dollar

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Country

USD 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) 0.7830 0.7836 1.2771 1.2762

Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months Forward 1.8983 1.9038 0.5268 0.5253

6 Months Forward 1.8904 1.8959 0.5290 0.5275

Canada (Dollar) 0.8037 0.8068 1.2442 1.2395

1 Month Forward 0.8037 0.8069 1.2442 1.2393

3 Months Forward 0.8043 0.8074 1.2433 1.2385

6 Months Forward 0.8057 0.8088 1.2412 1.2364


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The directquotefor British poundis:

1 = $1.9077

Country

USD equiv

Friday

USD equiv

Thursday

Currency per

USD Friday

Currency per

USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377


Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months Forward 1.8983 1.9038 0.5268 0.5253

6 Months Forward 1.8904 1.8959 0.5290 0.5275

Canada (Dollar) 0.8037 0.8068 1.2442 1.23951 Month Forward 0.8037 0.8069 1.2442 1.2393

3 Months Forward 0.8043 0.8074 1.2433 1.2385

6 Months Forward 0.8057 0.8088 1.2412 1.2364


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The indirectquote for

British poundis:

.5242 = $1

Country

USD equiv

Friday

USD equiv

Thursday

Currency per

USD Friday

Currency per

USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377


Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months Forward 1.8983 1.9038 0.5268 0.5253

6 Months Forward 1.8904 1.8959 0.5290 0.5275


3 Months Forward 0.8043 0.8074 1.2433 1.2385

6 Months Forward 0.8057 0.8088 1.2412 1.2364


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Note that thedirect quote isthe reciprocalof the indirect

quote:

5242.

19077.1

=

Country

USD equiv

Friday

USD equiv

Thursday

Currency per

USD Friday

Currency per

USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377


Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months Forward 1.8983 1.9038 0.5268 0.5253

6 Months Forward 1.8904 1.8959 0.5290 0.5275


3 Months Forward 0.8043 0.8074 1.2433 1.2385

6 Months Forward 0.8057 0.8088 1.2412 1.2364


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The Bid-Ask Spread

The bid price is the price at which a dealer want

to buy a currency.

The ask price is the price at which a dealer wantto sell a currency.

It doesnt matter if were talking used cars or used

currencies: the bid-ask spread is simply thedifference between the bid and ask prices.

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The Bid-Ask Spread

A dealer could offer bid price of $1.4739 per

ask price of $1.4744 per

While there are a variety of ways to quote that,the bid-ask spread represents the dealers

expected profit.

Bid-Ask Spread = Ask PriceBid Price

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The Bid-Ask Spread

A dealer pricing pounds in terms of dollars would likely quote

these prices as 1217.

USD Bank

Quotations

American Terms European Terms

Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

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The Bid-Ask Spread

USD BankQuotations

Direct quotation Indirect quotation

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

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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?

1.971520

.507172

S($/)

S(/$)

Bid Ask

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Sample Problem

A businessman has just completed transactions in

Italy and England. He is now holding250,000

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

His currency dealer provides this quotation:GBP/USD 0.502576

USD/EUR 1.473944

Assuming no other fees, what are his proceeds

from conversion?

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Sample Problem Solution

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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?

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Cross Rate Bid-Ask Spread

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

USD BankQuotations


Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Euros 1.4738 1.4742 .6783 .6785

1 $1.9712

1.001

$1.4742 =1.3371

Starts with 1, sells for $, and then buy using $:

He has effectively sold at a/ bid price of1.3371/2-28


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

USD BankQuotations


Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Euros 1.4738 1.4742 .6783 .6785

1 $1.47381.00

1$1.9717

= 0.7475

Starts with1, sells for $, and then sell $ for :

He has effectively sold at a / bid price of 0.7475/2-29


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BankQuotations

S(/) S(/)

Bid Ask Bid Ask

: 0.7475 0.7479 1.3371 1.3378

Recall that the reciprocal of

the S(/) bid is the S(/) ask.=

.7475

1.00 1.3378

1.00

Recall that the reciprocal of

the S(/) bid is the S(/) ask.=

1.3371

1.00 .7479

1.00

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What Does Triangular Arbitrage Mean?

The process of converting one currency to another, converting it

again to a third currency and, finally, converting it back to the

original currency within a short time span.

This opportunity for riskless profit arises when the currency'sexchange rates do not exactly match up. Triangular arbitrage

opportunities do not happen very often and when they do, they only

last for a matter of seconds.

Traders that take advantage of this type of arbitrage opportunityusually have advanced computer equipment and/or programs to

automate the process. (source: http://www.investopedia.com/terms/t/triangulararbitrage.asp)


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$

HSBC

S(/$)=1.50

Credit Agricole

S(/)=85

Barclays

S(/$)=120

Suppose weobserve these

banks posting theseexchange rates.

First calculate any impliedcross rate to see if an

arbitrage opportunityexists.

1.00

80=

1.50 $1.00

$1.00 120


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To evaluate if an arbitrage opportunity exists,

always ask the question:

Is the cross rate implied by the first two quotes

consistent with the third quote?


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$

HSBC

S(/$)=1.50

Credit Agricole

S(/)=85

Barclays

S(/$)=120

The implied S(/) cross rate is

Credit Agricole has posted aquote ofS(/)=85 so thereis an arbitrage opportunity.

So, how can we make money?

1.00

80=

1.50 $1.00

$1.00 120

The price of is higher at Credit Agricole (CA) than the impliedprice from Barclays and HSBC => sell to CA.

BUY LOW SELL HIGH!


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$

HSBC

S(/$)=1.50

Credit Agricole

S(/)=85

Barclays

S(/$)=120

1. Sell our $ to HSBCfor ,

2. Sell our to CA for,

3. Sell those to B for$.

1

2

3

$

It doesnt matter where you start the key is to go in

the right direction.


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Sell$100,000 for at S(/$) = 1.50

receive 150,000

Sell our150,000 for at S(/) = 85

receive 12,750,000

Sell12,750,000 for $ at S(/$) = 120

receive $106,250

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


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The Forward Market



Forward Cross Exchange Rates

Forward Premium

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The Forward Market

A forward contract is an agreement to buy or sell

an asset in the future at prices agreed upon today.

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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 monthmaturities are readily available for forward

contracts.

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Consider these exchange

rates: for British pounds,

the spot exchange rate is

$1.9717 = 1.00 whilethe 180-day forward rate

is $1.9593 = 1.00

Whats up with that?

Country/currency in US$ per US$

UK pound 1.9717 .5072

1-mos forward 1.9700 .5076

3-most forward 1.9663 .50866-mos forward 1.9593 .5104

Clearly market participants

expect that the pound willbe worth less in dollars in

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Forward Premium

Forward premium (or discount) of a forward rate = Annualized

deviation of the forward rate from the spot rate.

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%

1.601.55

1.55 2=f180,v$

F180($/)S($/)

S($/)=

360

180

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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 FX forward, you arelong.

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Payoff Profiles

0S180($/)

F180

($/) = .009524

Long position

loss

profitIf you agree to buy anything in the

future at a set price and the spot

price later rises then you gain.

If you agree to buy anything in the


price later falls then you lose.2-43


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Payoff Profiles

0S180($/)

F180

($/) = .009524

Short positionloss

profitIf you agree to sell anything in the


price later falls then you gain.

If you agree to sell anything in the


price later rises then you lose.2-44


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Forward Cross Exchange Rates

Its just an delayed example of the spot cross

rate discussed before.

In generic terms

)/($

)/($)/(

and

)/($

)/($)/(

kF

jFjkF

jF

kFkjF

N

NN

N

NN

=

=

Notice that the $s cancel.

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Forward Cross Rates

Currencies January 4, 2008

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-mos forward 1.4744 .6782

6-mos forward 1.4726 .6791

UK pound 1.9717 .50721-mos forward 1.9700 .5076

3-mos forward 1.9663 .5086

6-mos forward 1.9593 .5104

The 3-month forward /

cross rate is0.7498

1.00=

$1.4744 1.00

1.00 $1.9663

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Summary

Spot rate quotations

Direct and indirect quotes

Bid and ask prices

Cross Rates Triangular arbitrage


Forward premium (discount) Forward points

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End of Week 2

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foreign exchange market notes

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