Chapter 5 FIN417
Quoted "Big Fig" versus "Small Fig"
A dealer pricing pounds in terms of dollars would likely quote these prices as 50-55.
GBP
British pound
FX Market Participants
Interbank market (wholesale) Client market (retail) Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks
Correspondent Banking Communications
International commercial banks communicate with one another using: SWIFT: CHIPS: ECHO:
JPY
Japanese yen
Correspondent Banking Relationships
Large commercial banks maintain demand deposit accounts with one another, which facilitates the efficient functioning of the FX market.
Give a full definition of the market for foreign exchange.
Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.
CAD
Canadian dollar
CHIPS:
Clearing House Interbank Payments System.
ECHO:
Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions
Dollar-Based Holding Period Return
HPR = gain / pain HPR$ = 0.0010 Annualized dollar HPR = 0.1944% = -0.0972% × 2
Spot Foreign Exchange Microstructure
Market microstructure refers to the mechanics of how a marketplace operates •The bid-ask spreads in the spot FX market: -Increase with FX exchange rate volatility. -Decrease with dealer competition. •Private information is an important determinant of spot exchange rates.
ZAR
South African rand
Banks find it necessary to accommodate their clients' needs to buy or sell FX forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure it has created for itself by accommodating a client's forward transaction?
Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To illustrate, suppose a bank customer wants to buy dollars three months forward against British pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months until they are needed to deliver against the dollars it has sold forward. The British pounds received will be used to liquidate the sterling loan.
CHF
Swiss francs
SWIFT:
The Society for Worldwide Interbank Financial Telecommunications
Direct Quotation
The U.S. dollar equivalent
What is meant by a currency trading at a discount or at a premium in the forward market?
The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price.
How are foreign exchange transactions between international banks settled?
The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. As an example of how the network of correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer's account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporter's bank account. The importer's bank will then debit its books to offset the debit of U.S. importer's account, reflecting the decrease in its correspondent bank account balance.
Forward Premium
The interest rate differential implied by forward premium or discount •For example, suppose the € is appreciating from S($/€) = 1.1321 to F180($/€) = 1.1389. •The 180-day forward premium is given by:
What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange?
The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market.
Who are the market participants in the foreign exchange market?
The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks. International banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment banks, mutual funds, pension funds, and hedge funds, whose 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.Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly judge the future direction of price movements in one currency versus another or 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. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it "fixes" or "pegs" its currency against. Intervention is the 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 alternatively, selling one's own currency for foreign currency in order to increase its supply and lower its price.
indirect quotation
The price of a U.S. dollar in the foreign currency
A CAD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CAD1.3436-CAD1.3441. What is implied about the trader's beliefs by his prices?
The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars by standing willing to buy $ at only CAD1.3435/$1.00 and offering to sell from inventory at the slightly lower than market price of CAD1.3440/$1.00.
Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the United States?
The value of the British pound in U.S. dollars has gone up from about 1.90 to about 1.45. Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct.
Why does most interbank currency trading worldwide involve the U.S. dollar?
Trading in currencies worldwide is against a common currency that has international appeal. That currency has been the U.S. dollar since the end of World War II. However, the euro and Japanese yen have started to be used much more as international currencies in recent years. More importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a market against all other currencies.
Spot Rate Quotations
direct quotation indirect quotation
What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?
riangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate. Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.
Spot Cross Rates Suppose that S($/€) = 1.0500 (i.e., $1.0500 = €1.0000) and S($/£) = 1.2500 (i.e., £1.0000 = $1.2500). What must the S(£/€) cross rate be?
£1.0000/$1.2500×$1.0500/€1.0000=£0.8400/€1.0000
Second Sample Currency Conversion Problem •An Italian has just completed transactions in America and England. •He is now holding $125,000 and £500,000, and wants to convert both amounts to euro. •His currency dealer provides this quotation: GBP/USD 0.7997- 00 USD/EUR 1.1250 - 55
£500,000÷£0.8000=$625,000 $625,000+125,000=750,000/1.255= €666,370.50
The Bid-Ask Spread as %
•A dealer might offer: -A bid price of $1.1250/€. -An ask price of $1.1255/€. •While there are a variety of ways to quote the above, the bid-ask spread represents the dealer's expected profit.
Swaps
•A swap is an agreement to provide a counterparty with something he or she wants in exchange for something that you want. -Often on a recurring basis, e.g., every six months for five years. •Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent.
Interbank market (wholesale)
•About 100-200 banks worldwide stand ready to make a market in foreign exchange. •Nonbank dealers account for about 40% of the market. •There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.
Non-Deliverable Forward Contracts
•Due to government-initiated capital controls, the currencies of some emerging market countries not freely traded. •For many of these currencies, trading in non-deliverable forward contracts exists. •A non-deliverable forward contract is settled in cash, usually U.S. dollars. -Settlement is calculated by the difference between the forward price agreed to in the contract and the spot price at maturity of the contract multiplied by the contract size.
The Forward Market
•Forward Rate Quotations •Long and Short Forward Positions •Non-Deliverable Forward Contracts •Forward Cross Exchange Rates •Forward Premium •Swap Transactions
Long and Short Forward Positions
•If 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." •So, if you have agreed to sell an FX forward, you are short, and if you have agreed to buy an FX forward, you are long.
Spot FX Trading
•In the interbank market, the standard size trade is about U.S. $10 million. •A bank trading room is a noisy, active place. •The stakes are high. •The "long term" is about 10 minutes.
Exchange-Traded Currency Funds
•Individual shares are denominated in the U.S. dollar and trade on the New York Stock Exchange. -Consider an ETF where each share represents 100 euros. The price of one share at any point in time will reflect the spot dollar value of 100 euros plus accumulated interest minus expenses. •Six additional currency trusts exist on the Australian dollar, British pound sterling, Canadian dollar, Mexican peso, Swedish krona, and the Swiss franc. •Currency is now recognized as a distinct asset class, like stocks and bonds. Currency ETFs facilitate investing in these currencies.
The Bid-Ask Spread
•The bid price is the price a dealer is willing to pay you for something. •The ask price is the amount a dealer wants you to pay for something. •It doesn't matter if we're talking used cars or used currencies: the bid-ask spread is the difference between the bid and ask prices.
Forward Rate Quotations
•The forward market for FX 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
