International FinanceFINA 5331

Lecture 2: The Foreign Exchange Market

Aaron Smallwood Ph.D.

Foreign Exchange MarketProducts and Activities

• A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies).

• A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

Foreign Exchange MarketProducts and Activities

• Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk.

• A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery.

• Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

Foreign Exchange MarketProducts and Activities

• Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation.

• Arbitrage is the simultaneous, or nearly simultaneous, purchase of securities in one market for sale in another market with the expectation of a risk-free profit.

FX Players

• Broadly speaking the FX market consists of 5 groups– International banks– Bank customers– Non-bank dealers

• Include investment banks, mutual funds, and hedge funds.

– FX brokers– Central banks

The Market for Foreign Exchange

• The FOREX market is the largest market in the world.

• According to the BIS, in 2010, daily turnover in April in FOREX market hit almost $4 TRILLION dollars.

•Table 1

•Global foreign exchange market turnover by instrument1

•Average daily turnover in April, in billions of US dollars

•Instrument •1998 •2001 •2004 •2007 •2010

•Foreign exchange instruments •1,527 •1,239 •1,934 •3,324 •3,981

•Spot transactions² •568 •386 •631 •1,005 •1,490

•Outright forwards² •128 •130 •209 •362 •475

•Foreign exchange swaps² •734 •656 •954 •1,714 •1,765

•Currency swaps •10 •7 •21 •31 •43

•Options and other products³ •87 •60 •119 •212 •207

•Memo: Turnover at April 2010 exchange rates Exchange-traded derivatives 5

•4 •1,705 11 •1,505 12 •2,040 26 •3,370 80 •3,981 166

•1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 Previously classified as part of the so-called "Traditional FX market". 3 The category "other FX products" covers highly leveraged transactions and/or trades whose notional amount is variable and where a decomposition into individual plain vanilla components was impractical or impossible. 4 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2010 exchange rates. 5 Sources: FOW TRADEdata; Futures Industry Association; various futures and options exchanges. Reported monthly data were converted into daily averages of 20.5 days in 1998, 19.5 days in 2001, 20.5 in 2004, 20 in 2007 and 20 in 2010.

Daily Trading Volumes by Hour

Spot Exchange Rates

Spot Rate Quotations

• Indirect quotation– the price of a U.S. dollar in the foreign

currency– e.g. the yuan price of the dollar = RMB

6.1374 on June 28. • Direct Quotation

– the price of a unit of foreign currency: given by 1/Indirect Quotation

– e.g. $/Euro = 1/0.7686=$1.3010

Appreciation versus Depreciation

• A currency is said to appreciate, either when its direct quotation for another falls, or when it’s indirect quotation rises.– Example: On March 24, 2011, the RMB price of the

dollar was: RMB 6.5605– The yuan has been gradually appreciating against the

dollar• A currency is said to depreciate if its direct

quotation rises, or when its indirect quotation falls.– The dollar has been depreciating against the RMB (as

seen by the decrease in it’s indirect quote for the yuan).

The Bid-Ask Spread

• The bid price is the price a dealer is willing to pay you for something.

• The ask price is the amount the dealer wants you to pay for the thing.

• The bid-ask spread is the difference between the bid and ask prices.

Example:

• If the bid ask spread for RMB is:– $0.1600 -$0.1610:– How many RMB do we receive if we sell

$10,000?

$10,000/0.1610 = 6,211.18.– What is we wanted to sell RMB 10,000?

RMB10,000 * .1600 = $1,600.

Cross Rates• Suppose that S($/€) = 2

– i.e. $1 = 0.50 €

• and that S(¥/€) = 150

– i.e. €1 = ¥150

• What must the $/¥ cross rate be?

(2)/150= $0.01333.

$ $ €since ,

¥ € ¥

Triangular Arbitrage

$

£¥

Credit Lyonnais

S($/£)=1.50

Credit Agricole

S(¥/£)=185

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.

Triangular Arbitrage

Barclays

S(¥/$)=120

The implied S(¥/£) cross rate is S(¥/£) = 180

Credit Agricole has posted a quote of S(¥/£)=185 so there is an arbitrage opportunity.

So, how can we make money?

Buy the £ @ ¥180; sell @ ¥185. Then trade yen for dollars.

$Credit Lyonnais

S($/£)=1.50

Credit Agricole

S(¥/£)=185¥ £

Triangular Arbitrage

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell $ for £,

2. Sell £ for ¥,

3. Sell ¥ for $.

$Credit

Lyonnais

S($/£)=1.50

Credit Agricole

S(¥/£)=185

¥ £

1

2

3

$

Triangular Arbitrage

Sell $100,000 for £ at S($/£) = $1.50

receive £66,666.67

Sell our £ 66,666.67 for ¥ at S(¥/£) = 185

receive ¥12,333,333.33

Sell ¥ 12,333,333.33 for $:S(¥/$) = 120

receive $102,777.78

profit per round trip = $ 102,777.78- $100,000 = $2,777.78

Cross Currency Exchange Rates with Bid-Ask Spreads

• Consider the example on page 122– Suppose, relative to the US $, we are given the bid

ask spread in the market for pounds (e.g. $/£). What then is the bid ask spread in the market for $?

• Bid price is the inverse of the ask price.• If bid-ask spread in the market for pounds is: $1.9712-17,

the bid price in the market for $=

– Can show that the ask price is 0.5073

5072.09717.1/1£/$ tS

Triangular Arbitrage

• Previous triangular arbitrage is unrealistic since traders face no transactions costs.

• We want to consider examples with bid-ask spreads.

• See example on pages 122-123, with the following quotes:– Market for pounds: $1.9712-17– Market for euros: $1.4739-44– Market for pounds: €1.3305-10

• Implied price in the third market is 1.3370-77. POUND UNDERVALED!

Exploit the arbitrage opportunity

• Suppose we start with $1,000,000• First, we need to get euros so we can buy

pounds in the 3rd market.– Start by selling dollars for euros:

• We receive: $1,000,000/1.4744 = €678,242.00

– Sell euros for pounds:• We receive: €678,242.00/1.3310 = £509,573.25

– Finally, sell pounds for dollars• We receive: £509,573.25*1.9712 = $1,004,470.79

• PROFIT: $4,470.79.