Foreign Exchange Markets

Foreign Exchange Markets

The FOREX market provides the physical and institutional structure through which the money of one country is exchanged for that of another country A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate

Foreign Exchange Markets

There are six main characteristics of the FOREX markets which will be discussed
The geographic extent The three main functions The markets participants Its daily transaction volume Types of transactions including spot, forward and swaps Methods of stating exchange rates, quotations, and changes in exchange rates

FOREX Market Geography

Geographically, the FOREX market spans the globe with prices moving and currencies trading on a 24 hour basis Major exchanges are located in Singapore, Hong Kong and Tokyo in the East Then it moves to Bahrain, and London for the European area And on to New York, San Francisco and Sydney

Introduction
The Foreign Exchange market, also referred to as the "Forex" or "FX" market is the largest financial market in the world, with a daily average turnover of US$1.9 trillion 30 times larger than the combined volume of all U.S. equity markets.
"Foreign Exchange" is the simultaneous buying of one currency and selling of another. Currencies are traded in pairs, for example Euro/US Dollar (EUR/USD) or US Dollar/Japanese Yen (USD/JPY).

Some Interesting facts

Before Internet era, it required as much as US$1 million to open an account. From 1997 to the end of 2000, daily forex trading volume surged from US$5 billion to US$1.5 trillion. The forex market continues to grow at a phenomenal rate. 85% of all daily transactions involve trading a group of currencies known as the "Majors."

How to Read a Currency Quote

currency pair base currency quote currency Bid price Ask Price

SIMPLE !!

Few Jargons !!
lot Long market Short market Margin Leverage
Trading currencies on margin lets you increase your buying power. Here's a simplified example: If you have $2,000 cash in a margin account that allows 100:1 leverage, you could purchase up to $200,000 worth of currency-because you only have to post 1% of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power.

Example of a FOREX trade

Suppose you feel that the EUR is undervalued against the dollar. To execute this strategy, you would buy Euros (simultaneously selling Dollars) and then wait for the exchange rate to rise. So you make the trade: purchasing 100,000 EUR (1 lot) and selling 101,260 Dollars. (Remember, at 1% margin, your initial margin deposit would be 1,000 Euros.) As you expected, EUR/USD rises to 1.0236/42. Since you bought Euros and sold Dollars in your previous trade, you must now sell Euros for Dollars to realize any profit. You can now sell 1 EUR for 1.0236 Dollars. When you sell the 100,000 Euros at the current EUR/USD rate of 1.0236, you will receive 102,360 USD. Since you originally sold (paid) 101,260 USD, your profit is US $1100. Total profit = US $1100.00

Tools for determining future movements in Money Market

Fundamental Analysis Thorough analysis of economic and political data with the goal of determining future movements in a financial market.
Technical Analysis An effort to forecast future market activity by analyzing market data such as charts, price trends, and volume.

Some reasons to trade in FOREX

24-hour forex trading Superior liquidity 100:1 Leverage in forex trading Lower transaction costs Equal profit potential in both rising and falling markets

Some Cautions

The market could move against you. You could lose your entire investment. Due to the leverage effect!!

FOREX Market Geography

Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
25,000

20,000

15,000

10,000

5,000

Greenwich Mean Time

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

10 AM Lunch Europe In Tokyo In Tokyoopening

Asia closing

Americas London open closing

Afternoon in America

6 pm Tokyo In NY opens

FOREX Market Functions

The FOREX market is the mechanism by which participants transfer purchasing power between countries, obtains or provides credit for international trade, and minimizes exposure to exchange rate risk
Transferring of purchasing power is necessary because international trade and capital transactions normally involve parties in countries with different currencies yet each party wishes to transact in their own currency

FOREX Market Functions

Because the movement of goods between countries takes time, inventory in transit must be financed. The FOREX market provides a source of credit via specialized instruments such as letters of credit The FOREX market provides hedging facilities for transferring foreign exchange risk to someone else more willing to carry that risk

FOREX Market Participants

The FOREX market consists of two tiers, the interbank or wholesale market, and the client or retail market Five broad categories of participants operate within these two tiers
Bank and non bank foreign exchange dealers Individuals and firms conducting commercial or investment transactions Speculators and arbitragers Central banks and treasuries Foreign exchange brokers

Bank/Non-Bank Dealers
These participants profit from buying currencies at a bid price and then reselling them at an offer or ask price Competition among dealers narrows the spread between the bid and offer rate contributing to the markets efficiency Dealers on behalf of large international banks often act as market makers, often willing to stand in and buy or sell these currencies without having a counterpart with which to unload the inventory

Bid price: The price a buyer is willing to pay. Offer (Ask price): the price a seller is willing to receive. Bid-Ask spread: The amount that the ask price exceeds the bid. Market maker: A broker-dealer willing to accept the risk of holding a particular currency in order to facilitate trading in that currency.

Bank/Non-Bank Dealers
They trade amongst other banks and dealers in order to keep their inventory levels at manageable levels Currency trading is profitable and often contributes between 10% - 20% of a banks average net income Small- to medium-sized banks rarely act as market makers yet still participate in the interbank market

Commercial Investment
Importers, exporters, portfolio investors, MNEs, tourists and others use the FOREX market to facilitate execution of commercial or investment transactions Some of these participants use the market to hedge foreign exchange rate risk

Speculators & Arbitragers

Speculators and arbitragers seek to profit from trading in the market itself They operate for their own interest, without need or obligation to serve clients or ensure a continuous market Speculators seek all their profit from exchange rate changes Arbitragers try to profit from simultaneous differences in exchange rates in different markets A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks

Central Banks & Treasuries

Central banks and treasuries use the market to acquire or spend their countrys currency reserves as well as to influence the price at which their own currency trades They may act to support the value of their currency because of their governments policies or obligations or because of commitments entered through joint float agreements such as the European Monetary System (EMS) Consequently their motive is not to profit but rather influence the foreign exchange value of their currency in a manner that will benefit their interests

Foreign Exchange Brokers

Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming principals in the transaction For this service they charge a small commission They maintain instant access to hundreds of dealers worldwide via open lines and at times may maintain such lines with several banks, with separate lines for differing currencies, spot and forward rates

Types of transactions

Inter-Bank Market Transactions

Transactions within this market can be executed on a spot, forward, or swap basis
A spot transaction requires almost immediate delivery of foreign exchange A forward transaction requires delivery of foreign exchange at some future date A swap transaction is the simultaneous exchange of one foreign currency for another

Spot Transactions
A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day
The settlement date is often referred to as the

value date

This is the date when most dollar transactions are settled through the computerized Clearing House Interbank Payment Systems (CHIPS) in New York

Outright Forward Transactions

This transaction requires delivery at a future value date of a specified amount of one currency for another The exchange rate is agreed upon at the time of the transaction, but payment and delivery are delayed Forward rates are contracts quoted for value dates of one, two, three, six, nine and twelve months
Terminology typically used is buying or selling

forward

A contract to deliver dollars for euros in six months is both buying euros forward for dollars and selling dollars forward for euros

Swap Transactions
A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Both purchase and sale are conducted with the same counterpart A common type of swap is a spot against forward
The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market Since this transaction occurs at the same time and with the same counterpart, the dealer incurs no exchange rate exposure

Swap Transactions
Forward-forward swaps A dealer sells 20,000 forward for dollars for delivery in two months at $1.6870/ and simultaneously buys 20,000 forward for delivery in three months at $1.6820/
The difference between the buying and selling price is equivalent to the interest rate differential Thus a swap can be viewed as a technique for borrowing another currency on a fully collateralized basis

Swap Transactions
Non-deliverable forwards (NDFs) NDFs possess the same characteristics as traditional forward contracts except that they are settled only in US dollars and the foreign currency being sold or bought forward is not delivered
The dollar-settlement feature reflects the fact that NDFs are contracted offshore and are beyond the reach and regulatory frameworks of the home country governments Pricing of NDFs reflects basic interest rate differentials

FOREX Market Size

The Bank for International Settlements (BIS) estimates that daily global net turnover in traditional FOREX market activity to be US$1,210 billion in April 2001

FOREX Market Size

Global Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)
800 700 600 500 400 300 200 100 0 1989 1992 1995 1998 2001 Spot Forwards Swaps

Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, October 2001, www.bis.org. Next survey planned for April
2004.

FOREX Market Size

Two of the three categories fell between 1998 and 2001 with spot market daily turnover falling the most, from $568 billion in 1998 to $387 billion in 2001 Forward transactions increased slightly from $128 billion in 1998 to $131 billion in 2001 Swaps fell to $656 billion in 2001 from $734 billion in 1998
BIS attributes the introduction of the Euro, the growing share of electronic broking in the spot market and consolidation in banking as explanations for the reduction

FOREX Market Size

Geographic Distribution of Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars)

700 600 500 400 300 200 100 0 1989

United States United Kingdom Japan Singapore Germany

1992

1995

1998

2001

Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, October 2001, www.bis.org. Next survey planned for April 2004.

FOREX Market Size

Currency Distribution of Global Foreign Exchange Market Turnover
(percentage shares of average daily turnover in April)
90 80 70 60 50 40 30 20 10 0
1989 1992 1995 1998 2001 Source: Bank for International Settlements, Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001, October 2001, www.bis.org. Next survey planned for April 2004. US dollar euro Deutshemark French franc EMS currencies Japanese yen Pound sterling Swiss franc

FOREX Rates & Quotes

A foreign exchange quote is a statement of willingness to buy or sell at an announced rate
In the retail market (newspapers and exchange booths), quotes are often given as the home currency price of the foreign currency

Interbank quotes professionals state forex quotes in one of two ways

The foreign currency price of one dollar
Sfr1.6000/$, read as 1.600 Swiss francs per dollar European quote

The dollar price of a unit of foreign currency

$0.6250/Sfr, read as 0.625 dollars per Swiss franc American quote

FOREX Rates & Quotes

The former quote is considered the European quote and the latter is the American quote Almost all European currencies, except two, are quoted the European way
The Pound Sterling and the Euro are the exceptions Additionally, Australian and New Zealand dollars are also quoted in American terms

FOREX Rates & Quotes

Bid and Ask Quotations
Interbank quotes are given as a bid and

ask

The bid is the price at which a dealer will buy another currency The ask or offer is the price at which a dealer will sell another currency
Example: 118.27 - 118.37/$ is the bid/ask for Japanese yen The bank will buy yen at 118.27 per dollar and sell yen at 118.37 per dollar making profit on the spread

FOREX Rates & Quotes

Expressing Forward Quotations on a Points Basis

The previously mentioned rates for yen were considered outright quotes Forward quotes are different and typically quoted in terms of points A point is the last digit of a quotation, with convention dictating the number of digits to the right of the decimal
Hence a point is equal to 0.0001 of most currencies

FOREX Rates & Quotes

Expressing Forward Quotations on a Points Basis
The yen is quoted only to two decimal points A forward quotation is not a foreign exchange rate, rather the difference between the spot and forward rates Example:
Bid
Outright spot: Plus points (3 months) Outright forward: 118.27 -1.43 116.84

Ask
118.37 -1.40 116.97

FOREX Rates & Quotes

Forward Quotations in Percentage Terms
Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate
This is similar to the forward discount or premium calculated earlier

The important thing to remember is which currency is being used as the home or base currency
For indirect quotes (i.e. quote expressed in foreign currency terms), the formula is

FC

Spot - Foward 360 x x 100 Foward days

FOREX Rates & Quotes

Forward Quotations in Percentage Terms
For direct quotes (i.e. quote expressed in home currency terms), the formula is

Forward - Spot 360 f x x 100 Spot days

H

FOREX Rates & Quotes

Forward Quotations in Percentage Terms
Example: Indirect quote

105.65 - 105.04 360 f x x 100 2.32% p.a. 105.04 90

Example: Direct quote

0.009520183 - 0.009465215 360 f x x 100 2.32% p.a. 0.009465215 90

$

FOREX Rates & Quotes

Direct and Indirect Quotes
A direct quote is a home currency price of a unit of a foreign currency
Sfr1.6000/$ is a direct quote in Switzerland $0.625/Sfr is a direct quote in the US

An indirect quote is a foreign currency price in a unit of the home currency

Sfr1.600/$ is an indirect quote in the US, $0.625/Sfr is a direct quote in the US and an indirect quote in Switzerland

FOREX Rates & Quotes

Cross Rates
Many currencies pairs are inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency Example: A Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and Japanese yen () are quoted in US dollars
Assume the following quotes:

Japanese yen

121.13/$

Mexican peso

Ps9.190/$

FOREX Rates & Quotes

Cross Rates
The Mexican importer can buy one US dollar for Ps9.190 and with that dollar buy 121.13; the cross rate would be

121.13/$ Japanes yen/US dollar 13 .1806 / PS Mexican pesos/US dollar PS 9.190 / $

FOREX Rates & Quotes

Intermarket Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage Example: Assume the following exchange rates are quoted
Citibank Barclays Bank Dresdner Bank $0.9045/ $1.4443/ 1.6200/

FOREX Rates & Quotes

Intermarket Arbitrage
The cross rate between Citibank and Barclays is $1.4443/ 1.5968/ $0.9045/

This cross rate is not the same as Dresdners rate quote of 1.5800/, so an opportunity exists for risk-less profit

FOREX Rates & Quotes

Citibank
End with $1,014,533 (6) Receive $1,014,533 (1) Start with $1,000,000 Sell $1,000,000 to Barclays Bank at $1.4443/

Dresdner Bank
(5) Sell 1,121,651 to Citibank at $0.9045/ Receive 1,121,651 (2) (3)

Barclays Bank
Receive 692,377 Sell 692,377 to Dresdner Bank at 1.6200/

(4)

Thank you