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International Finance FINA 5331 Lecture 1: The Foreign Exchange Market: Please read Chapter 5

International Finance FINA 5331 Lecture 1: The Foreign Exchange Market: Please read Chapter 5 Aaron Smallwood Ph.D. Foreign Exchange Market Products and Activities.

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International Finance FINA 5331 Lecture 1: The Foreign Exchange Market: Please read Chapter 5

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  1. International Finance FINA 5331 Lecture 1: The Foreign Exchange Market: Please read Chapter 5 Aaron Smallwood Ph.D.

  2. Foreign Exchange MarketProducts and Activities • A spot contract is a binding commitment for an exchange of funds, with normal settlement and delivery of bank balances following in two business days (one day in the case of North American currencies). • A forward contract, or outright forward, is an agreement made today for an obligatory exchange of funds at some specified time in the future (typically 1,2,3,6,12 months).

  3. Foreign Exchange MarketProducts and Activities • Forward contracts typically involve a bank and a corporate counterparty and are used by corporations to manage their exposures to foreign exchange risk. • A foreign exchange swap is the simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery. • Foreign exchange swaps can be used by dealers to manage the maturity structure of their currency positions.

  4. Foreign Exchange MarketProducts and Activities • Speculation entails more than the assumption of a risky position. It implies financial transactions undertaken when an individual’s expectations differ from the market’s expectation. • Arbitrage is the simultaneous, or nearly simultaneous, purchase of securities in one market for sale in another market with the expectation of a risk-free profit.

  5. FX Players • Broadly speaking the FX market consists of 5 groups • International banks • Bank customers • Non-bank dealers • Include investment banks, mutual funds, and hedge funds. • FX brokers • Central banks

  6. The Market for Foreign Exchange • The FOREX market is the largest market in the world. • According to the BIS, in 2010, daily turnover in April in FOREX market hit almost $4 TRILLION dollars.

  7. Daily Trading Volumes by Hour

  8. Spot Exchange Rates

  9. Spot Rate Quotations • Indirect quotation • the price of a U.S. dollar in the foreign currency • e.g. the yuan price of the dollar = RMB 6.5605 on March 24. • Direct Quotation • the price of a unit of foreign currency: given by 1/Indirect Quotation • e.g. $/Euro = 1/0.7055=$1.4174

  10. The Bid-Ask Spread • The bid price is the price a dealer is willing to pay you for something. • The ask price is the amount the dealer wants you to pay for the thing. • The bid-ask spread is the difference between the bid and ask prices.

  11. Cross Rates • Suppose that S($/€) = .50 • i.e. $1 = 2 € • and that S(¥/€) = 50 • i.e. €1 = ¥50 • What must the $/¥ cross rate be?

  12. $ Barclays S(¥/$)=120 Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 ¥ £ Triangular Arbitrage Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

  13. $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 ¥ £ Triangular Arbitrage The implied S(¥/£) cross rate is S(¥/£) = 80 Barclays S(¥/$)=120 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.

  14. $ $ Credit Lyonnais S(£/$)=1.50 3 1 2 Credit Agricole S(¥/£)=85 ¥ £ Triangular Arbitrage As easy as 1 – 2 – 3: 1. Sell $ for £, 2. Sell £ for ¥, 3. Sell ¥ for $. Barclays S(¥/$)=120

  15. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250

  16. The Forward Market • A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. • If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

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