Chapter 5 The Market for Foreign Exchange (FX or FOREX)

1、The Market for Foreign Exchange (FX or FOREX)Chapter 5Lecture ObjectivesIntroduce the institutional framework within which exchange rates are determinedLay the foundation for much of the discussion throughout the courseLecture Outline Structure of the FX Market The Spot Market The Forward MarketStru

2、cture of the FX MarketThe FX market Involves market participants buying and selling of different currencies all over the world. A worldwide network of traders, connected by telephone lines and computer screens there is no central headquarters. Trading also occurs around the clock.Includes trading cu

3、rrencies spot and forward, bank deposits of foreign currencies, foreign trade financing, trading in currency options, futures and swaps.Size of the FOREX MarketGlobal Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)494568386621100539819712813020836247554673465694417

4、14176501000200030004000500060007000SpotForwardsSwapsSource: Bank for International Settlements, “Triennial Central Bank Survey” April 2010.1995 1998 2001 2004 2007 2010World FX transactions$2.5 trillion/day (2010)Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2010.

5、38%56%5%1%SpotForwards and FX SwapsOptionsOthersDistribution of FX Trading Centers Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2010.Australia4%Canada1% France3%Germany2%Switzerland5%Japan6%Sweden1%United Kingdom36%United States18%Denmark 2%Hong Kong SAR5%Luxembo

6、urg1%Russia1%Singapore5%Spain1%Countries with shares less than 1%9%Major FX Trading Centers(Average daily volume ($b) during April of 1995-2010)Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2010.0200400600800100012001400160018002000199519982001220420072010New York

7、LondonTokyoTop 5 Most Traded Currencies (in terms of turnover)RankCurrencyCodeSymbol1United StatesUSD$2EurozoneEUR3Japanese YenYen4British Pound SterlingGBP5Swiss FrancCHFFrWorld FX transactions for USD PairSource: Bank for International Settlements, “Triennial Central Bank Survey” April 2010.USD/EU

8、RUSD/JPYUSD/GBPUSD/CHFUSD/AUDUSD/CADUSD/Others39%15%12%16%7%4%5%Top 10 currency traders % of overall volume, May 2011Source: Euromoney FX survey FX survey 2011: The Euromoney FX survey is the largest global poll of foreign exchange service providers. The FX market in the U.S. is the most active mark

9、et in the U.S.($904 billion turnover per day, in April 2010)01002003004005006007008009001000199519982001220420072010The FX market in the U.S. is the most active market in the U.S.$904 billion turnover per day, in April 2010 Comparisons with U.S. asset markets:10 times the turnover of U.S. govt bonds

10、50 times the turnover of NYSE stocks Comparisons with real activity in U.S.:10 times U.S. daily GDP30 times U.S. daily exports + importsPrimary functions of FX Market Currency conversions associated with international payments process Provision of credit to clients(also part of international payment

11、s process) Managing exchange rate riskStructure of the FX MarketThe FX market is a two-tiered market: Client Market (Retail)Non-financial companies; account about 17.8% in 2008.Central banks, hedge funds, mutual funds, insurance companies, and pension funds account for 40.3% Interbank Market (Wholes

12、ale) About 100-200 banks worldwide stand ready to make a market in foreign exchange.Dealers account for about 38.9% of the market in 2010.There are FX brokers who match buy and sell orders but do not carry inventory. Market participants include international banks, their customers, nonbank dealers,

13、FX brokers, and central banks.Direct vs. brokered interbank trades Direct dealing Banks face another banks bid-ask spread, at which they can transact immediately Brokered tradesGet best price of all posted buys/sellsIf you post an order, may not get executedElectronic brokerage has become the primar

14、y method of trading interbank spot FX; drawback is that it covers only major currencies. Much (56%) of FX trading is in the interbank (wholesale) market56% of all dealers trades are with other dealers31% are with other financial institutions (brokers, mutual funds, .)13% are with nonfinancial custom

15、ers 66% of all trades are with foreign counterpartiesHowever, the retail orders are the important ones that determine exchange ratesInterbank traders are intermediaries (market makers)temporarily take positions intradaily, butwork hard to zero out their positions regularly and by the end of the day

16、The Spot MarketSpot Rate QuotationsThe Bid-Ask SpreadSpot FX tradingCross RatesSpot Rate Quotations“Spot” - settlement happens on the second working day after the deal is done. The exceptions are US dollar trades against the Canadian Dollar and Mexican Peso, which are settled next day. When looking

17、at foreign exchange quotations, it is necessary to decide immediately which is the “home” currency and which the “foreign” currency. For the purposes of this class, the dollar will always be the “home” currency.Spot Rate Quotations There are two ways of quoting spot rates:No of units of home currenc

18、y per 1 unit of foreign currencyNo of units of foreign currency per 1 unit of home currency These are called, respectively, “Direct” and “Indirect” quotations. If the home currency is the dollar, they are sometimes called “American” and “European” quotations, respectively. Direct quotation: the U.S.

19、 dollar equivalente.g. “a Japanese Yen is worth about a penny” Indirect Quotation: the price of a U.S. dollar in the foreign currencye.g. “you get 77 yen to the dollar”Spot Rate Quotations For example:US$1 = S$1.789 is equivalent toS$1 = US$0.559 Note: No different from any other price.10 US dollar/

20、One umbrella1/10 umbrella/$ We will use the notation, for example, S$/US$ as the numbers of Singapore dollars per 1 dollar - that is an indirect quotation from an American perspective. The Wall Street Journal gives both quotes.Spot Rate QuotationsCountryUSD equiv FridayUSD equiv ThursdayCurrency per

21、 USD FridayCurrency per USD ThursdayArgentina (Peso)0.23120.23214.32594.3083Australia (Dollar)1.04841.04190.95380.9598Brazil (Real)0.56530.56531.76891.7689Britain (Pound)1.55751.54890.64210.64561 Month Forward1.55711.54850.64220.64583 Months Forward1.55621.54760.64260.64626 Months Forward1.55481.546

22、10.64320.6468The direct quote for British pound is: 1 = $1.5575The indirect quote for British pound is: .6421 = $10.980.971.022371.028817836 Months Forward0.970.961.031501.038002833 Months Forward0.960.961.038161.044707831 Month Forward0.95980.95381.04191.0484Australia (Dollar)0.64680.64321.54611.55

23、486 Months Forward0.64620.64261.54761.55623 Months Forward0.64580.64221.54851.55711 Month Forward0.64560.64211.54891.5575Britain (Pound)1.76891.76890.56530.5653Brazil (Real)1.01121.01320.98890.9869Canada (Dollar)4.30834.32590.23210.2312Argentina (Peso)Currency per USD ThursdayCurrency per USD Friday

24、USD equiv ThursdayUSD equiv FridayCountrySpot Rate QuotationsNote that the direct quote is the reciprocal of the indirect quote:.642115575. 10.980.971.022371.028817836 Months Forward0.970.961.031501.038002833 Months Forward0.960.961.038161.044707831 Month Forward0.95980.95381.04191.0484Australia (Do

25、llar)0.64680.64321.54611.55486 Months Forward0.64620.64261.54761.55623 Months Forward0.64580.64221.54851.55711 Month Forward0.64560.64211.54891.5575Britain (Pound)1.76891.76890.56530.5653Brazil (Real)1.01121.01320.98890.9869Canada (Dollar)4.30834.32590.23210.2312Argentina (Peso)Currency per USD Thur

26、sdayCurrency per USD FridayUSD equiv ThursdayUSD equiv FridayCountrySpot Rate QuotationsThe Bid-Ask SpreadIn general, banks do not charge commissions on foreign currency transactions. They profit from bid-ask spread.The bid-ask spread is the difference between the bid and ask prices.The bid price is

27、 the price a dealer is willing to pay you for a foreign currency.The ask price is the amount the dealer wants you to pay for the foreign currency.The Bid-Ask Spread Banks quote: US$/ 1.794 - 1.796 1.794 is the “Bid” price. A bank will buy pounds for $1.794/pound; same as bank selling $1.794 for 1.1.

28、796 is the “Offer” price. A bank will sell pounds for $1.796; same as bank buying $1.796 for 1 pound. Banks profit = ASK-BID = “Bid-Ask Spread”The Bid-Ask Spread Banks quote: US$/ 1.794 - 1.796 You pay US$1.796 for every pound you buy.You receive US$1.794 for every pound you sell. If you started wit

29、h one million dollars and converted it into pounds, then back to dollars, how much would you have after the two conversions? The Bid-Ask SpreadBanks quote: /US$ 1.0820 - 1.08261.What rate does the bank pay for every dollar you sell?2.What rate does the bank receive for every dollar you buy?3.What is

30、 the banks profit?Cross RatesSuppose that S($/) = .50 i.e. $1 = 2 and that S(/) = 50 i.e. 1 = 50What must the $/ cross rate be?,$ since100 $1or .01 )/($1001$50121$SCross RatesSuppose that S($/) = 1.082 i.e. 1 = $1.082and that S(CHF/$) = 1.572i.e. $1 = CHF 1.572What must the /CHF cross rate be?CHF1.7

31、0091CHF1.5721$082. 1$10.5879 1 CHFor .5879 CHF)/(SCross RatesSuppose that S($/) = 1.20 and that S($/) = 0.009. What must the S(/) cross rate be?Suppose that S(AUD/$) = 2. What must the S(AUD/) cross rate be?Triangular Arbitrage$Credit Lyonnais S($/)=1.50Credit AgricoleS(/)=185BarclaysS(/$)=120Suppos

32、e we observe these banks posting these exchange rates.First calculate the implied cross rates to see if an arbitrage exists.Triangular Arbitrage$Credit Lyonnais S($/)=1.50Credit AgricoleS(/)=185BarclaysS(/$)=120The implied S(/) cross rate is S(/) = 180.Credit Agricole has posted a quote of S(/)=185

33、so there is an arbitrage opportunity.So, how can we make money?Cross Exchange Rate EquilibriumS(d/e)S(e/f)S(f/d) = 1If S(d/e)S(e/f)S(f/d) 1, then either S(d/e), S(e/f), or S(f/d) must fall. Sell the currency in the denominator for the currency in the numerator of each spot rate.Cross Exchange Rates

34、and Triangular ArbitrageCalculate S(d/e)S(e/f)S(f/d).S(/$) = 120S($/)=1.50S(/)=185Then S(/$) S($/)1/S(/) = 0.973. Sell the currency in the numerator for the currency in the denominator of each spot rate.Triangular Arbitrage$Credit Lyonnais S($/)=1.50Credit AgricoleS(/)=185BarclaysS(/$)=120As easy as

35、 1 2 3:1. Sell our $ for , 2. Sell our for , 3. Sell those for $.123$Triangular ArbitrageSell $150,000 for at S($/) = 1.50 receive 100,000 Sell our 100,000 for at S(/) = 185 receive 18,500,000Sell 18,500,000 for $ at S(/$) = 120 receive $154,167profit per round trip = $ 154,167- $150,000 = $4,167The

36、 Forward MarketForward Rate QuotationsLong and Short Forward PositionsForward PremiumThe Forward MarketA forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.If you have ever had to order an out-of-stock textbook, then you have entered into a forward con

37、tract.Forward Rate QuotationsThe forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.Forward Rate QuotationsConsider the example from

38、above:for British pound, the spot rate is $1.5627 = 1.00While the 180-day forward rate is $1.5445 = 1.00Whats up with that?Spot Rate QuotationsClearly the market participants expect that the pound will be worth less in dollars in six months.1.49751.51060.66780.6626 Months Forward1.48881.5020.67170.6

39、6583 Months Forward1.48351.49680.67410.66811 Month Forward1.48131.49430.67510.6692Canada (Dollar)0.64610.64751.54771.54456 Months Forward0.64230.64371.55681.55353 Months Forward0.63980.64121.56291.55961 Month Forward0.63860.63991.5661.5627Britain (Pound)3.47343.40250.28790.2939Brazil (Real)1.68521.6

40、9320.59340.5906Australia (Dollar)3.03773.02210.32920.3309Argentina (Peso)Currency per USD ThursdayCurrency per USD FridayUSD equiv ThursdayUSD equiv FridayCountryForward Rate QuotationsS(USD/CAD)= 0.6399 F30 (USD/CAD)= 0.6391 This is 1 month forward rateF90 (USD/CAD)= 0.6376 This is 3 month forward

41、rateF180 (USD/CAD)= 0.6352 This is 6 month forward rateMarket expects that USD will appreciate (CAD depreciate).A forward currency is at a forward discount if the forward rate expressed in USD is below the spot rateA forward currency is at a forward premium if the forward rate expressed in USD is ab

42、ove the spot rateWhat about CAD? Long and Short Forward PositionsIf you have agreed to sell anything (spot or forward), you are “short”.If you have agreed to buy anything (forward or spot), you are “long”.If you have agreed to sell forex forward, you are short.If you have agreed to buy forex forward

43、, you are long.Forward Premium and DiscountIts just the interest rate differential implied by forward premium or discount.For example, suppose the is appreciating from S($/) = .5235 to F180($/) = .5307The forward premium is given by:0275.5235.5235.5307.180360)/($)/($)/($180$,180SSFfv is traded at a

44、premium of 2.75%.How about $?Forward Premium and DiscountSpot US$/ 1.60006-mo Forward1.5900What is the forward premium/discount on the US$?What about , is it trading at a premium ordiscount? Know the structure of the FX market Know the difference between wholesale (interbank) market and retail marke

45、t Who are the participants in the FX market? Know how to read/use spot and forward quotes; direct and indirect method Know how to define and calculate the bid-ask spread Calculate currency cross-rates, with and without bid-ask quotes, when given two spot or forward FX quotations involving three curr

46、encies Calculate the profit/loss on a triangular arbitrage opportunity given three currency quotations, with and without bid-ask spread Calculate the profit or loss of short and long forward positions Define and calculate the forward discount or premiumGreece to Eliminate 15,000 Government JobsNYT,

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