PPT The Foreign Exchange Market PowerPoint presentation

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PPT The Foreign Exchange Market PowerPoint presentation

The Foreign Exchange Market

The FOREX market consists of two tiers, the interbank or wholesale market, and. and the United States (New York) make up roughly 50% of the foreign exchange market. PowerPoint PPT presentation

Title: The Foreign Exchange Market

Chapter 5

  • The Foreign Exchange Market

Foreign Exchange Markets Learning Objectives

  • Examine the functions performed by the foreign

exchange (FOREX) market, its participants, size,

geographic and currency composition

  • Understand the definitions and distinguish

    between spot, forward, swap, and other types of

    foreign exchange financial instruments

  • Learn the forms of currency quotations used by

    currency dealers, financial institutions, and

    agents

  • Analyze the interaction among changing currency

    values, cross exchange rates and opportunities

    arising from inter-market arbitrage

    • Foreign Exchange Markets

    • The FOREX market provides the physical and

    institutional structure through which

  • The money of one country is exchanged for that of

    another country

  • The rate of exchange between currencies is

    determined

  • Foreign exchange transactions are physically

    completed

  • 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

    • Foreign Exchange Markets

    • There are six main characteristics of the FOREX

    markets which will be discussed

  • The geographic extent
  • The three main functions
  • The markets participants
  • Its daily transaction volume
  • Types of transactions including spot, forward and

    swaps

  • Methods of stating exchange rates, quotations,

    and changes in exchange rates

    • Geographic Extent of the Market

    • Geographically, the FOREX market spans the globe

    with prices moving and currencies trading every

    hour of every business day

  • Major world trading starts each morning in Sydney

    and Tokyo

  • Then moves west to Hong Kong and Singapore
  • Continuing to Europe and finishing on the West

    Coast of the U.S.

    • Exhibit 5.1 Measuring Foreign Exchange Market

    Activity Average Electronic Conversions per Hour

    Functions of the FOREX Market

    • The FOREX market is the mechanism by which

    participants

  • Transfer purchasing power between countries
  • This is necessary as international trade and

    capital transactions normally involve parties

    living in countries with different national

    currencies

  • Obtain or provides credit for international trade

    transactions

  • Inventories in transit must be financed
  • Minimize exposure to exchange rate risk
  • FOREX markets provide instruments utilized in

    hedging or transferring risk to more willing

    parties

    • Market Participants

    • The FOREX market consists of two tiers, the

    interbank or wholesale market, and the client or

    retail market

  • Five broad categories of participants operate

    within these two tiers

  • Bank and non bank foreign exchange dealers
  • Individuals and firms conducting commercial or

    investment transactions

  • Speculators and arbitragers
  • Central banks and treasuries
  • Foreign exchange brokers

    • Bank and Non-bank Dealers

    • These participants profit from buying currencies

    at a bid price and then reselling them at an

    offer or ask price

  • Competition among dealers narrows the spread

    between the bid and offer rate contributing to

    the markets efficiency

  • Dealers on behalf of large international banks

    often act as market makers, often willing to

    stand in and buy or sell these currencies without

    having a counterpart with which to unload the

    Individuals and Firms Conducting

    Commercial/Investment Transactions

    • Importers, exporters, portfolio investors, MNEs,

      tourists and others use the FOREX market to

      facilitate execution of commercial or investment

      transactions

    • Some of these participants use the market to

      hedge foreign exchange rate risk

      • Speculators and Arbitragers

      • Speculators and arbitragers seek to profit from

      trading in the market itself

    • They operate for their own interest, without need

      or obligation to serve clients or ensure a

      continuous market

    • Speculators seek all their profit from exchange

      rate changes

    • Arbitragers try to profit from simultaneous

      differences in exchange rates in different

      markets

    • A large proportion of speculation and arbitrage

      is conducted on behalf of major banks by traders

      employed by those banks

      • Central Banks and Treasuries

      • Central banks and treasuries use the market to

      acquire or spend their countrys currency

      Continuous Linked Settlement

      • Continuous Linked Settlement (CLS) system (since

      2002) eliminates losses if either party unable to

      settle

    • CLS links with Real-Time Gross Settlement (RTGS)

      Transactions in the Interbank Market

      • Transactions within this market can be executed

        on a spot, forward, or swap basis

      • A spot transaction requires almost immediate

        delivery of foreign exchange

      • A forward transaction requires delivery of

        foreign exchange at some future date

      • A swap transaction is the simultaneous exchange

        Outright Forward 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

        • Terminology typically used is buying or selling

          forward

        • A contract to deliver dollars for euros in six

          months is both buying euros forward for dollars

          and selling dollars forward for euros

          • Swap Transactions

          • 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

        • Both purchase and sale are conducted with the

          same counterpart

        • A common type of swap is a spot against forward
        • The dealer buys a currency in the spot market and

          simultaneously sells the same amount back to the

          same bank in the forward market

        • Since this transaction occurs at the same time

          and with the same counterpart, the dealer incurs

          no exchange rate exposure

          • Swap Transactions

          • Forward-forward swaps A dealer sells 20,000

          forward for dollars for delivery in two months at

          1.8420/ and simultaneously buys 20,000 forward

          for delivery in three months at 1.8400/

        • The difference between the buying and selling

          price is equivalent to the interest rate

          differential

        • Thus a swap can be viewed as a technique for

          borrowing another currency on a fully

          collateralized basis

          • bought forward is not delivered

        • The dollar-settlement feature reflects the fact

          that NDFs are contracted offshore and are beyond

          the reach and regulatory frameworks of the home

          country governments

        • Pricing of NDFs reflects basic interest rate

          differentials

          • Size of the FOREX Market

          • The Bank for International Settlements (BIS)

          estimates that daily global net turnover in

          traditional FOREX market activity to be US3.2

          trillion in April 2007

        • Spot transactions at 1,005 billion/day
        • Outright forward transactions at 363 billion/day
        • Swap transactions at 1,714 billion/day

          • averages in April, billions of U.S. dollars)

          Exhibit 5.4 Foreign Exchange Market Turnover by

          Currency Pair (Daily averages in April)

          Foreign Exchange Rates Quotations

          • A foreign exchange quote is a statement of

          willingness to buy or sell at an announced rate

        • In the retail market (newspapers and exchange

          booths), quotes are often given as the home

          currency price of the foreign currency

        • Interbank quotes professional dealers or

          brokers may state quotes in one of two ways

        • The foreign currency price of one dollar
        • Sfr1.6000/, read as 1.600 Swiss francs per

          dollar

        • The dollar price of a unit of foreign currency
        • 0.6250/Sfr, read as 0.625 dollars per Swiss franc

          • Foreign Exchange Rates Quotations

          • The former quote is considered to be in European

          terms and the latter is considered to be

          American terms

        • Almost all European currencies, except two, are

          quoted the European way

        • The Pound Sterling and the Euro are the

          exceptions

        • Additionally, Australian and New Zealand dollars

          are also quoted in American terms

          • Foreign Exchange Rates Quotations

          • Direct and Indirect Quotes
          • A direct quote is a home currency price of a unit

          of a foreign currency

        • Sfr1.6000/ is a direct quote in Switzerland
        • An indirect quote is a foreign currency price in

          a unit of the home currency

        • Sfr1.600/ is an indirect quote in the US,
        • 0.625/Sfr is a direct quote in the US and an

          indirect quote in Switzerland

          • Foreign Exchange Rates Quotations

          • Interbank quotes are given as a bid and ask
          • The bid is the price at which a dealer will buy

          another currency

        • The ask or offer is the price at which a dealer

          will sell another currency

        • Example 118.27 — 118.37/ is the bid/ask for

          Japanese yen

        • The bank will buy yen at 118.27 per dollar and

          sell yen at 118.37 per dollar making profit on

          the spread

          • Exhibit 5.5 Spot and Forward Quotations for the

          Euro and Japanese Yen

          Foreign Exchange Rates Quotations

          • Expressing Forward Quotations on a Points Basis
          • The previously mentioned rates for yen were

          considered outright quotes

        • Forward quotes are different and typically quoted

          in terms of points

        • A point is the last digit of a quotation, with

          convention dictating the number of digits to the

          right of the decimal

        • Hence a point is equal to 0.0001 of most

          currencies

          • Foreign Exchange Rates Quotations

          • Expressing Forward Quotations on a Points Basis
          • The yen is quoted only to two decimal points
          • A forward quotation is not a foreign exchange

          rate, rather the difference between the spot and

          forward rates

        • Example

          • Foreign Exchange Rates Quotations

          • Forward Quotations in Percentage Terms
          • Forward quotations may also be expressed as the

          percent-per-annum deviation from the spot rate

        • This is similar to the forward discount or

          premium calculated earlier

        • The important thing to remember is which currency

          is being used as the home or base currency

        • For indirect quotes (i.e. quote expressed in

          foreign currency terms), the formula is

          • Foreign Exchange Rates Quotations

          • Forward Quotations in Percentage Terms
          • For direct quotes (i.e. quote expressed in home

          currency terms), the formula is

          Foreign Exchange Rates Quotations

          • Forward Quotations in Percentage Terms
          • Example Indirect quote
          • Example Direct quote

          Exhibit 5.6 Foreign Exchange Rate Quotations on

          the U.S. Dollar/British Pound in the Financial

          Press

          Foreign Exchange Rates Quotations

          • Cross Rates
          • Many currencies pairs are inactively traded, so

          their exchange rate is determined through their

          dollars

        • Assume the following quotes

          • Japanese yen 110.73/ Mexican peso MXP 11.4456/

          Foreign Exchange Rates Quotations

          • Cross Rates
          • The Mexican importer can buy one US dollar for

          11.4456 Mexican pesos and with that dollar buy

          Exhibit 5.7 Key Currency Cross Rates

          Foreign Exchange Rates Quotations

          • Intermarket Arbitrage
          • Cross rates can be used to check on opportunities

          Foreign Exchange Rates Quotations

          • Intermarket Arbitrage
          • The cross rate between Citibank and Barclays is
          • This cross rate is not the same as Dresdners

          rate quote of 1.5100/

        • Therefore, an opportunity exists for risk-less

          Exhibit 5.8B Triangular Arbitrage

          Summary of Learning Objectives

          • The three functions of the foreign exchange

            market (FOREX) are to transfer purchasing power,

            provide credit, and minimize foreign exchange

            rate risk

          • The FOREX is composed of two tiers the interbank

            market and the client market. Participants

            within these tiers include bank and nonbank

            foreign exchange dealers, individuals and firms

            conducting commercial and investment functions,

            speculators and arbitragers, central banks and

            treasuries and foreign exchange brokers

            • Summary of Learning Objectives

            • Geographically, the FOREX market spans the globe,

            Summary of Learning Objectives

            • European terms quotations are the foreign

            currency price of one US dollar. American terms

            are the dollar price of a foreign currency

          • Quotations can also be direct or indirect. A

            direct quote is the home currency price of a unit

            of foreign currency, while an indirect quote is


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