Chapter 4 The Market for Foreign
Exchange
Management 3460 Institutions and Practices in
International Finance
Fall 2003Greg Flanagan
Oct 2, 2003 2
Chapter Objectives The student will be able to:
Explain the Function and Structure of the FOREX MarketFX Market ParticipantsCorrespondent Banking RelationshipsWholesale/retailDirect and indirect
Oct 2, 2003 3
Chapter Objectives The student will be able to:
Explain the Spot market Spot Rate Quotations S(j/k)The Bid-Ask SpreadSpot FX TradingCross Exchange Rate QuotationsTriangular Arbitrage
Oct 2, 2003 4
Chapter Objectives The student will be able to:
Explain the Forward market
Forward Rate Quotations FN(j/k)
Long and Short Forward Positions
Forward Cross-Exchange Rates
Swap Transactions
Forward Premium
Oct 2, 2003 5
FOREX Market Participants
The FOREX market is a two-tiered market: Interbank Market (Wholesale)
• About 700 banks worldwide stand ready to make a market in Foreign exchange.
• Nonbank dealers account for about 20% of the market.• There are FX brokers who match buy and sell orders but do
not carry inventory and FX specialists.
Client Market (Retail) Market participants include international banks, their
customers, nonbank dealers, FX brokers, and central banks.
Oct 2, 2003 6
Correspondent Banking Relationships
Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market.
International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications.
CHIPS: Clearing House Interbank Payments System
ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions—in cooperation with fedwire (The US Fed reserve system).
Oct 2, 2003 7
Spot Rate Quotations
The direct quote for British pound is:
£1 = $1.5627
CountryUSD equiv Friday
USD equiv Thursday
Currency per USD Friday
Currency per USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.5906 0.5934 1.6932 1.6852
Brazil (Real) 0.2939 0.2879 3.4025 3.4734
Britain (Pound) 1.5627 1.566 0.6399 0.6386
1 Month Forward 1.5596 1.5629 0.6412 0.6398
3 Months Forward 1.5535 1.5568 0.6437 0.6423
6 Months Forward 1.5445 1.5477 0.6475 0.6461
Canada (Dollar) 0.6692 0.6751 1.4943 1.4813
1 Month Forward 0.6681 0.6741 1.4968 1.4835
3 Months Forward 0.6658 0.6717 1.502 1.4888
6 Months Forward 0.662 0.6678 1.5106 1.4975
Oct 2, 2003 8
Spot Rate Quotations
The indirect quote for British pound is:
£.6399 = $1
1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per USD Thursday
Currency per USD Friday
USD equiv Thursday
USD equiv FridayCountry
Oct 2, 2003 9
Spot Rate Quotations
Note that the direct quote is the reciprocal of the indirect quote:
6399.
15627.1
1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per USD Thursday
Currency per USD Friday
USD equiv Thursday
USD equiv FridayCountry
Oct 2, 2003 10
Reciprocal FX Markets
BR Direct BR Indirect
1.5627
£
QUS$
D
US$
Q£
S
D
S
US Indirect US Direct
.6399
Oct 2, 2003 11
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.
Oct 2, 2003 12
Cross Rates Suppose that S($/€) = .50
i.e. $1 = 2 € and that S(¥/€) = 50
i.e. €1 = ¥50 What must the $/¥ cross rate be?
,¥
€
€
$
¥
$ since
¥100 $1or .01 ¥)/($¥100
1$
¥50
1€
2€
1$ S
Oct 2, 2003 13
Triangular Arbitrage
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
$
£¥
Suppose we observe these banks posting these exchange rates.
First calculate the implied cross rates to see if an arbitrage exists.
Oct 2, 2003 14
Triangular Arbitrage
80¥
1£
120¥
1$
1$
50.1£
The implied S(¥/£) cross rate is S(¥/£) = 80
Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.
So, how can we make money?
Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.
Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
$
£¥
Oct 2, 2003 15
Triangular Arbitrage
As easy as 1 – 2 – 3: Credit Lyonnais
S(£/$)=1.50
Credit Agricole
S(¥/£)=85
Barclays
S(¥/$)=120
$
£¥
1. Sell our $ for £, 1
22. Sell our £ for ¥,
3
3. Sell those ¥ for $.
Oct 2, 2003 16
Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £ 150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000Sell ¥ 12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $ 106,250- $100,000 = $6,250
Oct 2, 2003 17
Spot Foreign Exchange Microstructure
Market Microstructure refers to the mechanics of how a marketplace operates.
Bid-Ask spreads in the spot FX market:increase with FX exchange rate volatility
decrease with dealer competition. Private information is an important
determinant of spot exchange rates.
Oct 2, 2003 18
The Forward Market
A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.
If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.
Oct 2, 2003 19
Forward Rate Quotations
The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.
Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.
Longer-term swaps are available.
Oct 2, 2003 20
Forward Rate Quotations
Consider the example :
for Japanese yen, the spot rate is
$1.5627 = £1.00
While the 180-day forward rate is
$1.5445 = £1.00 What’s up with that?
Oct 2, 2003 21
Spot Rate Quotations
The market participants expect that the pound will be worth less in dollars in six months.
1.49751.51060.66780.6626 Months Forward
1.48881.5020.67170.66583 Months Forward
1.48351.49680.67410.66811 Month Forward
1.48131.49430.67510.6692Canada (Dollar)
0.64610.64751.54771.54456 Months Forward
0.64230.64371.55681.55353 Months Forward
0.63980.64121.56291.55961 Month Forward
0.63860.63991.5661.5627Britain (Pound)
3.47343.40250.28790.2939Brazil (Real)
1.68521.69320.59340.5906Australia (Dollar)
3.03773.02210.32920.3309Argentina (Peso)
Currency per USD Thursday
Currency per USD Friday
USD equiv Thursday
USD equiv FridayCountry
Oct 2, 2003 22
Long and Short Forward Positions
If you have agreed to sell anything (spot or forward), you are “short”.
If you have agreed to buy anything (forward or spot), you are “long”.
If you have agreed to sell FX forward, you are short.
If you have agreed to buy forex forward, you are long.
Oct 2, 2003 23
Payoff Profiles
S180($/¥)
F180($/¥) = .009524
Short position
0
loss
profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain.
F180($/¥) = .0095
.0024
Oct 2, 2003 24
Payoff Profiles
S180($/¥)
F180($/¥) = .009524
Short position
0
loss
profitIf you agree to sell in the future at a set price and the spot price later rises then you lose.
F180($/¥) = .0096
-.0076
Oct 2, 2003 25
Payoff Profiles
loss
0 S180($/¥)
Short position-F180($/¥)
F180($/¥)Long position
profitSince this is a zero-sum game, the long position payoff is the
opposite of the short.
F180($/¥) = .009524
Oct 2, 2003 26
Forward Cross Exchange Rates
It’s just an “delayed” example of the spot cross rate discussed above.
In generic terms
)/($
)/($)/(
and
)/($
)/($)/(
kF
jFjkF
jF
kFkjF
N
NN
N
NN
Oct 2, 2003 27
SWAPS A swap is an agreement to provide a
counterparty with something he wants in exchange for something that you want.
Swap transactions are a simultaneous sale of spot FX and a forward purchase of an equal amount (or vice versus)
account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.
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