forex euro currency markets

8/14/2019 Forex Euro Currency Markets

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The Foreign Exchange and Eurocurrency Markets


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Symbols and acronymsSymbols and acronyms

Upper Case Symbols = Prices

lower case symbols = changes in a price levelPt

d (orPtf) = price of an asset at time t in currency d (or f)

ptd (orpt

f) = inflation in currency d (or f) during period t

Std/f= spot exchange rate at time t between d and f

std/f= change in the spot exchange rate during period t

Fd/f= forward exchange rate between currencies d and f

ftd/f= change in the forward rate during period t


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Foreign exchange (Foreign exchange (fxfx) markets) markets

Markets

Spot market

trade in cash today with delivery in two business days Forward market

trade at a pre-specified price and on a pre-specified future date

Volume volume in April 2003 averaged $2.0 trillion per day

about 75% in the interbank market

Operational eINRiciency small retail transactions can be expensive

large interbank transactions have very low costs


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Major foreign exchange trading centersMajor foreign exchange trading centers

(Average daily volume during April of 1989, 1992, 1995, and 1998(Average daily volume during April of 1989, 1992, 1995, and 1998))

Source:Bank for International Settlements triennial survey of central banks.

0

London New York Tokyo

1989 1992 1995 1998

100

200

300

400

500

600

700


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Rule #1Rule #1

Keep track of your units.Keep track of your units.

An example: S$/INR= $.0250/INR SINR/$ = 1/ S$/INR=INR 40/$

Dollar value of a bottle of Champagne:Buy 1 bottle of wine PINR= INR400/btl

Spot exchange rate SINR/$ = INR40/$

How much is this in dollars?

P$ = PINR/SINR/$= (INR400/btl)/(INR4.00/$) = $10/btl

= PINRS$/INR= (INR400/btl)($.025/INR) = $10/btl


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Rule #2:Rule #2:

Always buy or sell the currency in theAlways buy or sell the currency in thedenominatordenominatorof a foreign exchange quote.of a foreign exchange quote.

Example of buying low and selling high:Buy wine at INR400/btl and sell at INR500/btl INR100/btl Profit

Buy INRs at $.020/INR

Sell $s at INR50/$Sell INRs at $.025/INR Buy $s at INR40/$

$.005/INR Profit INR10/$ Profit


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Forward premiums or discountsForward premiums or discounts

Percentage forward premium or discount

= (F1d/f

S0d/f

) / S0d/f

Forward premium

nominal value in the forward exchange market is

higher than in the spot exchange market

Forward discount

nominal value in the forward exchange market islower than in the spot exchange market


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An example ofAn example of

forward premiums and discountsforward premiums and discounts

Suppose S0

$/INR= $0.020/INR and F1

$/INR= $0.025/INR

Rupee forward premium

= ($.025/INR$.020/INR)/($.020/INR) = +25%

so the Rupee is selling at a 25% forward premium.

Alternatively, S0

INR/$ = INR50.00/$ S0$/INR= $0.020/INR

F1

INR/$ = INR40.00/$ F1$/INR= $0.025/INR

Dollar forward premium

= (INR40/$INR50/$)/(INR50/$) = 20%

so the dollar is selling at a 20% forward discount.


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Percentage changes in foreign exchange ratesPercentage changes in foreign exchange rates

Percentage change in the value of a foreign currency

= (S1d/f S0d/f) / S0d/fAn example: S

0INR/$ = INR50/$ S

0$/INR= $0.020/INR

S1INR/$ = INR40/$ S1$/INR= $0.025/INR

Percentage change in the franc = (S1$/INRS

0$/INR) / S

0$/INR

= ($0.025/INR$0.020/INR)/($0.020/INR) = +25%

Percentage change in the dollar = (S1INR/$S

0INR/$ ) / S

0INR/$

= (INR40/$INR50/$)/(INR50/$) = 20%


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The interbank Eurocurrency marketThe interbank Eurocurrency market

Eurocurrencies are bank deposits or loans residing

outside of the country issuing the currency

Few regulationsNo reserve requirements, interest rate regulations or caps,withholding taxes, deposit insurance requirements, or credit

allocation regulations; less stringent disclosure requirements

Low risk Relatively short maturities: Maturities of less than 5 years

Low interest rate risk: Interest rates tied to a variable rate

base such as the London Interbank Offer Rate (LIBOR)

Low default risk: Traded between large commercial banks,investment banks and multinational corporations

Highly competitive

Daily volume of several hundred billion dollars ensures

competitive bid and offer prices


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Spreads in domestic and EurocurrencySpreads in domestic and Eurocurrency

credit marketscredit markets

LIBOR

Eurocurrency

deposit rate in

the interbank

market

LIBID

Domestic loan rate for

commercial accounts

1/8%

Eurocurrency

loan rate in the

interbank

market

1/8%1/2%2%

Domestic deposit rate forcommercial accounts

Eurocurrency loan

rate for commercial

accounts

Eurocurrency deposit

rate for commercial

accounts


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Linkages between credit & currency marketsLinkages between credit & currency markets

$

Eurocurrencies

U.S.

internal

credit market

U.K.

internal

credit market

Japanese

internal

credit market

external credit markets


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Exposure to foreign exchange riskExposure to foreign exchange risk(contract price INR400,000)(contract price INR400,000)

Expected receipt in Rupees

at E[S1$/INR] = $.025/INR

Actual exchange

S1$/INR= $.020/INR

Net loss from

original position

Risk (or payoff) profile

of underlying exposure

V

$/INR

S$/INR

$.05/IN

R

$.05/INR

+ slope

+INR400,000 +$10,000 at$.025/INR

+INR400,000 +$8,000 at$.020/INR

$2,000


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Currency hedging with forwardsCurrency hedging with forwards(contract price INR400,000)(contract price INR400,000)

Buy $10,000 forward +$10,000

at F1$/INR= $.025/INR

Sell INR400,000 forward INR400,000

Market exchange of INR +$8,000

for $ at S1

$/INR= $.020/INR

INR400,000

Net gain on forward +$2,000

Risk profile

of a forward

contract

V

$/INR

S$/INR-$0.05/INR

+$0.05/IN

R


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Net currency exposureNet currency exposure

Underlying position

(long INR)

Sell INR forward(short INR and long dollars)

Net position

Net exposure V$/INR

long francs

S$/INR

short francs

+INR400,000

+$10,000

INR40,0000

+$10,000


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Example of foreign exchange tradingExample of foreign exchange trading

Market Participants

Dealers: make a market in foreign currency (quote bid & offer prices)

Traders: trade for their own acct

Rules of the Game - Buy ringgits low and sell ringgits high One contract Rg1,000,000,000 (Malaysian ringgits)

Trades can be for up to 10 contracts

Record transactions as either a ringgit purchase or saleDealer quotes are good for two minutes


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Arbitrage profit in the MalaysianArbitrage profit in the Malaysian ringgitringgit marketmarket

Bank A: $0.26602/Rg BID and $0.26612/Rg OFFER

Bank B: $0.26617/Rg BID and $0.26627/Rg OFFER

Bank A Bank B$0.26627/Rg Offer

$0.26617/Rg Bid Sell to B

$0.26612/Rg Offer Buy from A

$0.26602/Rg Bid

1. Buy Rg1 billion from Bank A at $0.26612/Rg offer price

2. Sells Rg1 billion to Bank B at its $0.26617/Rg bid price

Arbitrage Profit = ($0.00005/Rg)(Rg1 billion) = $50,000

with NO NET INVESTMENT and NO RISK.


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Sample foreign exchange ledgerSample foreign exchange ledger

NAME Bank of Cash, Credit, and Industry DATE October 19, 2003

Counterparty Contracts Price Total $/Rg Cumulative Rg balance

1. Penn Square BUY 1 0.22004 $0.22004 +1

2. Citicorp BUY 3 0.22010 $0.66030 +4

3. Bk of Tokyo SELL 2 0.22016 +$0.44032 +2

4. Bk of Tokyo SELL 4 0.22020 +$0.88080 2

5. . . .

FINAL CLOSING RATES: $.22018/Rg BID and $0.22023/Rg OFFER

Closing trade BUY 2 0.22023 $0.44046 0

Sum of dollar transactions: +$0.00032/Rg

Times contract size x Rg1,000,000,000

Profit (loss) +$320,000


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Opening prices:Opening prices:

$0. 21945/Rg BID & $0.21950/Rg OFFER$0. 21945/Rg BID & $0.21950/Rg OFFER

News announcements: The member nations of the G7 have announced that they

are buying dollars in an effort to stabilize the dollar.

The U.S. Federal Reserve announces that in an effort tostimulate economic activity it is lowering the discount

rate on overnight loans to commercial banks.

The U.S. government reports that the U.S. money supplyM1 increased by $1 billion more than expected in the

most recent quarter.


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The Impact of News EventsThe Impact of News Events

The member nations of the G7 have announced that they are

buying dollars in an effort to stabilize the dollar.

Value of the U.S. dollar

Value of the Malaysian ringgit

The Malaysian ringgit depreciates

and the spot rate S$/Rg falls

P$P$

S$

D$

D$

Q$

QRg

DRg

DRg

SRg

PRg

PRg


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The Impact of News EventsThe Impact of News EventsThe U.S. Federal Reserve announces that in an effort to

stimulate economic activity it is lowering the discount rate on

overnight loans to commercial banks.

This makes it easier for U.S. businesses to borrow and increases economic

activity. If this also increases U.S. inflation, then the value of the U.S.

dollar should fall. This will result in an appreciation of the ringgit against

the dollar.

Increases in the domestic discount rate usually, but not always, lead to

increases in the value of the domestic currency.


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The Impact of News EventsThe Impact of News EventsThe government reports that U.S. money supply M1 increased by

$1 billion more than expected in the most recent quarter.

While this would seem to result in a larger supply of dollars and hence alower value for the dollar, the increase in the money supply has already

occurred and hence should be reflected in the market price of the dollar.

On the other hand, if the U.S. Federal Reserve is likely to react to this

announcement by increasing the discount rate to slow down the economy,then the dollar may rise in anticipation of Fed policy.

If the dollar rises against the ringgit, then the ringgit will fall against the

dollar.

forex euro currency markets

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