CHAPTER 7

The Foreign Exchange Market

PART I. INTRODUCTION

I. INTRODUCTIONA. The Currency Market:

where money denominated in one currency is bought

and sold with money denominated in

another currency.

INTRODUCTION

B. International Trade and Capital Transactions:

facilitated with the ability

to transfer purchasing power

between countries

INTRODUCTION

C. Location1. OTC-type: no specific

location2. Most trades by phone,

telex, or SWIFT

SWIFT: Society for Worldwide Interbank Financial Telecommunications

PART II.ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET

A. Participants at 2 Levels1. Wholesale Level (95%)

- major banks2. Retail Level

- business customers

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Two Types of Currency Markets

1. Spot Market:

- immediate transaction

- recorded by 2nd business day

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Market:- transactions take place at a

specified future date

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

C. Participants by Market1. Spot Market

a. commercial banks

b. brokers

c. customers of commercial and central banks

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Marketa. arbitrageurs

b. traders

c. hedgers

d. speculators

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

II. CLEARING SYSTEMSA. Clearing House Interbank

Payments System (CHIPS)

- used in U.S. for electronic

fund transfers.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. FedWire

- operated by the Fed

- used for domestic transfers

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

III. ELECTRONIC TRADINGA. Automated Trading

- genuine screen-based market

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Results:

1. Reduces cost of trading

2. Threatens traders’

oligopoly of information

3. Provides liquidity

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET

A. Largest in the world

2004: US$1.9 trillion daily

or

US$475 trillion a year

In 1999 the US GDP was US$9.1

trillion

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Market Centers (2004): #1: London = $753 billion daily

#2: New York= $461 billion daily

#3: Tokyo = $199 billion daily

PART III.THE SPOT MARKET

I. SPOT QUOTATIONSA. Sources

1. All major newspapers2. Major currencies have

four different quotes:a. spot priceb. 30-dayc. 90-dayd. 180-day

THE SPOT MARKET

B. Method of Quotation1. For interbank dollar

trades:

a. American terms

example: $1.21/€

b. European terms

example: Peso1.713/$

THE SPOT MARKET

2. For nonbank customers:

Direct quote gives the home

currency price (always in the numerator) of

one unit of foreign currency.

EXAMPLE: $1.81/£

Since this is a direct quote, we know that

in the U.S., one pound transacted at $1.81.

THE SPOT MARKET

C. Transactions Costs1. Bid-Ask Spread

used to calculate the feecharged by the bank

Bid = the price at which the bank is willing to buy

Ask = the price it will sellthe currency

THE SPOT MARKET

4. Percent Spread Formula (PS):

100xAsk

BidAskPS

THE SPOT MARKET

D. Cross Rates

1. The exchange rate

between 2 non - US$

currencies.

THE SPOT MARKET

2. Calculating Cross RatesSuppose you want to calculate the £/€

cross rate.

You know £.5556/US$ and €.8334/US$then

£/ € = £.5556/US$ €.8334/US$

= £.6667/ €

THE SPOT MARKET

E. Currency Arbitrage1. If cross rates differ from one financial center to another, and profit opportunities exist.

2. Buy cheap in one int’l market,sell at a higher price in

another

3. The Critical Role of Available Information

THE SPOT MARKET

F. Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of original transaction.

THE SPOT MARKETG. Exchange Risk

1. Bankers = middlemen

a. Incurring risk of adverse

exchange rate moves.

b. Increased uncertainty about future exchange rate requires1.) Demand for higher risk

premium2.) Bankers widen bid-ask

spread

MECHANICS OF SPOT TRANSACTIONS

SPOT TRANSACTIONS: ExampleStep 1. Currency transaction:

verbal agreement, U.S. importer specifies:

a. Account to debit (his acct)b. Account to credit (exporter)

MECHANICS OF SPOT TRANSACTIONS

Step 2. Bank sends importer

contract note including:- amount of foreign

currency

- agreed exchange rate

- confirmation of Step 1.

MECHANICS OF SPOT TRANSACTIONS

Step 3. SettlementCorrespondent bank in HongKong transfers HK$ fromnostro account to exporter’s.

Value Date.

U.S. bank debits importer’saccount.

PART IV.THE FORWARD MARKET

I. INTRODUCTIONA. Definition of a Forward Contract:

an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

THE FORWARD MARKET

2. Purpose of a Forward:

Hedgingthe act of reducing exchange

rate risk.

THE FORWARD MARKET

B. Forward Rate Quotations1. Two Methods:

a. Outright Rate: quoted to commercial customers.

b. Swap Rate: quoted in the

interbank market as a discount or premium.

THE FORWARD MARKET

CALCULATING THE FORWARDPREMIUM OR DISCOUNT

= F-S x 12 x 100 S n

where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the

forward contract