Foreign Exchange Foreign Exchange Markets Markets

TOPIC 7

MAF306 International Finance and Investments

Foreign Exchange MarketsForeign Exchange Markets

Objectives

to describe how the foreign exchange (FX) market is organized

understand it’s role, importance & participants

to examine the distinction between spot and forward exchange rates

to understand FX quotations and conventions

to calculate forward premiums and discounts

To consider FX arbitrage

READING

Shapiro Ch 7

Is this where you might like Is this where you might like to be??to be??

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An international holiday?......What role do FX markets play?

Why do we need FE Markets?

Transfer of purchasing power across nationsFacilitate I/N trade ….ie buy stuff!Determine ER (ie D & S in the market – see lecture 2 for factors that influence ER)Facilitate FE stability (central bank intervention – see lecture 2)Facilitate FE risk management (see lecture 9 & 10)Give assistance or foreign aid (eg. Third world countries, nations affected by natural disasters)

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The Foreign Exchange Market

its trading volumes - As of April 2014, average daily turnover in the FX

market exceeded US$5 trillion!!the extreme liquidity of the marketthe large number of, and variety of, traders in the marketits geographical dispersionthe 24-hour-a-day trading – no fixed opening/closing timestransactions are done via telephones, computer dealing systems, or through brokers, there is no physical transfer of one currency for another currency – electronic book-keeping

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What makes Foreign Exchange Markets Unique?

Foreign Exchange Markets Foreign Exchange Markets

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Most traded currencies,Size (per day) and 24-hour trading

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Global foreign exchange daily turnover(measured in billions of USD, BIS Dec 2007, see Figure 7.4B, p 263

for updated figure)

Location?The FX market spans the globe in 2012

The Foreign Exchange Market

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FX turnover: Top currencies

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Location?The FX market spans the globe

- London accounts for > 40% of the daily trading (2015) - New York: 17.9% - Tokyo: 5.4%

Historically, most trades by phone, telex, or SWIFT (SWIFT: Society for Worldwide Interbank Financial

Telecommunications)

More recently, electronic trading- Increases liquidity - Reduces trading cost- Makes information more accessible

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The Foreign Exchange Market

Bank and foreign exchange dealersCentral banksIndividuals and companies conducting commercial and investment transactions Speculators and arbitrageursHedgersCentral banks and treasuries

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Participants in the FE Market

Two Types of Currency MarketsSpot Market: immediate transaction – cash market settled on the 2nd business day after the date of transaction

Forward Market: transactions at a pre-specified price take place on a specified future date

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Organisation of the Foreign Exchange Market

Spot QuotationsSources

all major newspapers major currencies have four different quotes:

spot price 30-day forward price 90-day forward price 180-day forward price

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The Spot Market

The Foreign Currency Market

where money denominated in one currency is bought and sold with money denominated in another currency

EG. US$1 buys A$0.71 OrA$1 buys US$1.40

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The Foreign Exchange Market

In the currency market convention all currencies are quoted in the following manner:-

1 unit of a currency = x units of another currency

Example: 1 unit of US$ = JPY122.65

This quotation means that it costs JPY122.65 to buy one US$ or if one wishes to convert 1 US$ into JPY one would receive JPY122.65.

Foreign Exchange Rates and Foreign Exchange Rates and QuotationsQuotations

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Depreciation/Depreciation/AppreciationAppreciation

Currency is appreciating against another currency……when that the currency is now worth more in terms of the other currency.•For example:

• Before• Now

1 US$ = 1.4680 CHF

1 US$ = 1.4710 CHF

The US$ is appreciating against CHF because it costs 1.4710 CHF to buy 1 US$ now which is more than before by 0.0030 CHF

Foreign exchange quotes either direct or indirect.

In this pair of definitions, the home or base country of the currencies being discussed is critical.

A direct quote is a home currency price of a unit of foreign currency. (1 FC=x units DC)

An indirect quote is a foreign currency price of a unit of home currency. (1 DC=x units FC)

The form of the quote depends on what the speaker regard as “home.”

Foreign Exchange Rates and Foreign Exchange Rates and QuotationsQuotations

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FX quotation conventionsFX quotation conventions

American TermsUSD price per unit of foreign currency

for example, USD 1.09/AUD1

A Direct quote in the US

An Indirect quote outside the U.S. (e.g. in Australia)

European TermsForeign currency price of one USDFor example ¥108.10/US$1An Indirect quote in the USA Direct quote outside the US (e.g. in Japan)

Most interbank quotations around the world are stated in European termsExceptions to this include EUR, GBP, AUD, NZD

Direct/indirect quotes for foreign Direct/indirect quotes for foreign currencycurrency

Direct quotes place the domestic (home) currency (always) in the numerator and the foreign currency in the denominator (d/f);

e.g. €0.0090/¥ for a resident of Europe OR AUD0.917/USD for a resident of Australia

Indirect quotes place the domestic currency in the denominator and the foreign currency in the numerator (f/d);

e.g. ¥110.95/€ for a resident of Europe OR USD1.09/AUD for a resident of Australia

Direct quote and indirect quote are reciprocals

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Reciprocal Reciprocal RatesRates

The reciprocal rate is the inverse/reciprocal of a conventional quote.

Examples:1 US$ = SGD 1.7650Reciprocal rate is: 1 SGD = US$ 1/1.7650 = US$ 0.5666

1 AU$ = US$ 0.7850Reciprocal rate is:1 US$ = AU$ 1.2739

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Commodity and Term Currency

Quoted currency - commodity currency or base currency

expressed in terms of a number of units of the other currency.

The other currency is know as the term currency.

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Commodity and Term Currency

Example: (a) 1 AU$ = US$ 0.7850

(b) 1 US$ = SGD 1.7725

In (a) the commodity currency is the Australian dollar. One Australian dollar is expressed as 0.7850 units of US dollars and the US$ is the term currency.

In (b) US$ is the commodity currency and SGD is the term currency.

Transactions CostsBid-Ask Spread

used to calculate the fee charged by the bank bid = the price at which the bank/FE dealer is willing to buy ask = the price it will sell the currencyPercent Spread Formula

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The Spot Market

100xAsk

BidAskPS

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BID and ASK (or buy and BID and ASK (or buy and sell)sell)• Spot rate is always quoted as a 2-way

price

- Buying price or the bid price on the left hand side

- ASK/selling price or the offer price on the right hand side.

• Example: the dealer quotes spot US$/AU$1 as follows

0.7850/0.7860 or

(BID) (ASK or Sell)

0.7850-60 (BID)- (ASK)

What does this mean (see next slide)?

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BID and ASK…cont• The interbank dealer (also called price maker) is

prepared to buy Australian dollar against US dollars at a price of 1 AU$ to 0.7850 US$ (bid price, i.e., buy cheap)

• he is prepared to sell the Australian dollars against the US dollars at the price of 1 AU$ to 0.7860 US$ (offer price, i.e., sell high).

• Further explanation1. For bid/buy transaction: buy AU$10,000 (i.e.,

pay/sell US$) = 10000 x 0.785 = US$7850 (pay less)

2. For offer/sell transaction: sell AU$10,000 (i.e., receive/buy US$) = 10000 x 0.786 = US$7860 (receive more)

• In the buy transaction, the dealer wants to give/pay less

• In the sell transaction, the dealer wants to receive more

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FE FE SpreadSpread

The spread = difference between the bid rate and the offer rate.

In the above US$/A$1 price, the spread is 10 points or 10 pips i.e 0.7860 - 0.7850 = 0.0010 or 10 pips A pip/point refers to one unit in the final decimal place to which a given exchange rate is conventionally quoted.In the above example, the spread is = 10000 x (0.7860 – 0.7850) = US$10

Why is the interbank market spread is narrow than the retail market? (Answer: see the topic: International financial markets)

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Multiple Choice Time! No Multiple Choice Time! No 11

From the viewpoint of a British investor, which of the following would be a direct quote in the foreign exchange market?

(a) SF2.40/£(b) $1.50/£(c) £0.55/€(d) $0.90/€ Ans C

Multiple Choice Question Time! Multiple Choice Question Time! No 2No 2

Assume that a bank's bid rate on Japanese yen is $.0041 and its ask rate is $.0043.  Its bid‑ask percentage spread is:a. about 4.99%.b. about 4.88%.c. about 4.65%.d. about 4.43%.

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ANSWER: C SOLUTION: Bid‑ask percentage spread = ($.0043 ‑ $.0041)/$.0043 = 4.65%

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Multiple Choice Time! No 3Multiple Choice Time! No 3

Most foreign exchange transactions are through the U.S. dollar. If the transaction is expressed as the foreign currency per dollar this is known as _____________ whereas ___________ are expressed as dollars per foreign unit.

(a) European terms; indirect(b) American terms; direct(c) American terms; European terms(d) European terms; American termsAns d

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““Market Makers” in FX Market Makers” in FX MarketsMarkets

Brokers/banks stand willing to trade both ways at their buy/bid and sell/ask rate to make profit

 Creates an efficient market

  transaction costs of search for prices and counterparts Provides “immediacy” service at fee - the market spread

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Market Spreads in Spot Market Market Spreads in Spot Market (Buy-Sell Spread)(Buy-Sell Spread)Buy-sell or Bid-ask spread using direct

quotes Supply (Market Makers)

Demand (Market Makers)

A$/US$

Qty of US$

Supply (Public)

Demand (Public)

So

Sbuy

A$1.300

SSell

A$1.316S

P

R

E

A

D

A$1.316/US$ = US$0.76/AU$

A$1.300/US$ = US$0.77/AU$

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Market Spreads in Spot Market Market Spreads in Spot Market (Buy-Sell Spread)(Buy-Sell Spread)

Assume initially the public demand and supply functions in the spot market are Dp and Sp

If public’s “bid” and “ask” tenders could be revealed to each other Equilibrium at “So” would occur

Dmm (market marker’s Demand curve) - dealers willingness to purchase US$ (with $A) from the public

Smm – (market maker’s supply curve) – dealers willingness to sell US$ (for $A) to the public

 

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Market Spreads in Spot Market Market Spreads in Spot Market (Buy-Sell Spread)(Buy-Sell Spread)

Intersection of Dmm with Sp determines the exchange rate at which US$ are bought from the public, i.e. Sbuy

Intersection of Dp with Smm determines the exchange rate at which US$ are sold to the public, i.e. Ssell

Difference between buy and sell rates = buy-sell spread or market spread dealer’s profits

Bid-ask Spread % Spread = (Ask price – Bid price)/Ask price x 100

Ask price is ALWAYS higher !

Increased uncertainty about future exchange rate requires:demand for higher risk premiumbankers widen bid-ask spread

 

ExerciseExercise 1 1

Bank of Tokyo (the market maker) quotes the following rates for: JPY/US$1 = 81.55/81.58

If you are a buyer/seller of JPY, what is the rate you choose if you wish to buy/sell JPY?

If you are a buyer/seller of US$, what is the rate you choose if you wish to buy/sell US$?

* Note: Bank always buys low/sells high

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ExerciseExercise 1 1Bank of Tokyo (the market maker) quotes the following rates for: JPY/US$1 = 81.55/81.58

If you are a buyer/seller of JPY, what is the rate you choose if you wish to buy/sell JPY?

(Hint: Reverse and invert to get buy/sell rates for Yen (see p 265-266)…so 1/81.58 (0.01225 US cents/1 Yen) becomes buy rate for Yen and 1/81.55 becomes sell rate (0.01226 US cents /1 Yen)

BoT Buyer of Yen = 0.01225 US centsBoT Sell Yen = 0.01226 US cents

If you are a buyer/seller of US$, what is the rate you choose if you wish to buy/sell US$?

Buyer of US$ = 81.55 yen to buy US$1Sell US$ = 81.58 yen received for each US$ sold

* Note: Bank always buys low/sells high

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Cross ratesCross rates• Monday, September 10, 2012, listed the yen–dollar and euro–dollar rates as ¥78.56 and €0.7802, respectively. Suppose you want to know the euro–yen exchange rate, how do you get this rate? i.e.

• Because the dollar is the common currency here, cancel it. Think in terms of the currencies involved: When you divide the euro–dollar exchange rate by the yen–dollar exchange rate, the dollars cancel and you get the euro– yen exchange rate: 36

Cross Ratesthe exchange rate between 2 non-US$ currencies

Calculating Cross Rates (European terms)Suppose you want to calculate the £/€ cross rate:

You know £.5556/US$ and €.8334/US$then:

£/ € rate = £.5556/US$ €.8334/US$ = £.6667/ €

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The Spot Market

GBP EUR GBP USD GBPx

USD USD USD EUR EUR

The Spot MarketThe Spot Market

Calculating Cross Rates (American terms)

Again you want to calculate the £/€ cross rate:

You know US$1.7999/£ and US$1.1999/ €

then:

£/ € rate = US$1.1999/ € US$1.7999/£

= £.6667/ €

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USD USD USD GBP GBPx

EUR GBP EUR USD EUR

The rates given are as follows:

US$/AU$1 = 0.7250CHF/US$1 = 1.4610

What rate is not given?

The cross rate for A$ in terms of CHF ie CHF/A$1

Given 1 AU$ = 0.7250 US$ and its reciprocal rate:

1 US$ = 1.3793 AU$

and 1 US$ = 1.4610 CHF

CHF = Swiss FrancQ: What is the cross rate for A$ in terms of CHF?

Q: What is the cross rate for CHF in terms of AU$?

Cross Cross RRateate Exercise 2 Exercise 2

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Given 1 AU$ = 0.7250 US$ and its reciprocal rate: 1

US$ = 1.3793 AU$

and 1 US$ = 1.4610 CHF (Swiss Franc)

Therefore, Using American terms (or direct quotes)……

USD USD

USD x

GBP GBP EUR GBP EUR USD EUR

Q: What is the cross rate for A$ in terms of CHF?

1 AU$ = 1.4610/1.3793 = 1.0592 CHF (i.e., CHF/A$1)Q: What is the cross rate for CHF in terms of AU$?

Ans.: 1 CHF = 1.3793/1.4610 = 0.9441 AU$ (i.e., A$/CHF1, which is the reciprocal rate of CHF/A$1).

Cross rateCross rate Exercise 2 Exercise 2

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Cross Rate Cross Rate ExerciseExercise 3 3

What is the cross rate for € in terms of SGD?

Hint: Need to get US$ in denominator for both! Hence take reciprocal…

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• Given SGD/US$1 1.2835

US$/€ 1 1.2165

Cross Rate Cross Rate ExerciseExercise 3 3

What is the cross rate for € in terms of SGD?

Hint: Need to get US$ in denominator for both! Hence take reciprocal…

•€/US$1 =1/1.2165 =0.8220Then use European terms…

•€ = 1.2835/0.8220 = SGD$1.5614

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• Given SGD/US$1 1.2835

US$/€ 1 1.2165

Currency Arbitrage

if cross rates differ from one financial centre to another, then profit opportunities exist buy cheap in one I/N market, sell at a higher price in another the critical role of available information

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The Spot Market

The Spot MarketThe Spot Market

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Currency arbitrage: An example

The different euro/pound rates mean that there is an arbitrage advantage of buying currency in one market and selling it for a higher rate in another

The Spot MarketThe Spot MarketTriangular currency arbitrage

Note: transaction (2) has an error, it should be divided:

A$1 000 000/1.8410= £543 183

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Definition of a Forward Contract:- an agreement between two parties for

the delivery, on a specified future date, of a specified amount of currency against another currency at a fixed exchange rate

Use of a Forward:- Hedging: reducing/eliminating exchange rate

risk for existing FX position- Speculation: taking open positions in the FX

market

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The Forward Market

Forward premiumA currency’s value in the forward exchange market is higher than in the spot exchange market

Forward discount A currency’ value in the forward exchange market is lower than in the spot exchange market

Quoted in the interbank market as a discount or premium to the spot rate

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The Forward Market

Calculating the Percentage Forward Premium or Discount on foreign currency (Direct formula Eq 7.1, Shapiro p274)

where f1 = the 1-period forward rate (F) e0 = the current spot rate (S)

n = the number of days in the forward contract

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The Forward Market

1 0

0

360* *100

f e

e n

Calculating the Percentage Forward Premium or Discount on foreign currency (Indirect formula)

where f1’ = the 1-period forward rate (indirect quote)

e0’ = the current spot rate (indirect quote)

n = the number of days in the forward contract

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The Forward Market

' '0 1

'1

360* *100

e f

f n

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The Forward MarketThe Forward MarketCalculating the Forward Premium or Discount….using S for e0, and F for f1

Direct = 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

Indirect = S-F x 12 x 100 F n

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Percentage Forward Percentage Forward Premium/DiscountsPremium/Discounts

Allows % comparison of annualised premium and discounts in the forward market with i/r differentials (will utilise with IRP, topic 8)

Note: both formulas calculate the forward premium/discount of the foreign currency relative to the domestic currency.

Regardless of using direct or indirect quotes, the calculation of the premium should be the same, provided that the currency quote is consistent with the formula used, i.e., direct quote use direct formula, indirect quote use indirect formula.

What if you are given indirect quote and direct formula?

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Indirect Quotes % Forward Premium/DiscountsIndirect Quotes % Forward Premium/Discounts

An example, assume the following indirect quotes (i.e. AUD is the home currency)

Spot rate e0’ = SFr1.7126/AUD

Forward rate f1’ = SFr 1.7373/AUD Forward contract number of days = 180 (6 months)

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Indirect Quotes and % Forward Indirect Quotes and % Forward Premium/DiscountPremium/Discount

SFr is selling at a forward discount relative to AUDAUD is selling at a forward premium relative to SFrUsing indirect formula, the forward premium/discount of SFr is calculated as:

Therefore, SFr is selling at a forward discount of 2.84%

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' '0 1

'1

360* *100

1.7126 1.7373 360* *100

1.7373 1802.84%

e f

f n

Direct Quotes and % Forward Premium/DiscountDirect Quotes and % Forward Premium/Discount

In order to use the DIRECT formula

Convert indirect quotes to direct quotes:

Spot rate e0 = 1/1.7126= AUD0.5839/SFr

Forward rate f1= 1/1.7373=AUD 0.5756/SFr

Using direct formula, the forward premium/discount of SFr is calculated as:

Again, SFr is selling at a forward discount of 2.84%

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1 0

0

360* *100

0.5756 0.5839 360* *100

0.5839 1802.84%

f e

e n

Multiple Choice Time! No 4Multiple Choice Time! No 4

A forward contract can be used to lock in the __________ of a specified currency for a future point in time.a. purchase priceb. sale pricec. A or Bd. none of the above

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ANSWER: C

Multiple Choice Time! No 5Multiple Choice Time! No 5

The spot and 180‑day forward rates for the euro are $1.3310 and $1.3402, respectively. The Euro is said to be selling at a forward (answer rounded up) a. discount of 6.9% b. premium of 6.9% c. discount of 1.4% d. premium of 1.4%

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Multiple Choice Time 5 solutionMultiple Choice Time 5 solution1. We want to know the forward premium/discount of the Euro, therefore treat Euro as the foreign currency and the exchange rates as direct quotes:

e0 = $1.3310/EUR and f1 = $1.3402/EUR

2. Use direct formula

3. Answer (d)

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1 0

0

360* *100

1.3402 1.3310 360* *100

1.3310 1801.38%

f e

e n