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International Finance The Market for Foreign Exchange

International Finance The Market for Foreign Exchange. EXCHANGE RATE DETERMINATION. An exchange rate measures the value of one currency in units of another currency. A decline in a currency’s value is often referred to as depreciation.

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International Finance The Market for Foreign Exchange

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  1. International Finance The Market for Foreign Exchange

  2. EXCHANGE RATE DETERMINATION An exchange rate measures the value of one currency in units of another currency. A decline in a currency’s value is often referred to as depreciation. Increase in a currency value is often referred to as appreciation. Percentage change in foreign currency value = (S – St-1)/St-1 Appreciation and Depreciation of the foreign currency. “the dollar was mixed in trading”

  3. FOREX Market Participants • The FOREX market is a two-tiered market: • Interbank Market (Wholesale) • About 700 banks worldwide stand ready to make a market in Foreign exchange. • Nonbank dealers account for about 20% of the market. • There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. • Client Market (Retail) • Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

  4. Correspondent Banking Relationships • Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. • International commercial banks communicate with one another with: • SWIFT: The Society for Worldwide Interbank Financial Telecommunications. • CHIPS: Clearing House Interbank Payments System • ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

  5. 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.

  6. 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.

  7. Monday, September 21, 10.45 a.m. BANK A: "Bank A calling. USD-CHF 25 please. (Bank A dealer is asking for a Swiss franc versus US dollar quote. She specifies the size of the deal, viz. 25 million dollars since this is more than the "market lot" of 10 million.) BANK B: "Forty-Fifty-two" (Bank B is specifying a two-way price-the price at which it will buy a US dollar against Swiss franc and the price at which it is willing to sell a US dollar. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 1.4540/1.4552. Bank B will pay CHF 1.4540, its "bid rate", when it buys a dollar and will want to be paid CHF 1.4552, its "ask rate" when it sells a dollar.

  8. BANK A: "Mine" (Bank A dealer finds bank B's price acceptable and wishes to buy USD 25 million. She conveys this by saying "mine", that is, "I buy the specified quantity at your specified price". If she wished to sell, she might have said "Yours".) BANK B: OK. I sell you USD 25 million against CHF at 1.4552 value 23 September. UBS Geneva for my CHF. (Bank B confirms the quantity, price and settlement date. It also specifies where it would like its CHF to be transferred.) BANK A: CITIBANK NYK for my dollars. Bank B has been "hit on its ask side", that is, the caller, bank A wished to buy dollars

  9. EXCHANGE RATE EQUILIBRIUM An exchange rate at a given point in time represents a price of a currency. Price is determined by the demand for that currency relative to supply. The point where the demand and supply equal represent the equilibrium exchange rate.

  10. Demand for a currency $1.6 Quantity of £ US corporations would be encourage to purchase more British goods when the pound was worthless.

  11. Supply of the currency for sale British demand for US dollars is the British supply of pounds for sale. Quantity of £

  12. Equilibrium exchange rate determination

  13. FACTORS INFLUENCE EXCHANGE RATES Relative inflation rates Relative interest rates Relative income levels Government controls Expectations

  14. Effect of relative inflation rates If U.S inflation suddenly increased substantially while British inflation remained the same? There is a sudden & substantial increase in British inflation

  15. Effect of relative interest rates U.S interest rates rise while British interest rates remain constant

  16. Effect of relative income levels U.S. income level substantially rises while the British income level remains unchanged

  17. Types of transactions and settlement dates Settlement date or value date Settlement location Dealing locations Settlements can be take place only on a day which both banks are open A London bank can sell Swiss Francs against US Dollars to a Paris bank. Settlement locations may be New York & Geneva, while dealing locations are London & Paris.

  18. In spot transaction the settlement date is two business days ahead. (For European currencies or Yen traded against USD) London bank sells JPY against USD to a Paris bank on Monday. The value date is… Deals done on a Friday, the settlement date is …… Value date for forward transactions (one month -30 days – forward contract) First find the value date for a spot transaction, then add one calendar month to arrive at the value date. One month forward transaction entered on June 20, find the value date. If the value date agreed on became a bank holiday, then follow the same as spot. Three month forward deal is done on November 26, the value date is …… Rolling forward must not take in to the next calendar month, in such case u must shift it backward.

  19. Exchange rate quotations An exchange rate between two currencies A and B, can be stated As units of B per unit of A As units of A for unit of B Quotations in European terms Quotes given as number of units of a currency per USD EUR 1.0275 per USD CHF 1.4500 per USD LKR 103 per USD Quotations in American terms Quotes given as number of USD per unit of a currency USD 0.4575 per CHF USD 1.3542 per GBP Direct quotes and indirect quotes

  20. A currency pair is denoted by 3 letter SWIFT codes and two currencies separated by an oblique or hyphen USD/CHF : US Dollar – Swiss Franc GBP/JPY : USD/LKR : The first currency in the pair is the base currency, second is the quoted currency A quotation consists of two prices Bid (left of the oblique) Ask (right of the oblique) –offer price Bid – the amount of quoted currency the dealer will give in return for one unit of the base currency. Ask – the price at which the dealer is willing to sell (offering) one unit of the base currency

  21. Arbitrage in spot markets Eg- 01 Bank A B GBP/USD 1.4550/1.4560 1.4538/1.4548 Pounds can be bought from B at $1.4548 and sold for a net profit of $0.0002 per Pound Eg- 02 Bank A B GBP/USD 1.4550/1.4560 1.4545/1.4555 There is no arbitrage, as in Eg. 01

  22. Inverse quotations and two-point arbitrage Quotation from a bank in Zurich USD/CHF 1.4955/1.4962 Quotation from a bank in New York CHF/USD 0.6695/0.6699 Having a arbitrage Implied (CHF/USD)bid = 1/(USD/CHF)ask Implied (CHF/USD)ask = 1/(USD/CHF)bid

  23. Cross-rates and three-point arbitrage A bank in New York offer following quotes USD/JPY : 110.25/111.10 USD/AUD : 1.6520/1.6530 At the same time a bank in Sydney offer following quotes AUD/JPY : 68.30/69.00 Is there an arbitrage opportunity ? Step 01 Sell JPY, buy USD and then sell USD and buy AUD. Both these transactions in New York. Step 02 Sell AUD for JPY in Sydney

  24. 1 JPY sold in New York gets USD [1/(USD/JPY)ask(N)] = USD(1/111.10) USD [1/(USD/JPY)ask(N)] sold against AUD gets AUD {[1/(USD/JPY)ask(N)] (USD/AUD)bid(N)} = AUD (1/111.10)(1.6520) Finally the amount of JPY obtained by selling AUD JPY {[1/(USD/JPY)ask(N)] (USD/AUD)bid(N) (AUD/JPY)bid(S) JPY (1/111.10)(1.6520)(68.30) = JPY 1.0156 A risk less profit of JPY 0.0156 per JPY No arbitrage condition requires 1/(USD/JPY)ask(N) X (USD/AUD)bid(N) X (AUD/JPY)bid(S) < 1

  25. Spot Rate Quotations The direct quote for British pound is: £1 = $1.688

  26. Spot Rate Quotations The indirect quote for British pound is: £.5924 = $1

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

  28. Cross Rates A Mexican importer needs Japanese Yen to pay for purchases in Tokyo. Both the Mexican Peso (Ps) and the Japanese Yen (¥) are commonly quoted against the U.S Dollar. Japanese Yen ¥121.13/$ Mexican Peso Ps9.1900/$ (¥/USD) / (Ps/USD) = (¥/USD) * (USD/Ps) = ¥13.1806/Ps Cross in reciprocal

  29. Cross Rates in Intermarket Arbitrage • Following exchange rates are quoted Citibank quotes U.S Dollar per Euro $0.9045/€ Barclays bank quotes USD per Pound Sterling $1.4443/£ Dresdner bank quotes Euros per Pound Sterling €1.6200/£ Go for the cross between Barclays & Citibank

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

  31. 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.

  32. 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. • Longer-term swaps are available.

  33. Forward Rate Quotations Can be made on two ways. Outright rate Points of premium or discount Eg. Spot 1 M. 3 M. 6 M. (FFr/USD) 5.2321/2340 25/20 40/32 20/26 Express these quotes in outright terms.

  34. Forward Rate Quotations Eg. Quotations for the USD against INR Spot 1 M. 3 M. 6 M. INR,32.1010/1100 225/275 300/350 375/455 Spread .0090 .0050 .0050 .0080 Premium or Discount [(Fwd rate – Spot rate)/ Spot rate] * (12/n) * 100 If FR > SR, it implies premium < SR, it implies discount

  35. Arbitrage in Forward Market (CIA) Arbitrage operates on the differential of interest rates & the premium or discount on exchange rates. Rule If the interest differential is greater than the premium or discount , place the money in the currency that has higher rate of interest.

  36. Arbitrage in Forward Market (CIA) Eg. Exchange rate: Can$ 1.317 per USD (spot) Can$ 1.2950 per USD (6 M. Forward) 6 M interest rate: USD 10% Can$ 6% Work out the possibilities of arbitrage gain

  37. Arbitrage in Forward Market (CIA) Eg. Exchange rate: Can$ 0.665 per DM (spot) Can$ 0.670 per DM (3 months) Interest rate: DM 7% Can$ 9% Calculate the arbitrage gain possibilities from the above data

  38. 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.

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