The Market for Foreign Exchange Chapter Objectives:

Chapter Four

4

INTERNATIONAL FINANCIAL MANAGEMENT

•This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. EUN / RESNICK •This chapter lays theSecond foundation for much of the Edition discussion throughout the remainder of the text, thus it deserves your careful attention.

Chapter Outline




Function and Structure of the FOREX Market The Spot Market The Forward Market

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Chapter Outline


Function and Structure of the FOREX Market  





FX Market Participants Correspondent Banking Relationships

The Spot Market The Forward Market

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Chapter Outline



Function and Structure of the FOREX Market The Spot Market      




Spot Rate Quotations The Bid-Ask Spread Spot FX Trading Cross Exchange Rate Quotations Triangular Arbitrage Spot Foreign Exchange Market Microstructure

The Forward Market

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Chapter Outline




Function and Structure of the FOREX Market The Spot Market The Forward Market     

Forward Rate Quotations Long and Short Forward Positions Forward Cross-Exchange Rates Swap Transactions Forward Premium

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The Function and Structure of the FOREX Market



FOREX Market Participants Correspondent Banking Relationships

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FOREX Market Participants


The FOREX market is a two-tiered market: 

Interbank Market (Wholesale)  About

700 banks worldwide stand ready to make a market in Foreign exchange.  Nonbank dealers account for about 20% of the market.  There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. 




Client Market (Retail)

Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

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Correspondent Banking Relationships





Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. International commercial banks communicate with one another with: 

 

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 FOREX transactions.

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The Spot Market





Spot Rate Quotations The Bid-Ask Spread Spot FX trading Cross Rates

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Spot Rate Quotations


Direct quotation  




the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny”

Indirect Quotation  

the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”.

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Spot Rate Quotations The direct quote for British pound is: £1 = $1.688

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Spot Rate Quotations The indirect quote for British pound is: £.5924 = $1

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Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote:

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The Bid-Ask Spread








The bid price is the price a dealer is willing to pay you for something. The ask price is the amount the dealer wants you to pay for the thing. The bid-ask spread is the difference between the bid and ask prices.

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Spot FX trading







In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes.

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Cross Rates


Suppose that S($/DM) = .50 




and that S(¥/DM) = 50 




i.e. $1 = 2 DM i.e. DM1 = ¥50

What must the $/¥ cross rate be?

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Triangular Arbitrage Suppose we observe these banks posting these exchange rates.

$ Barclays S(¥/$)=120

First calculate the implied cross rates to see if an arbitrage exists. McGraw-Hill/Irwin reserved.

Credit Lyonnais

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S(£/$)=1.50

¥

£ Credit Agricole S(¥/£)=85

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Triangular Arbitrage The implied S(¥/£) cross rate is S(¥/£) = 80

$ Barclays

Credit Lyonnais

S(¥/$)=120

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

S(£/$)=1.50

¥

£ Credit Agricole S(¥/£)=85

So, how can we make money? McGraw-Hill/Irwin reserved.

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Triangular Arbitrage As easy as 1 – 2 – 3:

$

1. Sell our $ for £,

Barclays

2. Sell our £ for ¥,

S(¥/$)=120

Credit Lyonnais S(£/$)=1.50

3. Sell those ¥ for $.

¥

£ Credit Agricole S(¥/£)=85

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Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250 McGraw-Hill/Irwin reserved.

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Spot Foreign Exchange Microstructure





Market Microstructure refers to the mechanics of how a marketplace operates. Bid-Ask spreads in the spot FX market:  




increase with FX exchange rate volatility and decrease with dealer competition.

Private information is an important determinant of spot exchange rates.

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The Forward Market






Forward Rate Quotations Long and Short Forward Positions Forward Cross Exchange Rates Swap Transactions Forward Premium

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The Forward Market





A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

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Forward Rate Quotations








The forward market for FOREX 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. Longer-term swaps are available.

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Forward Rate Quotations Consider the example from above: for Japanese yen, the spot rate is ¥115.75 = $1.00 While the 180-day forward rate is £112.80 = $1.00
What’s up with that?


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Spot Rate Quotations Clearly the market participants expect that the yen will be worth MORE in dollars in six months. McGraw-Hill/Irwin reserved.

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Long and Short Forward Positions











If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.

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Payoff Profiles profit

If you agree to sell anything in the future at a set price and the spot price later falls then you gain. S180($/¥)

0 F180($/¥) = .009524

If you agree to sell anything in the future at a set price and the spot loss price later rises then you lose. Short position McGraw-Hill/Irwin reserved.

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Payoff Profiles profit short position

0 F180(¥/$) = 105

F180(¥/$) = 105 or F180($/¥) = .009524.

-F180(¥/$) loss McGraw-Hill/Irwin reserved.

Whether the payoff profile slopes up or down depends S180(¥/$) upon whether you use the direct or indirect quote:

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Payoff Profiles profit short position

S180(¥/$)

0 F180(¥/$) = 105 -F180(¥/$) loss McGraw-Hill/Irwin reserved.

When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105 4-29

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Payoff Profiles profit short position 15¥

S180(¥/$)

0 F180(¥/$) = 105 -F180(¥/$) loss McGraw-Hill/Irwin reserved.

120

If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. 4-30

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Payoff Profiles profit F180(¥/$)

Since this is a zero-sum game, the short position long position payoff is the opposite of the short. S180(¥/$)

0 F180(¥/$) = 105 -F180(¥/$) loss McGraw-Hill/Irwin reserved.

Long position 4-31

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Payoff Profiles profit -F180(¥/$)

The long in this forward contract agreed to BUY ¥ in 180 days at F180(¥/$) = 105 If, in 180 days, S180(¥/$) = 120, the long will lose by having to buy ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. S180(¥/$)

0

120 F180(¥/$) = 105

–15¥ Long position

loss McGraw-Hill/Irwin reserved.

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Forward Cross Exchange Rates





It’s just an “delayed” example of the spot cross rate discussed above. In generic terms

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SWAPS





A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. Swap transactions account for approximately 51 percent of interbank FX trading, whereas outright trades are less than 9 percent.

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Comparative Advantage as the Basis for Swaps Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

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Comparative Advantage as the Basis for Swaps A is the more credit-worthy of the two firms. A pays 2% less to borrow in dollars than B and A pays .4% less to borrow in pounds than B:

A has a comparative advantage in borrowing in dollars B has a comparative advantage in borrowing in pounds. McGraw-Hill/Irwin reserved.

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One Feasible Swap: Swap Bank

$8%

$8%

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£12%

Company A

£11%

$9.4%

Company

£12%

B

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One Feasible Swap: Swap Bank

$8%

$8%

Company £11% A A’s net position is to borrow at £11%

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£12%

$9.4%

Company

£12%

B

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One Feasible Swap: Swap Bank

$8%

$8%

£12%

Company A

£11%

$9.4%

Company

£12%

B B’s net position is to borrow at $9.4%

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One Feasible Swap: Swap Bank

$8%

$8%

£12%

Company A

£11%

$9.4%

Company

£12%

B

A saves £.6%

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One Feasible Swap: Swap Bank

$8%

$8%

£12%

Company A

£11%

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Company

£12%

B

A saves £.6%

reserved.

$9.4%

B saves $.6%

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One Feasible Swap: The swap bank makes money too.

Swap Bank

$8%

$8%

£12%

Company A

£11%

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Company

£12%

B

A saves £.6%

reserved.

$9.4%

B saves $.6%

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SWAPS





A swap can be viewed as a portfolio of spot and forward positions. In the above example, firm A would borrow in dollars and then swap for pounds with the bank and simultaneously enter into a series of forward contracts with the bank to exchange dollars for pounds.

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Forward Premium








It’s just the interest rate differential implied by forward premium or discount. For example, exhibit 4.4 shows the DM appreciating from S($/DM) = .5235 to F180($/DM) = .5307 The forward premium is given by:

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End Chapter Four

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