Chapter 5: 110-134

Outright Forward Transaction

- Is an uncovered speculative position in a currency, even though it might be part of a currency hedge to the bank customer on the other side of the transaction - Exempt from new over-the-counter regulation as "swaps" under the Dodd-Frank Act

Offer or Ask Price

- Higher than bid price - The price FX traders sell currency

Interbank Market

- In this, the world's largest banks exchange currencies at spot and forward rates - Adjusts the inventory positions they hold in various foreign currencies - Most trades are speculative or arbitrage transactions - Network of correspondent banking relationships

Central Bank

- Institution designed to oversee the banking system and regulate the quantity of money in the economy - National monetary authority of a particular country - Sometimes intervenes

Foreign Exchange Market Participants

- International banks - Bank customers - Nonbank dealers - FX brokers - Central Banks

Spot Market

- Involves almost the immediate purchase or sale of foreign exchange

Forward Premium or Discount

- A condition under which the forward rate of one currency relative to another currency is lower/higher than the spot rate - Common to express as an annualized percentage deviation from the spot rate = ((F($/j) - S($/j))/S($?j))*(360/#days)

Currency against currency

- A nondollar trade - The bank will frequently handle this trade for its customer by selling X for dollars and then dollar for Y - If banks sold directly then this would entail an informational complexity that would be virtually impossible to handle

Over The Counter Markets

- All security markets except the organized exchanges - Spot and foreign exchange markets - Trading does not take place in a central marketplace where buyers and sellers congregate

Society of Worldwide Interbank Financial Telecommunications (SWIFT)

- Allows international commercial banks to communicate instructions to one another - Private nonprofit message transfer system with headquarters in Brussels, with intercontinental switching centers in the Netherlands and Virginia

Cross-Exchange Rate

- An exchange rate between currency pair where neither currency is the US dollar - Can be calculated from the US dollar rates for the two currencies, using either European or American term quotations

Exchange-Traded Fund (ETF)

- Bundle of stocks or bonds that are in an index that tracks the overall movement of a market, but unlike a mutual fund can be traded like a stock - Portfolio of financial assets in which shares representing fractional ownership of the fund trade on an organized exchange - Allow small investors the opportunity to invest portfolios of financial assets that they would find difficult to construct individually

Banks specialization

- Certain banks specialize in making a direct market between nondollar currencies, pricing at narrower bid-ask spread than the cross rate spread - The implied cross-rate bid-ask spread quotations impose a discipline on the nondollar market makers - If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible

International Banks

- Core of FX market - Actively "make a market" in foreign exchange: they are willing to buy or sell foreign currency for their own account - Serve retail clients (bank customers) in conducting foreign commerce or making international investment in financial assets that require foreign exchange

Spot Rate

- Currency quotations can be stated in direct or indirect terms

Triangular Arbitrage

- Currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies - The process of trading out of the US dollar into a second currency, then trading it for a their currency, which is in turn traded for US dollars - Purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate

Forward Rate

- Exchange rate at which two parties agree to exchange currencies on a specified future date - Quoted on most major currencies for a variety of maturities

European Terms

- Foreign exchange quotations for the U.S. dollar, expressed as the number of non-U.S. currency units per U.S. dollar - The US dollar is priced in terms of the foreign currency

Foreign Exchange

- Foreign money needed to carry out international transactions - Buyer has converted his purchasing power into the purchasing power of the seller's country

Quoting Forward Rates in terms of Forward Points is Convenient because

- Forward points may remain constant for long periods of time, even if the rates fluctuate frequently - In swap transactions where the trade is attempting to minimize currency exposure, the actual spot and outright forward rates are often of no consequence

Market for Foreign Exchange

- Is the largest financial market in terms of the value of daily transactions and has a variety of participants, including large multinational banks (the sell side) and corporations, investment fund managers, hedge fund managers, investors, governments, and central banks (the buy side) - Participants in the foreign exchange markets are referred to as hedgers if they enter into transactions that decrease an existing foreign exchange risk and as speculators if they enter into transactions that increase their foreign exchange risk. - Encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated into a foreign currency, foreign trade financing, trading in foreign currency options and future contracts, and currency swaps - Two-tiered market

Market Psychology

- Key ingredient in currency trading, and a dealer can often infer another's trading intention from the currency position being accumulated

Corresponding Banking Relationships

- Large commercial banks maintaining demand deposit accounts with one another - Allows for the efficient functioning of the foreign exchange market

Nonbank dealers

- Large nonbank financial institutions such as investment banks, mutual funds, pension funds, and hedge funds, who size and frequency of trades make it cost-effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs

Non-Deliverable Forward Contract (NDF)

- Like a forward contract, represents an agreement regarding a position in a specified currency, a specified exchange rate, and a specified future settlement date, but does not result in delivery of currencies. Instead, a payment is made by one party in the agreement to the other party based on the exchange rate at the future date - Settled in cash, usually in US dollars, at the difference between the spot exchange on the maturity date of the contract and the NDF rate rimes the notational amount of the contract - ie: 1000CNY * (S($/CNY) of 0.1658 - F($/CNY) of 0.1653)

Bank Customers

- MNCs - Money managers - Private speculators

Forward Market

- Market for currency transactions at forward rates - Involves contracting today for the future purchase or sale of foreign exchange - Maybe the same price as the spot price, but it is usually higher (at a premium) or lower (at a discount) than the spot price

Speculative Transactions

- Market participants attempt to correctly judge future direction of price movements in one currency versus another

Arbitrage Transactions

- Market participants attempt to profit from temporary price discrepancies in currencies between competing dealers

FX Brokers

- Match dealer orders to buy and sell currencies for a fee, but do not take a position themselves - Have knowledge of the quotes offered by many dealers in the market

Intervention

- Process of using foreign currency reserves to buy one's own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or selling one's own currency for foreign currency in order to increase supply and lower its price - Central bank traders often lose bank reserves in attempting to accomplish their goal

Swap Transactions

- Provide a means for the bank to mitigate the currency exposure in a forward trade

CHIPS

- Provides a clearinghouse for the interbank settlement for over 95 percent of US dollar payments between international banks

S(j/k)

- Refers to the price of one unit of currency k in terms of currency j

Indirect Quotations

- The US perspective the price of one US dollar in the foreign currency

Bid-Ask Spread

- The difference between the bid price and the asked price - Will facilitate acquiring an disposing of inventory - Wider than the interbank spread in order to cover the fixed costs of a transaction that exist regardless of which tier the trade is made in

ECHO

- The first global clearinghouse for settling interbank FX transactions - Was a multilateral netting system that on each settlement date netted a client's payments and receipts in each currency, regardless of whether they are due to or from multiple counterparties - Eliminates risk and inefficiency of individual settlement

American Terms

- The foreign exchange rate quotation that represents the number of American dollars that can be bought with one unit of local currency. - It is standard practice to price certain currencies in terms of the US dollar

Bid Price

- The price FX traders buy currency for inventory - Lower than ask price

Direct Quotations

- The price of one unit of the foreign currency in U.S. dollars, from the US perspective

Forward Swap Transaction

- The simultaneous sale (or purchase) or spot foreign exchange against a forward purchase (or sale) of approximately an equal amount of the same currency - Exempt from new over-the-counter regulation as "swaps" under the Dodd-Frank Act

Depreciate

- To decrease in value

Appreciate

- To increase in value

Interbank Trading Rooms

- Typically organized with individual traders dealing in a particular currency - Most trading goes through the dollar

Two Tier Market of Foreign Exchange

- Wholesale/Interbank Market - Retail/Client Market

Structure of the Foreign Exchange Market

-Informal in structure: No central place or floor where trading takes place -Thousands of telecommunications links between financial institutions around the globe -Open 24 hours a day -Trading concentrated in UK, US & Japan -US $ involved in 89 % of transactions -Astronomical growth in FX transactions - Outgrowth of one of the primary functions of a commercial banker: to assist clients in the conduct of international commerce