Foreign Exchange Market

1. Definition and Organization of the Foreign Exchange Markets

• foreign exchange markets are markets on which individuals, firms and banks buy and sell foreign currencies:– foreign exchange trading occurs with the help of the

telecommunication net between buyers and sellers of foreign exchange that are located all over the world

– a single international foreign exchange market for every single currency

– foreign exchange trading takes place at least in some of the world financial centers in every moment

The Currency MarketWhere money denominated in one currency is

bought and sold with money denominated in another currency.

International Trade and Capital Transactions:• facilitated with the ability to transfer

purchasing power between countries.

Location1. OTC-type: no specific location2. Most trades by phone, telex, or SWIFT

SWIFT: Society for Worldwide Interbank Financial Telecommunications

Participants in the foreign exchange market

Participants at 2 Levels1. Wholesale Level (95%) - major banks2. Retail Level (business customers)

Two Types of Currency Markets1. Spot Market: - immediate transaction - recorded by 2nd business day2. Forward Market: - transactions take place at a specified future date

Participants by Market

• Spot Marketa. commercial banksb. Brokersc. customers of commercial and central banks

• Forward Marketa. arbitrageursb. tradersc. hedgersd. speculators

CLEARING SYSTEMS

A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.

B.FedWire- operated by the Fed- used for domestic transfers

ELECTRONIC TRADING

A. Automated Trading- genuine screen-based market

B.Results:

1. Reduces cost of trading

2. Threatens traders’ oligopoly of information

3. Provides liquidity

2. Foreign Exchange Market FunctionsClearing of Currencies and Provision of Credit

• Clearing of currencies:– service of exchanging one currency for another

• Provision of Credit:– trader that bought a certain good from the

manufacturer, needs time to sell this good to the final customer and to pay the manufacturer with the money he received from the customer

Foreign Exchange Market and Insurance Against Foreign Exchange Risk

– activities with which the foreign exchange market participants avoid exchange rate risk or activities with which they are closing their open foreign exchange position– closed foreign exchange position:• size of the assets in a certain currency is equal

to the size of the liabilities in the same currency• full insurance against exchange rate risk with

respect to this currency

Foreign Exchange Market and Insurance Against Foreign Exchange Risk

– open foreign exchange position:• long: net assets in a certain currency• short: net liabilities in a certain currency

– in the spot or forward foreign exchange market– standardized forward contracts and options

Foreign Exchange Markets and Conscious Foreign Exchange Risk Acceptance

• activities in which economic agents consciously open their foreign exchange positions – long or short – hoping to get profits in all foreign exchange market segments

3. Foreign Exchange Market Participants Economic Agents and Types of Activities on Foreign

Exchange Markets Client buys $

with €

Local bank

Main banks’ interbank market

Local bank

Client buys € with $

Purchases and sales of big multinational

companies

Brokers

Economic Agents and Types of Activities on Foreign Exchange Markets

• bank clients (individuals, firms, non-banking financial institutions):– all those groups of legal and physical persons that

need foreign currency in doing their commercial or investment business

• commercial banks:the most important group of foreign exchange market

participants they buy and sell foreign currencies for their clients

and trade for themselves

• brokers:– agents that connects dealers interested in buying

and selling foreign exchange, but does not become an active client in the transaction

– they provide their client, the bank, with the information about the exchange rates at which banks are willing to buy or sell a particular currency

Economic Agents and Types of Activities on Foreign Exchange Markets

• central banks:foreign exchange market interventions are meant

to influence the exchange rate of the domestic currency in a way that is beneficial for the domestic economy and, consequently, for the country

it does not necessarily have a profit, it can also have a loss

Economic Agents and Types of Activities on Foreign Exchange Markets

Economic Agents and Motivation for the Foreign Exchange Market Participation

• arbitragers:– they want to earn a profit without taking

any kind of risk (usually commercial banks):• try to profit from simultaneous exchange rate

differences in different markets• making use of the interest rate differences that

exist in national financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)

Economic Agents and Motivation for the Foreign Exchange Market Participation

• hedgers and speculators:hedgers do not want to take risk while

participating in the market, they want to insure themselves against the exchange rate changes

speculators think they know what the future exchange rate of a particular currency will be, and they are willing to accept exchange rate risk with the goal of making profit

every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction

4. Size and Structure of Foreign Exchange Market Transactions

• the biggest share of all financial markets in the world

5. Types of Foreign Exchange Market Transactions Spot Foreign Exchange

Transactions• almost immediate delivery of foreign

exchange

Outright Forward Transactions

buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity

forward exchange rates: 1, 3, 6, 9 months, one year

Swap Transactions

• simultaneous purchase and sale of a given amount of foreign exchange for two different value dates:– “spot against forward” swaps:

Hedging• the act of reducing exchange rate risk

Forward Rate QuotationsTwo Methods:

a) Outright Rate: quoted to commercial customers.

b) Swap Rate: quoted in the interbank market as a discount or premium.

Futures positions• Futures are similar to forwards• First, futures positions require a margin deposit to be posted

and maintained daily. • If a loss is taken on the contract, the amount is debited from

the margin account after the close of trading. • In other words, these futures are cash settled and no

underlying instruments or principals are exchanged. • Secondly, all contract specifications such as expiration time,

face amount, and margins are determined by the exchange instead of by the individual trading parties.

Futures

• basic characteristics of futures:– the amount of the currency that is being traded – type of currency quotation– contract expiration – last day of trading with the contract– settlement day– margin requirements

• information about futures trading• futures usage:– arbitrage between outright forward contract and

futures– rarely used as an insurance instrument (rigidity!)

• similarities and differences between outright forward contract and futures:– both need to be executed unconditionally– they are usually established for at most one year

Characteristic Futures Outright Forward Contract Size of the contracts standardized for a given currency depends on the individual needs of the

client Location and trade activity

at the stock exchange or at a given location; actively traded in an organized market

with the provision of agents, connected among each other with the help of telecommunications; not traded in an organized market

Duration of the contract

standardized, but at most a year depends on the individual needs of the client , but not more than a year

Contract has to be executed

yes yes

Insurance and Security of doing Business with the Instrument

insurance explicitly required (margin requirements); high security of doing business with the instrument

insurance not required explicitly (implicit insurance are affiliat ions of two partners up till now); lower security than futures

Trade regulation regulated with the stock exchange rules

regulation not explicit ly determined

Options• Options are a way of buying or selling a currency

at a certain point in the future.• An option is a contract which specifies the price at

which an amount of currency can be bought at a date in the future called the expiration date.

• Unlike forwards and futures, the owner of an option does not have to go through with the transaction if he or she does not wish to do so.

Types of options• The buyer of a call has the right but not the obligation to buy the

underlying asset at the strike price on or before a specified date in the future.

• However, the seller has a potential obligation to sell the underlying asset at the strike price on or before a specified date in the future if the holder of the option exercises his or her right.

• The buyer of a put has the right but not the obligation to sell the underlying asset at the strike price on or before a specified date in the future.

• On the other hand, the seller of a put has a potential obligation to buy the underlying asset at the strike price on or before a specified date in the future if the holder of the option exercises his/her right.

Options

• basic characteristics of options:– financial instrument that gives the buyer the

right, but not the obligation, to buy or sell a standardized amount of a foreign currency, that is traded, at a fixed price at a particular time, or until a particular time in the future

– call option and put option– American and European options– three different prices:

• exercise/strike price• cost, price or value of the option• underlying or actual spot exchange rate

Options

• types of options trading:– in organized markets:• standardized contracts with given strike prices,

standardized durations (1, 3, 6, 9, 12 months) and expirations • only certain currencies, contract amounts are

standardized – over-the-counter trading:• expiration date, strike price and contract amount

depend on the individual needs of the client • counterparty risk!• retail and interbank market

• Usage of options:– when the economic agent expects that the

exchange rate trend of a particular currency could change drastically

– when the economic agent does not know for sure that a certain foreign exchange flow will occur in the future

– advantages:• fixed option costs• options do not need to be executed

Options

6. Quotations of Currencies on ForeignExchange Markets

• quotation of a currency tells us at what price is a financial mediator willing to buy or sell a certain currency

Currency Quotations in Spot Foreign Exchange Markets

European and American quotationdirect and indirect quotation (which currency is regarded

as a domestic/basis currency)

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.