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    The Foreign Exchange Market

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    Atul Jain
    The document summarizes key aspects of the foreign exchange market, including its organization, participants, spot and forward markets, and interest rate parity theory. The foreign exchange market facilitates international trade and capital flows. It is decentralized and operates through phone, internet, and electronic networks. Major participants include banks, brokers, companies, and traders who engage in spot or forward transactions.

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    The Foreign Exchange Market

    Uploaded by

    Atul Jain
    82 views42 pages
    The document summarizes key aspects of the foreign exchange market, including its organization, participants, spot and forward markets, and interest rate parity theory. The foreign exchange market facilitates international trade and capital flows. It is decentralized and operates through phone, internet, and electronic networks. Major participants include banks, brokers, companies, and traders who engage in spot or forward transactions.

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    ch07

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    The document summarizes key aspects of the foreign exchange market, including its organization, participants, spot and forward markets, and interest rate parity theory. The foreign exchange market facilitates international trade and capital flows. It is decentralized and operates through phone, internet, and electronic networks. Major participants include banks, brokers, companies, and traders who engage in spot or forward transactions.

    Copyright:

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    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    82 views42 pages

    The Foreign Exchange Market

    Uploaded by

    Atul Jain
    The document summarizes key aspects of the foreign exchange market, including its organization, participants, spot and forward markets, and interest rate parity theory. The foreign exchange market facilitates international trade and capital flows. It is decentralized and operates through phone, internet, and electronic networks. Major participants include banks, brokers, companies, and traders who engage in spot or forward transactions.

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    of 42

    CHAPTER 7

    THE FOREIGN
    EXCHANGE
    MARKET
    CHAPTER OVERVIEW

    I. INTRODUCTION
    II. ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET
    III. THE SPOT MARKET
    IV. THE FORWARD MARKET
    V. INTEREST RATE PARITY
    THEORY
    PART I. INTRODUCTION

    I. INTRODUCTION
    A. The Currency Market:
    where money denominated in one
    currency is bought and sold
    with money denominated in
    another currency.
    INTRODUCTION

    B. International Trade and


    Capital Transactions:
    - facilitated with the ability
    to transfer purchasing power
    between countries
    INTRODUCTION

    C. Location
    1. OTC-type: no specific
    location
    2. Most trades by phone,
    telex, or SWIFT
    SWIFT: Society for Worldwide
    Interbank Financial
    Telecommunications
    PART II.
    ORGANIZATION OF THE FOREIGN
    EXCHANGE MARKET

    I . PARTICIPANTS IN THE
    FOREIGN EXCHANGE MARKET
    A. Participants at 2 Levels
    1. Wholesale Level (95%)
    - major banks
    2. Retail Level
    - business customers.
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    B. Two Types of Currency


    Markets
    1. Spot Market:
    - immediate transaction
    - recorded by 2nd
    business day
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    2. Forward Market:
    - transactions take place at a
    specified future date
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    C. Participants by Market
    1. Spot Market
    a. commercial banks
    b. brokers
    c. customers of commercial
    and central banks
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    2. Forward Market
    a. arbitrageurs
    b. traders
    c. hedgers
    d. speculators
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    II. CLEARING SYSTEMS


    A. Clearing House Interbank
    Payments System
    (CHIPS)
    - used in U.S. for electronic
    fund transfers.
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    B. FedWire

    - operated by the Fed

    - used for domestic transfers


    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    III. ELECTRONIC TRADING


    A. Automated Trading
    - genuine screen-based
    market
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    B. Results:
    1. Reduces cost of trading
    2. Threatens traders’
    oligopoly of information
    3. Provides liquidity
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    IV. SIZE OF THE MARKET


    A. Largest in the world
    1995: $1.2 trillion daily
    ORGANIZATION OF THE
    FOREIGN EXCHANGE MARKET

    B. Market Centers (1995):


    London = $464 billion
    daily
    New York= $244 billion
    daily
    Tokyo = $161 billion
    daily
    PART III.
    THE SPOT MARKET
    I. SPOT QUOTATIONS
    A. Sources
    1. All major newspapers
    2. Major currencies have four
    different quotes:
    a. spot price
    b. 30-day
    c. 90-day
    d. 180-day
    THE SPOT MARKET

    B. Method of Quotation
    1. For interbank dollar
    trades:
    a. American terms
    example: $.5838/dm
    b. European terms
    example: dm1.713/$
    THE SPOT MARKET

    2. For nonbank customers:


    Direct quote
    gives the home currency
    price of one unit of foreign
    currency.
    EXAMPLE: dm0.25/FF
    THE SPOT MARKET

    C. Transactions Costs
    1. Bid-Ask Spread
    used to calculate the fee
    charged by the bank
     Bid = the price at which
    the bank is willing to buy
     Ask = the price it will sell
    the currency
    THE SPOT MARKET

    4. Percent Spread Formula (PS):

    Ask  Bid
    PS  x100
    Ask
    THE SPOT MARKET

    D. Cross Rates
    1. The exchange rate
    between 2 non - US$
    currencies.
    THE SPOT MARKET

    2. Calculating Cross Rates


    When you want to know
    what the dm/ cross rate
    is, and you know
    dm2/US$ and .55/US$

    then dm/ = dm2/US$  .55/US$


    = dm3.636/ 
    THE SPOT MARKET

    E. Currency Arbitrage
    1. If cross rates differ from
    one financial center to
    another, and profit
    opportunities exist.
    THE SPOT MARKET

    2. Buy cheap in one int’l market,


    sell at a higher price in
    another

    3. Role of Available Information


    THE SPOT MARKET

    F. Settlement Date Value Date:

    1. Date monies are due

    2. 2nd Working day after date of


    original transaction.
    THE SPOT MARKET

    G. Exchange Risk
    1. Bankers = middlemen
    a. Incurring risk of adverse
    exchange rate moves.
    b. Increased uncertainty
    about future exchange
    rate requires
    THE SPOT MARKET

    1.) Demand for higher risk


    premium

    2.) Bankers widen bid-ask


    spread
    MECHANICS OF SPOT
    TRANSACTIONS
    SPOT TRANSACTIONS: An
    Example
    Step 1. Currency transaction:
    verbal agreement, U.S. importer
    specifies:
    a. Account to debit (his acct)
    b. Account to credit (exporter)
    MECHANICS OF SPOT
    TRANSACTIONS
    Step 2. Bank sends importer
    contract note including:
    - amount of foreign
    currency
    - agreed exchange rate
    - confirmation of Step 1.
    MECHANICS OF SPOT
    TRANSACTIONS
    Step 3. Settlement
    Correspondent bank in Hong
    Kong transfers HK$ from
    nostro account to exporter’s.
    Value Date.
    U.S. bank debits importer’s
    account.
    PART III.
    THE FORWARD MARKET
    I. INTRODUCTION
    A. Definition of a Forward
    Contract
    an agreement between a bank and a
    customer to deliver a specified
    amount of currency against another
    currency at a specified future date
    and at a fixed exchange rate.
    THE FORWARD MARKET

    2. Purpose of a Forward:
    Hedging
    the act of reducing exchange
    rate risk.
    THE FORWARD MARKET

    B. Forward Rate Quotations


    1. Two Methods:
    a. Outright Rate: quoted to
    commercial customers.
    b. Swap Rate: quoted in the
    interbank market as a discount or
    premium.
    THE FORWARD MARKET

    CALCULATING THE FORWARD


    PREMIUM OR DISCOUNT

    = F-S x 12 x 100
    S n
    where F = the forward rate of exchange
    S = the spot rate of exchange
    n = the number of months in the
    forward contract
    THE FORWARD MARKET

    C. Forward Contract Maturities


    1. Contract Terms
    a. 30-day
    b. 90-day
    c. 180-day
    d. 360-day
    2. Longer-term Contracts
    PART IV.
    INTEREST RATE PARITY THEORY

    I. INTRODUCTION
    A. The Theory states:
    the forward rate (F) differs from
    the spot rate (S) at equilibrium by
    an amount equal to the
    interest differential (rh - rf)
    between two countries.
    INTEREST RATE PARITY
    THEORY
    2. The forward premium or
    discount equals the interest
    rate differential.
    (F - S)/S = (rh - rf)
    where rh = the home rate
    rf = the foreign rate
    INTEREST RATE PARITY
    THEORY
    3. In equilibrium, returns on
    currencies will be the same
    i. e. No profit will be realized
    and interest parity exists
    which can be written
    (1 + rh) = F
    (1 + rf) S
    INTEREST RATE PARITY
    THEORY
    B. Covered Interest Arbitrage
    1. Conditions required:
    interest rate differential does
    not equal the forward premium or
    discount.
    2. Funds will move to a country
    with a more attractive rate.
    INTEREST RATE PARITY
    THEORY
    3. Market pressures develop:
    a. As one currency is more
    demanded spot and sold
    forward.
    b. Inflow of fund depresses
    interest rates.

    c. Parity eventually reached.


    INTEREST RATE PARITY
    THEORY
    C. Summary:
    Interest Rate Parity states:
    1. Higher interest rates on a
    currency offset by forward
    discounts.
    2. Lower interest rates are
    offset by forward premiums.

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