0. The Foreign Exchange Market (Part I)

1. Overview of the Lecture
Description of the foreign exchange market
Rates and quotations
Currency arbitrage
© 2002 by Stefano Mazzotta

2. 1. Description of the Foreign Exchange Market

3. What is the foreign exchange market?
It is a set of banks, brokerage firms, and dealers that brings buyers and sellers of foreign exchange together.
It is a system which allows institutions and individuals
to transfer purchasing power from one currency to another,
to engage in international transactions,
to manage their exchange rate risk exposure.
© 2002 by Stefano Mazzotta

4. Major markets
United Kingdom, United States, Japan, Germany, Switzerland, Singapore, Honk Kong, France...
All the time-zones are covered, from Tokyo to San Francisco, through London and New York.
© 2002 by Stefano Mazzotta

5. Size of the market Average Daily volume in is about $1,500,000,000,000
Compare:
NYSE - $30,000,000,000
NASDAQ - $23,000,000,000
TSE - $1,400,000,000
Canada’s GDP - $605,000,000,000
© 2002 by Stefano Mazzotta

6. Major participants Large commercial banks Foreign exchange brokers
continuously making the market,
receive compensation by making the “bid-ask” spread.
Foreign exchange brokers
facilitate trading between dealers,
keep list of suppliers and demanders of different currencies.
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7. Other participants Central banks Commercial entities
conduct intervention.
Commercial entities
regular but not continuous participants of the market.
Speculators and arbitrageurs
trade to profit from the market itself.
© 2002 by Stefano Mazzotta

8. Interbank market
A highly liquid interbank market is formed by an informal arrangement of large commercial banks and foreign exchange brokers.
Day-to-day exchange rate day movements is mainly the result of the activity of interbank trades.
© 2002 by Stefano Mazzotta

9. Interbank market transactions
Spot transaction
requires almost immediate delivery of foreign exchange.
Forward transaction
requires delivery of foreign exchange at some future date.
Currency Swap transaction
is the simultaneous purchase and sale of a foreign currency .
© 2002 by Stefano Mazzotta

10. Efficiency The foreign exchange market is very efficient due to
its 24-hour trading schedule
extensive telecommunication network
shear size of the market
computerized quotation system
© 2002 by Stefano Mazzotta

11. 2. Rates and Quotations

12. Price quotes The prices are quoted in pairs:
Bid - price at which the bank buys the currency
Ask - price at which the bank sells the currency
The spread, i.e. | bid – ask |, is the profit of the bank (dealer)
Home country based quotes:
direct quote - a home currency price of a foreign currency, e. g., EUR/USD in France
indirect quote - a foreign currency price of home currency, e. g., USD/EUR in France
© 2002 by Stefano Mazzotta

13. Example The pound sterling is quoted at $1.6618-35.
(This notation is a shorthand for USD/GBP)
What is the “bid-ask” spread?
= $0.0017
What is the spread in percentage points?
© 2002 by Stefano Mazzotta

14. Example
The pound sterling is quoted in New York at $ This is a direct quote.
What is the indirect quote?
Therefore, the indirect quote is:
What is the direct quote of a dollar in London?
© 2002 by Stefano Mazzotta

15. Bid and ask quotes relation
Suppose, there are 2 currencies: A and B.
Then:
And:
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16. Example The bank quote for is 1.6050-72 SF/$
What is the SF/$ exchange rate for a customer who wants to exchange $ for SF?
What is the $/SF exchange rate for a customer who wants to exchange SF for $?
© 2002 by Stefano Mazzotta

17. The U.S. dollar based quotations
If currencies are quoted against USD, they can be quoted in
American terms: $ per unit of foreign currency
European terms: units of foreign currency per 1$
Nowadays, almost all except U.K. and Euro exchange rates are expressed in European terms.
© 2002 by Stefano Mazzotta

18. Example EXCHANGE RATES Tuesday, February 6, 1990
The New York foreign exchange selling rates below apply to trading among banks in amounts of $1 million and more, as quoted at 3 p.m. Eastern time by Bankers Trust Co. Retail transactions provide fewer units of foreign currency per dollar.
Currency
U.S. $ equiv. per U.S. $
Country Tues. Mon. Tues. Mon.
Britain (Pound)
Canada (Dollar)
France (Franc)
Source: The Wall Street Journal
© 2002 by Stefano Mazzotta

19. Cross rates Definition: Reason: Result:
Exchange rate between two foreign currencies.
Reason:
Most currencies are quoted against the U.S. $ and not against each other.
Result:
The U.S. $ rate can be used to compute a cross rate.
© 2002 by Stefano Mazzotta

20. Example of cross rate quotation
See
See also
© 2002 by Stefano Mazzotta

21. Cross Rates 23 Dec 2002 USD GBP CHF JPY CAD AUD EUR NZD DKK SEK 8.8943
14.18
6.2715
7.3879
5.7331
4.9990
9.1318
4.5917
1.2295
7.2342
11.53
5.1010
6.0090
4.6630
4.0660
7.4274
3.7347
0.8134
1.9371
3.0879
1.3659
1.6090
1.2486
1.0887
1.9888
0.2678
0.2178
0.9740
1.5526
0.6868
0.8090
0.6278
0.5474
0.5028
0.1346
0.1095
1.7792
2.8362
1.2546
1.4779
1.1468
1.8267
0.9185
0.2459
0.2000
1.5514
2.4731
1.0939
1.2887
0.8720
1.5928
0.8009
0.2145
0.1744
120.39
191.91
84.89
77.60
67.67
123.60
62.15
16.64
13.54
1.4182
2.2608
1.1780
0.9141
0.7971
1.4561
0.7322
0.1960
0.1595
0.6273
0.4423
0.5211
0.4044
0.3526
0.6441
0.3239
0.0867
0.0705
1.5941
0.7051
0.8306
0.6446
0.5621
1.0267
0.5163
0.1382
0.1124
© 2002 by Stefano Mazzotta

22. Example Let e(USD/EUR) = 0.97 Let e(USD/CAD) = 0.63
What is the EUR/CAD cross-rate?
So, 1 Canadian dollar can buy 0.65 euros.
© 2002 by Stefano Mazzotta

23. The general rule for cross rates
Suppose, there are 3 currencies: A, B, and C.
Suppose, the spot exchange rates e(A/B) and e(B/C) are known.
What is the cross exchange rate e(A/C)?
© 2002 by Stefano Mazzotta

24. Cross rates and bid-ask spreads
With bid-ask spreads, the general rule to compute cross rates is:
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25. Example: Question The spot quote for CHF/USD is 1.5150-72
The spot quote for CAD/USD is
What is the direct spot quote for CHF/CAD?
© 2002 by Stefano Mazzotta

26. Example: Solution (part I)
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27. Example: Solution (part II)
So, the direct spot CHF/CAD quote is
© 2002 by Stefano Mazzotta

28. 3. Currency Arbitrage

29. Currency arbitrage Definition: Cause:
Realization of a riskless profit by simultaneous buying a currency in one market and selling it in another market.
Cause:
Exchange rate quote inconsistencies across different money centers.
© 2002 by Stefano Mazzotta

30. Example Bank of America’s quote of $1C is $0.7056-76.
Royal Bank’s quote of $1C is $
How to make easy money?
Buy $C from Royal Bank by paying $ and sell $C to BoA receiving $.
Make about $ per $ or $40 per $100,000.
© 2002 by Stefano Mazzotta

31. Arbitrage exclusion condition
In the absence of taxes, etc., the arbitrage exclusion condition is to have overlapping bid-ask quotes.
Bid1
Ask1
Bid2
Ask2
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32. Triangular arbitrage The essence: 1 unit of currency A buys currency B
Currency B buys currency C
Currency C buys more than 1 unit of currency A
A A B C
© 2002 by Stefano Mazzotta

33. Example: part 1 - the set up
The GBP is bid at in New York:
e(USD/GBP) =
Swiss franc is offered at $ in Zurich:
e(USD/CHF) =
London offers pounds sterling at CHF :
e(CHF/GBP) =
Amount of money: $1,000,000
© 2002 by Stefano Mazzotta

34. Example: part 2 - the strategy
Sell $1,000,000 in Zurich at e(USD/CHF) and receive CHF 1,599,
Sell these Swiss francs in London at e(CHF/GBP) and receive GBP505,
Sell the pounds sterling in New York at e(USD/GBP) and receive $1,001,
Net profit: $1,242.64
© 2002 by Stefano Mazzotta

35. Example: part 3 - market adjustment mechanism
Large number of arbitrage transactions will cause:
Swiss franc to appreciate with respect to U.S. dollar in Zurich
Swiss franc to depreciate against the pound sterling in London
Sterling will fall in New York
Markets adjust quickly and eliminate arbitrage opportunities
© 2002 by Stefano Mazzotta

36. Triangular arbitrage condition
For triangular arbitrage to exist, the following must hold:
Or, equivalently:
© 2002 by Stefano Mazzotta

37. Exercise
To familiarize yourself with the currency spot market sign up to:
Take a position of your choice in ONE currency. Individually.
Take note of anything that you find interesting, related or unrelated to what we discussed
In one week we will have a class discussion of your findings
© 2002 by Stefano Mazzotta