International Financial

Management

Topic 3:
The Market for Foreign Exchange (1)
 Outline
Function
Function and
and Structure
Structure of
of the
the FX
FX Market
Market
The
The Spot
Spot
pp Market
Market
The
The Forward
Forward Market
Market
Exchange
Exchange-Traded
Exchange Traded
Exchange-Traded
Traded Currency Funds

1
FX Market

Market size
Average daily global turnover (2016): US$ 5.1 trillion
High liquidity
OT
O C (over-the-counter)) markets:
a worldwide linkage of bank currency traders,
nonbank dealers, and FX brokers
Connected to one another via a network of
telephones,
telephones computer terminals and automated
dealing systems

2
4
8
 Circadian Rhythms of the FX Market
Electronic Conversations per Hour
average peak
45000
40000
35000
30000
25000
20000
15000
10000
5000
0
11:00
00 3 00
3:00 5 00
5:00 07:00
07 00 9:00
9 00 11:00
11 00 1:00
1 00 15:00
15 00 5:00
5 00 19 19:00
00 9:00
9 00 11 11:00
00
10 am in Lunch Europe Asia Lunch Americas London New 6 pm in
Tokyo hour in coming in going out hour in coming in going out Zealand NY
Tokyo London coming in
9
FX Market Participants

The FX market is a two-tiered market:

Interbank
I t b k Market
M k t (Wholesale)
(Wh l l )
International banks
Nonbank dealers
FX brokers
Client Market (Retail)
Market participants include international banks,
their customers
customers, nonbank dealers
dealers, FX brokers
brokers, and
central banks.

10
Correspondent Banking Relationships

Large commercial banks maintain demand deposit

accounts with one another, which facilitates the efficient
functioning of the FX market.
Correspondent Banking Relationships

International commercial banks communicate with one

another using:
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 FX transactions.
 Correspondent Banking Relationships
Consider US Importer purchasing merchandise from Dutch
Exporter invoiced in Euro at 750,000
US Importer accept the rate of $1.4747/ offered by US Bank
US Bank debits $1,105,800=750,000x1.4744 for purchasing
US Bank instructs its correspondent bank, EZ Bank to debit
750,000, and credit it to Dutch Exporters bank account
US B
Bankk credits
dit itits b
books
k $1
$1,105,800
105 800
US Dutch
(750 000)
Merchandise (750,000)
Importer Exporter

US Bank EZ Bank Dutch Bank

12
The Spot Market

Spot Rate Quotations

The Bid-Ask Spread
Cross Rates

13
Currency Terminology

Spot exchange rate is the quoted price for another currency to be

delivered at once, or in two days for interbank transactions.
About one-third of all FX trading is done in the Spot market.

Must be able to distinguish between quoted currency and

measurement currency.
Foreign Exchange Quotations
Direct quote: the price of one unit of the foreign currency in home currency
terms (home currency/foreign currency)
Indirect quote: the price of one unit of the home currency in foreign currency
terms (foreign currency/home currency)
Example: If the US$ is the home currency and the Swiss Franc (SFr) is the
foreign currency:
Direct quote: US$0.5830/SFr is read as: 0.5830 US dollars per Swiss franc
Indirect quote: SFr 1.7153/US$ is read as:1.7153 Swiss francs per US dollar
Foreign Exchange Quotations
Currency In US$ per US$
Pound 1.9717 .5072

For US-based investors:

The direct quote for the pound: $1.9717 per
The indirect quote for the pound: .5072 per $

Note that the direct quote is the reciprocal of the indirect

quote
Foreign Exchange Quotations

The $ is used so commonly in currency transactions, currencies

are often quoted relative to the $.
American Terms: Expresses the rate as the US dollar price of one unit
of the foreign currency ($/foreign currency).
European Terms: Expresses the rate as the foreign currency price of
one US dollar (foreign currency/$).
Bid and Ask Quotes

A bid is the price at which a dealer will buy a currency.

Bid Price = Dealers Buying Price, Clients Selling Price
An ask is the price at which a dealer will sell a currency.
Ask Price = Dealers Selling Price, Clients Buying Price
Dealers buy at the bid and sell at the ask, making their profit from
the spread between the buying and selling prices (called The Bid-
Ask Spread).
Always Ask > Bid.
Bid and Ask Quotes

Things to remember:
The dealer buys denominator (quoted) currency at the BID (client sells
the denominator currency at the bid).
The dealer sells denominator (quoted) currency at the ASK (client buys
the denominator currency at the ask).

The commercial client ALWAYS gets the worse end of the

deal!!!
The Bid-Ask Quote

big
fi
figure small figure
USD Bank American Terms European Terms
Quotations
Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073

A dealer pricing pounds in terms of dollars would likely quote these

prices as 1217.
12 17.
Anyone trading $10m knows the big figure.

17
The Bid-Ask Quote
USD Bank American Terms European Terms
Quotation Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073

Notice that the reciprocal

of the S($/) bid is the
S(/$) ask.
.5073 1
=
1 $1.9712
Example: Currency Conversion with
Bid-Ask Quotes
Adams in New York wants to take a $10,000 position
in the pound.
p
After his trade, what will be his position?
Bid Ask
S($/): 1.9715 20
S(/$): 0.5071 72
1
$10,000 =5,071
1.9720($/)
$10,000 0.5071(/$) =5,071
19
Example: Currency Conversion with
Bid-Ask Quotes
A businessman has just completed transactions in
Italyy and England.
g He is now holding
g 250,000
, and
500,000 and wants to convert to U.S. dollars.
His currency dealer provides this quotation:
GBP/USD 0.5025 76
USD/EUR 1 4739 44
1.4739

Assuming no other fees, what are his proceeds

from conversion?
20
 Example: Currency Conversion with
Bid-Ask Quotes

USD/EUR 1.4739 - 44
He sells 250,000 at the dealers bid price:
250,000 x 1.4739 ($/) = $368,475.00

GBP/USD 0.5025 76
He uses 500,000 to buy US$ at the dealers ask
price:
500,000 x [1/0.5076 (/$)]= $985,027.58

Total = $1,353,502.58
Cross Rates
Suppose that S($/) = 1.50 (i.e., $1.50 =
1.00) and that S($/) = 2.00 (i.e., $2.00 =
1.00 ).
What must the / cross rate be?
Spot FX cross rates

Pay attention to your currency algebra!!!

Three possible settings
Spot FX cross rates

$1.9712/
Sb ( / ) = Sb ($/ ) Sb (/$) = = 1.3371/
$1.4742/

$1.9717/
Sa ( /) = Sa ($/) Sa (/$) = = 1.3378/
$1.4738/

23
Cross Rate Bid-Ask Spread
Bank
B k A
American
i Terms
T E
European T
Terms
Quotations
Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073
Euros 1 4738
1.4738 1 4742
1.4742 .6783
6783 .6785
6785

Sb ( / ) = Sb ($/ ) Sb (/$)

1
1 9712($/)
1.9712($/) = 1.3371(/)
1 3371(/)
1.4742($/)

24
Cross Rate Bid-Ask Spread
Bank
B k A
American
i Terms
T E
European T
Terms
Quotations
Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073
Euros 1 4738
1.4738 1 4742
1.4742 .6783
6783 .6785
6785

Sa ( / ) = Sa ($/ ) Sa (/$)

1
1 9717($/)
1.9717($/) = 1.3378(/)
1 3378(/)
1.4738($/)

25
Cross Rate Bid-Ask Spread
Bank American Terms European Terms
Quotations
Bid Ask Bid Ask
Pounds 1.9712 1.9717 .5072 .5073
Euros 1.4738 1.4742 .6783 .6785

Sb((/)) Sa((/)) Sb((/)) Sa((/))

1.3371 1.3378(/) 0.7475(/) 0.7479(/)
Recall that the reciprocal of 1
the Sb(/) is the Sa(/), and = 0.7479(/)
1.3371(/)
vice
i versa.
26
 Two types of arbitrage opportunities to consider...

With respect to the exchange rate between two countries, the

quotes in one country should be aligned with the quotes in the
other. If not, a bilateral arbitrage opportunity exists.
A triangular arbitrage opportunity occurs if the quoted rates
between two currencies are not aligned with the cross-rates
implied by the exchange rates of the two currencies against a
third currency.

1.8
Triangular Arbitrage
Steps involved:
Infer the cross rate for 2 currencies from the exchange
rate of each currency with a third currency.
Compare the cross rate and the quoted rate to determine
if there is an opportunity to make profit by buying low in
one place and selling high elsewhere.
List all the transactions involved to utilize the arbitrage
opportunity.
Whatever currency you start with, you should end up
with that same currency (think of exchange rate risk!)
 Example: Spot market arbitrage
Compute arbitrate profit given the following exchange rates
(start with $1,000,000)
$/: $1.9724/ in New York / = 1.4665
$/: $
$/ $1.3450/
3 50/ in Frankfurt
a ut
/: 1.4655/ in London
New York

Sell pounds for dollars in New York : Sell $1,000,000 for euros in Frankfurt :
507 332/(1/($1 9724/)) = $1,000,661
507,332/(1/($1.9724/)) $1 000 661 $1 000 000/($1 3450/ ) = 743,494
$1,000,000/($1.3450/ 743 494
Profit = $661

London Frankfurt
Sell euros for pounds in London :
32
743,494/(1.4655/) = 507,332
Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics of

h
how a marketplace
k t l operates.
t
Bid-Ask spreads in the spot FX market:
increasewith FX exchange rate volatility and
decrease with dealer competition.
p
Private information is an important determinant of
spot exchange rates.

31
International Financial
Management

Topic 3 cont'd:
The Market for Foreign Exchange (2)
 Outline
Function
Function and
and Structure
Structure of
of the
the FX
FX Market
Market
The
The Spot
Spot
pp Market
Market
The
The Forward
Forward Market
Market
Exchange
Exchange-Traded
Exchange Traded
Exchange-Traded
Traded Currency Funds

1
Review

Foreign Exchange Quotations

Directquotation vs Indirect
quotation
American terms vs European
terms
The Bid-Ask Quotes
Cross Rate Bid-Ask
id Ask Quotation
Triangular Arbitrage

2
Triangular Arbitrage
Steps involved:
Infer the cross rate for 2 currencies from the exchange
rate of each currency with a third currency.
Compare the cross rate and the quoted rate to determine
if there is an opportunity to make profit by buying low in
one place and selling high elsewhere.
List all the transactions involved to utilize the arbitrage
opportunity.
Whatever currency you start with, you should end up
with that same currency (think of exchange rate risk!)
 Example: Spot market arbitrage
Compute arbitrate profit given the following exchange rates
(start with $1,000,000)
$/: $1.9724/ in New York / = 1.4665
$/: $
$/ $1.3450/
3 50/ in Frankfurt
a ut
/: 1.4655/ in London
New York

Sell pounds for dollars in New York : Sell $1,000,000 for euros in Frankfurt :
507 332/(1/($1 9724/)) = $1,000,661
507,332/(1/($1.9724/)) $1 000 661 $1 000 000/($1 3450/ ) = 743,494
$1,000,000/($1.3450/ 743 494
Profit = $661

London Frankfurt
Sell euros for pounds in London :
32
743,494/(1.4655/) = 507,332
The Forward Market

Forward Rate Quotations

Long and Short Forward Positions
Forward Cross Exchangge Rates

4
Forward Rate Quotations

The forward market for FX 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.
There are three ways to express forward rates:
Outrightrate
Swap rate (forward point quotation)
As an annualized percentage forward premium or discount
Forward Rate Quotations
Consider these exchange rates: Country/currency in US$ per US$
UK pound 1 9717
1.9717 .5072
5072
for British pounds, the spot 1-m forward 1.9700 .5076
exchange rate is $1.9717 = 1.00
3-m
3 m forward 1.9663 .5086
while
hil th
the 180
180-day
d fforward d rate
t is
i
$1.9593 = 1.00 6-m forward 1.9593 .5104

Clearly market participants expect

Clearl e pect that the pound
po nd will
ill be
worth less in dollars in six months.

6
Forward Rate Quotations
($/)
S
Spot 1 9712
1.9712 1 9717
1.9717
Forward Point Quotations Outright Forward Quotations
30 d
30-day 19 - 17 1 9693
1.9693 1 9700
1.9700
90-day 54 - 57 1.9766 1.9774
180-day 124 - 131 1.9836 1.9848

Converting swap rate to outright rate add the premium to or

subtract the discount from the spot rate.

7
Forward Premium/Discount
Forward Premium/Discount
For example, suppose the is
appreciating from S($/) = 1.55 to F180($/)
= 1.60.
The 180-day forward premium is given by:

F180($/) S($/) 360 1.60 1.55

f = = 2
S($/) 180 1.55
= 0.0645, or 6.45%
Long and Short Forward Positions

If you have agreed to sell anything (spot or

f
forward),
d) you are short.
h t
If you have agreed to buy anything (forward or
spot), you are long.
If y
you have agreed
g to sell FX forward, yyou are
short.
If you have agreed to buy FX forward, you are
long.

10
Payoff Profiles
profit
fit
If you agree to sell a specific currency in
the future at a set price and the spot price
later falls then you gain.

0 S180($/SFr)

F180($/SFr) = .9077
If yyou agree
g to sell a specific
p
currency in the future at a set
price and the spot price later Short position
loss
rises then you lose.
11
Payoff Profiles
profit
fit

.0070

0 S180($/SFr)
.9007 .9107
F180($/SFr) = .9077
-.0030

Short position
loss
12
 Payoff Profiles
profit

Consider the payoffs at

maturity to a long position
$0.1407 in a six month forward
contract.

$1.90/
Spot exchange in 6 months $/
$2.10/
$0.0593 $1.9593/
loss
Payoff Profiles
profit
fit
Long position

0 S180($/SFr)

F180($/SFr) = .9077

Short position
loss
13
Forward Market Hedge

If you are going to owe foreign currency in the

f t
future, agree to
t buy
b theth foreign
f i currency now by b
entering into long position in a forward contract.
If you are going to receive foreign currency in the
future, agree to sell the foreign currency now by
entering into short position in a forward contract.

14
Forward Market Hedge

You are a U.S. importer of British woolens and have

j t ordered
just d d nextt years inventory.
i t P
Paymentt off
1,000,000 is due in one year.

How can yyou fix the cash outflow in dollars?

One way is to put yourself in a position that

delivers 1,000,000 in one year.
=> long forward contract on the pound.
15
 Forward Cross Rates
Currencies
U.S.-dollar foreign-exchange rates in late New York trading.
--------Friday-------
The 3-month forward cross
Country/currency in US$ per US$
rate is: Euro area euro 1.4744 .6783
1-mos forward 1.4747 .6781
3-mos forward 1.4744 .6782
6-mos forward 1.4726 .6791
UK pound 1.9717 .5072
1-mos forward 1.9700 .5076
3-mos forward 1.9663 .5086
6-mos forward 1.9593 .5104
Forward FX cross rate algebra

Pay attention to your currency algebra!!!

Three possible settings

Same as those introduced for Spot FX cross rates

Forward cross rate
Compute the forward cross rate for yen in terms of euros
F30 for /$: 0.8107 0.8124
F30 for /$: 107.347 107.442

Forward bid cross rate / = Fb(/$):Fa(/$)

Forward ask cross rate / = Fa(/$):Fb(/$)

Forward cross rate example
Given the quotations (/$) and (/$), think of buying and
selling $
Step 1: Set up the algebra:
(/) = (/$) / (/$)
Step 2: Determine Bid (/). This is the price at which
you sell for . You could do so indirectly by using the
to buy $ (at ask), and then selling $ for (at bid).
Bid(/) = Bid(/$) / Ask(/$) = 0.8107 / 107.442 =
0.00754/.
Step 3: Determine Ask (/). This is the price at which
you buy using . You could do so indirectly by using
the to buy $ (at ask), and then selling $ for (at bid).
Ask(/) = Ask(/$) / Bid(/$) = 0.81240 / 107.347 =
0.00757/.