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The Foreign Exchange Market

The forex market is an electronically linked network of banks, forex brokers and dealers. Trading is done by phone, telex or SWIFT (Society for ...

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The Foreign Exchange Market

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  1. The Foreign Exchange Market International Corporate Finance P.V. Viswanath

  2. Market Organization • The forex market is an electronically linked network of banks, forex brokers and dealers. • Trading is done by phone, telex or SWIFT (Society for Worldwide Interbank Financial Telecommunications), an international bank-communications network. • The purpose of the market is to permit transfers of purchasing power denominated in one currency to another. P.V. Viswanath

  3. Market Organization • The interbank market is a wholesale market in which major banks trade with each other. • In the spot market, currencies trade for immediately delivery (within 2 business days). • In the forward market, contracts are made to buy and sell for future delivery. • The swap market involves packages of spot and forward contracts. P.V. Viswanath

  4. Participants • Foreign Exchange Brokers – specialists in matching net supplier and demander banks. • Arbitrageurs – seek to earn risk-free profits by taking advantage of differences in interest rates among countries • Traders use forward contracts to eliminate or cover the risk of loss on export or import orders denominated in foreign currencies. • Hedgers (mostly multinationals) engage in forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities • Speculators expose themselves to currency risk in order to profit from exchange rate fluctuations. P.V. Viswanath

  5. Clearing System • Most electronic funds transfers involving international transactions take place through the Clearing House Interbank Payments System (CHIPS), a computerized network developed by the New York Clearing House Association. Most large US banks and US branches of foreign banks are members of CHIPS. • At the beginning of the day, each bank puts in a security deposit into (prefunds) its CHIPS account. • Interbank transfers during the day are processed electronically through CHIPS. • At the end of the day, all CHIPS member bank balances are netted out and their balances remitted back to them using Fedwire. P.V. Viswanath

  6. How Fedwire Works • The Fedwire system is used by the Fed’s member banks to make interbank transactions. CHIPS is a clearing system, while Fedwire is a mechanism to accomplish any interbank transaction. • In a typical funds transfer, an individual or a business instructs its bank to send a funds transfer. • The sending bank debits the sender's account and initiates a fedwire funds transfer. • The Federal Reserve, in turn, debits the account of the sending bank and credits the account of the receiving bank; the Fed notifies the receiving bank about the transfer. • The receiving bank credits the recipient's account and notifies the recipient of the receipt of the funds. The transfer is final when the funds are received. Funds can be used by the recipient immediately thereafter. P.V. Viswanath

  7. How CHIPS Works P.V. Viswanath

  8. Spot Quotations: Direct and Indirect • Direct quotation – home currency price of the foreign currency quoted. In the US, this would be equivalent to quoting in: • American terms (no. of US$ per unit of foreign currency). e.g. on 6/2/04, $1.2216 per €. This would be an indirect quote in Europe. • Indirect quotation – foreign currency price of the home currency. In the US, this would be equivalent to quoting in: • European terms (no. of units of foreign currency per $). e.g. on 6/2/04, €0.8186 per $. This would be a direct quote in Europe. P.V. Viswanath

  9. Bid-ask spread • The bid price of a security is the price which the person quoting (e.g. a dealer) is willing to pay for it – the price at which anybody can sell it. • The ask price is the price at which the dealer is willing to sell it – the price at which anybody can buy it. • The bid-ask spread is the difference. • The direct (American) quote for the euro on 6/2/04 was 1.2262 -67, i.e. you could buy a € for 1.2267 (ask), but if you wanted to sell it, you could get only $1.2262. • The spread is 0.0005 per €. • The percentage spread is 100(Ask-Bid)/Ask = 100(0.0005)/1.2267 = 0.04% P.V. Viswanath

  10. Cross rates • Most currencies are quoted against the dollar; hence it may be necessary to work out the cross rates for currencies other than the dollar. • For example, the euro was quoted on 6/2/04 at 1.2208 -12 (direct), while the yen was quoted at 109.99 -04 (indirect). • A Japanese trader who wants to buy the euro would, implicitly be buying the dollar for yen and then trading the dollar for euros. • 100 yen would buy $(100/110.04) or $0.9088; this could be used to buy €0.9088/1.2212 = €0.7442 • €1 would buy $1.2208, which would buy 1.2208(109.99) = 134.28 yen; to buy 100 yen, you would need €100/134.28 = €0.7447. • Hence the (indirect) cross quote in Japan would be €0.7442 -7. P.V. Viswanath

  11. Currency Arbitrage • If traders quote currencies in terms of more than one base currency, the possibility exists that the different quotes may be inconsistent. • Thus, if one dealer quotes the dollar against the € and the same or another dealer quotes € against the yen, and there is also a dollar quote against the yen, then consistency requires that the cross dollar-yen quote equal the direct dollar-yen quote. • If it doesn’t, the possibility of making money by trading against these dealers exists, assuming that the discrepancy is sufficiently large to outweigh the bid-ask spreads in the two transactions. P.V. Viswanath

  12. Currency Arbitrage • Suppose the pound is bid at $1.5422 in New York and the euro is offered at $0.9251 in Frankfurt and simultaneously, the pound is quoted at €1.6650, ask, in London. • An arbitrageur can sell £1 for $1.5422 in New York, buy 1.5422/0.9251 = €1.6671 with the dollars in Frankfurt, and finally buy 1.6671/1.6650 = £ 1.0012391 with the euros, in London for a profit of 0.124%. P.V. Viswanath

  13. Currency Arbitrage P.V. Viswanath

  14. Settlement risk • Settlement risk is the risk that a settlement in a transfer system does not take place as expected. • This can happen if one party defaults on its clearing obligations to one or more counterparties. • Settlement risk comprises both credit and liquidity risks. The former arises when a counterparty cannot meet an obligation for full value on due date and thereafter because it is insolvent. • Liquidity risk refers to the risk that a counterparty will not settle for full value at due date but could do so at some unspecified time thereafter, causing the party which did not receive its expected payment to have to finance the shortfall at short notice. P.V. Viswanath

  15. The Case of Bankhaus Herstatt • On 26th June 1974 the Bundesaufsichtsamt für das Kreditwesen withdrew the banking licence of Bankhaus Herstatt, a small bank in Cologne active in the FX market, and ordered it into liquidation during the banking day but after the close of the interbank payments system in Germany. • Prior to the announcement of Herstatt's closure, several of its counterparties had, through their branches or correspondents, irrevocably paid Deutsche Mark to Herstatt on that day through the German payments system against anticipated receipts of US dollars later the same day in New York in respect of maturing spot and forward transactions. P.V. Viswanath

  16. The Case of Bankhaus Herstatt • Upon the termination of Herstatt's business at 10.30 a.m. New York time on 26th June (3.30 p.m. in Frankfurt), Herstatt's New York correspondent bank suspended outgoing US dollar payments from Herstatt's account. • This action left Herstatt's counterparty banks exposed for the full value of the Deutsche Mark deliveries made (credit risk and liquidity risk). • Moreover, banks which had entered into forward trades with Herstatt not yet due for settlement lost money in replacing the contracts in the market (replacement risk), and others had deposits with Herstatt (traditional counterparty credit risk). (Source: http://riskinstitute.ch/140960.htm) P.V. Viswanath

  17. The BCCI case, 1991 • An institution in London was due to settle on 5th July 1991 a dollar/sterling foreign exchange transaction into which it had entered two days previously with BCCI SA, London. • The sterling payment was duly made in London on 5th July. BCCI had sent a message to its New York correspondent on 4th July (a public holiday in the United States) to make the corresponding US dollar payment for value on 5th July. The payment message was delayed beyond the time of the correspondent bank's initial release of payments (at 7 a.m.) by the operation of a bilateral credit limit placed on BCCI's correspondent by the recipient CHIPS member. P.V. Viswanath

  18. The BCCI case, 1991 • The payment remained in the queue until shortly before 4 p.m. (New York time), when it was cancelled by BCCI's correspondent, shortly after the correspondent had received a message from BCCI's provisional liquidators in London on the subject of the action it should take with regard to payment instructions from BCCI London. In this way, BCCI's counterparty lost the principal amount of the contract. • A major Japanese bank also suffered a principal loss in respect of a dollar/yen deal due for settlement on 5th July, since yen had been paid to BCCI SA Tokyo that day, through the Foreign Exchange Yen Clearing System, and the assets of BCCI SA in New York State were frozen before settlement of the US dollar leg of the transaction took place. P.V. Viswanath

  19. The BCCI case, 1991 • The UK institution's loss illustrates a particular aspect of the difficulties which face the private sector under current circumstances in any attempt to coordinate the timing of payments; in this instance, the loss would almost certainly not have occurred but for the measures in place to reduce risk domestically within CHIPS (the bilateral credit limit). • Moreover, the closure of BCCI by the banking supervisors illustrates that it is generally not possible to close a bank which is active in the foreign exchange market at a time when all the relevant payments systems have settled all its transactions due on a given day. In this case, the closure required the Luxembourg Court to appoint a liquidator, an action which under Luxembourg law can take place only within the normal business day of the Court. P.V. Viswanath

  20. Forward Exchange Rates • The forward exchange rate is the rate that is contracted today for the exchange of currencies at a specified rate in the future. • A contract for such a simple exchange is an outright forward contract. • A swap contract is a combination of a spot contract and a forward contract • A swap-in Canadian is an agreement to buy Canadian dollars spot and sell Canadian dollars forward. • A swap-out is the reverse. • A forward-forward involves two forward contracts of different maturities. P.V. Viswanath

  21. Hedging with Forwards • The forward market can be used to hedge foreign exchange risk. • Suppose a US company buys textiles from England with payment of £1 m. due in 90 days. The importer is implicitly short pounds. If the pound were to rally during the next 90 days, the importer would lose out – he would have to pay a larger amount in dollars. • He could go long in the forward market, i.e., buy pounds for forward delivery in 90 days. • Suppose he can negotiate a forward rate of $1.72 per £1. In 90 days, the bank will give him £1m. and he will give the bank $1.72m., irrespective of how the exchange rate changes. • Implicitly, his loss/gain in the forward market is offset by his gain/loss in the spot market. P.V. Viswanath

  22. Hedging with Forwards P.V. Viswanath

  23. Forward Market Transactions • If the actual price is quoted, it’s called an outright quote. • In the interbank market, the forward rate is quoted as a discount/premium from the spot. This is called the swap rate. The difference is known as points. • On 6/2/04, the spot GBP/USD quote was 1.8350/ 1.8355 on Moneyline. • The one-year forward rate was quoted as -536.25/-533.25 • This implies an outright quote of (1.8350-.053625)/ (1.8355-.053325) or 1.781375/ 1.782175. P.V. Viswanath

  24. Forward Points Outright Forward Rates Period Bid Ask Period Bid Ask 1 Month      -0.005080      -0.004890 1 Month      1.825090      1.827360 3 Month      -0.015090      -0.014540 3 Month      1.815090      1.817710 12 Month      -0.050810      -0.050010 12 Month      1.779370      1.782240 Forward rates On June 2, 2004, the GBP/USD spot rate was 1.8302/1.8323 and the forward rates on www.ozforex.com.au were: We can compute the implied forward discount as (forward – spot)/spot x (360/#days).Hence the 3-month pound bid is quoted at a discount of 3.33%, since [(1.81509-1.8302)/ 1.8302]x(360/90) = -0.033 P.V. Viswanath

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