CHAPTER 7

The Foreign
Exchange Market
PART I. INTRODUCTION
I. INTRODUCTION
A. The Currency Market:
where money denominated
in one currency is bought
and sold with money
denominated in another
currency.
INTRODUCTION
B. International Trade and Capital
Transactions:
facilitated with the ability
to transfer purchasing power
between countries
INTRODUCTION
C. Location
1. OTC-type: no specific
location
2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide Interbank Financial
Telecommunications
PART II.
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
I . PARTICIPANTS IN THE FOREIGN
EXCHANGE MARKET
A. Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level
- business customers
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
B. Two Types of Currency Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business day
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
2. Forward Market:
- transactions take place at a
specified future date
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial
and central banks
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
II. CLEARING SYSTEMS
A. Clearing House Interbank
Payments System (CHIPS)
- used in U.S. for electronic
fund transfers.
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic transfers
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
III. ELECTRONIC TRADING
A. Automated Trading
- genuine screen-based
market
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
B. Results:
1. Reduces cost of trading
2. Threatens traders
oligopoly of information
3. Provides liquidity
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
IV. SIZE OF THE MARKET
A. Largest in the world
2004: US$1.9 trillion daily
or
US$475 trillion a year
In 1999 the US GDP was US$9.1 trillion
ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
B. Market Centers (2004):
#1: London = $753 billion daily
#2: New York= $461 billion daily
#3: Tokyo = $199 billion daily
PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have
four different quotes:
a. spot price
b. 30-day
c. 90-day
d. 180-day
THE SPOT MARKET
B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $1.21/
b. European terms
example: Peso1.713/$
THE SPOT MARKET
2. For nonbank customers:
Direct quote gives the home currency
price (always in the numerator) of one
unit of foreign currency.
EXAMPLE: $1.81/
Since this is a direct quote, we know that in
the U.S., one pound transacted at $1.81.
THE SPOT MARKET
C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee
charged by the bank
Bid = the price at which
the bank is willing to buy
Ask = the price it will sell
the currency
THE SPOT MARKET
4. Percent Spread Formula (PS):
100 x
Ask
Bid Ask
PS

=
THE SPOT MARKET
D. Cross Rates
1. The exchange rate
between 2 non - US$
currencies.
THE SPOT MARKET
2. Calculating Cross Rates
Suppose you want to calculate the /
cross rate.
You know .5556/US$ and .8334/US$
then
/ = .5556/US$ .8334/US$
= .6667/
THE SPOT MARKET
E. Currency Arbitrage
1. If cross rates differ from one financial
center to another, and profit opportunities
exist.
2. Buy cheap in one intl market,
sell at a higher price in
another
3. The Critical Role of Available Information
THE SPOT MARKET
F. Settlement Date Value Date:
1. Date monies are due
2. 2nd Working day after date of
original transaction.
THE SPOT MARKET
G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty
about future exchange
rate requires
1.) Demand for higher risk
premium
2.) Bankers widen bid-ask
spread
MECHANICS OF SPOT
TRANSACTIONS
SPOT TRANSACTIONS: Example
Step 1. Currency transaction:
verbal agreement, U.S. importer
specifies:
a. Account to debit (his acct)
b. Account to credit (exporter)
MECHANICS OF SPOT
TRANSACTIONS
Step 2. Bank sends importer
contract note including:
- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.
MECHANICS OF SPOT
TRANSACTIONS
Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporters.
Value Date.
U.S. bank debits importers
account.
PART IV.
THE FORWARD MARKET
I. INTRODUCTION
A. Definition of a Forward Contract:
an agreement between a bank and a
customer to deliver a specified amount of
currency against another currency at a
specified future date and at a fixed
exchange rate.
THE FORWARD MARKET
2. Purpose of a Forward:
Hedging
the act of reducing exchange
rate risk.
THE FORWARD MARKET
B. Forward Rate Quotations
1. Two Methods:
a. Outright Rate: quoted to
commercial customers.
b. Swap Rate: quoted in the
interbank market as a
discount or premium.
THE FORWARD MARKET
CALCULATING THE FORWARD
PREMIUM OR DISCOUNT
= F-S x 12 x 100
S n
where F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the
forward contract