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FINS3616 Chapter 2 Summary

The foreign exchange market is decentralized and operates through large banks trading currencies with each other. Most transactions involve large institutions trading millions of dollars worth of currencies at a time. The market sees trillions of dollars traded daily globally making it the largest market in the world. Currencies are quoted either directly, showing the dollar cost of a currency, or indirectly, showing the amount of a currency needed to purchase a dollar. Arbitrage helps keep currency rates aligned across different currency pairs. Banks profit by quoting slightly different buy and sell rates and managing their currency inventory.

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Shruti Iyengar
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1K views5 pages

FINS3616 Chapter 2 Summary

The foreign exchange market is decentralized and operates through large banks trading currencies with each other. Most transactions involve large institutions trading millions of dollars worth of currencies at a time. The market sees trillions of dollars traded daily globally making it the largest market in the world. Currencies are quoted either directly, showing the dollar cost of a currency, or indirectly, showing the amount of a currency needed to purchase a dollar. Arbitrage helps keep currency rates aligned across different currency pairs. Banks profit by quoting slightly different buy and sell rates and managing their currency inventory.

Uploaded by

Shruti Iyengar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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2

The Foreign Exchange Market

2.1 The Organisation of the Foreign Exchange Market

Interbank Market very large, diverse, over the counter market, not a physical trading
place where buyers and sellers gather to agree on a price to exchange currencies.

Most transactions in the interbank market are large trades with values of $1 million or
more, most retail investors and small businesses cannot access the foreign exchange
market directly.

Large multinational corporations, such as IBM, and very large money-management


firms, such as the mutual fund company Fidelity, can directly access the foreign
exchange interbank market.

2.1.1

Size of the Market


Foreign Exchange Market is the largest market in the world measured by dollar
volume of trade.
The main factor behind the large increase in volumes is undoubtedly the
globalization process, which led to increased cross-border trades in goods,
services, and securities, all requiring transactions in the forex market. More
recently, the speculative activities and high- volume, high-frequency trading by
hedge funds have also played an increasingly important role.

2.1.2

Types of Contracts Traded


Spot Market - market for immediate exchanges of currency
Swaps, Forwards Contracts, Derivative Securities (Futures and Options) later
discussed.
USD involved spot contracts are settled within 2 business days (payment of
one currency and the receipt occurs in 2 business days).
EXCEPTIONS to the above USD spot contracts - if between US & Canada and US
& Mexico; spot contract to be settled within 1 day. Other exceptions are for
Middle Eastern nations.

2.1.3

Foreign Exchange Dealers


MAIN PARTICIPANTS Commercial Banks, Investment Banks, and Brokerage
Firms.
TRADERS Forex dealers; making market in several currencies and stand ready
to buy and sell currencies they specialise in. They provide LIQUIDITY to the
market (i.e. transaction costs are low)
Forex dealers try to buy a foreign currency at a low rate and sell the foreign
currency at a higher rate, thus making a profit.

2.1.4

Foreign Exchange Brokers


Forex brokers do not attempt to buy low and sell high, instead function as a
financial intermediary they match buyers and sellers but do not put their own
money at risk.
Foreign exchange dealers often use these brokers to unwind very large positions
in a particular currency in order to preserve their anonymity.

2.1.5

Other Participants on the Foreign Exchange Market


Central Banks of different governments participate to influence the foreign
exchange value of their currency.
MNCs participate to exchange currencies to conduct their day to day
international trades.
If the trades are large enough, the highly liquid interbank market can be tapped.
The more removed from the interbank market participants are the higher the
transaction costs are likely to be.
ECN Electronic Communication Network; collects and matches buy and sell
orders. Trades are often totally anonymous - because the market price for a
particular currency is visible for all participants on the platform, electronic
trading ensures transparency.

2.1.6

The Competitive Market Place


Perfectly competitive market - many firms compete with one another, and the
cost of entering the market is low.
Competitive pressures and the growing importance of online trading have made
foreign exchange trading a high volumelow margin business, which requires
tremendous investments in technology. Smaller banks can no longer afford to
make markets in the major currencies, but they now tend to specialize in
regional currencies.
Despite the somewhat increased market shares of the major traders, no single
dealer dominates the market, and the foreign exchange market remains very
competitive.

2.2 Currency Quotes and Prices


2.3.1

Exchange Rates
Trade Liberalisation relative price of two monies
Notice that we treat the slash symbol (/) as a divisor in a ratio to indicate the
amount of the first currency that is necessary to purchase one unit of the second
currency.

2.3.2

Exchange Rate Quotes


Indirect Quote (European Quote - the amount of foreign currency needed to buy
dollars) this would be direct in Europe
Direct Quote (American Quote) dollar price of a foreign currencythat is, the
number of dollars it takes to purchase one unit of the foreign currency this
would be considered indirect in Europe.

2.3.3

Vehicle Currencies and Currency Cross Rates


USD is a vehicle currency i.e. actively used in many international financial
transactions.
Exchange rates between two currencies that do not involve the dollar are often
called cross-rates.
Triangular Arbitrage process that keeps the cross rates in line with exchange
rates quoted relative to the USD.
Pure Arbitrage Profits earn risk less profits (in perfectly competitive
markets this is near impossible to achieve)
The direct quote for the cross-rate should equal the implied cross-rate, using
the dollar as an intermediary currency:

Effectiveness of Triangular Arbitrage:


- All transactions must be completed simultaneously (physically not
possible).
- Traders place orders to conduct the arbitrage (market forces will work
against this to decrease/increase rate so cross rates align with the implied
rates).
-Profitable starting from any currency as long as we trade in the same
direction and go completely around the triangle.

2.3 Inside the Interbank Market I: Bid Ask Spreads and Bank Profits
2.3.4

Bid - Ask Spreads


Bid Rate rate at which traders want to buy base currency.
Ask Rate rate at which traders want to sell base currency.
Bid Ask Spread: Difference b/w Ask Rate and Bid Rate.
If you are confused about whether to use the bid or ask exchange rate in a
particular transaction, just remember that you will ALWAYS TRANSACT WITH
THE BANK TO YOUR DISADVANTAGE.
Invert a bid rate you get and ask rate.

2.4.1

The Magnitude of Bid Ask Spreads

Varying the magnitude of the bidask spread as a function of market


conditions helps traders manage their inventory risk.
Financial customers obtain better spreads than corporate customers and
that better performing money managers obtain better spreads than poorly
performing ones.

2.4 Inside the Interbank Market II: Communications and Fund Transfers
2.4.1

Communication Systems
Society of Worldwide Interbank Financial Telecommunications (SWIFT)
Transfer of dollars will be done through the Clearing House Interbank Payments
System (CHIPS), and the transfer of euros will be done through the TransEuropean Automated Real-time Gross Settlement Express Transfer (TARGET).

2.4.2

Cross Currency Settlement (or Herstatt) Risk


The risk that only one leg of the transaction may occur is very real. It is known as
cross-currency settlement risk, or Herstatt risk.

Bilateral netting reduces the amount of settlement risk by lowering the number
and size of payments that would otherwise be needed to settle the underlying
transactions on a trade-by-trade basis.

2.5 Describing Changes in Exchange Rate

Appreciation / Depreciation is referring to the BASE currency (denominator currency) describe changes in exchange rates when exchange rates are allowed to be flexible.

Discrete changes in the values of exchange rates under such a fixed exchange rate
system are called devaluations and revaluations of the currencies.
- If the monetary authorities are increase the domestic currency price of foreign
exchange they are devaluing their money (converse is also true). Devaluation increases
the prices of foreign goods.
- If a revaluation changes the relative prices across countries, it benefits domestic
consumers but hurts domestic workers and producers. This is because the goods and
services produced in the country have to compete with imports that have become
cheaper after the revaluation.

2.5.1

Rates of Appreciation and Depreciation

If the rate of depreciation of the pound relative to the dollar is required:


Rate of Dep. Pound Relative to Dollar = [(1/1+Rate of Apr. Dollar)] - 1

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