Foreign Exchange Market

Encompasses:
Conversion of purchasing power across currencies
Bank deposits of foreign currency
Credit denominated in foreign currency
INTERNATIONAL FINANCE Foreign trade financing
Trading in foreign currency derivatives
Chapter 5 Largest financial market in world
Always open 24/7 somewhere in the world

London is worlds largest trading center

5-1

Function and Structure of FX Market Market Characteristics

Spot and forward FX markets are over-the- Dealers
counter markets Internationalbanks
Trading uses electronic linkage of dealers Nonbank dealers (investment banks, hedge funds)
Reuters and Electronic Broking Services (EBS) are
Hold inventory of currencies and trade for clients
largest vendors of quote screens (majority of
trades over these platforms) and for own speculative purposes
International banks are core of market FX Brokers
Wholesale (interbank market) (about 85%) Match dealer orders to buy and sell currencies for
Retail (client market) a fee but do not take a position themselves
5-2 5-3

Trading in Markets Market Attributes

Interbank trading (about 86% of FX trades) Correspondent banking relationships
Standard size trade: about $10,000,000 Large commercial banks maintain demand
Part for adjusting inventory deposit accounts with one another
Most are speculative or arbitrage transactions Facilitates the efficient functioning of the market
Speculation: market participants try to correctly
anticipate the future direction of price movements in
Currency intervention
currencies Process of entering the FX market to try to
Arbitrage: try to profit from temporary price increase or decrease supply of ones own
discrepancies in currencies across dealers currency to alter its price
5-4 5-5

1
 Spot Rate Quotations The indirect quote
Spot market The direct quote for British pound is:
for British pound .5242 = $1
Immediate purchase or sale of FX is: $1.9077 = 1
USD
Cash settlement typically in one to two days equiv USD equiv Currency per Currency per
Country Friday Thursday USD Friday USD Thursday
Spot rate: the current rate of exchange
Britain ((Pound)) 1.9077 1.9135 0.5242 0.5226
U.S. perspective: 1 Month
Forward 1.9044 1.9101 0.5251 0.5235
Direct quote: the price of one unit of foreign 3 Months
currency in dollars ($2.00 = 1.00) Forward 1.8983 1.9038 0.5268 0.5253
6 Months
Indirect quote: the price of one dollar in the Forward 1.8904 1.8959 0.5290 0.5275
foreign currency (0.50 = $1.00) Note that the direct quote is the 1
1.9077 =
reciprocal of the indirect quote: .5242
5-6

Bid-Ask Spread The Bid-Ask Spread

Bid: price the dealer is willing to pay A dealer could offer:
Ask: price the dealer wants you to pay bid price of $1.4512 per 1.00
ask price of $1.4525 per 1.00
The bid-ask spread is the difference between
the bid and ask prices OR, equivalently:
bid price of 0.688468 per $1.00
Thedifference between the bid and ask prices
represents the dealers expected profit ask price of 0.689085 per $1.00

5-8 5-9

The Bid-Ask Spread Bid-Ask Trading Cost

small figure
Using the quotes on the previous page:
big
Suppose you buy $10,000,000 worth of Euros
figure
Bid Ask Five minutes later you convert the Euros back to
S($/ ) 1 4512
1.4512 1 4525
1.4525 dollars and the quotes have not changed
Initial:
S( /$) 0.6885 0.6891 $10,000,000/(1.4525) = 6,884,681.58
A dealer would quote these prices as 12-25 Reverse:
(6,802,721.09)(1.4512) = $9,991,049.91
It is presumed that anyone trading $10 mil
Cost: $8,950.09
already knows the big figure
5-10 5-11

2
Cross-Exchange Rate (Cross-rate) Cross Rates
Exchange rate between two currencies based Suppose that ($/) = 1.50
on each of their exchange rates with a third i.e. $1.50 = 1.00
currency and that S($/) = 0.01
i $0.01
i.e. $0 01 = 1.00
1 00
U.S. perspective:
What must the / cross rate be?
You have $/ and $/ exchange rates
Cross rate would be / calculated using $ 1.00 $0.01 0.006667
=
exchange rates $1.50 1.00 1.00
/ = (/$) x ($/)
or, 1.00 = 150
5-12 5-13

Cross-Rate Importance Triangular Arbitrage

Most interbank trading goes through the U.S. If markets exist for foreign currencies relative
dollar to the dollar and relative to each other:
Suppose a bank customer wants to trade out There must be some mechanism to ensure that the
off British
B iti h pounds
d into
i t Swiss
S i francs
f (referred
( f d to
t prices in the various markets are the same
as a currency-against-currency trade) Triangular arbitrage serves that purpose for
The bank frequently handles this trade by selling currency markets
British pounds for dollars and then selling dollars
The implied cross-rate and the actual exchange
for Swiss francs
rate for the two foreign currencies must be the
Some banks do make markets in other currencies
same or traders will profit from the difference
5-14 5-15

Triangular Arbitrage Triangular Arbitrage

Suppose we observe these banks posting these exchange Implied cross rate: one pound costs 220 yen
rates.
Actual exchange rate: one pound costs 240 yen
Barclays: /$ = 110
Credit Lyonnais: /$ = 0.5 More yen per pound with the actual rate
C d Agricole:
Credit A l /
/ = 240
How do we profit?
The implied cross rate using the dollar based quotes is: Convert dollars to pounds
0.50 $1.00 1.00 Then covert pounds to yen (using actual rate)
=
$1.00 110 220 Then convert yen to dollars

The difference in the implied cross rate and the actual Use $100,000 for example
exchange rate for / offers an arbitrage opportunity
5-16 5-17

3
Triangular Arbitrage Triangular Arbitrage

Sell $100,000 for at S(/$) = 0.50 Here we have to go

clockwise to make $
receive 50,000
moneybut it doesnt Barclays
,
Sell our 50,000 ffor at S(/)
( ) = 240 Credit Lyonnais
matter where we start.
start S(/$) 110
S(/$)=110
2 3 S(/$)=0.50
receive 12,000,000
1
Sell 12,000,000 for $ at S(/$) = 110 Credit Agricole

receive $109,091 S(/)=240

profit per round trip = $109,091 $100,000 = $9,091 If we went counter clockwise, we would have a loss
exactly equal to our gain from going clockwise.
5-18 5-19

Spot Market FX Microstructure Forward FX Market

Mechanics of how a marketplace operates Forward contract: involves contracting today
Bid-Ask spreads in the spot FX market: for the future purchase or sale of foreign
increase with FX exchange rate volatility and exchange at a price agreed upon today
decrease with dealer competition.
competition Bank
B k quotest for
f 11, 3
3, 6
6, 9
9, and
d 12 month
th
Private information is an important determinant maturities are readily available
of spot exchange rates Forward rate quotations appear directly under the
Traders indicate that adjustment to economic spot quotations for major currencies
announcements take place in about 10 minutes Premium: forward prices are stronger than spot
1/3 of traders say it happens in less than 10 seconds Discount: forward prices are weaker than spot

5-20 5-21

Spot Rate Quotations

Long and Short Forward Positions
Pound at discount to Canadian Dollar at
dollar in forward market premium to U.S. Dollar If you have agreed to sell anything (spot or
in forward market
forward), you are short.
Country USD equiv Friday Currency per USD Friday
Britain (Pound) 1.9077 0.5242 If you have agreed to buy anything (forward
1 Month Forward 1.9044 0.5251 or spot), you are long.
3 Months Forward 1.8983 0.5268
6 Months Forward 1.8904 0.5290 If you have agreed to sell FX forward, you
Canada (Dollar) 0.8037 1.2442 are short.
1 Month Forward 0.8037 1.2442
3 Months Forward 0.8043 1.2433
If you have agreed to buy FX forward, you
6 Months Forward 0.8057 1.2412 are long.
5-23

4
Hedging Lower Risk Speculating Increase Risk
U.S. firm to be paid 500,000 in one month Use $1,000,000 as contract size
Enter1-month forward contract at $1.9044/1.00 to sell Expect pound to be worth more than $1.9044/1.00 in
500,000 one month long forward (guarantees buy price)
Receive: (500
(500,000)(1.9044)
000)(1 9044) = $952,200
$952 200 If spot rate is $1.9144/1.00 in one month
Buy pounds using forward contract:
U.S. firm to pay 500,000 in one month
$1,000,000/1.9044 = 525,099.77
Enter 1-month forward contract at $1.9044/1.00 to
Sell pounds in spot market:
buy 500,000
525,099.77 X 1.9144 = $1,005,251
Pay: (500,000) (1.9044) = $952,200
Profit = $5,251
No exchange rate risk remains Note: If spot rate is less than 1.9044, you have a loss
5-24 5-25

Speculating Increase Risk Summary

Use $1,000,000 as contract size Spot versus forward market
Expect pound to be worth less than $1.9044/1.00 in
Bid-Ask Spread
one month short forward (guarantees sell price)
If spot rate is $1.8944/1.00 in one month Cross-Rates
Buy pounds in spot market: Triangular Arbitrage
$1,000,000/1.8944 = 527,871.62
Hedging and Speculation
Sell pounds using forward contract:
527,871.62 X 1.9044 = $1,005,278.72

Profit = $5,278.72
Note: If spot rate is larger than 1.9044, you have a loss
5-26 5-27