Foreign Exchange INTERNATIONAL FINANCIAL MANAGEMENT · PDF fileINTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK ... how can we make money? ... If you have agreed to sell forex forward,

INTERNATIONAL

FINANCIAL

MANAGEMENT

EUN / RESNICKSecond Edition

4Chapter Four

The Market for

Foreign Exchange

Chapter Objectives:

•This chapter serves to introduce the student to the

institutional framework within which exchange rates

are determined.

•This chapter lays the foundation for much of the

discussion throughout the remainder of the text, thus

it deserves your careful attention.

McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights

reserved. 4-1

Chapter Outline

� Function and Structure of the FOREX Market

� The Spot Market

� The Forward Market


reserved. 4-2

Chapter Outline


� FX Market Participants

� Correspondent Banking Relationships

� The Spot Market



reserved. 4-3

Chapter Outline


� The Spot Market

� Spot Rate Quotations

� The Bid-Ask Spread

� Spot FX Trading

� Cross Exchange Rate Quotations

� Triangular Arbitrage

� Spot Foreign Exchange Market Microstructure



reserved. 4-4

Chapter Outline


� The Spot Market


� Forward Rate Quotations

� Long and Short Forward Positions

� Forward Cross-Exchange Rates

� Swap Transactions

� Forward Premium


reserved. 4-5

The Function and Structure of the

FOREX Market

� FOREX Market Participants

� Correspondent Banking Relationships


reserved. 4-6

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, FOREX brokers, and central banks.


reserved. 4-7

Correspondent Banking Relationships

� Large commercial banks maintain demand deposit

accounts with one another which facilitates the efficient

functioning of the forex 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 FOREX transactions.


reserved. 4-8

The Spot Market

� Spot Rate Quotations

� The Bid-Ask Spread

� Spot FX trading

� Cross Rates


reserved. 4-9

Spot Rate Quotations

� Direct quotation

� the U.S. dollar equivalent

� e.g. “a Japanese Yen is worth about a penny”

� Indirect Quotation

� the price of a U.S. dollar in the foreign currency

� e.g. “you get 100 yen to the dollar”.


reserved. 4-10


The direct

quote for

British

pound is:

£1 = $1.688


reserved. 4-11


The indirect

quote for

British

pound is:

£.5924 = $1


reserved. 4-12


Note that

the direct

quote is the

reciprocal of

the indirect

quote:


reserved. 4-13

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.


reserved. 4-14

Spot FX trading

� In the interbank market, the standard size trade is

about U.S. $10 million.

� A bank trading room is a noisy, active place.

� The stakes are high.

� The “long term” is about 10 minutes.


reserved. 4-15

Cross Rates

� Suppose that S($/DM) = .50

� i.e. $1 = 2 DM

� and that S(¥/DM) = 50

� i.e. DM1 = ¥50

� What must the $/¥ cross rate be?


reserved. 4-16

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.


reserved. 4-17


$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

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?


reserved. 4-18


$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell our $ for £,

2. Sell our £ for ¥,

3. Sell those ¥ for $.


reserved. 4-19


Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000

Sell our £ 150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥ 12,750,000 for $ at S(¥/$) = 120

receive $106,250

profit per round trip = $ 106,250- $100,000 = $6,250


reserved. 4-20

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 and

� decrease with dealer competition.

� Private information is an important determinant of

spot exchange rates.


reserved. 4-21

The Forward Market

� Forward Rate Quotations

� Long and Short Forward Positions

� Forward Cross Exchange Rates

� Swap Transactions

� Forward Premium


reserved. 4-22

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.


reserved. 4-23

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.


reserved. 4-24

Forward Rate Quotations

� Consider the example from above:

for Japanese yen, the spot rate is

¥115.75 = $1.00

While the 180-day forward rate is

£112.80 = $1.00

� What’s up with that?


reserved. 4-25


Clearly the

market

participants

expect that

the yen will

be worth

MORE in

dollars in

six months.


reserved. 4-26

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 forex forward, you are

short.

� If you have agreed to buy forex forward, you are

long.


reserved. 4-27

Payoff Profiles

0S180($/¥)

F180($/¥) = .009524

Short positionloss

profitIf you agree to sell anything in the

future at a set price and the spot

price later falls then you gain.

If you agree to sell anything in the

future at a set price and the spot

price later rises then you lose.


reserved. 4-28

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

profit

Whether the

payoff profile

slopes up or

down depends

upon whether

you use the direct

or indirect quote:

F180(¥/$) = 105 or

F180($/¥) = .009524.

short position


reserved. 4-29

Payoff Profiles

loss

0S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

When the short entered into this forward contract,

he agreed to sell ¥ in 180 days at F180(¥/$) = 105

profitshort position


reserved. 4-30

Payoff Profiles

loss

0S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

120

If, in 180 days, S180(¥/$) = 120, the short will make

a profit by buying ¥ at S180(¥/$) = 120 and

delivering ¥ at F180(¥/$) = 105.

15¥

profitshort position


reserved. 4-31

Payoff Profiles

loss

0S180(¥/$)

F180(¥/$) = 105

Long position-F180(¥/$)

F180(¥/$) short positionprofit

Since this is a zero-sum game, the

long position payoff is the

opposite of the short.


reserved. 4-32

Payoff Profiles

loss

0S180(¥/$)

F180(¥/$) = 105

Long position

-F180(¥/$)

profitThe long in this forward contract agreed to BUY ¥

in 180 days at F180(¥/$) = 105

If, in 180 days, S180(¥/$) = 120, the long will

lose by having to buy ¥ at S180(¥/$) = 120 and

delivering ¥ at F180(¥/$) = 105.

120

–15¥


reserved. 4-33

Forward Cross Exchange Rates

� It’s just an “delayed” example of the spot cross

rate discussed above.

� In generic terms


reserved. 4-34

SWAPS

� A swap is an agreement to provide a counterparty

with something he wants in exchange for

something that you want.

� Swap transactions account for approximately 51

percent of interbank FX trading, whereas outright

trades are less than 9 percent.


reserved. 4-35

Comparative Advantage

as the Basis for Swaps

Consider two firms A and B: firm A is a U.S.–based

multinational and firm B is a U.K.–based

multinational.

Both firms wish to finance a project in each other’s

country of the same size. Their borrowing

opportunities are given in the table below.


reserved. 4-36

A is the more credit-worthy of the two firms.

A pays 2% less to borrow in dollars than B and A

pays .4% less to borrow in pounds than B:

Comparative Advantage

as the Basis for Swaps

A has a comparative advantage in borrowing in dollars

B has a comparative advantage in borrowing in pounds.


reserved. 4-37

One Feasible Swap:

Company

A

Swap

Bank

$8% £12%

$8%

£11%£12%

$9.4%

Company

B


reserved. 4-38

$8% £12%

$8%

£11%£12%

$9.4%

A’s net position is to

borrow at £11%

One Feasible Swap:

Company

A

Swap

Bank

Company

B


reserved. 4-39

$8% £12%

$8%

£11%£12%

$9.4%

B’s net position is to

borrow at $9.4%

One Feasible Swap:

Company

A

Swap

Bank

Company

B


reserved. 4-40

$8% £12%

$8%

£11%£12%

$9.4%

One Feasible Swap:

Company

A

Swap

Bank

Company

B

A saves £.6%


reserved. 4-41

$8% £12%

$8%

£11%£12%

$9.4%

B saves $.6%

One Feasible Swap:

Company

A

Swap

Bank

Company

B

A saves £.6%


reserved. 4-42

$8% £12%

$8%

£11%£12%

$9.4%

B saves $.6%

One Feasible Swap:

Company

A

Swap

Bank

Company

B

A saves £.6%

The swap bank

makes money too.


reserved. 4-43

SWAPS

� A swap can be viewed as a portfolio of spot and

forward positions.

� In the above example, firm A would borrow in

dollars and then swap for pounds with the bank

and simultaneously enter into a series of forward

contracts with the bank to exchange dollars for

pounds.


reserved. 4-44

Forward Premium

� It’s just the interest rate differential implied by

forward premium or discount.

� For example, exhibit 4.4 shows the DM

appreciating from S($/DM) = .5235 to

F180($/DM) = .5307

� The forward premium is given by:


reserved. 4-45

End Chapter Four

Documents

Foreign Exchange INTERNATIONAL FINANCIAL MANAGEMENT · PDF fileINTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK ... how can we make money? ... If you have agreed to sell forex forward,