1

The Foreign Exchange MarketThe Foreign Exchange Market

International Finance

Dr. A. DeMaskey

2

Learning ObjectivesLearning Objectives

What is the foreign exchange market, its function, participants, size, geographic and currency composition?

What is the difference between spot, forward, and swap transactions in the foreign exchange market?

What currency quotations are used by currency dealers and financial institutions when conducting foreign exchange transactions?

What currency arbitrage opportunities do exist in the foreign exchange market, and how profitable are they?

3

The Foreign Exchange Market

The Foreign Exchange Market

The FOREX market provides the physical and institutional structure through which the money of one country is exchanged for that of another country.

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.

4

Functions of the Foreign Exchange Market

Functions of the Foreign Exchange Market

Transfer of purchasing power

Provision of credit

Minimizing foreign exchange risk

5

Structure of the Foreign Exchange Market

Structure of the Foreign Exchange Market

An over-the-counter market– No centralized marketplace– A network of telephones, telex machines,

computer terminals, and automated dealing systems.

Not confined to any one country No fixed opening and closing times

6

The World of Foreign Exchange Dealing

The World of Foreign Exchange Dealing

7

Size of the MarketSize of the Market

Worldwide daily trading volume

Daily trading volume in the U.K.

U.S. daily turnover

Daily turnover in Tokyo

8

Market ParticipantsMarket Participants

Two Tier Market

International BanksBank Customers

CentralBanks

Non-Bank Dealers

FXBroker

9

Transactions in the Interbank Market

Transactions in the Interbank Market

Spot Transactions

Outright Forward Transactions

Swap Transactions

10

Global Foreign Exchange Market Turnover

Global Foreign Exchange Market Turnover

Two of the three categories fell between 1998 and 2001 with spot market daily turnover falling the most, from $568 billion in 1998 to $387 billion in 2001.

Forward transactions increased slightly from $128 billion in 1998 to $131 billion in 2001.

Swaps fell to $656 billion in 2001 from $734 billion in 1998.– The BIS attributes the introduction of the Euro, the growing share

of electronic broking in the spot market and consolidation in banking as explanations for the reduction

11

Foreign Exchange Rate Quotations

Foreign Exchange Rate Quotations

American Terms U.S. dollar price of

one unit of foreign currency

A direct quote in the U.S.

An indirect quote in Europe

European Terms Foreign currency price

of one U.S. dollar A direct quote in

Europe An indirect quote in

the U.S.

12

Bid and Ask QuotationsBid and Ask Quotations

Bid Rate and Offer/Ask Rate

– Outright quotations

– Abbreviation

Reversing Bid and Offer Rate

Bid-Ask Spread

13

Cross RatesCross Rates

Exchange rate determined through the relationship to a widely traded third currency.

Example: – A Mexican importer needs Japanese yen to pay for

purchases in Tokyo. Both the Mexican peso (Ps) and Japanese yen (¥) are quoted in US dollars

– Assume the following quotes:

Japanese yen ¥121.13/$

Mexican peso Ps9.190/$

14

Currency ArbitrageCurrency Arbitrage

Capitalizing on the discrepancy in quoted prices.– No investment

– No risk

Locational Arbitrage Triangular Arbitrage

15

Locational ArbitrageLocational Arbitrage When quoted exchange rates vary among locations,

participants in the foreign exchange market can capitalize on the discrepancy.

Suppose the euro is quoted in London at 0.6064-80 and the pound sterling is quoted in Frankfurt at 1.6244-59.

16

Triangular ArbitrageTriangular Arbitrage Cross rates can be used to check on opportunities for intermarket arbitrage. Example: Assume the following exchange rates are quoted in New York,

Frankfurt, and London, respectively:– $1.4443/£– $0.9045/€– €1.6200/£

17

Forward TransactionsForward 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

18

Forward Market ParticipantsForward Market Participants

A r b i t r a g e r

T r a d e r

H e d g e r S p e c u l a t o r

19

Forward QuotationsForward Quotations

Outright Rate

Swap Rate

– Discount or Premium

– Annualized Percentage Discount or Premium

– Swap Rate Expressed in Points

20

Swap RateSwap Rate

Outright forward rate = Spot rate ±Swap rate/point

A point is the last digit of a quotation. Add points to spot rate if currency is

trading at a forward premium. Subtract points from spot rate if currency is

trading at a forward discount.

21

Bid and Ask Forward Quotations

Bid and Ask Forward Quotations

If forward ask in points > forward bid in points forward premium

If forward ask in points < forward bid in points forward discount

22

Bid-and-Ask Forward Quotations in Points

Bid-and-Ask Forward Quotations in Points

Suppose you receive the following quotes for pound sterling relative to the U.S. dollar for spot, 1-, 3-, and 6-month forward:

“1.6075-85 10-15 14-22 20-30”