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Chapter 6 Outline

Chapter 6 Outline. Foreign Exchange Market Spot Market Forward Market. 6.A Foreign Exchange Market (1). Foreign exchange market permits transfers of purchasing power denominated in one currency to another.

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Chapter 6 Outline

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  1. Chapter 6 Outline • Foreign Exchange Market • Spot Market • Forward Market Chapter 6: The Foreign Exchange Market

  2. 6.A Foreign Exchange Market (1) • Foreign exchange market permits transfers of purchasing power denominated in one currency to another. • Interbank market – wholesale market in which major banks trade with one another. Accounts for ~95% of foreign exchange transactions. Spot market – where currencies are traded for immediate delivery 35% Forward market – where contracts are made to buy or sell currencies for future delivery 12% Swap transactions – involve a package of a spot and a forward contract 53% Chapter 6: The Foreign Exchange Market

  3. 6.A Foreign Exchange Market (2) • Methods of trading • Telephone still predominant • Telex (dead) • SWIFT (Society for Worldwide Interbank Financial Telecommunications) system • Internet-based systems • Market participants • Large commercial banks • Foreign exchange brokers in the interbank market • Commercial customers (primarily MNCs) • Central banks • The role of human brokers has declined as electronic brokers have significantly increased their share of the foreign exchange market. Chapter 6: The Foreign Exchange Market

  4. 6.A Foreign Exchange Market (3) • Quotations • Up to four different foreign exchange quotes are displayed in major newspapers. • Spot rate • Forward rates, including 30-, 90-, and 180-day forward • Quotes are for dealers in the interbank market for >$1m in a single transaction. Your rate will suck unless using credit cards (with small fees). • When interbank trades involve dollars, rates are expressed in American/Direct terms ($/foreign currency) or European/Indirect terms (foreign currency/$). Chapter 6: The Foreign Exchange Market

  5. 6.A Foreign Exchange Market (4) • Forward market participants • Arbitrageurs – seek to earn risk-free profits by taking advantage of interest rates differentials among countries. Use forward contracts to eliminate the exchange rate risk involved in transferring their funds between countries. • Traders – use forward contracts to eliminate or cover the risk on export or import orders denominated in foreign currencies. • Hedgers – use forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities. • Speculators – actively expose themselves to exchange risk by buying or selling currencies forward to profit from exchange rate fluctuations. • Thus, arbitrageurs, traders, and hedgers seek to eliminate or minimize exchange risk while speculators expose themselves to risk through forward market transactions. Chapter 6: The Foreign Exchange Market

  6. 6.A Foreign Exchange Market (5) • Clearing System • In the U.S., where all foreign exchange transactions involving dollars are cleared, electronic funds transfers between banks are processed through the Clearing House Interbank Payments System (CHIPS). • Settlement payments are debited from and credited to a settlement account established by the New York Federal Reserve Bank for member banks. • Member banks with debit positions deposit funds into their settlement accounts through FedWire to cover their part of a transaction. Chapter 6: The Foreign Exchange Market

  7. Fuji Bank - + ¥1.5 bil. $15 mil. Citibank - + $15 mil. ¥1.5 bil. 6.A Foreign Exchange Market (6) • Example of CHIPS process: Fuji Bank sells $15 million to Citibank for ¥1.5 billion. Fuji Bank CHIPS 1 Enters transaction into CHIPS system Approves and releases transaction • Stores transaction • Makes appropriate debits and credits to Fuji and Citibank settlement accounts • Makes permanent record of transaction • Issues a settlement report to each member bank 2 4 3 5 6 Chapter 6: The Foreign Exchange Market

  8. 6.A Foreign Exchange Market (7) • Electronic trading systems • First created in 1992 • Enable automatic matching and execution of foreign exchange transactions • Reduce cost of trading by eliminating brokers and reducing the number of transactions traders had to engage in to obtain market prices • Gather and publish information on prices and quantities of currencies as they are traded • FXall largest electronic trading system Chapter 6: The Foreign Exchange Market

  9. 6.B Spot Market (2) • Spot Quotations, continued • Quotes are given in pairs that reflect the bid-ask price. • E.g., pound sterling is quoted at $1.9719-28. • $1.9719 is the (bid) rate at which banks will buy pounds • $1.9728 is the (ask) rate at which banks will sell pounds • The spread equals the dealer’s profit • The bid-ask spread is often quoted by the last two numbers; e.g., 19-28. • Bid-ask quote expressed in American and European terms and as direct and indirect quotes: *Note that the bid and ask prices are reversed in quoting in European terms. Chapter 6: The Foreign Exchange Market

  10. Ask price – Bid price Ask price x 100 Percent Spread = 6.B Spot Market (3) • Spot quotations, continued • Bid-ask spreads are expressed as a percentage cost of transacting in the foreign exchange market as follows: • Cross rates • Most currencies are quoted against the dollar. • A cross rate is the exchange rate between two non-dollar currencies Chapter 6: The Foreign Exchange Market

  11. 6.B Spot Market (4) • Cross rates, continued • Example: Compute direct bid and ask cross rates for the pound in Zurich • Direct quote for pound sterling = $1.9719-36 • Direct quote for SFr = $0.8130-47 Bid rate for £ in $ Ask rate for SFr in $ $1.9719 $0.8147 = = SFr2.4204 Bid cross rate = Ask rate for £ in $ Bid rate for SFr in $ $1.9736 $0.8130 = SFr2.4227 Ask cross rate = = • Thus, the direct quote for the pound in Zurich is SFr2.4204-27. Chapter 6: The Foreign Exchange Market

  12. 6.B Spot Market (5) • Currency arbitrage • Triangular currency arbitrage – traders take advantage of exchange rate inconsistencies in different money markets by buying a currency in one market and simultaneously selling it in another. • E.g., compute profit given the following exchange rates, FYI • $/£ = $1.9724 in New York • $/€ = $1.3450 in Frankfurt • €/£= €1.4655 in London New York Sell pounds in New York for dollars: £507,332/(1/$1.9724) = $1,000,661 Sell $1,000,000 in Frankfurt for euros: $1,000,000/($1.3450) = €743,494 Profit = $661 London Frankfurt Sell euros in London for pounds: €743,494/€1.4655 = £507,332 Chapter 6: The Foreign Exchange Market

  13. 6.B Spot Market (7) • Exchange risk • Bank losses and gains from exchange rate transactions result from the immediate adjustment of quotes in response to new political and economic information affecting exchange rates. • E.g., given a $/£ exchange rate of $1.9712, a bank buys $985,600 for £500,000 (£500,000/(1/$1.9712) = $985,600) in the foreign exchange market. • If no offsetting transaction to cover its position is made simultaneously, it is exposed to exchange rate risk. • If the bank then decides to cover its position in the interbank market, increases or decreases in the exchange rate will affect its exchange loss/gain. • If the exchange rate increases to $1.9801 before the bank completes its transaction, the bank will pay $990,050 to buy £500,000, thus incurring a loss of $990,050 - $985,600 = $4,450. • If the exchange rate increases, the bank will realize an exchange gain. Chapter 6: The Foreign Exchange Market

  14. 6.C Forward Market (1) • A forward contract between a bank and a customer calls for delivery on a fixed future date of a specified amount of one currency against dollar payment at a fixed exchange rate. • Negotiating a forward contract for payment of a future liability eliminates exchange risk by locking in a known future exchange rate. • E.g., a U.S. company buys textiles from England, with payment of £1 million due in 90 days. Day 0 90 e0 = $1.97 e90 > $1.98 f90 = $1.98 Exchange risk: If e90 > f90, cost of payable will increase No exchange risk: £1,000,000 = $1,980,000 • Implicit gains/losses on forward positions are related to the difference between ftand et at the forward contract’s maturity. Chapter 6: The Foreign Exchange Market

  15. 6.C Forward Market (2) • Forward rate quotations • Actual price of f1is the outright rate • Swap rate – quoted as the premium on or discount from eo, e.g.: • eo for yen = $0.008225, f1 for yen = $0.008421 • Swap rate is 0.008421-0.008225 = 196 • Determining whether swap rate is a premium or discount on f1 • When forward bid < ask rate, f1 is at a premium. • When forward bid > ask rate, f1is at a discount. • Converting swap rate to outright rate – add the premium to or subtract the discount from eo Chapter 6: The Foreign Exchange Market

  16. 6.C Forward Market (3) • Forward cross rates • Computed in the same way as spot cross rates • Example: Compute the forward cross rates for yen in terms of euros* • f30 for €/$ = €0.81070 - €0.81243 • f30 for ¥/$ = ¥107.347 - ¥107.442 Ask rate for € Bid rate for ¥ €0.81243 ¥107.347 = = = €0.0075683 Bid cross rate = Bid rate for € Ask rate for ¥ €0.81170 ¥107.442 Ask cross rate = = = €0.0075548 • Forward cross rates for yen in terms of euros are €0.0075683 - €0.0075548. *Note that this example is in European terms, as opposed to previous example computing bid/ask cross rates for pounds in Zurich, which was in American terms. Thus, ask and bid rates are reversed in the cross rate formulas. Chapter 6: The Foreign Exchange Market

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