The Market for Foreign Exchange A summary

Objective Getting acquainted with the environment in which currencies are traded world-wide

Outline Definitions The players The mechanisms The functions Types of quotations

Foreign exchange rate The price of one currency expressed in terms of another currency

Foreign exchange: Glossary of terms convertibility = exchanging paper money for gold fixed exchange rate system = a system in which governments maintain a fixed exchange rate for long periods of time floating exchange rate system = a system in which exchange rates are determined by the market devaluation = decrease in the price of a currency under a fixed exchange rate system revaluation = increase in the price of a currency under a fixed exchange rate system weakening (depreciation) = decrease in the price of a currency under a floating exchange rate system strengthening (appreciation) = increase in the price of a currency under a floating exchange rate system

Current Currency Arrangements Pegged to another currency to the US$: Argentina, Bahamas, Barbados, etc. Pegged to a basket of currencies to the SDR: Libya, Rwanda to other baskets: Algeria, Burundi, Morocco, etc. Managed float (dirty float)‏ China, Egypt, Indonesia, Israel, Tunisia, etc. Independently floating New Zealand, S. Africa, Australia, Canada, India, Japan, Switzerland, Russia, US

Change is relative s 0 = C$ 1.35/US$ s 1 = C$ 1.37/US$ The US$ appreciated by ( )/1.35 = 1.48 % against the C$ (the price of US$ in terms of C$ increased by 1.48%)‏ Conversely, the C$ depreciated by (1/s 1 -1/s 0 )/(1/s 0 ) = (s 0 - s 1 )/s 1 = % against the US$

Participants Central banks Commercial banks MNC Foreign exchange brokers Dealers Speculators (arbitrageurs)

Size of the Forex Over US $1,600 billion/day worldwide (late 1990s)‏ About $ 1.2 trillion (today)

Top foreign exchanges London New York Tokyo

Functions Transfer of purchasing power Minimizing foreign exchange risk

Clearing systems The Clearing House Interbank Payments System (CHIPS)‏ The Society for Worldwide Interbank Financial Telecommunications (SWIFT)‏ Continuing Link Settlement Services (CLSS)

Types of transactions Spot Forward

Spot transactions Immediate purchase or sale of foreign exchange Cash settlement is made two days after the transaction (one day for North American currencies).

Spot rates: Quotations Direct vs. Indirect and American vs. European

Spot rates: Direct quotation The price of foreign currency in terms of domestic currency If you are in Paris, the Swiss franc is at: s = € 1.51 If you are in Frankfurt, the Euro is at: s = Chf 0.66

Spot rates: Indirect quotation The price domestic currency in terms of foreign currency In Toronto, the US$ is at: s = US$ 0.65 In New York, the C$ is at: s = C$ 1.538

Spot rates: European terms For US$ only, the dollar is at: s = € 1.1 (indirect from US perspective)

Spot rates: American terms For US$ only, the Euro is at: s = US$ (direct from US perspective)

Bid-ask spread The form in which foreign exchange prices are quoted by dealers and market-makers. C$ It shows the price at which the dealer is willing to buy and sell foreign currency Big figure: it is assumed known by all traders C$ Small figure: the one that is referred to when quoting and negotiating:

How to convert a direct into an indirect quote In Montreal: C$ In Miami: US$

Cross-rates Some currency pairs are rarely traded Ex: A$ and Dkr Their exchange rate is determined through a widely traded third currency: s(1) = A$1.3806/US$ s(2)= Dkr6.468/US$ cross rate: A$0.2135/DKr or Dkr4.685/A$

Triangular Currency Arbitrage Taking advantage of exchange rate "inconsistencies" Quoted exchange rates: Frankfurt: s = € 1.1/US$ London: s = € 1.5/£ New-York: s = US$ 1.7/£ The cross rate between the US$ and the British pound is USD 1.37 or £ 0.73

The arbitrage (1)‏ Start in Frankfurt with $1 Buy 1.1 Euros in Frankfurt With 1.1 Euros buy £ 0.73 in London With £ 0.73 buy US$1.24 in New York

The arbitrage (2)‏ Start in London with E1 Buy £0.667 in London With £0.667 buy US$1.13 in NY With US$1.13 buy E1.24 in Frankfurt

The arbitrage (3)‏ ETC.

Shortcut to assessing a triangular arbitrage opportunity (1.1) € /US$ x (0.667) £ / € x (1.7)US$/ £ = 1.24 Since 1.24 > 1, there is an arbitrage opportunity.

Arbitrage: Question What if instead of making money you are loosing money? Maybe transactions costs more than offset any gains or Maybe you’re going the wrong way….

Transaction costs Bid-ask spread Commissions and fees

Forward exchange rates Forward contract A contract between a bank and a customer calling for the delivery of a foreign currency at a fixed future date and at an agreed-upon rate.

Quotation of forward rates Explicit Forward point quotation

Explicit quotation

Forward point quotation Points are added to or subtracted from the last two digits of the spot bid-ask quotation

Forward contract: What for? Hedging Reducing the foreign exchange risk of doing business Speculating Betting on foreign exchange fluctuations in the hope of making a profit

Hedging using forward contracts Assume Corel sells US$25 m worth of WordPerfect to Stack-Rack, a Roanoke Va. based company. Shipment of the software and payment will take place in one month. Corel has two options: It can wait until payment date, receive US$ 25 m from Stack-Rack, and buy C$ in the spot market (go unhedged)‏ It can lock in a forward rate of C$1.5465, and receive C$38.66 m, regardless of the spot rate one month from now (hedge)‏

Speculating using forward contracts Assume an American trader buys C$10 m three-month forward in the hope that the US$ will weaken against the C$. In three months, the spot rate turns to be: s = C$ Our trader delivers on the C$10 m forward contract and immediately sells the C$10 m on the spot US$profit = 10 m / m /