Introduction to Currency Markets

FIN 40500: International Finance

“Sherman, set the way-back machine for 1850!”

Prior to the late 1800s, international transactions were made with gold and silver coins…no exchange rate was necessary!!

The most prominent coins were Spanish

US Coins were modeled after Spanish coins

One Peseta = .8465 ounces of Silver

One Doubloon = .88 ounces of Gold (one Doubloon = 16 Pesetas)

One US Dollar = .8465 ounces of Silver

One US Dollar = 0.056 ounces of Gold

1 Pound = 3.98 oz. silver

1 Sovereign = .2354 oz. goldNote that if, for example, the US was running a

trade deficit with Britain, Gold and Silver would flow out of the US and into Britain (price-specie flow mechanism)….when this happens, what happens to prices?

1 Dollar = .86 oz. silver

1 Dollar = 0.056 oz. gold

As countries moved to paper currency in the late 1860s, governments would regulate the value of that currency by fixing the price of gold

4.40 Per Ounce

$20.67 Per Ounce

VS

These two prices imply an exchange rate between the US Dollar and the British Pound

4.40 Per Ounce

$20.67 Per Ounce

= $4.70 Per

$1 = .0483 oz gold 1 Pound = .227 oz gold

Suppose that the exchange rate were $4.00 per

$20.67 Per Ounce

4.40 Per Ounce

(The British Pound is Undervalued)

1 Start with $1, convert it to Pounds ( = .25 )

2 Buy Gold in England ( .0658 oz )

3 Ship the gold back to the US and sell it ( = $1.17 )

The gold standard era saw very stable exchange rates!

$20.67 Per Ounce

4.40 Per Ounce

The Gold Standard maintained the price-specie flow mechanism

Note that if, for example, the US was running a trade deficit with Britain, Excess demand for British pound notes would cause the Pound to appreciate – arbitrage would cause gold to flow out of the US and into England

$4.70 Per

In July 1944, delegates from 44 nations gathered at the Mount Washington hotel in Bretton Woods New Hampshire. The result was the Bretton Woods Agreement

1 oz = $35

$1 = 360 JPY

$1 = .2481 GBP

$1 = 3.33 DEM

$1 = 119 FRF

$1 = 575 ITL

1972

1971

1970

1968

1967

1966

1965

The British Pound is attacked – The Bank of England devalues by 14%

August 15, 1971: Nixon is forced to suspend convertibility of dollars to gold

Johnson’s Great Society programs and the Vietnam war create large US deficits

Bretton Woods collapses and the currency boom begins!

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400.00

Jan-71 Jan-75 Jan-79 Jan-83 Jan-87

From 1971 until 1987 the US followed a policy of managed floating (market based exchange rate with periodic “re-alignments”).

The Plaza Accord (1985) purposely devalued the dollar against the Yen and Deutschmark by 51%

The Smithsonian Agreement (1971-1973) attempted to return to the Bretton Woods system but without dollar/gold convertibility

The Louvre Accord (1987) ended the dollar devaluation policy of the plaza accord

USD/JPY

Currency Weight (%)

Belgian Franc 8.183

German Mark 31.915

Danish Krone 2.653

Spanish Peseta 4.138

French Franc 20.306

British Pound 12.452

Greek Drachma .437

Irish Punt 1.086

Italian Lira 7.84

Luxembourg Franc .322

Dutch Guilder 9.87

Portuguese Escudo .695

In the meantime, the Europeans were developing an exchange rate system of their own. Called the ERM (European exchange rate mechanism), this system involved member countries to peg to an artificial currency called a European Currency Unit

The ECU was the original recipe for the Euro

1.25

1.35

1.45

1.55

1.65

1.75

1.85

1.95

2.05

8/1/90 8/1/91 8/1/92 8/1/93 8/1/94 8/1/95

In 1992, George Soros (Quantum Fund) believed the British pound was overvalued and began selling. On September 19, 1992 the British government was forced to withdraw from the ERM and devalue the pound.

George Soros made a profit of $1B!!!

GB

P/U

SD

Political turmoil and economic weaknesses led to a collapse of the Mexican Peso in 1994.

This currency problem eventually spread through Latin America through what has become knows as the “Tequila Effect” (Not to be confused with the

other “Tequila Effect”)

2003

2002

2001

2000

1999

1998

1997

Currency markets have had a turbulent decade!!!

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0.90

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1.10

1.20

1.30

1.40

Jan-99 Jan-01 Jan-03 Jan-05

In January, 2002, the Euro officially entered circulation in Europe. Since the emergence of the Euro in 1999, the dollar has had a bumpy ride!

Will the Euro survive as a major currency?

USD/EUR

The foreign exchange market is unique not just because of its geographic dispersion, but also because of its extreme liquidity and tremendous volume – around $1.9T PER DAY!!

$600B in Spot market Transactions

$1.3T in Derivative Market Transactions

$200B in Forwards

$1T in Swaps

$100B in Options

Name % of Volume

Deutsche Bank 17

UBS 12.5

Citigroup 7.5

HSBC 6.4

Barclays 5.9

Merrill Lynch 5.7

JP Morgan Chase 5.3

Goldman Sachs 4.4

ABN Amro 4.2

Morgan Stanley 3.9

The ten most active traders account for 73% of the volume

With trading centers in New York City, London, Tokyo and Sydney, currency markets operate 24 hours a day, 5 days a week.

12 AM

12 PM

11 PM

5 PM

Eastern Standard Time

Australia: 5PM - 2AM

3 AM

8PM - 5AM Tokyo

London: 3AM -11AM

9 PM

8 AM

New York City: 8AM -5PM

0

5000

10000

15000

20000

25000

30000

12:00AM 4:00AM 8:00AM 12:00AM 4:00PM 8:00PM

Tra

nsa

ctio

ns/

Hour

Japan9%

Other19%

US16%

UK32%

France3%

Germany5%

Singapore6%Switzerland

4%

Canada3%

Australia3%

Unlike other asset markets, England dominates foreign exchange trading

Why is this?

USD/JPY20%

USD/EUR31%

EUR/All8%

USD/Other17%

USD/AUD4%

USD/CAD4%USD/CHF

5%USD/GBP11%

The six “Majors” are: The US Dollar (USD), Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Australian Dollar (AUD), and the Canadian Dollar (CAD)

The “Majors”

Spot transactions are executed immediately (delivery usually takes place two days after the transaction date). A spot exchange rate is simply the price of one currency in terms of another currency.

USD/JPY = 110.49 (1 USD = 110.49 JPY)

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Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06

Overall, the trend is a dollar depreciation (A decrease in USD/JPY)

The dollar appreciated against the Yen in the early eighties (USD/JPY increased )

US

D/J

PY

VS

In currency markets you need to PAY ATTENTION TO THE UNITS!!!!

VS

EUR/USD = 1.2885 (1 EUR = 1.2885 USD)

0.8000

0.9000

1.0000

1.1000

1.2000

1.3000

1.4000

Jan-99 Jan-01 Jan-03 Jan-05

The dollar appreciated sharply against the Euro after its 1999 release (a decrease in EUR/USD)

The dollar has been depreciating against the Euro since 2001 (an increase in EUR/USD)

Suppose that you took a long position in dollars @ 110.00 and then reversed it @ 110.10

Long: $10,000,000 USD/JPY 110.00

Short: $10,000,000 USD/JPY 110.10

Profit = .10 ( $10,000,000) = Y 1,000,000

These prices are in terms of Yen per dollar!!

Y 1,000,000 110.10

= $9,082.65

Again…pay attention to the units!!!

Calculating Profits/Losses

As a currency dealer, you need to decide where to buy, where to sell and at what prices

USD/CHF = 1.2050 – 1.2055 Spread = 5 “Pips”

Offer Price for Dollars (the price the market maker is willing to sell dollars)

Bid Price for Dollars (the price in which the market maker is willing to buy dollars)

Profits (Per dollar traded) = $1 (.0005) =.0005 CHF

1.2050 = $0.0000415

What influences the spread?

Liquidity

News/Announcements

Trade Size

Why can’t we increase the spread to increase profits?

Unlike other assets, there is no centralized exchange that determines currency prices. The “market” is a network of dealers.

As an individual dealer, you “skew” your price relative to the market

USD/AUS

Market = 1.2884 – 1.2890

You: 1.2882 – 1.2888 ?

You: 1.2884 – 1.2890 ?

You: 1.2886 – 1.2892 ?

What affects your price?

Economic Fundamentals

Technical Analysis

Order Flow

Your Position

We will talk about both of these methods this semester

Market: EUR/USD = 1.2882 – 89

Current Order: Buy 10 Million Euro

What price will you quote?

Scenario #1: Your current position is long 25M Euro

Scenario #2: Your current position is short 25M Euro

Scenario #3: Your current position is square; order to sell 20M Euro if 1.2881 deals stop loss

Scenario #4: Your current position is long 25M Euro; order to sell 20M Euro if 1.2881 deals stop loss

Scenario #5: You’re short 20M Euros. NEWS: FED SEEN BUYING EUROS IN THE MARKET

Market: EUR/USD = 1.2882 – 89

Current Order: 10 Million Euro

What price will you quote?

Scenario #1: German unemployment soars to 8.9%, much higher than expected

Scenario #2: Fed raises Fed Funds 50 Basis Points

Scenario #3: S&P downgrades Japanese debt to A from Aa

Scenario #4: Rice’s trip to the Middle East ends with no resolution. Violence continues

Scenario #5: US department of labor announces 350,000 new jobs created in July. Much higher than the expected number of 100,000

Arbitrage insures that currency prices will be the same at different locations around the world. (Arbitrage will raise the price in NYC and lower the price in London)

Suppose that a dealer were offering Euro at $1.22 in New York City while a dealer in London was offering Euro at $1.24

1 Sell Euro short in London 2Use the proceeds to buy Euro in New York

3Use your newly acquired Euro to pay off your short position

Suppose that a dealer in New York City was offering the following prices:

Euro/USD = $1.25

USD/JPY = Y115

Euro/JPY = Y135

1 Sell Euro short at $1.25

2 Use the dollars to buy Yen at Y115

3 Use the Yen to buy Euro at Y135

Repay your short position

USD/JPY = Y115Euro/JPY = Y135

The USD/JPY, and Euro/JPY rates imply a Euro/USD rate (Cross Rates)

Euro/USD =Y135

Y115= $1.17

Voice Brokers Direct Market

Electronic Exchange

Bid

Offer

Bid/Offer

Bid/Offer

Bid/Offer

Bid Offer

Banks contact brokers through dedicated phone lines. The broker quotes a bid or offer

Traders contact market makers via phone or computer. Each trader is given a bid and offer and can accept either (or both)

Traders submit orders to a computer network which automatically match up buys and sells

Offer

Electronic 30%

Voice Brokers

40%

Direct Market

60%

Direct Market

10%

Voice Brokers

5%

Electronic 85%

Voice Brokers

5%

Electronic 95%

1994 2000 2002

Since the early nineties, trading in currency markets have shifted towards electronic trading platforms. Any trade less than $10M will almost definitely be handled by computer

Prices have become more transparent

Spreads collapsing

Volume, Volume, Volume!!!

CAD/USD .90631 month forward .90653 months forward .90756 months forward .9090

0.904

0.905

0.906

0.907

0.908

0.909

0.91

0 8 14 20 26 30 36 42

Forward contracts involve transactions to be made at a later date.

Contract signed Transaction Made

(Spot Rate = .9087)

Long position in CAD earns .0012 CAD profit per CAD of contract size

Futures are standardized forward contracts, many futures are traded in centralized markets (Chicago Mercantile Exchange)

JPY: 12,500,000 Yen GBP: 62,500 Pounds Euro: 125,000 Euro CAD: 100,000 Canadian Dollars

Options give the buyer the right to buy/sell currency, but not the requirement

Call: The right to buy at a specific “strike price” Put: The right to sell at a specific “strike price”

Currency Swaps represent agreements to exchange one currency for another at multiple pre-specified prices/dates.

Derivative markets offer a variety of ways to hedge currency risk

Questions to be Answered

What causes exchange rates to change? How can we detect overvalued/undervalued currencies?

What causes currency crashes? What underlying conditions make them more likely?

How do Multinational Corporations deal with exchange rate risk?