Chapter 4: The FX Market

1. Chapter 4: The FX Market • No single market although there are some physical locations, such as the CME, where currencies are exchanged • Institutions and people, such as • banks • dealers • physical markets facilitate the trading of currencies • 24 hours a day market with over $1 trillion traded each day

2. Growth of FX market has somewhat stalled in the most recent years • Why? • Vehicle/Key currencies: $, €, ¥, and £ • Major FX centers (by volume): London, New York, Tokyo, Singapore, Frankfurt • Ways to trade currencies: • Spot • Forward • Futures and Options

3. FX market is an OTC market dominated by banks • Trading done by phones and computer terminals (electronic) • Banks as market makers • Banks trade among themselves and with Speculators Arbitrageurs Other dealers and brokers Non-financial firms Central banks

4. Functions of FX markets 1. Transfer purchasing power from one currency to another • investments channeled to the most productive use 2. Facilitate international trade through specialized instruments • L/C, draft, B/L, etc. • see Chapter 20 3. Provide an opportunity for speculators to bet on changes • important source of liquidity

5. 4. Provide a means to hedge against currency risk • alleviate some of the risks of international business 5. Make international portfolio diversification accessible

6. FX market efficiency • Allocational efficiency • Is capital channeled to the globally most productive use? • Higher among freely floating currencies • Operational efficiency • Are currency markets frictionless? • The most operationally efficient markets in the world • Informational efficiency • Are prices right? • Can anybody make extraordinary profits?

7. Market participants • Interbank (wholesale) vs. Client (retail) market • Bank and non-bank dealers • market makers • provide liquidity • Firms and individuals conducting commercial and investment transactions • “end users” • trade for the purpose of receiving foreign currency • Speculators and Arbitragers • trade based on their beliefs about future FX rates • trade for the purpose of profit-making • on the lookout for locational and triangular arbitrage opportunities

8. Central Banks and Treasuries • conduct their monetary policy through trading • often knowingly take a loss • FX Brokers • execute trades for their clients for a fee • often dealers (and even central banks) go through a broker in order to remain anonymous

9. Quoting system in FX trading • Banks quote a bid rate and an ask rate • Bid = rate at which the bank will buy the currency in the denominator • Memory tip: Bank Buys at Bid • Ask = rate at which the bank will sell the currency in the denominator

10. So: • if we want to sell the currency in the denominator, we would do that at the Bank's bid rate • if we want to buy the currency in the denominator, we would do that at the Bank's ask rate • Rule #1: • Always keep track of your currency units • Rule #2: • Always think of buying or selling the currency in the DENOMINATOR of a foreign exchange quote

11. Bank makes money on its bid-ask spread • bid-ask spread = ask rate - bid rate • can be computed as a % • the less traded and more volatile the currencies, the bigger the spread • because of higher risk

12. Direct and Indirect Quotes • direct quote: Home Currency (HC)/Foreign Currency (FC) • in U.S., direct quote is $/FC • consistent w/ Rule #2 when trading a unit of foreign currency • indirect quote: FC/HC • in U.S. then, indirect quote is FC/$ • convention in most countries • U.S. professionals traditionally use the indirect quote (e.g., DM/$) • a.k.a. European terms • Exception: British pound, Australian and NZ dollar, Irish punt

13. traders located in the UK traditionally use the indirect quote • i.e., a UK bank would give quotes in terms of FC/GBP

14. Spot rates • for "immediate" delivery • actually - 2 days for most currencies • WSJ quotes are for large transactions - $1M and above

15. Appreciation & Depreciation of currencies • currencies change values over time relative to one another • for instance, the U.S. $ has been depreciating relative to the Euro • $ is ”weak", € is ”strong" • with direct quotes: • if spot rate increases, the FC has appreciates relative to the $ • it now takes more $'s to "buy" one unit of FC • What does this say about the $? • What if spot rate has decreased?

16. How about indirect quotes? • FC/HC = FC/$ • if spot rate has gone up, what has happened to FC? • depreciated relative to the $

17. Forward rates • These are rates of exchange for future delivery • quoted in WSJ for 30 days, 90 days etc . . . • can be much longer - 5 to 10 years • entering into a contract to exchange currencies at a given date in the future, at the specified rate of exchange • OTC • typically through banks

18. there is a bid-ask spread as there was for spot rates • the longer the contract, the larger the bid-ask spread • non-standardized • no money exchanges hands until the specified contract date • Forward premium/discount • assume that we are using direct quotes: $/FC • if F (Forward rate) > S (Spot rate), the foreign currency is appreciating relative to the $ • so the forward rate contains a premium for the FC • in that case, forward $ is selling at a discount relative to the FC

19. Calculation of Forward premium/discount • on a Points Basis: • point = the last digit of the conventional quotation for the currency • e.g., 6 mo € in Exhibit 4.5, p. 108 is quoted Bid +112, Ask +113 • “outright” fwd quote would then be 1.0897+.0112=1.1009Bid, 1.0901+.0113=1.1014Ask • in annualized percentage terms: • (F - S)/S * 360/# days of forward contract • If this is negative (assuming direct quotes)  FC selling at a forward discount

20. Cross Rate • The exchange rate between two currencies that is implied by their relationship to a third currency • Example: If we have spot rates of $0.1065/Mexican peso and $0.1250/Norwegian krone, what is the implied peso/krone rate?

21. % Changes in FX Rates • Again, easiest to keep the referent currency in the denominator (Rule #2 rules) • Simple % Change: • Annualized:

22. Hedging with Forwards • Forward contracts can be used to hedge currency risk • Eliminate FX-related value variation of future claims or obligations • Example: • A U.S. company can lock in the dollar value of their Account Receivable denominated in a foreign currency • Note: A forward hedge eliminates both the “upside” and the “downside”

23. Counter party risk in forwards: • Forward is a credit instrument • It is also a ‘zero sum game’ • The “losing” party will have an incentive to “disappear” • Forwards are mostly issued by commercial banks and used by large companies • Banks have more effective means of hedging the default risk • Large firms have ‘more to lose’ by defaulting

24. Futures contract on foreign currency • similar to a forward contract, a futures contract is an agreement to buy or sell: • a specified amount of foreign currency • at a specified exchange rate • on a specified date in the future

25. traded on an exchange (not OTC) (e.g., Chicago Mercantile Exchange (CME)) • all trades through a clearing house • no bid-ask spreads • brokerage commissions • margin requirements (usually $1,000 to 2,000 per contract) • marking to market • standardized: • contract amounts • settlement dates :3rd Wednesdays in March, June, September, December • standardization increases liquidity

26. futures market caters to a clientele that cannot enter a forward contract • ultimate payoff from a futures contract - same as for a forward contract of the same size • closing out a position: • a position can (and often is) closed out by entering an identical contract of opposite sign • uses of futures: • hedging • speculation

27. Example: • Buy a SWF contract (contract size SWF 125,000) at $0.5960 • total value of the contract = DEM 125,000 x $0.5960 = $74,500 • Original margin =$2,500 • Maintenance margin = $2,000 • If the day 0 settlement price of the contract is $0.5968, the contract value is $74,600 • $100 transferred to the buyer’s margin account, which is then paid out to the buyer • On day 1, the settlement price is $0.5980, and the contract value is $74,750 • The buyer gains another $150

28. The price changes from $0.5968 to $0.5980 = 12 ticks • A tick is the minimum price movement in the contract • a movement of 1 tick $0.0001 would change the contract value by 125,000 x $0.0001 = $12.50 • Day 2: settlement price = $0.5969 • contract value $74,612.50 • margin account = $2,500 - 137.50 = $2,362.50 • Day 3: settlement price = $0.5929 • contract value = $74,112.50 • margin account = $2,362.50 - 500 = $1,862.50 < $2,000 • MARGIN CALL • the buyer must replenish the margin account to the original $2,500

29. The contract was originally bought at $0.5960 • If the investor closes it out at $0.5929, the total impact comes from a fall of 31 ticks • Net gain = -31 x $12.50 = ($387.50) • ignores round-trip commission

30. A comparison of currency fwd & futures contracts ForwardsFutures Location Interbank Exchange floor Maturity Negotiated 3rd week of the month Amount Negotiated Standard contract (e.g. ¥12,500,000 ) Fees Bid-ask Commissions (e.g. $30 per contract) Counterparty Bank CME Clearinghouse Collateral Negotiated Margin account Settlement At maturity Most are settled early Trading hours24 hours During exchange hours

31. Hedging w/ Futures • Currency forward contracts can provide a perfect hedge when the size and the timing of a foreign currency transaction are known. • Exchange-traded futures contracts come in only a few currencies, contract sizes, and maturity dates, and hence may not provide a perfect hedge against transaction exposure to foreign currency risk.