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Multinational Business Finance 723g33. CHAPTER 6 THE FOREIGN EXCHANGE MARKET. [email protected]. The Foreign Exchange Market. Foreign exchange means the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts. - PowerPoint PPT Presentation
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The Foreign Exchange Market
• Foreign exchange means the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts.
• 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.
• $ 1 €
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Geography
• The foreign exchange market spans the globe, with currencies trading somewhere every hour of every business day.
6-3
Exhibit 6.1 Measuring Foreign Exchange Market Activity: Average Electronic Conversions Per Hour
6-4
Exhibit 6.2 Global Currency Trading: The Trading Day
Start of the day
The Foreign Exchange Market
• The Foreign Exchange Market provides: – the physical and institutional structure through
which the money of one country is exchanged for that of another country;
– the determination of rate of exchange between currencies, and
– is where foreign exchange transactions are physically completed.
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Functions of the Foreign Exchange Market
• The foreign exchange Market is the mechanism by which participants:– transfer purchasing power between countries;
– obtain or provide credit for international trade transactions, and
– minimize exposure to the risks of exchange rate changes.
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Market structure• The foreign exchange market consists of two tiers:Tier 1:
– the interbank or wholesale market (multiples of $1 trillion US or equivalent in transaction size), and
Tier 2:
– the client or retail market (specific, smaller amounts).
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Market Participants
Four broad categories of participants:
1. Bank and nonbank foreign exchange dealers,
2. Individuals and firms,
3. Speculators and arbitragers, and
4. Central banks and treasuries.
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1. Bank and Nonbank Foreign Exchange Dealers
• Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.
• The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price.
• Dealers in large international banks often function as “market makers.”
• These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies.
6-10
Exhibit 6.8 Bid, Ask, and Mid-Point Quotation
2. Individuals and Firms
• Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market.
• Their use of the foreign exchange market is necessary for their underlying commercial or investment purpose.
• Some of the participants use the market to “hedge” foreign exchange risk.
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3. Dealers, Speculators and Arbitragers
• Speculators and arbitragers seek to profit from trading in the market itself.
• They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market.
• While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.
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4: Central Banks and Treasuries
• Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded.
• The motive is not to earn a profit• Central banks and treasuries differ in motive
from all other market participants.
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Transactions in the Interbank Market
• A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place on the second following business day.
• The date of settlement is referred to as the value date.
6-15
Exhibit 6.3 Foreign Exchange Settlement in Europe
Transactions in the Interbank Market• An outright forward transaction (or a forward)
requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.
• The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity.
• Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months.
6-17
Transactions in the Interbank Market• 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 (settlement date).
• Both purchase and sale are conducted with the same counterparty.
• Some different types of swaps are:
– spot against forward,
– forward-forward with different value dates,
– nondeliverable forwards (NDF).
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Market Size
• In April 2004, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1.9 trillion.
• This most recent period showed dramatic growth in foreign exchange trading over that seen in April 2001.
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Exhibit 6.4 Global Foreign Exchange Market Turnover, 1989-2010 (average daily turnover in April, billions of U.S. dollars)
Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1991-2010 (average daily turnover in April)
Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair (daily average in April)
Foreign Exchange Rates and Quotations
• A foreign exchange rate is the price of one currency expressed in terms of another currency.
• A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.
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Foreign Exchange Rates and Quotations
• Most foreign exchange transactions involve the US dollar.
• Professional dealers and brokers may state foreign exchange quotations in one of two ways:– the foreign currency price of one dollar, or– the dollar price of a unit of foreign currency.
• Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.
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Foreign Exchange Rates and Quotations
• Foreign exchange quotes:
direct or indirect quote
the home country of the currencies being discussed is critical.
• A direct quote is a home currency price of a unit of foreign currency. ex: SKr/$
• An indirect quote is a foreign currency price of a unit of home currency. ex: $/Skr
• The form of the quote depends on what the speaker regard as “home.”
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Foreign Exchange Rates and Quotations
• For example, the exchange rate between US dollars and the Swiss franc is normally stated:– SF 1.6000/$ (direct quote)
• However, this rate can also be stated as:– $0.6250/SF (indirect quote)
• most interbank quotations around the world are stated in European terms.
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Foreign Exchange Rates and Quotes
• Forward rates are typically quoted in terms of points. 1 points typically corresponds to 0,0001 in value.
• Rather, it is the difference between the forward rate and the spot rate.
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Foreign Exchange Rates and Quotes
• Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate.
• This method of quotation makes it easier to compare premiums or discounts in the forward market
• If a currency increases in value in the future, it is traded at a premium, if decreases, it is at a discount against the other currency.
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Forward premium (¥ vs. $)• For quotations expressed in foreign currency
terms (indirect quotation ) the formula becomes:f ¥ = Spot – Forward 360
• For quotations expressed in home currency terms (direct quotation) the formula becomes:f ¥ = Forward – Spot 360
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100nForward
xx
100n Spot
x x
Example 1
Suppose we know that Spot rate: ¥118,27/$ <=>$0,0084/¥3-month Forward: ¥ 116,84/$ <=> $0,0085/¥Dollar is selling forward at a discount against Yen. Yen is selling foward at a premium against USD.The forward premium of Yen (home currency terms)is ((118,27-116,84)/116,84)*360/90*100=+4,90%
6-30
Example 1: cont.
Suppose we know that Spot rate: ¥118,27/$ <=>$0,0084/¥3-month Forward: ¥ 116,84/$ <=> $0,0085/¥•USD is selling at a discount against JPY.•Forward discount=•(116,84-118,27)/118,27*360/90*100=-4,836%
6-31
Exhibit 6.9 Exchange Rates: New York Closing Snapshot
Exhibit 6.9 Exchange Rates: New York Closing Snapshot (cont.)
Foreign Exchange Rates and Quotes
• Some currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate).
• Cross rates can be used to check on opportunities for intermarket arbitrage.
• one bank’s (Dresdner) quotation on €/£ is not the same as calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank).
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Intermarket Arbitrage• Citibank quote - $/€ $1.1.3297/€• Barclays quote - $/£ $1.5585/£• Dresdner quote - €/£ €1.1722/£• Cross rate calculation:
$1.5585/£
Because the rates are unequal, a triangular arbitrage opportunity exists.
For another example, see Exhibit 6.11
$1.3297/€= € 1.1721/£
=
Exhibit 6.10 Key Currency Rate Calculations for January 3, 2012
Exhibit 6.11 Triangular Arbitrage by a Market Trader
Foreign Exchange Rates changes (example: note the two notations are identical!!!)
• Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations):
%∆ = Ending rate – Beginning Rate
Quotations expressed in foreign currency terms (indirect quotations): =
Beginning rate –Ending rate
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Beginning Ratex 100
Beginning Ratex 100
Example 2:
• Mexican peso has changed from MXP10/USD to MXP 11/USD, what is the percentage change in the value of dollar, and peso?
Dollar appreciated in terms of MXP! (11-10)/10=10%
Peso depreciated in terms of USD! (1/11-1/10)*(1/10)=(10-11)/11=-9,09%
6-39
Exhibit 6.12 Spot and Forward Quotations for the Euro and Japanese Yen
1,0897+0,0003=1,0900