International FinanceFINA 5331

Lecture 1: The Foreign Exchange Market: Please read Chapter 5

Aaron Smallwood Ph.D.

Foreign Exchange MarketProducts and Activities

• A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies).

• A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

Foreign Exchange MarketProducts and Activities

• Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk.

• A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery.

• Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

Foreign Exchange MarketProducts and Activities

• Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation.

• Arbitrage is the simultaneous, or nearly simultaneous, purchase of securities in one market for sale in another market with the expectation of a risk-free profit.

FX Players

• Broadly speaking the FX market consists of 5 groups– International banks– Bank customers– Non-bank dealers

• Include investment banks, mutual funds, and hedge funds.

– FX brokers– Central banks

The Market for Foreign Exchange

• The FOREX market is the largest market in the world.

• According to the BIS, in 2010, daily turnover in April in FOREX market hit almost $4 TRILLION dollars.

•Table 1

•Global foreign exchange market turnover by instrument1

•Average daily turnover in April, in billions of US dollars

•Instrument •1998 •2001 •2004 •2007 •2010

•Foreign exchange instruments •1,527 •1,239 •1,934 •3,324 •3,981

•Spot transactions² •568 •386 •631 •1,005 •1,490

•Outright forwards² •128 •130 •209 •362 •475

•Foreign exchange swaps² •734 •656 •954 •1,714 •1,765

•Currency swaps •10 •7 •21 •31 •43

•Options and other products³ •87 •60 •119 •212 •207

•Memo: Turnover at April 2010 exchange rates Exchange-traded derivatives 5

•4 •1,705 11 •1,505 12 •2,040 26 •3,370 80 •3,981 166

•1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 Previously classified as part of the so-called "Traditional FX market". 3 The category "other FX products" covers highly leveraged transactions and/or trades whose notional amount is variable and where a decomposition into individual plain vanilla components was impractical or impossible. 4 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2010 exchange rates. 5 Sources: FOW TRADEdata; Futures Industry Association; various futures and options exchanges. Reported monthly data were converted into daily averages of 20.5 days in 1998, 19.5 days in 2001, 20.5 in 2004, 20 in 2007 and 20 in 2010.

Daily Trading Volumes by Hour

Spot Exchange Rates

Spot Rate Quotations

• Indirect quotation– the price of a U.S. dollar in the foreign

currency– e.g. the yuan price of the dollar = RMB

6.5605 on March 24. • Direct Quotation

– the price of a unit of foreign currency: given by 1/Indirect Quotation

– e.g. $/Euro = 1/0.7055=$1.4174

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.

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 ,

¥ € ¥

$1 €1 $1($ / ¥) .01 or $1 ¥100

€2 ¥50 ¥100S

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.

Triangular Arbitrage

Barclays

S(¥/$)=120

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¥ £

Triangular Arbitrage

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell $ for £,

2. Sell £ for ¥,

3. Sell ¥ for $.

$Credit

Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

¥ £

1

2

3

$

Triangular Arbitrage

Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000

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

receive ¥12,750,000

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

receive $106,250

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

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.