The Foreign Exchange Market
Eiteman et al., Chapter 4
Outline of the Chapter • Geographical Extent, Function, Market Participants of the Foreign Exchange Market • Transactions, Size of the Foreign Exchange Market • Rates and Quotations
Geographical Extent of the Foreign Exchange Market Global currency trading is a 24-hour-a-day process. Many large international banks operate trading rooms in major trading center on a round-the-clock basis. Some currency trading is conducted on an official trading floor by open bidding but most of it is done through dealers.
Functions of the Foreign Exchange Market • Transfer of Purchasing Power • Financing of Inventory in Transit • Hedging Facilities
Market Participants The foreign exchange market consists of two tiers: The interbank market and the retail market. Transactions in the interbank market are usually for large sums of money (multiples of millions of USD) whereas transactions in the retail market usually involve smaller amounts.
Market Participants There are five main categories of market participants in the foreign exchange market: • Bank and Nonbank Foreign Exchange Dealers • Individuals and Firms Conducting Commercial and Investment Transactions • Speculators and Arbitrageurs • Central Banks and Treasuries • Foreign Exchange Brokers. 6
Transactions in the Interbank Market
Spot Transactions: Delivery on the second following business day (value date). Outright Forward Transactions: Delivery at a future value date. Swap Transactions: 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 counterparty. “Spot against forward”, “forward-forward swaps”, “nondeliverable forwards (NDFs)”. 7
Size of the Market Daily global turnover in traditional foreign exchange market activity of $1,210 billion (Bank for International Settlements (BIS) triennial survey, April 2001). Decline since 1998, mostly due to the introduction of the euro. First decline since the BIS began surveying banks on foreign currency trading.
Foreign Exchange Rates and Quotations In the interbank market, since most foreign exchange transactions involve the U.S. dollar, quotations are usually either USD per foreign exchange or foreign exchange per USD. European Terms: Foreign currency price of one U.S. dollar. SF1.6000/$ ⇒ “1.6000 Swiss francs per dollar.” American Terms: U.S. dollar price of one unit of foreign currency. Used for the euro, British pound, Australian and New Zealand dollars. 9
Foreign Exchange Rates and Quotations American terms are used in quoting rates for most foreign currency options and futures, as well as in retail markets for tourists. Currency amounts must also be clearly stated. A billion represents different quantities in different countries.
Foreign Exchange Rates and Quotations Direct and Indirect Quotes A direct quote is the price of one unit of foreign currency in terms of the home currency. An indirect quote is the price of one unit of home currency in terms of a foreign currency. “SF1.6000/$” is a direct quote in Switzerland but an indirect quote in the U.S..
Foreign Exchange Rates and Quotations Bid and Ask Quotations Euro Spot & Forward ($/€) Term
1 month forward rates could also be written as 1.0914-20.
Foreign Exchange Rates and Quotations Forward Quotations in Percentage Terms Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate. For example, suppose we have FC/HC
3-month forward U105.04/$ $0.009520183/U
Foreign Exchange Rates and Quotations Forward Quotations in Percentage Terms Using the quotations in U/$, the forward premium (or discount) for the n-day forward contract is calculated as fU =
spotU/$ − forwardU/$ 360 × . forwardU/$ n
Using the values in the previous slide, this gives fU =
105.65 − 105.04 360 × = 2.32%. 105.04 90
Foreign Exchange Rates and Quotations Forward Quotations in Percentage Terms Using the quotations in $/U, the forward premium (or discount) for the n-day forward contract is calculated as fU =
forward$/U − spot$/U 360 × . spot$/U n
Using the values in the previous slide, this gives fU =
0.009520183 − 0.009465215 360 × = 2.32%. 0.009465215 90
Foreign Exchange Rates and Quotations Cross Rates Determining the exchange rate between two inactively traded currencies usually involves the use of a third widely traded currency, the U.S. dollar, for instance.
Foreign Exchange Rates and Quotations Cross Rates Suppose that we have Japanese yen:
and we are looking for the exchange rate U/Ps. The cross rate calculation would be Exchange rate U/$ U106.2000/$ = = U9.6827/Ps. Exchange rate Ps/$ Ps10.9680/$
Foreign Exchange Rates and Quotations Intermarket Arbitrage Cross rates can be used to check for intermarket arbitrage opportunities. Suppose Citibank quotes $1.2773/€, Barclays quotes $ 1.8245/£ and Dresdner quotes €1.4557/£. Then an arbitrage opportunity exists. The cross rate €/£ using Citibank and Barclays rates is €1.4284/£, and thus Dresdner seems to be overvaluing the British pound against the euro. 18
Foreign Exchange Rates and Quotations Intermarket Arbitrage The arbitrage opportunity thus involves changing dollars for pounds at Barclays, then pounds for euros at Dresdner and euros for dollars at Citibank. Take $1,000,000. At Barclays, you can change it for $1, 000, 000 = £548, 095. $1.8245/£
Foreign Exchange Rates and Quotations Intermarket Arbitrage For this amount, Dresdner will give you £548, 095 × €1.4557/£ = €797, 862. If you change these euros for dollars at Citibank, you obtain €797, 862 × $1.2773/€ = $1, 019, 110.
Foreign Exchange Rates and Quotations Measuring a Change in Spot Exchange Rates As in the case of the forward premium, the way to calculate percentage changes in the value of a currency depends on whether we are using direct quotes or indirect quotes. For example, suppose we want to calculate the percentage change in the value of the Canadian dollar (CAN$) vis-à-vis the U.S. dollar (US$) from September 2, 2003, to January 5, 2004.
Foreign Exchange Rates and Quotations Measuring a Change in Spot Exchange Rates We have the following data: CAN$/US$
September 2, 2003
January 5, 2004
The change in value of the CAN$ is 0.7799 − 0.7185 = 8.55%. 0.7185 22
Foreign Exchange Rates and Quotations Measuring a Change in Spot Exchange Rates When calculating the percentage in a stock price over some period of time, we use Pend − Pbeg , Pbeg where Pend is the stock price at the end of the period and Pbeg is the stock price at the beginning of the period. With exchange rates we do the same time, we take the difference between ending price and beginning price and divide it by the beginning price. 23
Foreign Exchange Rates and Quotations Measuring a Change in Spot Exchange Rates What is the price (or value) of a currency? It is its exchange rate expressed in a foreign currency. The price of a CAN$ in US$ as of September 2, 2003, was US$0.7185.
Foreign Exchange Rates and Quotations Measuring a Change in Spot Exchange Rates Let E d denote the direct quotation of a currency (HC/FC) and let E i denote the indirect quote (FC/HC). Note that E i = 1/E d . Then the percentage change in this currency over some period of time is i − Ei d − 1/E d Eend 1/Eend beg beg = i d Ebeg 1/Ebeg d d − Ed Ebeg Ebeg end = − 1 = . d d Eend Eend
Foreign Exchange Rates and Quotations Measuring a Change in Spot Exchange Rates In the Canadian dollar example, calculating the percentage change since September 22,2003, using direct quotes gives 1.3918 − 1.2822 = 8.55%. 1.2822 Obviously, both methods have to give the same answer.