Chapter 5

The Foreign Exchange Market

Copyright 2009 Pearson Prentice Hall. All rights reserved.

CONTENTS AND PURPOSE

1. 2. 3. 4. 5. 6. Definition and Organization of the Foreign Exchange Markets Foreign Exchange Market Functions Foreign Exchange Market Participants Size and Structure of Foreign Exchange Market Transactions Types of Foreign Exchange Market Transactions Quotations of Currencies on Foreign Exchange Markets

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

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Foreign Exchange Markets: Learning Objectives

Examine the functions performed by the foreign exchange (FOREX) market, its participants, size, geographic and currency composition Understand the definitions and distinguish between spot, forward, swap, and other types of foreign exchange financial instruments Learn the forms of currency quotations used by currency dealers, financial institutions, and agents Analyze the interaction among changing currency values, cross exchange rates and opportunities arising from inter-market arbitrage
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Foreign Exchange Markets

The FOREX market provides the physical and institutional structure through which
The money of one country is exchanged for that of another country The rate of exchange between currencies is determined Foreign exchange transactions are physically completed

A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate
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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

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Functions of the FOREX Market

The FOREX market is the mechanism by which participants
Transfer purchasing power between countries
This is necessary as international trade and capital transactions normally involve parties living in countries with different national currencies

Obtain or provides credit for international trade transactions

Inventories in transit must be financed

Minimize exposure to exchange rate risk

FOREX markets provide instruments utilized in hedging or transferring risk to more willing parties

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Foreign Exchange Market Functions Clearing of Currencies and Provision of Credit

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

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Foreign Exchange Markets

There are six main characteristics of the FOREX markets which will be discussed
The geographic extent The three main functions The markets participants Its daily transaction volume Types of transactions including spot, forward and swaps Methods of stating exchange rates, quotations, and changes in exchange rates

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Geographic Extent of the Market

Geographically, the FOREX market spans the globe with prices moving and currencies trading every hour of every business day Major world trading starts each morning in Sydney and Tokyo Then moves west to Hong Kong and Singapore Continuing to Europe and finishing on the West Coast of the U.S.
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Exhibit 5.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversions per Hour

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Foreign Exchange Market and Insurance Against Foreign 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:

open 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 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
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Market Participants
The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market. Five broad categories of participants operate within these two tiers
Bank and non bank foreign exchange dealers Individuals and firms conducting commercial or investment transactions Speculators and arbitragers Central banks and treasuries Foreign exchange brokers

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Foreign Exchange Market Participants Economic Agents and Types of Activities on Foreign Exchange Markets
Client buys $ with

Local bank

Bro kers

Main banks interbank market

Purchases and sales of big mu ltinational companies

Local bank

Client buys with $

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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

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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

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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)

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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

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Bank and Non-bank Dealers

These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price Competition among dealers narrows the spread between the bid and offer rate contributing to the markets efficiency Dealers on behalf of large international banks often act as market makers, often willing to stand in and buy or sell these currencies without having a counterpart with which to unload the inventory
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Bank and Non-bank Dealers

They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels Currency trading is profitable and often contributes between 10% - 20% of a banks average net income Small- to medium-sized banks rarely act as market makers yet still participate in the interbank market

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Individuals and Firms Conducting Commercial/Investment Transactions Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions Some of these participants use the market to hedge foreign exchange rate risk

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Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading in the market itself They operate for their own interest, without need or obligation to serve clients or ensure a continuous market Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks

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Central Banks and Treasuries

Central banks and treasuries use the market to acquire or spend their countrys currency reserves as well as to influence the price at which their own currency trades They may act to support the value of their currency because of their governments policies or obligations or because of commitments entered through joint float agreements such as the European Monetary System (EMS) Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests
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Continuous Linked Settlement

Continuous Linked Settlement (CLS) system (since 2002) eliminates losses if either party unable to settle CLS links with Real-Time Gross Settlement (RTGS) systems in seven major currencies Eventually we expect same-day settlement instead of the current lag of two days The U.S. Commodity Futures Trading Commission (CFTC) regulates foreign exchange trading

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Transactions in the Interbank Market

Transactions within this market can be executed on a spot, forward, or swap basis
A spot transaction requires almost immediate delivery of foreign exchange A forward transaction requires delivery of foreign exchange at some future date A swap transaction is the simultaneous exchange of one foreign currency for another
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Spot Transactions
A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day
The settlement date is often referred to as the value date This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York
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Outright Forward Transactions

This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months
Terminology typically used is buying or selling forward A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros
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Types of Foreign Exchange Market Transactions Spot Foreign Exchange Transactions almost immediate delivery of foreign exchange

Outright Forward Transactions

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

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Swap Transactions
A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counterpart A common type of swap is a spot against forward
The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure
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Swap Transactions
simultaneous purchase and sale of a given amount of foreign exchange for two different value dates:
b spot against forward swaps: a * d c
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

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Swap Transactions
Forward-forward swaps A dealer sells 20,000 forward for dollars for delivery in two months at $1.8420/ and simultaneously buys 20,000 forward for delivery in three months at $1.8400/
The difference between the buying and selling price is equivalent to the interest rate differential Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis

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Swap Transactions
Non-deliverable forwards (NDFs) NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered
The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments Pricing of NDFs reflects basic interest rate differentials

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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!)

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 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 Size of the contracts Location and trade activity

Futures standardized for a given currency at the stock exchange or at a given location; actively traded in an organized market standardized, but at most a year yes insurance explicitly required (margin requirements); high security of doing business with the instrument regulated with the stock exchange rules

Duration of the contract Contract has to be executed Insurance and Security of doing Business with the Instrument Trade regulation

Outright Forward Contract depends on the individual needs of the client with the provision of agents, connected among each other with the help of telecommunications; not traded in an organized market depends on the individual needs of the client , but not more than a year yes insurance not required explicitly (implicit insurance are affiliations of two partners up till now); lower security than futures regulation not explicitly determined
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Characteristic Contract partners Price determination Determination of the dayof the settlement Accesibility of the contract for nonbank agents Liquidity of the instrument and the contract amounts Costs of the instrument Currency quotation

Futures not in direct contact based on supply and demand standardized accessible to anyone

Outright Forward Contract in direct contact based on quotations depends on the individual needs of the client in practice accessible to big clients with good ratings

high liquidity; small contract amounts and small size of transactions

Riskiness of the instrument Profit yield/loss payment

low liquidity; high contract amounts and large size of transactions compared to the size of futures based on costs that the broker zarauna higher than for futures; based on the for the purchase of the instrument and difference in offer and bid price of the its sale later on currency that the bank offers the client number of units of $ for one unit of a number of domestic currency units for foreign currency (American quotation) one unit of a foreign currency (European quotation) very limited; stock exchange enters the higher than for futures; for this reason, contract, explicitly required insurance business is done only with credible partners daily once; at contract execution or when the contract expires Page 34

at-the-money

Options

in-the-money out-of-money

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

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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

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Options
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
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Profit/ loss

A. Buyer of a call option

Profit/ loss

C. Buyer of a put option

Unlimited profit Limited loss

Unlimited profit Limited loss

Profit/ loss

B. Seller of a call option

Profit/ loss

D.

Seller of a put option

Limited profit Unlimited loss

Unlimited loss

Limited profit

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Size of the FOREX Market

The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$3.2 trillion in April 2007
Spot transactions at $1,005 billion/day Outright forward transactions at $363 billion/day Swap transactions at $1,714 billion/day

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Exhibit 5.2 Global Foreign Exchange Market Turnover, 1989-2007 (daily averages in April, billions of U.S. dollars)

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Size of the FOREX Market

The United Kingdom (London) and the United States (New York) make up roughly 50% of the foreign exchange market The London trade alone makes up 34.1% of daily transactions in the foreign exchange market Switzerland has grown in recent years and is now the third largest market with 6.1% of world trading

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Exhibit 5.3 Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1992-2007 (daily averages in April, billions of U.S. dollars)

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Exhibit 5.4 Foreign Exchange Market Turnover by Currency Pair (Daily averages in April)

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Foreign Exchange Rates & Quotations

A foreign exchange quote is a statement of willingness to buy or sell at an announced rate
In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency

Interbank quotes professional dealers or brokers may state quotes in one of two ways
The foreign currency price of one dollar
Sfr1.6000/$, read as 1.600 Swiss francs per dollar

The dollar price of a unit of foreign currency

$0.6250/Sfr, read as 0.625 dollars per Swiss franc

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Foreign Exchange Rates & Quotations

The former quote is considered to be in European terms and the latter is considered to be American terms European Terms: express the rate as the foreign currency price of one U.S, dollar SF 1.6000/$ (1.6000 SF per dollar)
Almost all European currencies, except two, are quoted the European way The Pound Sterling and the Euro are the exceptions Additionally, Australian and New Zealand dollars are also quoted in American terms
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Foreign Exchange Rates & Quotations

Direct and Indirect Quotes
A direct quote is a home currency price of a unit of a foreign currency
Sfr1.6000/$ is a direct quote in Switzerland Sfr1.6000/$ is a indirect quote when used in the US

An indirect quote is a foreign currency price in a unit of the home currency

Sfr1.600/$ is an indirect quote in the US, $0.6250/Sfr is a direct quote in the US and an indirect quote in Switzerland
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Foreign Exchange Rates & Quotations

Interbank quotes are given as a bid and ask
The bid is the price at which a dealer will buy another currency The ask or offer is the price at which a dealer will sell another currency
Example: 118.27 - 118.37/$ is the bid/ask for Japanese yen The bank will buy yen at 118.27 per dollar and sell yen at 118.37 per dollar making profit on the spread

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Quotations of Currencies on Foreign Exchange 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 quotation direct and indirect quotation (which currency is regarded as a domestic/basis currency)
s s0 s t * 100 s0 s s0 st * 100 st

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Exhibit 5.5 Spot and Forward Quotations for the Euro and Japanese Yen

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Currency Quotations in Spot Foreign Exchange Markets

American quotation European quotation
Definition: Definition: number of units of $ needed to buy a unit of a number of units of a foreign currency needed to buy foreign currency $1

Direct quotation in the USA: Direct quotation outside the USA: number of units of a domestic currency ($) needed number of units of a domestic currency needed to to buy a unit of foreign currency buy a unit of a foreign currency ($)

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 ($)

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Currency Quotations in Spot Foreign Exchange Markets

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:

margin

offer/sell price - bid price offer/sell price

banks usually do not charge provision difference between the bid and offer/sell price represents the banks profit and is called a margin or Page spread

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Currency Quotations in Spot Foreign Exchange Markets

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
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Currency Quotations in Forward Foreign Exchange Markets

outright quotation tokovna 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

f s 360 * *100 s n
f USD s f 360 * *100 f n

f USD

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Publishing the Currency Quotations in the Leading World Financial Newspapers

Financial Times Wall Street Journal

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Foreign Exchange Rates & Quotations

Expressing Forward Quotations on a Points Basis
The previously mentioned rates for yen were considered outright quotes Forward quotes are different and typically quoted in terms of points A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal
Hence a point is equal to 0.0001 of most currencies

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Foreign Exchange Rates & Quotations

Expressing Forward Quotations on a Points Basis
The yen is quoted only to two decimal points A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates Example:
Bid Outright spot: Plus points (3 months) Outright forward: 118.27 -1.43 116.84 Ask 118.37 -1.40 116.97

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Foreign Exchange Rates & Quotations

Forward Quotations in Percentage Terms
Forward quotations may also be expressed as the percent-perannum deviation from the spot rate
This is similar to the forward discount or premium calculated earlier

The important thing to remember is which currency is being used as the home or base currency
For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is

FC

Spot - Foward 360 x x 100 Foward days

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Foreign Exchange Rates & Quotations

Forward Quotations in Percentage Terms
For direct quotes (i.e. quote expressed in home currency terms), the formula is
Forward - Spot 360 f x x 100 Spot days
H

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Foreign Exchange Rates & Quotations

Forward Quotations in Percentage Terms
Example: Indirect quote
105.65 - 105.04 360 f x x 100 2.32% p.a. 105.04 90

Example: Direct quote

0.009520183 - 0.009465215 360 f x x 100 2.32% p.a. 0.009465215 90
$

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Exhibit 5.6 Foreign Exchange Rate Quotations on the U.S. Dollar/British Pound in the Financial Press

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Foreign Exchange Rates & Quotations

Cross Rates
Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (MXP) and Japanese yen () are quoted in US dollars
Assume the following quotes:
Japanese yen
Mexican peso

110.73/$
MXP 11.4456/$

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Foreign Exchange Rates & Quotations

Cross Rates
The Mexican importer can buy one US dollar for 11.4456 Mexican pesos and with that dollar buy 110.73; the cross rate would be
110.73/$ Japanese yen/US dollar MXP11.4456/$ Mexican pesos/US dollar

9.6745/MXP

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Foreign Exchange Rates & Quotations

Intermarket Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage Example: Assume the following exchange rates are quoted
Citibank Barclays Bank Dresdner Bank $1.2223/ $1.8410/ 1.5100/

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Foreign Exchange Rates & Quotations

Intermarket Arbitrage
The cross rate between Citibank and Barclays is

$1.8410/ 1.5062/ $1.2223/

This cross rate is not the same as Dresdners rate quote of 1.5100/ Therefore, an opportunity exists for risk-less profit or arbitrage

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Exhibit 5.7 Key Currency Cross Rates

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Exhibit 5.8A Triangular Arbitrage

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Exhibit 5.8B Triangular Arbitrage

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Summary of Learning Objectives

The three functions of the foreign exchange market (FOREX) are to transfer purchasing power, provide credit, and minimize foreign exchange rate risk The FOREX is composed of two tiers: the interbank market and the client market. Participants within these tiers include bank and nonbank foreign exchange dealers, individuals and firms conducting commercial and investment functions, speculators and arbitragers, central banks and treasuries and foreign exchange brokers
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Summary of Learning Objectives

Geographically, the FOREX market spans the globe, with prices moving and currencies traded every hour of every business day A foreign exchange rate is the price of one currency expressed in terms of another currency A foreign exchange quotation is a statement of willingness to buy or sell currency at an announced price Transactions within the FOREX market are executed either on a spot basis requiring delivery two days after the transaction or on a forward basis requiring settlement at some designated future date

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Summary of Learning Objectives

European terms quotations are the foreign currency price of one US dollar. American terms are the dollar price of a foreign currency Quotations can also be direct or indirect. A direct quote is the home currency price of a unit of foreign currency, while an indirect quote is the foreign currency price of a unit of the home currency Direct and indirect are not synonymous for American and European terms, because the home currency will change for calculation purposes
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Summary of Learning Objectives

A cross rate is an exchange rate between two currencies, calculated from their common relationships with a third currency When cross rates differ from the direct rates between two currencies, intermarket arbitrage is possible

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Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.

Borrows at 7.20% for 30 days 1. Borrows $20 million Returns $20,120,000 Profit of $792,320 Exchange at $0.50/NZ$ Exchange at $0.52/NZ$ 4. Holds $20,912,320

Lends at 6.48% for 30 days 2. Holds NZ$40 million 3. Receives NZ$40,216,000

Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days. Borrows at 6.96% for 30 days 1. Borrows NZ$40 million Returns NZ$40,232,000 Profit of NZ$1,668,000 or $800,640 Exchange at $0.50/NZ$ Exchange at $0.48/NZ$ 4. Holds NZ$41,900,000

Lends at 6.72% for 30 days 2. Holds $20 million 3. Receives $20,112,000