1. Foreign Exchange Market(FEM) FF MENU

2. The Functions of FEM 1.Transfer of Purchasing Power. 2.International Credit such as L.C. 3.Minimize Exposure to Foreign Exchange Risk 4Market for Hedging & Arbitrageur 5Market for currency Swaps, futures & forward/Spot Transactions 1.Transfer of Purchasing Power. 2.International Credit such as L.C. 3.Minimize Exposure to Foreign Exchange Risk 4Market for Hedging & Arbitrageur 5Market for currency Swaps, futures & forward/Spot Transactions MENU

3. Participants in FEM 1. Banks & Non-banks 2. FEM Dealers- benefited from bid-ask spread 3. Market Makers-Position on certain Currencies 4. FEM Brokers (56%) 5. Exporter, Importer, Tourists MNCs, Portfolio Managers 6. Speculators & Arbitrageur 7. Central Banks MENU

4. Types of FEM Transactions u Spot Transactions: one day settlement (63% of market) u Forward Transactions: one, two, six & 12 month (6%) u Swaps Transactions: Simultaneous purchase or sale of FE, with two value dates: spot-forward, forward-forward Spot Transactions Forward Transactions Swaps Transactions Example: sell £20 mil forward for $ deliver in two months at $1.4870/£ & simultaneously buy back £20 mil forward for delivery in three month at $1.4820/£. MENU

5. Types of Quotations n Direct Quotation : n Home currency in terms of foreign currency. n $/ff=$.1265/ff: American Way Indirect Quotation: Indirect Quotation: n Foreign currency in terms of home currency n ff/$=ff7.9045/$. n Bid & ask spread: n buy(bid) at ff7.9030/$ & ask(offer) at ff7.9070/$ n Difference between bid-ask is dealer premium=transaction cost premium=transaction cost n Cross Rates: n Dutch Guilder/$ over Danish Koran DF3.0245/DK9.7215=DG.3111/Korana DF3.0245/DK9.7215=DG.3111/Korana n Point Quotation: n Difference between forward rate & spot rate (swap rate). MENU

6. TRIANGULAR ARBITRAGEUR U.S $ UK £ DM U.S $ UK £ DM $ 1 S($/£)=1.8930 S($/DM)=0.453 £ S(£/$)=0.526 1 0.239 £ S(£/$)=0.526 1 0.239 DM 2.205 4.190 1 If S(DM/$)*S(£/DM)*S($/£) is greater than one, successful arbitrageur. (2.205*0.239*1.893)=$0.9979, not successful arbitrageur Buying & selling of one currency for another & returning to the original one. MENU

7. The Interest Rate Parity Theory The Interest Rate Parity Theory  DEF: Except for transaction costs, the differences in national interest rate, for security of similar risk & maturity should be equal but opposite in sign, to forward exchange rate discount or premium for foreign currency.  It links National Monetary Market Rate to Foreign Exchange Rate.  Forward Exchange Rate Discount & Premium:  (Forward Rate-Spot Rate)/(Spot Rate)*12/n*100  (Spot Rate-Forward Rate)/(Forward Rate)*12/n*100  DM2.5885-2.5639/2.5639*12/3*100=+3.8379 per year:  It means DM is in 3.8379%, 3-month forward premium or the U.S. $ is in 3.8379%, 3-month forward discount. MENU

8. nTest for Parity –UK 3-Month Interest Rate=12% per year –U.S. 3-month Interest Rate=7% per year –Transaction Cost=.15% should be calculated at the beginning of transaction –Size of Transaction=$2,800,000.00 nCovered Interest Arbitrageur actions: –Step 1. Borrow $2.8mil at 7%/year for 3-month –Step 2. Exchange $2.8 mil for £ at spot rate of $1.4000/£ & receive £2mil. –Step 3. Invest £2mil for 3-month in UK at 12%/year or 3%/Quarter. –Step 4. Sell £2.06mil forward at 3-month forward rate of $1.3860/£: which include £2mil principal & £60,000 interest for the 3-month (3%*2mil=£60mil –Step 5. Pay transaction cost of $4,200 ($2.8*.15) The operation of Covered Interest Arbitrageur MENU

9. nCovered Interest Arbitrageur actions-con..: –Step 6. Three month after, redeem UK investment of £2,06mil –Step 7. Fulfill forward contract by selling £2060mil at $1.3860/£ forward rate & receive $2.855160. –Step 8. Repay loan of $2.8mil plus 3-month interest at 1.75%/Quarter ($2.8*1.75%=$49000). Profit Calculation: Profit Calculation: –Proceed from investment in UK=$2,855,160. –Principal+interest from borrowing=$2,849,000 –Transaction cost=$4200 –Net profit=$2,855160-2,849000-4200=$1,960.00 The operation of Covered Interest Arbitrageur-Con... MENU

10. Speculation in FEM u Spot Market Speculation: Spot rate:DG2.9000/$,Forward Rate=DG2.8000/$ Spot rate:DG2.9000/$,Forward Rate=DG2.8000/$ 6-month expected spot rate=DG2.700/$ 6-month expected spot rate=DG2.700/$ With $40,000, buy:$40,000*DG2.9=DG116000 With $40,000, buy:$40,000*DG2.9=DG116000 Sell at DG2.7/$ for $42965 (116000/2.7) Sell at DG2.7/$ for $42965 (116000/2.7) Make profit of 2965 or14.82%/Year Make profit of 2965 or14.82%/Year  Forward Market Speculation  B uy $40,000*DG2.8=DG112000  B uy back $ at DG2.7=$41,481  Profit=$1,481 MENU

11. Factors to be considered in forecasting the ER 1. Expected changes in spot rate, 2.Inflation rate differential, 3.Interest rate differential, 4.BOP problems, 5. Growth of Money supply 6. Business Cycle, 7. Change in International Monetary Reserve, 8. Increase in official-nonofficial rate spread 9. FE policies such as, FE. control, ceilings on interest rate, high import duties, export subsidies, excess G-Spending, 10. Elasticity of demand for exchange rate, Forward rate discount or premium 1. Expected changes in spot rate, 2.Inflation rate differential, 3.Interest rate differential, 4.BOP problems, 5. Growth of Money supply 6. Business Cycle, 7. Change in International Monetary Reserve, 8. Increase in official-nonofficial rate spread 9. FE policies such as, FE. control, ceilings on interest rate, high import duties, export subsidies, excess G-Spending, 10. Elasticity of demand for exchange rate, Forward rate discount or premium MENU

12. Foreign Change Market Cont.. n Purchasing power Parity (PPP)Theory : n Def: If the spot rate between two countries starts in equilibrium, any change in the difference of rate of inflation between them tends to be offset over the long run by equal, but opposite change in spot exchange rate. n If inflation rate in China increases by 4%, Chin's Ys deprecate by 4% n Current Account Balances are very sensitive to change in inflation Rate n International Fisher Effect (Fisher Open): n Difference in interest rate between two countries is equal, but opposite in sign to the spot exchange rate of foreign currency to home currency n Fisher Effect (Irving Fisher): n Differences in inflation rate between countries is equal to the interest rate differential between them. MENU

13. Foreign Change Market Cont.. n Foreign Currency Option (FCO) : n Def: FCO is a contract that gives buyers the right to buy or sell a given amount of foreign exchange at a fixed price (exercise price or strike price) per unit for a specific period of time.. n Types of FCO: American Option: Right to exercise on any day before the expiration date, European Option: only on the expiration date. n In-the Money Option: When you make profit, At-the-money option: when profit is zero, and Out of-the money option: when you have a loss n FCP is a flexible transaction of over 1 mil in major trading currencies for any time period up to one year, tailored to the customer's need. n This is a good alternative to the forward market. n FCP Premium: A percentage of transaction: n paid advance & according to following factors : 1. Strike price relative to spot rate : 2. Supply & demand for option : 3. Relative interest rate between countries : 4. Relative currency risk, and : 5. Maturity of the option. MENU

14. Foreign Exchange Market Cont.. n Maturity dates & size of FCO: n Saturday proceeding the third Wednesday of expiration Month March, June, September, and December. n Contract size: Cited as fixed contract per unit, such as DM62,500/per unit of option: with one mil$ one can buy:$ one mil/¨DM62,500=16 FCP contract n Price of FCP: No of cents per unit: £12,500*.02=$250. n An Exercise on FCP: n March $1.45 call option payees $.02 per £ ( purchase £12,500 at $1.45 option with expiration date of March. : If price of £ increase to $1.5100, buy £ at £1.4500 & sell £ 1.5000 & make $1.5100-1.4500=.06 per £ or 12500*.06=$750. : Subtract transaction cost of 250, & make a net profit of $750-250=$500. n Currency Future Market (CFM): : Def of CFM: CF are contract between the future dealers & client. : It does not involve commercial banks & traders : Difference between CFM & Forward Exchange Market, as inflation, contract is drawn up between banks & client; : Major Participants in CFM are: Importer & Exporter, Speculators & Arbitrageur, and those who invest abroad. MENU

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