Chapter 7 the foreign exchange market



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CHAPTER 7


CHAPTER OVERVIEW

  • I. INTRODUCTION

  • II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

  • III. THE SPOT MARKET

  • IV. THE FORWARD MARKET

  • V. INTEREST RATE PARITY THEORY



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



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



ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

  • IV. SIZE OF THE MARKET

  • A. Largest in the world

  • 1995: $1.2 trillion daily



ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

  • B. Market Centers (1995):

  • London = $464 billion daily

  • New York= $244 billion daily

  • Tokyo = $161 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: $.5838/dm

  • b. European terms

  • example: dm1.713/$



THE SPOT MARKET

  • 2. For nonbank customers:

  • Direct quote

  • gives the home currency price of one unit of foreign currency.

  • EXAMPLE: dm0.25/FF



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):



THE SPOT MARKET

  • D. Cross Rates

  • 1. The exchange rate between 2 non - US$ currencies.



THE SPOT MARKET

  • 2. Calculating Cross Rates

  • When you want to know what the dm/ cross rate is, and you know

  • dm2/US$ and .55/US$

  • then dm/ = dm2/US$  .55/US$

  • = dm3.636/ 



THE SPOT MARKET

  • E. Currency Arbitrage

  • 1. If cross rates differ from

  • one financial center to another, and profit opportunities exist.



THE SPOT MARKET

  • 2. Buy cheap in one int’l market,

  • sell at a higher price in another

  • 3. 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



THE SPOT MARKET

  • 1.) Demand for higher risk

  • premium

  • 2.) Bankers widen bid-ask spread



PART II. MECHANICS OF SPOT TRANSACTIONS

  • SPOT TRANSACTIONS: An 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 exporter’s.

  • Value Date.

  • U.S. bank debits importer’s

  • account.



PART III. 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



THE FORWARD MARKET

  • C. Forward Contract Maturities

  • 1. Contract Terms

  • a. 30-day

  • b. 90-day

  • c. 180-day

  • d. 360-day

  • 2. Longer-term Contracts



PART IV. INTEREST RATE PARITY THEORY

  • I. INTRODUCTION

  • A. The Theory states:

  • the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.



INTEREST RATE PARITY THEORY

  • 2. The forward premium or

  • discount equals the interest

  • rate differential.

  • (F - S)/S = (rh - rf)

  • where rh = the home rate

  • rf = the foreign rate



INTEREST RATE PARITY THEORY

  • 3. In equilibrium, returns on

  • currencies will be the same

  • i. e. No profit will be realized

  • and interest parity exists

  • which can be written

  • (1 + rh) = F

  • (1 + rf) S



INTEREST RATE PARITY THEORY

  • B. Covered Interest Arbitrage

  • 1. Conditions required:

  • interest rate differential does

  • not equal the forward premium or discount.

  • 2. Funds will move to a country

  • with a more attractive rate.



INTEREST RATE PARITY THEORY

  • 3. Market pressures develop:

  • a. As one currency is more

  • demanded spot and sold

  • forward.

  • b. Inflow of fund depresses

  • interest rates.

  • c. Parity eventually reached.



INTEREST RATE PARITY THEORY

  • C. Summary:

  • Interest Rate Parity states:

  • 1. Higher interest rates on a

  • currency offset by forward discounts.

  • 2. Lower interest rates are offset by forward premiums.



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