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  • CHAPTER 7

    THE FOREIGN EXCHANGE MARKET

  • CHAPTER OVERVIEWI.INTRODUCTIONII.ORGANIZATION OF THE FOREIGN EXCHANGE MARKETIII.THE SPOT MARKETIV.THE FORWARD MARKETV.INTEREST RATE PARITY THEORY

  • PART I. INTRODUCTION

    I.INTRODUCTIONA.The Currency Market:where money denominated in one currency is bought and sold with money denominated in another currency.

  • INTRODUCTIONB. International Trade and Capital Transactions:- facilitated with the abilityto transfer purchasing powerbetween countries

  • INTRODUCTIONC.Location1.OTC-type: no specific location2.Most trades by phone, telex, or SWIFTSWIFT: Society for Worldwide Interbank Financial Telecommunications

  • PART II.ORGANIZATION OF THE FOREIGN EXCHANGE MARKETI.PARTICIPANTS IN THE FOREIGN EXCHANGE MARKETA.Participants at 2 Levels1.Wholesale Level (95%)- major banks2.Retail Level- business customers.

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.Two Types of Currency Markets1.Spot Market:- immediate transaction- recorded by 2nd business day

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKET2.Forward Market:- transactions take place at a specified future date

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETC.Participants by Market1. Spot Marketa.commercial banksb.brokersc.customers of commercial and central banks

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKET2.Forward Marketa.arbitrageursb.tradersc.hedgersd.speculators

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETII.CLEARING SYSTEMSA. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.FedWire- operated by the Fed- used for domestic transfers

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETIII.ELECTRONIC TRADINGA.Automated Trading- genuine screen-based market

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.Results:1.Reduces cost of trading2.Threatens traders oligopoly of information 3.Provides liquidity

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETIV.SIZE OF THE MARKETA.Largest in the world1995: $1.2 trillion daily

  • ORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.Market Centers (1995): London =$464 billion dailyNew York= $244 billion dailyTokyo = $161 billion daily

  • PART III.THE SPOT MARKETI.SPOT QUOTATIONSA.Sources 1.All major newspapers2.Major currencies have four different quotes:a.spot priceb.30-dayc.90-dayd.180-day

  • THE SPOT MARKETB.Method of Quotation1.For interbank dollar trades:a.American termsexample: $.5838/dmb.European termsexample: dm1.713/$

  • THE SPOT MARKET2.For nonbank customers:Direct quotegives the home currency price of one unit of foreign currency.EXAMPLE:dm0.25/FF

  • THE SPOT MARKETC.Transactions Costs1. Bid-Ask Spreadused 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 MARKET4.Percent Spread Formula (PS):

  • THE SPOT MARKETD.Cross Rates1.The exchange rate between 2 non - US$ currencies.

  • THE SPOT MARKET2.Calculating Cross RatesWhen you want to know what the dm/ cross rate is, and you know dm2/US$ and .55/US$

    then dm/ = dm2/US$ .55/US$= dm3.636/

  • THE SPOT MARKETE.Currency Arbitrage1.If cross rates differ fromone financial center to another, and profit opportunities exist.

  • THE SPOT MARKET2.Buy cheap in one intl market,sell at a higher price in another

    3.Role of Available Information

  • THE SPOT MARKETF.Settlement Date Value Date:1.Date monies are due2.2nd Working day after date of original transaction.

  • THE SPOT MARKETG.Exchange Risk1.Bankers = middlemena.Incurring risk of adverseexchange rate moves.b.Increased uncertainty about future exchange rate requires

  • THE SPOT MARKET1.) Demand for higher riskpremium2.)Bankers widen bid-ask spread

  • PART II.MECHANICS OF SPOT TRANSACTIONSSPOT TRANSACTIONS: An ExampleStep 1.Currency transaction: verbal agreement, U.S. importer specifies:a. Account to debit (his acct)b. Account to credit (exporter)

  • MECHANICS OF SPOT TRANSACTIONSStep 2.Bank sends importercontract note including:- amount of foreigncurrency- agreed exchange rate- confirmation of Step 1.

  • MECHANICS OF SPOT TRANSACTIONSStep 3.SettlementCorrespondent bank in HongKong transfers HK$ fromnostro account to exporters.Value Date. U.S. bank debits importersaccount.

  • PART III.THE FORWARD MARKETI.INTRODUCTIONA. Definition of a Forward Contractan 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 MARKET2. Purpose of a Forward:Hedgingthe act of reducing exchangerate risk.

  • THE FORWARD MARKETB.Forward Rate Quotations1. Two Methods:a.Outright Rate: quoted to commercial customers.b.Swap Rate: quoted in theinterbank market as a discount or premium.

  • THE FORWARD MARKET CALCULATING THE FORWARDPREMIUM OR DISCOUNT= F-S x 12 x 100 S nwhere F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract

  • THE FORWARD MARKETC.Forward Contract Maturities1. Contract Termsa.30-dayb.90-dayc.180-dayd.360-day2.Longer-term Contracts

  • PART IV.INTEREST RATE PARITY THEORYI.INTRODUCTIONA. The Theory states:the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.

  • INTEREST RATE PARITY THEORY2. The forward premium ordiscount equals the interestrate differential. (F - S)/S = (rh - rf) where rh = the home raterf = the foreign rate

  • INTEREST RATE PARITY THEORY3.In equilibrium, returns oncurrencies will be the samei. e. No profit will be realizedand interest parity existswhich can be written(1 + rh) = F (1 + rf) S

  • INTEREST RATE PARITY THEORYB.Covered Interest Arbitrage1. Conditions required:interest rate differential doesnot equal the forward premium or discount.2.Funds will move to a countrywith a more attractive rate.

  • INTEREST RATE PARITY THEORY3. Market pressures develop:a.As one currency is moredemanded spot and soldforward.b. Inflow of fund depressesinterest rates.c.Parity eventually reached.

  • INTEREST RATE PARITY THEORYC.Summary:Interest Rate Parity states:1.Higher interest rates on a currency offset by forwarddiscounts.2.Lower interest rates are offset by forward premiums.


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