FIN 437 Vicentiu Covrig 1 The Market for Foreign Exchange The Market for Foreign Exchange (chapter 4 Eun and Resnick))

FIN 437 Vicentiu Covrig 2 FOREX Market Participants FX market involves participants buying and selling currencies all over the world It includes trading currencies spot and forward; bank deposits of foreign currencies; foreign trade financing; trading in currency options, futures and swaps FOREX market is a global over-the-counter market Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks

FIN 437 Vicentiu Covrig 3 Size of the FX market Largest in the world (1995): $1.2 trillion daily Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily Trading systems: - Screen based dealing using a phone or an type system - EBS: Electronic Brokerage System

FIN 437 Vicentiu Covrig 4 The Bid-Ask Spread In general, banks do not charge commissions on foreign currency transactions. They profit from bid-ask spread The bid-ask spread is the difference between the bid and ask prices The bid price is the price a dealer is willing to pay you for something (our case foreign currency); always listed first The ask price is the amount the dealer wants you to pay for the thing (our case foreign currency); listed second

FIN 437 Vicentiu Covrig 5 The Bid-Ask Spread Interbank dealer quotes: - American terms: Euro, British Pound, Australian Dollar - European terms: all others Ex: You want to transact with a dealer that gives you the following quotations: $1.6625(bid) (ask)/£. The dealer buys (gets) one pound from you for $ The dealer sells (gives) one pound to you for $ The bid-ask spread is a function of liquidity of the market, the XR volatility as well as dealers’ inventory The retail bid-ask spread is wider than interbank spread

FIN 437 Vicentiu Covrig 6 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)

FIN 437 Vicentiu Covrig 7 The Spot Market The spot market involves immediate purchase or sale of foreign exchange Direct quotation from US perspective the U.S. dollar equivalent the price of one unit of the foreign currency in US Dollars Indirect Quotation from US perspective the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar” The direct quote is the reciprocal of the indirect quote

FIN 437 Vicentiu Covrig 8 Cross Rates The cross rate is the rate of exchange between two non-US currencies Suppose that S($/Euro) = 1.25 and that S(Yen/$) = 110 Yen What must the Yen/Euro cross rate be? Yen/Euro= (Yen/$)x($/Euro) = 110x1.25= Suppose that S($/Euro) = 1.25 and that S($/AUD) = 0.5 What must the AUD/Euro cross rate be?

FIN 437 Vicentiu Covrig 9 Triangular Arbitrage $ £ ¥ Credit Lyonnais S($/£)=1.50 Credit Agricole S(¥/£)=185 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

FIN 437 Vicentiu Covrig 10 Triangular Arbitrage Sell $150,000 for £ at S($/£) = 1.50 receive £100,000 Sell our £ 100,000 for ¥ at S(¥/£) = 185 receive ¥18,500,000 Sell ¥ 18,500,000 for $ at S(¥/$) = 120 receive $154,167 profit per round trip = $ 154,167- $150,000 = $4,167 When cross rates differ from one financial center to another, profit opportunities exist. Currency arbitrage involves buying a currency in one market while simultaneously selling it at a higher price in a second market The implied ¥/£ is 180. Credit Agricole has posted a quote of S(¥/£)=185 so there is an arbitrage opportunity. So, how can we make money here?

FIN 437 Vicentiu Covrig 11 Triangular Arbitrage: exam type problem The Singapore dollar spot rate is 1.7 SGD/$, the Swiss franc spot rate is 1.35 SF/$ and the market cross-rate is 1.15SGD/SF. Calculate the implied cross-rate (SGD/SF). Calculate the triangular arbitrage profit that is possible if you start with $1 million. Show all your calculations. Cross rate: SGD/SF = (1.7 SGD/$)/(1.35SF/$)= 1.26SGD/SF Arbitrage Direction: exchange (sell) SGD for SF Triangular arbitrage: Sell $1,000,000 for SGD at S(SGD/$) = 1.7 receive SGD 1,700,000 Sell our SGD 1,700,000 for SF at S(SGD/SF) = 1.15 receive SF1,478,261 Sell SF1,478,261 for $ at S(SF/$) = 1.35 receive $1,095,008 profit per round trip = $ 1,095,008- $1,000,000 = $95,008

FIN 437 Vicentiu Covrig 12 The following sections in chapter 4 are not required for the exam: - Spot Foreign Exchange Microstructure - Swap transactions - Forward Market

FIN 437 Vicentiu Covrig 13 Learning outcomes Know the structure of the FX market Know the difference between wholesale (interbank) market and retail market Who are the participants in the FX market? Know how to read/use spot and forward quotes; direct and indirect method Calculate currency cross-rates, without bid-ask quotes, when given two spot or forward FX quotations involving three currencies Calculate the profit/loss on a triangular arbitrage opportunity given three currency quotations, without bid-ask spread Recommended end-of-chapter questions: 2,3,4 Recommended end-of-chapter problems: 1, 8