The
The Foreign
Foreign Exchange
Exchange Market
Market
Chapter Four
1
The
The Foreign
Foreign Exchange
Exchange
Market
Market
The FOREX market provides the physical and
institutional structure through which the money of
one country is exchanged for that of another
country.
A foreign exchange transaction is 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.
2
Functions
Functions of
of the
the Foreign
Foreign
Exchange
Exchange Market
Market
Transfer of purchasing power
Provision of credit
Minimizing foreign exchange risk
3
Structure
Structure of
of the
the Foreign
Foreign
Exchange
Exchange Market
Market
An over-the-counter market
– No centralized marketplace
– A network of telephones, telex machines,
computer terminals, and automated
dealing systems.
Not confined to any one country
No fixed opening and closing times
4
The
The World
World of
of Foreign
Foreign
Exchange
Exchange Dealing
Dealing
5
Market
Market Participants
Participants
Two Tier Market FX
Broker
International Banks
Bank Customers
Central Non-Bank
Banks Dealers
6
Transactions
Transactions in
in the
the Interbank
Interbank
Market
Market
Spot Transactions
Outright Forward Transactions
Swap Transactions
7
Global
Global Foreign
Foreign Exchange
Exchange
Market
Market Turnover
Turnover
Two of the three categories fell between 1998 and 2001
with spot market daily turnover falling the most, from
$568 billion in 1998 to $387 billion in 2001.
Forward transactions increased slightly from $128 billion
in 1998 to $131 billion in 2001.
Swaps fell to $656 billion in 2001 from $734 billion in
1998.
– The BIS attributes the introduction of the Euro, the growing share
of electronic broking in the spot market and consolidation in
banking as explanations for the reduction
8
Foreign
Foreign Exchange
Exchange Rate
Rate
Quotations
Quotations
American Terms European Terms
U.S. dollar price of Foreign currency price
one unit of foreign of one U.S. dollar
currency A direct quote in
A direct quote in the Europe
U.S. An indirect quote in
An indirect quote in the U.S.
Europe
9
Bid
Bid and
and Ask
Ask Quotations
Quotations
Bid Rate and Offer/Ask Rate
– Outright quotations
– Abbreviation
Reversing Bid and Offer Rate
Bid-Ask Spread
10
Cross
Cross Rates
Rates
Exchange rate determined through the relationship
to a widely traded third currency.
Example:
– A Mexican importer needs Japanese yen to pay for
purchases in Tokyo. Both the Mexican peso (Ps) and
Japanese yen (¥) are quoted in US dollars
– Assume the following quotes:
Japanese yen ¥121.13/$
Mexican peso Ps9.190/$
11
Currency
Currency Arbitrage
Arbitrage
Capitalizing on the
discrepancy in quoted
prices.
– No investment
– No risk
Locational Arbitrage
Triangular Arbitrage
12
Locational
Locational Arbitrage
Arbitrage
When quoted exchange rates vary among locations,
participants in the foreign exchange market can capitalize
on the discrepancy.
Suppose the euro is quoted in London at 0.6064-80 and the
pound sterling is quoted in Frankfurt at 1.6244-59.
13
Triangular
Triangular Arbitrage
Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage.
Example: Assume the following exchange rates are quoted in New York,
Frankfurt, and London, respectively:
– $1.4443/£
– $0.9045/€
– €1.6200/£
14
Forward
Forward Transactions
Transactions
This transaction requires delivery at a future value
date of a specified amount of one currency for
another
The exchange rate is agreed upon at the time of
the transaction, but payment and delivery are
delayed
Forward rates are contracts quoted for value dates
of one, two, three, six, nine and twelve months
15
Forward
Forward Market
Market Participants
Participants
Trader
Arbitrager
Hedger Speculator
16
Forward
Forward Quotations
Quotations
Outright Rate
Swap Rate
– Discount or Premium
– Annualized Percentage Discount or Premium
– Swap Rate Expressed in Points
17
Swap
Swap Rate
Rate
Outright forward rate =
Spot rate ±Swap rate/point
A point is the last digit of a quotation.
Add points to spot rate if currency is
trading at a forward premium.
Subtract points from spot rate if currency is
trading at a forward discount.
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