1. Copyright © 2012 by the McGraw-Hill Companies, Inc. All rights reserved. The Market for Foreign Exchange Chapter Five

2. Chapter Outline  Function and Structure of the FX Market –FX Market Participants –Correspondent Banking Relationships  The Spot Market –Spot Rate Quotations –The Bid-Ask Spread –Spot FX Trading –Cross Exchange Rate Quotations –Triangular Arbitrage –Spot Foreign Exchange Market Microstructure 5-2

3. Chapter Outline Continued  The Forward Market –Forward Rate Quotations –Long and Short Forward Positions –Forward Cross-Exchange Rates –Swap Transactions –Forward Premium  Exchange-Traded Currency Funds 5-3

4. FX Market Participants  The FX market is a two-tiered market: –Interbank market (wholesale) About 100-200 banks worldwide stand ready to make a market in foreign exchange. Nonbank dealers account for about 40% of the market. 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, FX brokers, and central banks. 5-4

5. Circadian Rhythms of the FX Market 5-5 Source: Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York, www.newyorkfed.org.

6. Correspondent Banking Relationships  Large commercial banks maintain demand deposit accounts with one another, which facilitates the efficient functioning of the FX market. 5-6

7. Correspondent Banking Relationships  Bank A is in London. Bank B is in New York.  The current exchange rate is £1.00 = $2.00.  A currency trader employed at Bank A buys £100m from a currency trader at Bank B for $200m settled using its correspondent relationship. Bank A London Bank B NYC $200£100 5-7

8. $600m£400m$1200m£100m $1,200m£400m $600m You can check your work: make sure that £1,300m = $1,200x(£1/$2) +£100 + £600 $200£100 Bank A buys £100m from Bank B for $200m Correspondent Banking Relationships AssetsLiabilities £ deposit at B£300m Other Assets£600m B’s Deposit$1,000m Other L&E£600m Total Assets£1,300mTotal L&E£1,300m AssetsLiabilities $ deposit at A$1000m Other Assets$800m A’s Deposit£300m Other L&E$800m Total Assets$2,200mTotal L&E$2,200m B’s Deposit£200m £ deposit at A£200mA’s Deposit$800m Bank A London Bank B NYC $ deposit at B$800m 5-8

9. Practice Problem  Bank X is in Milan. Bank Y is in London.  The current exchange rate is €1.10 = £1.00.  Show the correct balances in each account if a currency trader employed at Bank X buys £100,000,000 from a currency trader at Bank Y for €110,000,000. (The balance sheets are shown on the next slide.) 5-9

10. €110m£100m Check: £1,700m = €1,320m x +£100 + £400 £1.00 €1.10 Check: €2,020m = £400m x + € 770 + €810 € 1.10 £1.00 €770m £400m £100m €1,320m£100m€1,320m€770m£400m Bank X buys £100m from Y for €110m AssetsLiabilities £ deposit at Y£300m Other Assets£600m Y’s deposit€1,210m Other L&E£400m Total Assets£1,700mTotal L&E£1,700m AssetsLiabilities € deposit at X€1,210m Other Assets€590m X’s deposit£300m Other L&E €810m Total Assets€2,020mTotal L&E€2,020m Y’s deposit£200m £ deposit at X£200mX’s deposit€880m Bank X Milano Bank Y London € deposit at Y€880m Bank XBank Y €1.10 = £1.00 AssetsLiabilities £ deposit at Y£300m Other Assets£600m Y’s deposit Other L&E£400m Total Assets£1,700mTotal L&E£1,700m AssetsLiabilities € deposit at X€1,210m Other Assets€590m X’s deposit Other L&E€810m Total Assets€2,020mTotal L&E€2,020m Y’s deposit£200m £ deposit at X £200m X’s deposit Bank X Milano Bank Y London € deposit at Y€880m Bank XBank Y €1,210m£300m €880m Practice Problem 5-10

11. Correspondent Banking Relationships  International commercial banks communicate with one another using: –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 FX transactions. 5-11

12. Spot Rate Quotations  A direct quotation is: –The U.S. dollar equivalent. –E.g., “a Japanese Yen is worth about a penny.”  An indirect quotation is: –The price of a U.S. dollar in the foreign currency. –E.g., “you get 100 yen to the dollar.”  See Exhibit 5.4 in the textbook. 5-12

13. .5072 1 9717.1 = Spot Rate Quotations Currencies U.S.-dollar foreign-exchange rates in late New York trading. --------Friday------- Country/currencyin US$per US$ Euro area euro1.4744.6783 1-mos forward1.4747.6781 3-most forward1.4744.6782 6-mos forward1.4726.6791 British pound1.9717.5072 1-mos forward1.9700.5076 3-most forward1.9663.5086 6-mos forward1.9593.5104 The direct quote for the pound is: £1 = $1.9717 The indirect quote for the pound is: £.5072 = $1 Note that the direct quote is the reciprocal of the indirect quote: 5072. 1 9717.1  Currencies U.S.-dollar foreign-exchange rates in late New York trading. --------Friday------- Country/currencyin US$per US$Country/currencyin US$per US$ Canadian dollar.99841.0016Euro area euro1.4744.6783 1-mos forward.99861.00141-mos forward1.4747.6781 3-most forward.99881.00123-most forward1.4744.6782 6-mos forward.99791.00216-mos forward1.4726.6791 Japanese yen.009220108.46British pound1.9717.5072 1-mos forward.009250108.111-mos forward1.9700.5076 3-most forward.009306107.463-most forward1.9663.5086 6-mos forward.009378106.636-mos forward1.9593.5104 5-13

14. The Bid-Ask Spread  The bid price is the price a dealer is willing to pay you for something.  The ask price is the amount a dealer wants you to pay for something.  It doesn’t matter if we’re talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices. 5-14

15. The Bid-Ask Spread  A dealer could offer: –A bid price of $1.4739 per €. –An ask price of $1.4744 per €.  While there are a variety of ways to quote the above, the bid-ask spread represents the dealer’s expected profit. Percent Spread = × 100 Ask Price – Bid Price Ask Price 5-15 0.0339% = x 100 $1.4744 – $1.4739 $1.4744

16. The Bid-Ask Spread A dealer pricing pounds in terms of dollars would likely quote these prices as 12–17. Anyone trading $10m knows the “big figure.” USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 5-16

17. The Bid-Ask Spread USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 Notice that the reciprocal of the S($/£) bid is the S(£/$) ask. = £1.00 $1.9712 £.5073 $1.00 5-17

18. $10,000 × £1 $1.9720 = £5,071 Dealer will pay $1.9715 for 1 GBP; he is asking $1.9720. He will pay £.5071 for $1 and will charge £.5072 for $1 Currency Conversion with Bid-Ask Spreads  A speculator in New York wants to take a $10,000 position in the pound.  After his trade, what will be his position? 1.9715 – 20.5071 – 72 S($/£) S(£/$) Bid Ask 5-18

19. He sells €250,000 at the dealer’s bid price: €250,000 x $1.4739 €1.00 =$368,475 He sells £500,000 at the dealer’s ask price: £500,000 x $1.00 £.5076 =$985,027.58 $1,353,502.58 Sample Problem  A businessman has just completed transactions in Italy and England. He is now holding €250,000 and £500,000 and wants to convert to U.S. dollars.  His currency dealer provides this quotation: GBP/USD 0.5025 – 76 USD/EUR 1.4739 – 44  What are his proceeds from conversion?

20. ($985,027.58 + $100,000) x €1.00 $1.4744 = €735,911.27 £500,000 x $1.00 £.5076 $985,027.58 = Another Sample Problem  An Italian has just completed transactions in America and England. –He is now holding $100,000 and £500,000, and wants to convert both amounts to the euro.  His currency dealer provides this quotation: GBP/USD 0.5025 – 76 USD/EUR 1.4739 – 44  What are his proceeds from conversion? 5-20

21. Spot FX Trading  In the interbank market, the standard size trade is about U.S. $10 million.  A bank trading room is a noisy, active place.  The stakes are high.  The “long term” is about 10 minutes. 5-21

22. £0.75 €1.00 = $1.50£1.00 €1.00$2.00 × €1.00 = £0.75 Pay attention to your “currency algebra”! Cross Rates  Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and that S($/£) = 2.00 (i.e., £1.00 = $2.00).  What must the €/£ cross rate be? 5-22

23. £10,000 sell £ at bid $19,712 buy € at ask €13,371 Cross Rates with Bid-Ask Spreads To find the €/£ cross bid rate, consider a retail customer who: USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 Euros1.47381.4742.6783.6785 £10,000 × $1.9712 £1.00 €.6783 $1.00 × = €13,370.65 Starts with £10,000, sells £ for $, and buys €: He has effectively sold £ at a €/£ bid price of €1.3371/£. 5-23

24. £7,475$14,738 buy £ at ask sell € at bid €10,000 Cross Rates with Bid-Ask Spreads To find the €/£ cross ask rate, consider a retail customer who starts with €10,000, sells € for $, and buys £: €10,000 × $1.00 €.6785 £1.00 $1.9717 × = £7,474.97 He has effectively bought £ at a €/£ ask price of €1.3378/£. USD Bank Quotations American TermsEuropean Terms BidAskBidAsk Pounds1.97121.9717.5072.5073 Euros1.47381.4742.6783.6785 5-24

25. Cross Rates with Bid-Ask Spreads Bank Quotations American TermsEuropean Terms BidAskBidAsk £:$$1.9712$1.9717£.5072£.5073 €:$$1.4738$1.4742€.6783€.6785 £:€€1.3371€1.3378£0.7475£0.7479 direct indirect Recall that the reciprocal of the S(£/€) bid is the S(€/£) ask. = £.7479 €1.00€1.3371 £1.00 5-25

26. Triangular Arbitrage Bank QuotationsBidAsk Deutsche Bank £:$$1.9712$1.9717 Credit Lyonnais €:$$1.4738$1.4742 Credit Agricole £:€€1.3310€1.3317 “No Arbitrage” £:€€1.3371€1.3378 Suppose we observe these banks posting these exchange rates. As we have calculated the “no arbitrage” £/€ cross bid and ask rates, we can see that there is an arbitrage opportunity: £1 × $1.9712 £1.00 €1.00 $1.4742 × = €1.3371 5-26

27. Triangular Arbitrage Bank QuotationsBidAsk Deutsche Bank £:$$1.9712$1.9717 Credit Lyonnais €:$$1.4738$1.4742 Credit Agricole £:€€1.3310€1.3317 “No Arbitrage” £:€€1.3371€1.3378 By going through Deutsche Bank and Credit Lyonnais, we can sell pounds for €1.3371. The arbitrage is to buy the pounds from Credit Agricole for €1.3317. £1 × $1.9712 £1.00 €1.00 $1.4742 × = €1.3371 5-27

28. Triangular Arbitrage Bank QuotationsBidAsk Deutsche Bank £:$$1.9712$1.9717 Credit Lyonnais €:$$1.4738$1.4742 Credit Agricole £:€€1.3310€1.3317 Start with £1m. Sell £ to Deutsche Bank for $1,971,200: Buy € from Credit Lyonnais, receive €1,337,132: $1,971,200 × €1.00 $1.4742 = €1,337,132. Buy £ from Credit Agricole, receive £1,004,078.89. £10,000,000 × $1.9712 £1.00 = $1,971,200. 5-28

29. Spot Foreign Exchange Microstructure  Market microstructure refers to the mechanics of how a marketplace operates.  The bid-ask spreads in the spot FX market: –Increase with FX exchange rate volatility. –Decrease with dealer competition.  Private information is an important determinant of spot exchange rates. 5-29

30. The Forward Market  Forward Rate Quotations  Long and Short Forward Positions  Forward Cross Exchange Rates  Forward Premium  Swap Transactions 5-30

31. Forward Rate Quotations  The forward market for FX 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.  Longer-term swaps are available. 5-31

32. Forward Rate Quotations Consider the exchange rates shown to the right. For British pounds, the spot exchange rate is $1.9717 = £1.00 while the 180-day forward rate is $1.9593 = £1.00  What’s up with that? Country/currencyin US$per US$ UK pound1.9717.5072 1-mos forward1.9700.5076 3-most forward1.9663.5086 6-mos forward1.9593.5104 Clearly market participants expect that the pound will be worth less in dollars in six months. 5-32

33. Forward Rate Quotations  Consider the (dollar) holding period return of a dollar-based investor who buys £1 million at the spot exchange rate and sells them forward: $HPR = gain pain $1,959,300 – $1,971,700 $1,971,700 = –$12,400 $1,971,700 = $HPR = –0.00629 Annualized dollar HPR = –1.26% = –0.629% × 2 5-33

34. Forward Premium  The interest rate differential implied by forward premium or discount.  For example, suppose the € is appreciating from S($/€) = 1.55 to F 180 ($/€) = 1.60.  The 180-day forward premium is given by: = 0.0645, or 6.45% 1.60 – 1.55 1.55 × 2=f 180,€v$ F 180 ($/€) – S($/€) S($/€) =× 360 180 5-34

35. Long and Short Forward Positions  If you have agreed to sell anything (spot or forward), you are “short.”  If you have agreed to buy anything (forward or spot), you are “long.”  Sp, if you have agreed to sell an FX forward, you are short, and if you have agreed to buy an FX forward, you are long. 5-35

36. Payoff Profiles profit loss Spot exchange in 6 months $/£ Payoff from long position in £10,000 Country/currencyin US$per US$ UK pound1.9717.5072 1-mos forward1.9700.5076 3-most forward1.9663.5086 6-mos forward1.9593.5104 $1.9593/£ $2.10/£ $1,407 $1.90/£ −$593 Consider the payoffs at maturity to a long position in a six month forward contract on £10,000. 5-36

37. Forward Cross Rates Currencies U.S.-dollar foreign-exchange rates in late New York trading. --------Friday------- Country/currencyin US$per US$ Euro area euro1.4744.6783 1-mos forward1.4747.6781 3-mos forward1.4744.6782 6-mos forward1.4726.6791 UK pound1.9717.5072 1-mos forward1.9700.5076 3-mos forward1.9663.5086 6-mos forward1.9593.5104 The 3-month forward €/£ cross rate is: £0.7498 €1.00 = $1.4744£1.00 €1.00$1.9663 × 5-37

38. Currency Symbols  In addition to the familiar currency symbols (£, ¥, €, $) there are three-letter codes for all currencies. It is a long list, but selected codes include: CHFSwiss francs GBPBritish pound ZARSouth African rand CADCanadian dollar JPYJapanese yen 5-38

39. Swaps  A swap is an agreement to provide a counterparty with something he or she wants in exchange for something that you want. –Often on a recurring basis, e.g., every six months for five years.  Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.  Swaps are covered fully in Chapter 14. 5-39

40. Exchange-Traded Currency Funds  Individual shares are denominated in the U.S. dollar and trade on the New York Stock Exchange. –Consider an ETF where each share represents 100 euros. The price of one share at any point in time will reflect the spot dollar value of 100 euros plus accumulated interest minus expenses.  Six additional currency trusts exist on the Australian dollar, British pound sterling, Canadian dollar, Mexican peso, Swedish krona, and the Swiss franc.  Currency is now recognized as a distinct asset class, like stocks and bonds. Currency ETFs facilitate investing in these currencies. 5-40

41. Summary  Spot rate quotations –Direct and indirect quotes –Bid and ask prices  Cross Rates –Triangular arbitrage  Forward Rate Quotations –Forward premium (discount) –Forward points 5-41