CHAPTER 6 THE FOREIGN EXCHANGE MARKET

Multinational Business Finance723g33

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Yinghong.chen@liu.se

The Foreign Exchange Market

• Foreign exchange means the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts.

• 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.

• $ 1 €

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Geography

• The foreign exchange market spans the globe, with currencies trading somewhere every hour of every business day.

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Exhibit 6.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversions Per Hour

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Exhibit 6.2 Global Currency Trading: The Trading Day

Start of the day

The Foreign Exchange Market

• The Foreign Exchange Market provides: – the physical and institutional structure through

which the money of one country is exchanged for that of another country;

– the determination of rate of exchange between currencies, and

– is where foreign exchange transactions are physically completed.

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Functions of the Foreign Exchange Market

• The foreign exchange Market is the mechanism by which participants:

– transfer purchasing power between countries;

– obtain or provide credit for international trade transactions, and

– minimize exposure to the risks of exchange rate changes.

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Market structure• The foreign exchange market consists of two tiers:Tier 1:

– the interbank or wholesale market (multiples of $1 trillion US or equivalent in transaction size), and

Tier 2:

– the client or retail market (specific, smaller amounts).

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Market Participants

Four broad categories of participants:

1. Bank and nonbank foreign exchange dealers,

2. Individuals and firms,

3. Speculators and arbitragers, and

4. Central banks and treasuries.

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1. Bank and Nonbank Foreign Exchange Dealers

• Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.

• The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.

• Dealers in large international banks often function as “market makers.”

• These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.

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Exhibit 6.8 Bid, Ask, and Mid-Point Quotation

2. Individuals and Firms

• Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.

• Their use of the foreign exchange market is necessary for their underlying commercial or investment purpose.

• Some of the participants use the market to “hedge” foreign exchange risk.

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3. Dealers, Speculators and Arbitragers

• Speculators and arbitragers seek to profit from trading in the market itself.

• They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.

• While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.

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4: Central Banks and Treasuries

• Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.

• The motive is not to earn a profit

• Central banks and treasuries differ in motive from all other market participants.

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Transactions in the Interbank Market

• A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place on the second following business day.

• The date of settlement is referred to as the value date.

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Exhibit 6.3 Foreign Exchange Settlement in Europe

Transactions in the Interbank Market• An outright forward transaction (or a forward)

requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.

• The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.

• Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.

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Transactions in the Interbank Market• 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 (settlement date).

• Both purchase and sale are conducted with the same counterparty.

• Some different types of swaps are:

– spot against forward,

– forward-forward with different value dates,

– nondeliverable forwards (NDF).

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Market Size

• In April 2004, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1.9 trillion.

• This most recent period showed dramatic growth in foreign exchange trading over that seen in April 2001.

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Exhibit 6.4 Global Foreign Exchange Market Turnover, 1989-2010 (average daily turnover in April, billions of U.S. dollars)

Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1991-2010 (average daily turnover in April)

Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair (daily average in April)

Foreign Exchange Rates and Quotations

• A foreign exchange rate is the price of one currency expressed in terms of another currency.

• A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

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Foreign Exchange Rates and Quotations

• Most foreign exchange transactions involve the US dollar.

• Professional dealers and brokers may state foreign exchange quotations in one of two ways:– the foreign currency price of one dollar, or

– the dollar price of a unit of foreign currency.

• Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.

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Foreign Exchange Rates and Quotations

• Foreign exchange quotes:

direct or indirect quote

the home country of the currencies being discussed is critical.

• A direct quote is a home currency price of a unit of foreign currency. ex: SKr/$

• An indirect quote is a foreign currency price of a unit of home currency. ex: $/Skr

• The form of the quote depends on what the speaker regard as “home.”

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Foreign Exchange Rates and Quotations

• For example, the exchange rate between US dollars and the Swiss franc is normally stated:– SF 1.6000/$ (direct quote)

• However, this rate can also be stated as:– $0.6250/SF (indirect quote)

• most interbank quotations around the world are stated in European terms.

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Foreign Exchange Rates and Quotes

• Forward rates are typically quoted in terms of points. 1 points typically corresponds to 0,0001 in value.

• Rather, it is the difference between the forward rate and the spot rate.

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Foreign Exchange Rates and Quotes

• Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate.

• This method of quotation makes it easier to compare premiums or discounts in the forward market

• If a currency increases in value in the future, it is traded at a premium, if decreases, it is at a discount against the other currency.

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Forward premium (¥ vs. $)

• For quotations expressed in foreign currency terms (indirect quotation ) the formula becomes:

f ¥ = Spot – Forward 360

• For quotations expressed in home currency terms (direct quotation) the formula becomes:

f ¥ = Forward – Spot 360

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100nForward

xx

100n Spot

x x

Example 1

Suppose we know that Spot rate: ¥118,27/$ <=>$0,0084/¥3-month Forward: ¥ 116,84/$ <=> $0,0085/¥Dollar is selling forward at a discount against Yen. Yen is selling foward at a premium against USD.The forward premium of Yen (home currency terms)is ((118,27-116,84)/116,84)*360/90*100=+4,90%

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Example 1: cont.

Suppose we know that Spot rate: ¥118,27/$ <=>$0,0084/¥3-month Forward: ¥ 116,84/$ <=> $0,0085/¥•USD is selling at a discount against JPY.•Forward discount=•(116,84-118,27)/118,27*360/90*100=-4,836%

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Exhibit 6.9 Exchange Rates: New York Closing Snapshot

Exhibit 6.9 Exchange Rates: New York Closing Snapshot (cont.)

Foreign Exchange Rates and Quotes

• Some currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate).

• Cross rates can be used to check on opportunities for intermarket arbitrage.

• one bank’s (Dresdner) quotation on €/£ is not the same as calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank).

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Intermarket Arbitrage• Citibank quote - $/€ $1.1.3297/€

• Barclays quote - $/£ $1.5585/£

• Dresdner quote - €/£ €1.1722/£• Cross rate calculation:

$1.5585/£

Because the rates are unequal, a triangular arbitrage opportunity exists.

For another example, see Exhibit 6.11

$1.3297/€= € 1.1721/£

=

Exhibit 6.10 Key Currency Rate Calculations for January 3, 2012

Exhibit 6.11 Triangular Arbitrage by a Market Trader

Foreign Exchange Rates changes (example: note the two notations are identical!!!)

• Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations):

%∆ = Ending rate – Beginning Rate

Quotations expressed in foreign currency terms (indirect quotations): =

Beginning rate –Ending rate

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Beginning Ratex 100

Beginning Ratex 100

Example 2:

• Mexican peso has changed from MXP10/USD to MXP 11/USD, what is the percentage change in the value of dollar, and peso?

Dollar appreciated in terms of MXP! (11-10)/10=10%

Peso depreciated in terms of USD! (1/11-1/10)*(1/10)=(10-11)/11=-9,09%

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Exhibit 6.12 Spot and Forward Quotations for the Euro and Japanese Yen

1,0897+0,0003=1,0900