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The Market for Foreign Exchange

The Market for Foreign Exchange. Chapter 4. Chapter Four Outline. The structure and function of foreign exchange markets; Understanding the spot market (transaction now to trade currencies now) Quotations: direct versus indirect Trading Arbitrage opportunities.

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The Market for Foreign Exchange

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  1. The Market for Foreign Exchange Chapter 4

  2. Chapter Four Outline • The structure and function of foreign exchange markets; • Understanding the spot market (transaction now to trade currencies now) • Quotations: direct versus indirect • Trading • Arbitrage opportunities. • Forward market (transaction now to trade currencies later)

  3. 4.1 The FOREX (also FX) Market

  4. 4.2 Spot Rate Quotations: Perspective of a US investor • Direct quotation: $/JY; / means per • the U.S. dollar equivalent • e.g. “a Japanese Yen is worth about a penny” • Indirect quotation: JY/$ • the price of a U.S. dollar in the foreign currency • e.g. “you get 100 yen to the dollar”

  5. Spot Rate Quotations: US investor’s perspective The direct quote for British pound is: £1=$1.5627

  6. Spot Rate Quotations The indirect quote for British pound is: £.6399 = $1

  7. Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote:

  8. The Bid-Ask Spread • You versus the dealer (or bank). • The bid price is the price a dealer is willing to pay you for something. You receive this lower price. • The ask price is the amount the dealer wants you to pay for the thing. You pay this higher price. • E.g. Bid = RMB 6.10/$; Ask = RMB 6.30/$ • The bid-ask spread is the difference between the bid and ask prices.

  9. 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.

  10. Cross Rates

  11. Cross Rates3 currencies, 2 exchange rates: what is the 3rd exchange rate? • Suppose that S($/€) = .50 • i.e. $1 = 2 € • and that S(¥/$) = 100 • i.e. ¥1 = $0.01 • What must the ¥/ € cross rate be?

  12. Triangular Arbitrage Suppose we observe these banks posting these exchange rates. $ Barclays S($/£)=1.9589 Credit Lyonnais S(€/$)=0.7720 £ BNP Paribas S(€/£)=1.5100 € First calculate the implied cross rates to see if an arbitrage exists.

  13. Triangular Arbitrage The implied S(€/£) cross rate is S(€/£) = 1.5123 $ Barclays S($/£)=1.9589 Credit Lyonnais S(€/$)=0.7720 Paribas has posted a quote of Sa(€/£)=1.5100 so there is an arbitrage opportunity. £ BNP Paribas S(€/£)=1.5100 € So, how can we make money? Buy the £ @ €1.5100; sell @ €1.5123

  14. Triangular Arbitrage As easy as 1 – 2 – 3: $ 1. Sell our $ for €, 2. Sell our € for £, 3. Sell those £ for $. Barclays S($/£)=1.9589 Credit Lyonnais S(€/$)=0.7720 3 1 2 £ BNP Paribas S(€/£)=1.5100 €

  15. Triangular arbitrage: traverse the 3 currencies • Only 2 paths: clockwise, counter-clockwise • Path must be feasible: product of the 3 assembled FX rates must be dimensionless • E .G. feasible path (clockwise): ($/₤)(€/$)(₤/€) = (1.9589)(0.772)(1/1.51)=1.0015 >1 Arbitrage! • E.G. feasible path (counter-clockwise): (€/₤)($/€)(₤/$)=(1.51)(1/0.772)(1/1.9589)= 0.998<1 Loss! • E.G. infeasible path: ($/₤)(€/$)(€/₤) is nonsense!

  16. Triangular Arbitrage Sell $5,000,000 for € at S(€/$)= 0.7720 receive €3,860,000 Sell our €3,860,000 for £ at S(€/£) = 1.5100 receive £2,556,291 Sell £2,556,291 for $ at S($/£)= 1.9589 receive $5,007,519 profit per round trip = $7,519

  17. Spot Foreign Exchange Microstructure • Market Microstructure refers to the mechanics of how a marketplace operates. • Bid-Ask spreads in the spot FX market: • increase with FX exchange rate volatility and • decrease with dealer competition. • Private information is an important determinant of spot exchange rates.

  18. 4.3 The Forward Market • Forward Rate Quotations • Long and Short Forward Positions • Forward Cross Exchange Rates • Swap Transactions • Forward Premium

  19. The Forward Market • A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. • The forward exchange rate, F, is quoted now. • Buy forward: sign a contract with bank now to buy the FX later at contractual rate F. • Sell forward: sign a contract with bank now to sell the FX later at contractual rate F.

  20. Forward Rate Quotations • The forward market for FOREX 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. • 1-month F different from 3-month F, etc.

  21. Forward Rate Quotations Consider the example from above: • for British pound, the spot rate is • $1.5627 = £1.00 • While the 180-day forward rate is • $1.5445 = £1.00 • What’s up with that?

  22. Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 Brazil (Real) 0.2939 0.2879 3.4734 3.4025 Britain (Pound) 1.5627 1.566 0.6399 0.6386 1 Month Forward 1.5596 1.5629 0.6398 0.6412 3 Months Forward 1.5535 1.5568 0.6423 0.6437 6 Months Forward 1.5445 1.5477 0.6475 0.6461 Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1 Month Forward 0.6681 0.6741 1.4968 1.4835 3 Months Forward 0.6658 0.6717 1.502 1.4888 6 Months Forward 0.662 0.6678 1.5106 1.4975 Spot Rate Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months.

  23. 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”. • If you have agreed to sell forex forward, you are short. • If you have agreed to buy forex forward, you are long.

  24. Payoff Profile: Sell Forward profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. S180($/¥) 0 F180($/¥) = .009524 If you agree to sell anything in the future at a set price and the spot price later rises then you lose. Short position loss

  25. Payoff Profile: Buy Forward Long position profit The long in this forward contract agreed to BUY ¥ in 180 days at F180($/¥) = .009524 S180($/¥) 0 F180($/¥) =.009524 loss

  26. Anticipatory Hedging Rule • Hedge means protection. Situation of transactions (or contractual) exposure. • Whatever you will do in the future spot market you should do now in the forward mark. • Hedge a future spot sale of JPYs by selling JPYs forward. You, exporter to Japan, will receive JPY in future and want to protect yourself. • Hedge a future spot purchase of JPYs by buying JPYs forward. You, importer from Japan, will pay JPY in future and want to protect yourself.

  27. Forward Cross Exchange Rates • It’s just an “delayed” example of the spot cross rate discussed above. • In generic terms

  28. SWAPS • A swap is a compound transaction comprised of a spot transaction combined with a reversing forward transaction. E.g., Buy greenback (USD) spot and sell greenback forward. • Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.

  29. Jargon: Forward Premium or Discount • Forward Premium: F > S0 . • For example, S($/€) = .5235 to F360($/€) = .5307. • The euro exhibits a forward premium. The market expects the euro to appreciate over the next year. • Forward Discount: F < S0 . • For example, S(€/$) = 1.91 to F360 (€/$) = 1.884. • The $ exhibits a forward discount. The market expects the $ to depreciate over the year.

  30. Summary • Foreign exchange markets: • Allow the conversion of purchasing power from one currency to another; • Enables banking and credit across currencies, foreign trade financing and trading in foreign currency futures and options; • Trading in the spot market involves immediate purchase and sale of currencies; • In the forward market, buyers and sellers can enter into agreements to buy or sell currencies at a future date and a forward price quoted now.

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