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Multinational Business Finance 723g33. CHAPTER 6 THE FOREIGN EXCHANGE MARKET. Yinghong.chen@liu.se. The Foreign Exchange Market. Foreign exchange means the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts.
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Multinational Business Finance 723g33 CHAPTER 6 THE FOREIGN EXCHANGE MARKET Yinghong.chen@liu.se
The Foreign Exchange Market • Foreign exchangemeans the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts. • A foreign exchange transactionis an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate. • $ 1 €
Geography • The foreign exchange market spans the globe, with currencies trading somewhere every hour of every business day.
0 Exhibit 6.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversions Per Hour
Exhibit 6.2 Global Currency Trading: The Trading Day Start of the day
The Foreign Exchange Market • The Foreign Exchange Market provides: • the physical and institutional structure through which the money of one country is exchanged for that of another country; • the determination of rate of exchange between currencies, and • is where foreign exchange transactions are physically completed.
0 Functions of the Foreign Exchange Market • The foreign exchange Market is the mechanism by which participants: • transfer purchasing power between countries; • obtain or provide credit for international trade transactions, and • minimize exposure to the risks of exchange rate changes.
0 Market structure • The foreign exchange market consists of twotiers: Tier 1: • the interbank or wholesale market (multiples of $1 trillion US or equivalent in transaction size), and Tier 2: • the client or retail market (specific, smaller amounts).
Market Participants Four broad categories of participants: • Bank and nonbank foreign exchange dealers, • Individuals and firms, • Speculators and arbitragers, and • Central banks and treasuries.
0 1. Bank and Nonbank Foreign Exchange Dealers • Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets. • The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price. • Dealers in large international banks often function as “market makers.” • These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.
0 2. Individuals and Firms • Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. • Their use of the foreign exchange market is necessary for their underlying commercial or investment purpose. • Some of the participants use the market to “hedge” foreign exchange risk.
0 3. Dealers, Speculators and Arbitragers • Speculators and arbitragers seek to profit from trading in the market itself. • They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. • While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.
0 4: Central Banks and Treasuries • Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. • The motive is not to earn a profit • Central banks and treasuries differ in motive from all other market participants.
0 Transactions in the Interbank Market • A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place on the second following business day. • The date of settlement is referred to as thevalue date.
0 Transactions in the Interbank Market • An outright forward transaction (or a forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. • The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. • Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.
0 Transactions in the Interbank Market • A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates (settlement date). • Both purchase and sale are conducted with the same counterparty. • Some different types of swaps are: • spot against forward, • forward-forward with different value dates, • nondeliverable forwards (NDF).
0 Market Size • In April 2004, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1.9 trillion. • This most recent period showed dramatic growth in foreign exchange trading over that seen in April 2001.
Exhibit 6.4 Global Foreign Exchange Market Turnover, 1989-2010 (average daily turnover in April, billions of U.S. dollars)
Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1991-2010 (average daily turnover in April)
Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair (daily average in April)
0 Foreign Exchange Rates and Quotations • A foreign exchange rate is the price of one currency expressed in terms of another currency. • A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.
0 Foreign Exchange Rates and Quotations • Most foreign exchange transactions involve the US dollar. • Professional dealers and brokers may state foreign exchange quotations in one of two ways: • the foreign currency price of one dollar, or • the dollar price of a unit of foreign currency. • Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.
0 Foreign Exchange Rates and Quotations • Foreign exchange quotes: direct or indirect quote the home country of the currencies being discussed is critical. • A direct quote is a home currency price of a unit of foreign currency. ex: SKr/$ • An indirect quote is a foreign currency price of a unit of home currency. ex: $/Skr • The form of the quote depends on what the speaker regard as “home.”
0 Foreign Exchange Rates and Quotations • For example, the exchange rate between US dollars and the Swiss franc is normally stated: • SF 1.6000/$ (direct quote) • However, this rate can also be stated as: • $0.6250/SF (indirect quote) • most interbank quotations around the world are stated in European terms.
0 Foreign Exchange Rates and Quotes • Forward rates are typically quoted in terms of points. 1 points typically corresponds to 0,0001 in value. • Rather, it is the difference between the forward rate and the spot rate.
0 Foreign Exchange Rates and Quotes • Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate. • This method of quotation makes it easier to compare premiums or discounts in the forward market • If a currency increases in value in the future, it is traded at a premium, if decreases, it is at a discount against the other currency.
0 Forward premium (¥ vs. $) • For quotations expressed in foreign currency terms (indirect quotation ) the formula becomes: f ¥= Spot – Forward360 • For quotations expressed in home currency terms (direct quotation) the formula becomes: f ¥= Forward – Spot360 x x 100 n Forward 100 x x Spot n
Example 1 Suppose we know that Spot rate: ¥118,27/$ <=>$0,0084/¥ 3-month Forward: ¥ 116,84/$ <=> $0,0085/¥ Dollar is selling forward at a discount against Yen. Yen is selling foward at a premium against USD. The forward premium of Yen (home currency terms)is ((118,27-116,84)/116,84)*360/90*100=+4,90%
Example 1: cont. Suppose we know that Spot rate: ¥118,27/$ <=>$0,0084/¥ 3-month Forward: ¥ 116,84/$ <=> $0,0085/¥ • USD is selling at a discount against JPY. • Forward discount= • (116,84-118,27)/118,27*360/90*100=-4,836%
Exhibit 6.9 Exchange Rates: New York Closing Snapshot (cont.)
0 Foreign Exchange Rates and Quotes • Some currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate). • Cross rates can be used to check on opportunities for intermarketarbitrage. • one bank’s (Dresdner) quotation on €/£ is not the same as calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank).
Citibank quote - $/€ $1.1.3297/€ Barclays quote - $/£ $1.5585/£ Dresdner quote - €/£ €1.1722/£ Cross rate calculation: $1.5585/£ Because the rates are unequal, a triangular arbitrage opportunity exists. For another example, see Exhibit 6.11 = € 1.1721/£ = 0 Intermarket Arbitrage $1.3297/€
Exhibit 6.10 Key Currency Rate Calculations for January 3, 2012
x 100 x 100 Beginning Rate Beginning Rate 0 Foreign Exchange Rates changes (example: note the two notations are identical!!!) • Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations): %∆ = Ending rate – Beginning Rate Quotations expressed in foreign currency terms (indirect quotations): = Beginning rate –Ending rate
Example 2: • Mexican peso has changed from MXP10/USD to MXP 11/USD, what is the percentage change in the value of dollar, and peso? Dollar appreciated in terms of MXP! (11-10)/10=10% Peso depreciated in terms of USD! (1/11-1/10)*(1/10)=(10-11)/11=-9,09%
Exhibit 6.12 Spot and Forward Quotations for the Euro and Japanese Yen 1,0897+0,0003= 1,0900