The Foreign Exchange Market

The Foreign Exchange Market

The Foreign Exchange Market provides:

The physical and institutional structure through which the money of one country is exchanged for that of another country

The determination rate of exchange between currencies

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 date.

Functions of the ForeignExchange Market

The foreign exchange Market is the mechanism by which participants:

Transfer purchasing power between countries

Obtain or provide credit for international trade transactions

Minimize exposure to the risks of exchange rate changes

Market Participants

The foreign exchange market consists of two tiers:

The interbank or wholesale market

The client or retail market

Five categories of participants:

Bank and nonbank foreign exchange dealers

Individuals and firms

Speculators and arbitragers

Central banks and treasuries

Foreign exchange brokers

Types of Transactions

Spot transaction:

The purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day

Forward transaction:

To require delivery at a future date of a specified amount of one currency for a specified amount of another currency

The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity

Swap transaction:

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 counterparty

Foreign Exchange Rates and Quotations

A foreign exchange rate is the price of one currency expressed in terms of another currency

A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate

Foreign exchange rates (or quotations)can be displayed:

The foreign currency price of one dollar

The dollar price of a unit of foreign currency

For example, the exchange rate between US dollars and the Swiss franc is stated:

SF 1.6000/$ (European terms)

or

$0.6250/SF (American terms)

Foreign exchange quotes are at times described as either direct or indirect:

A direct quote is a home currency price of a unit of foreign currency

An indirect quote is a foreign currency price of a unit of home currency

Using above example, in the United States

SF 1.6000/$ (?)

and

$0.6250/SF (?)

When the home currency is SF then…..

Foreign exchange quotations are given as a bid and ask (also referred to as offer):

A bid is the price (i.e. exchange rate) in one currency at which a dealer will buy another currency.

An ask is the price (i.e. exchange rate) at which a dealer will sell the other currency.

Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices.

A bid for one currency is also the offer for the opposite currency.

For example, assume a bank makes the quotations for the Japanese yen as follow:

Bid Ask

118.27 yen/$ 118.37yen/$

If you want to buy $for yen from the bank then ....

If you want to sell $ for yen to the bank then ....

If you want to buy yen for $ from the bank then ....

If you want to sell yen for $ to the bank then ....

A forward quotation is usually expressed in points:

It is the difference between the forward rate and the spot rate

Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate.

For quotations expressed in direct quotations:

(Spot – Forward)/Forward *(360/n)*100

or

For quotations expressed in indirect quotations:

(Forward – Spot)/Spot *(360/n)*100

Example:

Foreign currency/home currency Home currency/foreign currency

Spot rate 105.65yen/$ 0.009465215$/yen

3-month forward 105.04yen/$ 0.009520183$/yen

Using indirect quotations:

Premium (or discount) = (Forward-Spot)/Spot *(360/n)*100

=(105.04-105.65)/105.65 *(360/90)*100

= -2.31%

Or using direct quotations:

Premium (or discount) =(Spot-Forward)/Forward *(360/n)*100

=(0.009465215-0.009520183)/0.009520183 * (360/90)*100

= -2.31%

Classroom problem:

Forward Premiums and Discounts
Calculate the percentage premium or discount.
Quoted / 180-day / Percent premium
Assumptions / Spot rate / Forward rate / or discount
Days forward / 180
European euro ($/euro) / 0.8000 / 0.8160
British pound ($/pound) / 1.5620 / 1.5300
Japanese yen (yen/$) / 120.00 / 118.00
Swiss franc (SF/$) / 1.6000 / 1.6200
Hong Kong dollar (HK$/$) / 8.0000 / 7.8000

Cross Rates and Intermarket Arbitrage

Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate)

Example:

Quote

yen/$: 121.13yen/$

peso/$: 9.19Ps/$

peso/yen NA

peso/yen = (peso/$)/(yen/$)=(9.19Ps/$)/(121.13yen/$)=0.0759Ps/yen

or

yen/peso = (yen/$)/(peso/$)=(121.13yen/$)/(9.19Ps/$)=13.1806yen/Ps

Intermarket arbitrage (triangular arbitrage)

Example

Citibank quote - $/€$0.9045/€

Barclays quote - $/£ $1.4443/£

Dresdner quote - €/£€1.6200/£

Cross rate calculation: ($1.4443/£)/($0.9045/€)=€1.5968/£

Start with 1£ → buy € from Dresdner bank, receive 1.6200 € → buy back£ using cross rate €1.5968/£ will receive 1.0145 £ (1.6200 €/€1.5968/£) → get net profit 0.0145 £.

Classroom problem:

Riskless profit on the franc
Can you make a profit via triangular arbitrage?
Assumptions / Values
Beginning funds in Swiss francs (SF) / 10,000,000.00
Mt. Fuji Bank (yen/$) / 120.00
Mt. Rushmore Bank (SF/$) / 1.6000
Matterhorn Bank (yen/SF) / 80.00

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