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$/yen
Using indirect quotations:
Premium (or discount) = (Forward-Spot)/Spot *(360/n)*100
=(105.04-105.65)/105.65 *(360/90)*100
= -2.31%
Or using direct quotations:
Premium (or discount) =(Spot-Forward)/Forward *(360/n)*100
=(0.009465215-0.009520183)/0.009520183 * (360/90)*100
= -2.31%
Classroom problem:
Forward Premiums and DiscountsCalculate the percentage premium or discount.
Quoted / 180-day / Percent premium
Assumptions / Spot rate / Forward rate / or discount
Days forward / 180
European euro ($/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/£)/($0.9045/€)=€1.5968/£
Start with 1£ → buy € from Dresdner bank, receive 1.6200 € → buy back£ using cross rate €1.5968/£ will receive 1.0145 £ (1.6200 €/€1.5968/£) → get net profit 0.0145 £.
Classroom problem:
Riskless profit on the francCan you make a profit via triangular arbitrage?
Assumptions / Values
Beginning funds in Swiss francs (SF) / 10,000,000.00
Mt. Fuji Bank (yen/$) / 120.00
Mt. Rushmore Bank (SF/$) / 1.6000
Matterhorn Bank (yen/SF) / 80.00
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