2. 1 Chapter Five The Market for Foreign Exchange Chapter Objectives: Chapter Objectives: This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention. This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention.

3. 2 2 Chapter Outline Function and Structure of the FOREX Market Function and Structure of the FOREX Market The Spot Market The Spot Market The Forward Market The Forward Market

4. 3 The Function and Structure of the FOREX Market FOREX Market Participants FOREX Market Participants Correspondent Banking Relationships Correspondent Banking Relationships

5. 4 10-4 FOREX Market FOREX Market Forex market is the largest and most active financial market in the world. Forex market is the largest and most active financial market in the world. On an average day in 2004, $1.88 trillion in foreign currency was traded in a market that operates 24 hours a day (P110) On an average day in 2004, $1.88 trillion in foreign currency was traded in a market that operates 24 hours a day (P110) The U.S. dollar is one side of roughly 90% of these currency transactions. The U.S. dollar is one side of roughly 90% of these currency transactions. London is the world’s largest foreign exchange trading center. London is the world’s largest foreign exchange trading center.

6. 5 FOREX Market Participants The FOREX market is a two-tiered market: The FOREX market is a two-tiered market: –Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in Foreign exchange. About 700 banks worldwide stand ready to make a market in Foreign exchange. Nonbank dealers account for about 20% of the market. 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. 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. Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

7. 6 Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. 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: 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.

8. 7 The Spot Market Spot Rate Quotations Spot Rate Quotations The Bid-Ask Spread The Bid-Ask Spread Spot FX trading Spot FX trading Cross Rates Quotations Cross Rates Quotations Triangular Arbitrage Triangular Arbitrage Spot Foreign Exchange Market Microstructure Spot Foreign Exchange Market Microstructure

9. 8 Spot Rate Quotations Direct quotation Direct quotation –the price of foreign currency in the domestic currency –e.g. “ a dollar is worth about 6.2 RMB ” Indirect Quotation Indirect Quotation –the price of domestic currency in the foreign currency –e.g. “ you get16.1 dollar yen to 100 RMB ”.

10. 9 Spot Rate Quotations The direct quote for British pound is: £1 = $1.688

11. 10 Spot Rate Quotations The indirect quote for British pound is: £.5924 = $1

12. 11 Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote:

13. 12 10-12 Exchange Rates Depreciation A decline in the value of one currency relative to another is called depreciation. A decline in the value of one currency relative to another is called depreciation.Appreciation The rise in the value of one currency relative to another is called an appreciation. The rise in the value of one currency relative to another is called an appreciation. Note: When one currency goes up in value relative to another, the other currency must go down.

14. 13 The Bid-Ask Spread The bid price is the price a dealer is willing to pay you for something. 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 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. The bid-ask spread is the difference between the bid and ask prices. E.g. $/ ￡ =1.9072/77 (small figure) E.g. $/ ￡ =1.9072/77 (small figure) Bid-Ask spreads in the spot FX market: Bid-Ask spreads in the spot FX market: –increase with FX exchange rate volatility and –decrease with dealer competition.

15. 14 Spot FX trading Forex purchase and sale take place nearly immediately. Forex purchase and sale take place nearly immediately. In the interbank market, the standard size trade is about U.S. $10 million. In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. A bank trading room is a noisy, active place. The stakes are high. The stakes are high. The “ long term ” is about 10 minutes. The “ long term ” is about 10 minutes.

16. 15 Cross Exchange Rates Suppose that S($/DM) =.50 Suppose that S($/DM) =.50 – i.e. $1 = 2 DM and that S( ¥ /DM) = 50 and that S( ¥ /DM) = 50 – i.e. DM1 = ¥ 50 What must the $/ ¥ cross rate be? What must the $/ ¥ cross rate be?

17. 16 Cross Exchange Rates Most interbank trading goes through the dollar. A nondollar trade is referred to a currency against currency trade. Most interbank trading goes through the dollar. A nondollar trade is referred to a currency against currency trade. A cross exchange rate is an exchange rate between a currency pair where neither currency is U.S. dollar. A cross exchange rate is an exchange rate between a currency pair where neither currency is U.S. dollar. nondollar trade must satisfy the bid-ask spread determined from the cross-rate formula, or a triangular arbitrage opportunity exists. nondollar trade must satisfy the bid-ask spread determined from the cross-rate formula, or a triangular arbitrage opportunity exists.

18. 17 Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

19. 18 Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money?

20. 19 Triangular Arbitrage $ £ ¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.

21. 20 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

22. 21 The Forward Market Forward Rate Quotations Forward Rate Quotations Forward Premium/discount Forward Premium/discount Long and Short Forward Positions Long and Short Forward Positions

23. 22 The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. 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. If you have ever had to order an out-of- stock textbook, then you have entered into a forward contract.

24. 23 Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. 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. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

25. 24 Forward Rate Quotations- outright forward rate Consider the example from above: 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? What ’ s up with that? –The market participants expect that the yen will be worth MORE in dollars in six months.

26. 25 Forward Premium/discount The forward premium The forward premium The forward discount The forward discount At par At par

27. 26 forward points Quotations-a shorthand method forward points Quotations-a shorthand method S($/ ￡ )= 1.9072-1.9077 S($/ ￡ )= 1.9072-1.9077 –One-month 32-30 –Three-month 57-54 –Six-month 145-138 Outright forward bid-ask rate is: Outright forward bid-ask rate is: –F 30 ($/ ￡ )=1.9072-0.0032/1.9077-0.0030=1.1.9040/1.9047 –F 60 ($/ ￡ )=1.9015/23 –F 180 ($/ ￡ )=1.8927/39 The bid-ask spread increases in time to maturity. The bid-ask spread increases in time to maturity.

28. 27 Long and Short Forward Positions If you have agreed to sell forex forward, you are short. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long. If you have agreed to buy forex forward, you are long.

29. 28 FOREX market covers a broad range of topics. FOREX market covers a broad range of topics. We have discuss the spot and forward market for FOREX in this chapter We have discuss the spot and forward market for FOREX in this chapter In chapter 7, we examine currency futures and option contracts; in chapter 14, currency swaps are discussed. In chapter 7, we examine currency futures and option contracts; in chapter 14, currency swaps are discussed.