Foreign Exchange Markets Guide

CHAPTER 7CHAPTER 7
THE FOREIGNTHE FOREIGN
EXCHANGEEXCHANGE
MARKETMARKET
www.StudsPlanet.comwww.StudsPlanet.com

CHAPTER OVERVIEWCHAPTER OVERVIEW
I.I. INTRODUCTIONINTRODUCTION
II.II. ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGEFOREIGN EXCHANGE
MARKETMARKET
III.III. THE SPOT MARKETTHE SPOT MARKET
IV.IV. THE FORWARD MARKETTHE FORWARD MARKET
V.V. INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORYwww.StudsPlanet.comwww.StudsPlanet.com

PART I. INTRODUCTIONPART I. INTRODUCTION
A.A. The Currency Market:The Currency Market:
where moneywhere money
denominated in onedenominated in one
currency is bought andcurrency is bought and
sold with moneysold with money
denominated in anotherdenominated in another
currency.currency.

INTRODUCTIONINTRODUCTION
B. International Trade andB. International Trade and
Capital Transactions:Capital Transactions:
- facilitated with the ability- facilitated with the ability
to transfer purchasing powerto transfer purchasing power
between countriesbetween countries

INTRODUCTIONINTRODUCTION
C.C. LocationLocation
1.1. OTC-type: no specificOTC-type: no specific
locationlocation
2.2. Most trades by phone,Most trades by phone,
telex, or SWIFTtelex, or SWIFT
SWIFT:SWIFT: Society for WorldwideSociety for Worldwide
Interbank FinancialInterbank Financial
TelecommunicationsTelecommunications

PART II.PART II.
ORGANIZATION OF THE FOREIGNORGANIZATION OF THE FOREIGN
EXCHANGE MARKETEXCHANGE MARKET
II .. PARTICIPANTS IN THEPARTICIPANTS IN THE
FOREIGN EXCHANGEFOREIGN EXCHANGE
MARKETMARKET
A.A. Participants at 2 LevelsParticipants at 2 Levels
1.1. Wholesale Level (95%)Wholesale Level (95%)
- major banks- major banks
2.2. Retail LevelRetail Level
- business- business
customers.customers.www.StudsPlanet.comwww.StudsPlanet.com

ORGANIZATION OF THEORGANIZATION OF THE
FOREIGN EXCHANGE MARKETFOREIGN EXCHANGE MARKET
B.B. Two Types of CurrencyTwo Types of Currency
MarketsMarkets
1.1. Spot Market:Spot Market:
- immediate transaction- immediate transaction
- recorded by 2nd- recorded by 2nd
business daybusiness day

2.2. Forward Market:Forward Market:
- transactions take place at a- transactions take place at a
specified future datespecified future date

C.C. Participants by MarketParticipants by Market
1.1. Spot MarketSpot Market
a.a. commercial bankscommercial banks
b.b. brokersbrokers
c.c. customers of commercialcustomers of commercial
and central banksand central banks

2.2. Forward MarketForward Market
a.a. arbitrageursarbitrageurs
b.b. traderstraders
c.c. hedgershedgers
d.d. speculatorsspeculators

II.II. CLEARING SYSTEMSCLEARING SYSTEMS
A. Clearing House InterbankA. Clearing House Interbank
Payments SystemPayments System
(CHIPS)(CHIPS)
- used in U.S. for electronic- used in U.S. for electronic
fund transfers.fund transfers.

B.B. FedWireFedWire
- operated by the Fed- operated by the Fed
- used for domestic transfers- used for domestic transfers

III.III. ELECTRONIC TRADINGELECTRONIC TRADING
A.A. Automated TradingAutomated Trading
- genuine screen-based- genuine screen-based
marketmarket

B.B. Results:Results:
1.1. Reduces cost of tradingReduces cost of trading
2.2. Threatens traders’Threatens traders’
oligopoly of informationoligopoly of information
3.3. Provides liquidityProvides liquidity

IV.IV. SIZE OF THE MARKETSIZE OF THE MARKET
A.A. Largest in the worldLargest in the world
1995: $1.2 trillion daily1995: $1.2 trillion daily

B.B. Market Centers (1995):Market Centers (1995):
London =London = $464 billion$464 billion
dailydaily
New York= $244 billionNew York= $244 billion
dailydaily
Tokyo = $161 billionTokyo = $161 billion
dailydaily

PART III.PART III.
THE SPOT MARKETTHE SPOT MARKET
I.I. SPOT QUOTATIONSSPOT QUOTATIONS
A.A. SourcesSources
1.1. All major newspapersAll major newspapers
2.2. Major currencies haveMajor currencies have
four different quotes:four different quotes:
a.a. spot pricespot price
b.b. 30-day30-day
c.c. 90-day90-day
d.d. 180-day180-day

B.B. Method of QuotationMethod of Quotation
1.1. For interbank dollarFor interbank dollar
trades:trades:
a.a. American termsAmerican terms
example: $.5838/dmexample: $.5838/dm
b.b. European termsEuropean terms
example: dm1.713/$example: dm1.713/$

2.2. For nonbank customers:For nonbank customers:
Direct quoteDirect quote
gives the home currencygives the home currency
price of one unit of foreignprice of one unit of foreign
currency.currency.
EXAMPLE:EXAMPLE: dm0.25/FFdm0.25/FF

C.C. Transactions CostsTransactions Costs
1.1. Bid-Ask SpreadBid-Ask Spread
used to calculate the feeused to calculate the fee
charged by the bankcharged by the bank
Bid = the price at whichBid = the price at which
the bank is willing to buythe bank is willing to buy
Ask = the price it will sellAsk = the price it will sell
the currencythe currency

4.4. Percent Spread Formula (PS):Percent Spread Formula (PS):
100x
Ask
BidAsk
PS
−
=

D.D. Cross RatesCross Rates
1.1. The exchange rateThe exchange rate
between 2 non - US$between 2 non - US$
currencies.currencies.

2.2. Calculating Cross RatesCalculating Cross Rates
When you want to knowWhen you want to know
what the dm/what the dm/ cross ratecross rate
is, and you knowis, and you know
dm2/US$ anddm2/US$ and .55/US$.55/US$
then dm/then dm/ = dm2/US$= dm2/US$ ÷÷
.55/US$.55/US$
= dm3.636/= dm3.636/ 

E.E. Currency ArbitrageCurrency Arbitrage
1.1. If cross rates differ fromIf cross rates differ from
one financial center toone financial center to
another, and profitanother, and profit
opportunities exist.opportunities exist.

2.2. Buy cheap in one int’l market,Buy cheap in one int’l market,
sell at a higher price insell at a higher price in
anotheranother
3.3. Role of Available InformationRole of Available Information

F.F. Settlement Date Value Date:Settlement Date Value Date:
1.1. Date monies are dueDate monies are due
2.2. 2nd Working day after date of2nd Working day after date of
original transaction.original transaction.

G.G. Exchange RiskExchange Risk
1.1. Bankers = middlemenBankers = middlemen
a.a. Incurring risk of adverseIncurring risk of adverse
exchange rate moves.exchange rate moves.
b.b. Increased uncertaintyIncreased uncertainty
about future exchangeabout future exchange
rate requiresrate requires

1.)1.) Demand for higher riskDemand for higher risk
premiumpremium
2.)2.) Bankers widen bid-askBankers widen bid-ask
spreadspread

MECHANICS OF SPOTMECHANICS OF SPOT
TRANSACTIONSTRANSACTIONS
SPOT TRANSACTIONS: AnSPOT TRANSACTIONS: An
ExampleExample
Step 1.Step 1. Currency transaction:Currency transaction:
verbal agreement, U.S.verbal agreement, U.S.
importer specifies:importer specifies:
a. Account to debit (his acct)a. Account to debit (his acct)
b. Account to creditb. Account to credit
(exporter)(exporter)

Step 2.Step 2. Bank sends importerBank sends importer
contract note including:contract note including:
- amount of foreign- amount of foreign
currencycurrency
- agreed exchange rate- agreed exchange rate
- confirmation of Step 1.- confirmation of Step 1.

Step 3.Step 3. SettlementSettlement
Correspondent bank in HongCorrespondent bank in Hong
Kong transfers HK$ fromKong transfers HK$ from
nostro account to exporter’s.nostro account to exporter’s.
Value Date.Value Date.
U.S. bank debits importer’sU.S. bank debits importer’s
account.account.

PART III.PART III.
THE FORWARD MARKETTHE FORWARD MARKET
A. Definition of a ForwardA. Definition of a Forward
ContractContract
an agreement between a bank andan agreement between a bank and
a customer to deliver a specifieda customer to deliver a specified
amount of currency againstamount of currency against
another currency at a specifiedanother currency at a specified
future date and at a fixed exchangefuture date and at a fixed exchange
rate.rate. www.StudsPlanet.comwww.StudsPlanet.com

2. Purpose of a Forward:2. Purpose of a Forward:
HedgingHedging
the act of reducing exchangethe act of reducing exchange
rate risk.rate risk.

B.B. Forward Rate QuotationsForward Rate Quotations
1.1. Two Methods:Two Methods:
a.a. Outright Rate:Outright Rate: quoted toquoted to
commercial customers.commercial customers.
b.b. Swap Rate:Swap Rate: quoted in thequoted in the
interbank market as ainterbank market as a
discount or premium.discount or premium.

CALCULATING THE FORWARDCALCULATING THE FORWARD
PREMIUM OR DISCOUNTPREMIUM OR DISCOUNT
== F-SF-S xx 1212 x 100x 100
SS nn
where F = the forward rate of exchangewhere F = the forward rate of exchange
S = the spot rate of exchangeS = the spot rate of exchange
n = the number of months in then = the number of months in the
forward contractforward contractwww.StudsPlanet.comwww.StudsPlanet.com

C.C. Forward Contract MaturitiesForward Contract Maturities
1.1. Contract TermsContract Terms
a.a. 30-day30-day
b.b. 90-day90-day
c.c. 180-day180-day
d.d. 360-day360-day
2.2. Longer-term ContractsLonger-term Contracts

PART IV.PART IV.
INTEREST RATE PARITY THEORYINTEREST RATE PARITY THEORY
A. The Theory states:A. The Theory states:
the forward rate (F) differsthe forward rate (F) differs
from the spot rate (S) atfrom the spot rate (S) at
equilibrium by an amountequilibrium by an amount
equal to the interestequal to the interest
differential (rdifferential (rhh - r- rff) between) between
two countries.two countries.

INTEREST RATE PARITYINTEREST RATE PARITY
THEORYTHEORY
2.2. The forward premium orThe forward premium or
discount equals the interestdiscount equals the interest
rate differential.rate differential.
(F - S)/S = (r(F - S)/S = (rhh - r- rff))
wherewhere rrhh = the home rate= the home rate
rrff = the foreign rate= the foreign rate

THEORYTHEORY
3.3. In equilibrium, returns onIn equilibrium, returns on
currencies will be the samecurrencies will be the same
i. e. No profit will be realizedi. e. No profit will be realized
and interest parity existsand interest parity exists
which can be writtenwhich can be written
(1 + r(1 + rhh)) == FF
(1 + r(1 + rff) S) S

THEORYTHEORY
B.B. Covered Interest ArbitrageCovered Interest Arbitrage
1. Conditions required:1. Conditions required:
interest rate differential doesinterest rate differential does
not equal the forwardnot equal the forward
premium or discount.premium or discount.
2.2. Funds will move to a countryFunds will move to a country
with a more attractive rate.with a more attractive rate.www.StudsPlanet.comwww.StudsPlanet.com

THEORYTHEORY
3.3. Market pressures develop:Market pressures develop:
a.a. As one currency is moreAs one currency is more
demanded spot and solddemanded spot and sold
forward.forward.
b. Inflow of fund depressesb. Inflow of fund depresses
interest rates.interest rates.

THEORYTHEORY
C.C. Summary:Summary:
Interest Rate Parity states:Interest Rate Parity states:
1.1. Higher interest rates on aHigher interest rates on a
currency offset bycurrency offset by
forwardforward discounts.discounts.
2.2. Lower interest rates areLower interest rates are
offset by forwardoffset by forward
premiums.premiums.www.StudsPlanet.comwww.StudsPlanet.com

Foreign Exchange Markets Guide

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