forex markets

UNIVERSITY OF LJUBLJANA FACULTY OF ECONOMICS

CONTENTS ENDwww.StudsPlanet.com



1. Definition and Organization of the Foreign Exchange Markets

2. Foreign Exchange Market Functions

3. Foreign Exchange Market Participants

4. Size and Structure of Foreign Exchange Market Transactions

5. Types of Foreign Exchange Market Transactions

6. Quotations of Currencies on Foreign Exchange Markets

CONTENTS AND PURPOSE

purpose: enhance theoretical knowledge from the first two chapters with

practical issues of foreign exchange markets functioning principles for the analysis of the international business finance

problems



1. Definition and Organization of the Foreign Exchange Markets

foreign exchange markets are markets on which individuals, firms and banks buy and sell foreign currencies: foreign exchange trading occurs with the help of the

telecommunication net between buyers and sellers of foreign exchange that are located all over the world

can actually talk about a single international foreign exchange market for every single currency

foreign exchange trading takes place at least in some of the world financial centers in every moment

interbank-markets client markets



Clearing of currencies: service of exchanging one currency for another

Provision of Credit: trader that bought a certain good from the manufacturer, needs

time to sell this good to the final customer and to pay the manufacturer with the money he received from the customer

2. Foreign Exchange Market FunctionsClearing of Currencies and Provision of Credit



Foreign Exchange Market and Insurance AgainstForeign Exchange Risk

hedging: activities with which the foreign exchange market participants

avoid exchange rate risk or activities with which they are closing their open foreign exchange position

closed foreign exchange position: size of the assets in a certain currency is equal to the size of the

liabilities in the same currency full insurance against exchange rate risk with respect to this currency

open foreign exchange position: long: net assets in a certain currency short: net liabilities in a certain currency

in the spot or forward foreign exchange market standardized forward contracts and options



Foreign Exchange Markets and Conscious Foreign Exchange Risk Acceptance

activities in which economic agents consciously open their foreign exchange positions – long or short – hoping to get profits

in all foreign exchange market segments



3. Foreign Exchange Market Participants Economic Agents and Types of Activities on

Foreign Exchange Markets Client buys $

with €

Local bank

Main banks’ interbank market

Local bank

Client buys € with $

Purchases and sales of big multinational

companies

Brokers



Economic Agents and Types of Activities on Foreign Exchange Markets

bank clients (individuals, firms, non-banking financial institutions): all those groups of legal and physical persons that need foreign

currency in doing their commercial or investment business

commercial banks: the most important group of foreign exchange market participants they buy and sell foreign currencies for their clients and trade for

themselves



Economic Agents and Types of Activities on Foreign Exchange Markets

brokers: agents that connects dealers interested in buying and selling

foreign exchange, but does not become an active client in the transaction

they provide their client, the bank, with the information about the exchange rates at which banks are willing to buy or sell a particular currency

central banks: foreign exchange market interventions are meant to influence the

exchange rate of the domestic currency in a way that is beneficial for the domestic economy and, consequently, for the country

it does not necessarily have a profit, it can also have a loss



Economic Agents and Motivation for the Foreign Exchange Market Participation

arbitragers: they want to earn a profit without taking any kind of risk (usually

commercial banks): try to profit from simultaneous exchange rate differences in different

markets making use of the interest rate differences that exist in national

financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)



Economic Agents and Motivation for the Foreign Exchange Market Participation

hedgers and speculators: hedgers do not want to take risk while participating in the market, they

want to insure themselves against the exchange rate changes speculators think they know what the future exchange rate of a particular

currency will be, and they are willing to accept exchange rate risk with the goal of making profit

every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction



4. Size and Structure of Foreign Exchange Market Transactions

Table 4.1: Size and Structure of Transactions in the Foreign Exchange Markets , 1989 – 1998 (mia $)

1989 1992 1995 1998 Traditional foreign exchange transactions

590 820 1190 1490

Spot market transactions 350 400 520 590

Forward market transactions

240 420 670 900

Untraditional foreign exchange transactions

- - 45 97

Source: Roberts, 1999, p. 33.

the biggest share of all financial markets in the worldCurrency Percentage

$ 87 DEM 30 ¥ 21 £ 11 FRF 5 CHF 7 Other 39 All currencies 200,00



5. Types of Foreign Exchange Market Transactions Spot Foreign Exchange Transactions

almost immediate delivery of foreign exchange

buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity

forward exchange rates: 1, 3, 6, 9 months, one year

Outright Forward Transactions



Swap Transactions

simultaneous purchase and sale of a given amount of foreign exchange for two different value dates: “spot against forward” swaps:

dc

ba *

a – annual swap rate (%),b – premium/discount during the time of the currency swap, c – spot exchange rate, and d - 1/part of the year, for which the currency swap is agreed upon (if the contract is valid for a three-month period, then this is one quarter of a year)

“forward-forward” swaps



Futures

basic characteristics of futures: the amount of the currency that is being traded type of currency quotation contract expiration last day of trading with the contract settlement day margin requirements

information about futures trading futures usage:

arbitrage between outright forward contract and futures rarely used as an insurance instrument (rigidity!)



similarities and differences between outright forward contract and futures: both need to be executed unconditionally they are usually established for at most one year

Characteristic Futures Outright Forward Contract Size of the contracts standardized for a given currency depends on the individual needs of the

client Location and trade activity

at the stock exchange or at a given location; actively traded in an organized market

with the provision of agents, connected among each other with the help of telecommunications; not traded in an organized market

Duration of the contract

standardized, but at most a year depends on the individual needs of the client , but not more than a year

Contract has to be executed

yes yes

Insurance and Security of doing Business with the Instrument

insurance explicitly required (margin requirements); high security of doing business with the instrument

insurance not required explicitly (implicit insurance are affiliat ions of two partners up till now); lower security than futures

Trade regulation regulated with the stock exchange rules

regulation not explicit ly determined



Characteristic Futures Outright Forward Contract Contract partners not in direct contact in direct contact Price determination based on supply and demand based on quotations Determination of the dayof the settlement

standardized depends on the individual needs of the client

Accesibility of the contract for non-bank agents

accessible to anyone in practice accessible to big clients with good ratings

Liquidity of the instrument and the contract amounts

high liquidity; small contract amounts and small size of t ransactions

low liquidity; high contract amounts and large size of transactions compared to the size of futures

Costs of the instrument

based on costs that the broker zaračuna for the purchase of the instrument and its sale later on

higher than for futures; based on the difference in offer and bid price of the currency that the bank offers the client

Currency quotation number of units of $ for one unit of a foreign currency (American quotation)

number of domestic currency units for one unit of a foreign currency (European quotation)

Riskiness of the instrument

very limited; stock exchange enters the contract, explicitly required insurance

higher than for futures; for this reason, business is done only with credible partners

Profit yield/loss payment

daily once; at contract execution or when the contract expires



Options

basic characteristics of options: financial instrument that gives the buyer the right, but not the

obligation, to buy or sell a standardized amount of a foreign currency, that is traded, at a fixed price at a particular time, or until a particular time in the future

call option and put option American and European options three different prices:

exercise/strike price cost, price or value of the option underlying or actual spot exchange rate

“at-the-money”“in-the-money”“out-of-money”



Options

types of options trading: in organized markets:

standardized contracts with given strike prices, standardized durations (1, 3, 6, 9, 12 months) and expirations

only certain currencies, contract amounts are standardized

over-the-counter trading: expiration date, strike price and contract amount depend on the

individual needs of the client counterparty risk! retail and interbank market

information about options trading



Usage of options: when the economic agent expects that the exchange rate trend of a

particular currency could change drastically when the economic agent does not know for sure that a certain

foreign exchange flow will occur in the future advantages:

fixed option costs options do not need to be executed

Options



Profit/ loss

Limited loss

Unlimited profit

A. Buyer of a call option

Profit/ loss

Limited loss

Unlimited profit

C. Buyer of a put option

Profit/ loss

Limited profit

Unlimited loss

B. Seller of a call option

Profit/ loss

Unlimited loss

Limited profit

D. Seller of a put option



6. Quotations of Currencies on ForeignExchange Markets

quotation of a currency tells us at what price is a financial mediator willing to buy or sell a certain currency

Currency Quotations in Spot Foreign Exchange Markets

European and American quotationdirect and indirect quotation (which currency is regarded

as a domestic/basis currency)

100*0

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sss t 100*0

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Currency Quotations in Spot ForeignExchange Markets

American quotation European quotation

Definition:

number of units of $ needed to buy a unit of a foreign currency

Definition:

number of units of a foreign currency needed to buy $1

Direct quotation in the USA:

number of units of a domestic currency ($) needed to buy a unit of foreign currency

Direct quotation outside the USA:

number of units of a domestic currency needed to buy a unit of a foreign currency ($)

Indirect quotation outside the USA:

number of units of a foreign currency ($) needed to buy a unit of a domestic currency

Indirect quotation in the USA :

number of units of a foreign currency needed to buy a unit of a domestic currency ($)




bid price and offer/sell price quotation: bid price is the exchange rate at which a bank is willing to buy

another currency offer/sell price is the exchange rate at which the same bank is

willing to sell the currency in question

transaction costs: banks usually do not charge provision difference between the bid and offer/sell price represents the

bank’s profit and is called a margin or spread

price offer/sell

price bid -price offer/sellmargin




cross exchange rate: can be calculated with the help of the relationship of two

currencies with a third currency

triangular currency arbitrage: it enables profit earning because of inconsistency between

currency quotations in different financial centers buying a particular currency in one financial center and selling it

in another financial center



Currency Quotations in Forward Foreign Exchange Markets

outright quotation točkovna quotation, forward premium/discount:

forward discount: when a currency is worth less (is cheaper relative to another currency) in the

forward foreign exchange market than in the spot foreign exchange market

forward premium: when a currency is worth more (is more expensive relative to another

currency) in the forward foreign exchange rate market than in the spot foreign exchange market

annual forward premium and discount

100*360

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100*

360*nf

fsfUSD



Financial TimesWall Street Journal

Publishing the Currency Quotations in the Leading World Financial Newspapers