Chapter 2 The Foreign Exchange Market Power Points

Chapter 2: The Foreign Exchange Market Power Points created by: Joseph F. Greco Ph. D. , California State University, Fullerton Mihaylo College of Business and Economics Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1

Chapter 2: The Foreign Exchange Market 2. 1 The Organization of the Foreign Exchange Market 2. 2 Currency Quotes and Prices 2. 3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits 2. 4 Inside the Interbank Market II: Communications and Fund Transfers 2. 5 Describing Changes in Exchange Rates Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 2

2. 1 The Organization of the Foreign Exchange Market • The Organization: Overview • Size of the Market • Types of Contracts Traded • Foreign Exchange Brokers • Computerized Trading Systems • The Competitive Marketplace Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 3

Exhibit 2. 1 The Structure of the Foreign Exchange Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 4

2. 1 The Organization of the Foreign Exchange Market • Size of the Market • Largest financial market in the world, measured by dollar volume of trade • Types of Contracts Traded • Focus in this chapter is on a spot market contract that is settled in 48 hours Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 5

London、New. York、Paris等市场 at the third day; 香港市场，Hong. Kong dollars exchange for dollars at the trading day for delivery; Hong. Kong dollars exchange for JPY at the next day. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6

Exhibit 2. 2 Foreign Exchange Trading Activity Around the World Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7

2. 1 The Organization of the Foreign Exchange Market • Foreign Exchange Dealers – Foreign exchange dealers – Market makers – Liquidity • Easy to match buyers and sellers • Low transaction costs Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 8

• Foreign Exchange brokers – market matching – financial intermediary • Easy to match buyers and sellers • Low transaction costs Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 9

2. 1 The Organization of the Foreign Exchange Market • Computerized Trading Systems • Dealing 3000 • EBS The Competitive Marketplace • low cost • no abnormal profits • no single dealer dorminates market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 10

Exhibit 2. 3 The Top 20 Dealers in the Foreign Exchange Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 11

2. 2 Currency Quotes and Prices: Overview • Exchange Rates • Exchange Rate Quotes • Vehicle Currencies and Currency Cross-Rates • Example: Trading currency in the New York market where both currencies are not expressed in U. S. dollars • Triangular Arbitrage Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 12

Example of cross rate • • • 1. USD/DEM=1. 8421/28, USD/HKD=7. 8085/95 so, DEM/HKD Answer: bid price of DEM=7. 8085/1. 8428=4. 2373 ask price of DEM=7. 8095/1. 8421=4. 2395 DEM/HKD=4. 2373/95 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 13

• • • 2. GBP/USD=1. 6125/35, AUD/USD=0. 7120/30 so, GBP/AUD Answer bid price of GBP=1. 6125/0. 7130=2. 2616 ask price of GBP=1. 6135/0. 7120=2. 2662 GBP/AUD=2. 2616/62 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14

• 3. GBP/USD=1. 6125/35, USD/JPY=150. 80/ 90 • so, GBP/JPY • Answer • bid price of GBP=1. 6125*150. 80=243. 17 • ask price of GBP=1. 6135*150. 90=243. 48 • GBP/JPY=243. 17/48 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 15

2. 2 Currency Quotes and Prices • Exchange Rate Quotes • Direct quotes • Indirect Quotes • European Quote • American Quote • Dollar price of a foreign currency Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 16

Exhibit 2. 4 Currencies and Currency Symbols Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17

Exhibit 2. 5 Currency Quotes in the Wall Street Journal Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18

2. 2 Currency Quotes and Prices • Vehicle Currencies and Currency Cross-Rates • Vehicle currency • Cross-rates • Example: Trading currency in the New York market where both currencies are not expressed in U. S. dollars Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 19

Exhibit 2. 6 Cross-rates Quotes in the Wall Street Journal Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 20

2. 2 Currency Quotes and Prices • Triangular Arbitrage • An arbitrage process involving three currencies Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21

Exhibit 2. 7 Triangular Arbitrage Diagram Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 22

Exhibit 2. 8 Good and Bad Triangular Arbitrages Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 23

• • New. York: USD/DEM, 1. 5020/30 New. York: USD/GBP, 0. 5875/0. 5885 London: GBP/DEM, 2. 5610/2. 5620 if customer holding 1000, first New. York 1000000*0. 5875=£ 587500 • London 587500*2. 5610=DM 1504587. 5 • New. York 1504587. 5/1. 503=1001056 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 24

• customer hold 1000, 000 Pound, London 1000000*2. 5610=DM 2561000 • Newyork. DM 2561000/1. 503=＄1703925. 5 • Newyork＄1703925. 5*0. 5875=£ 1001056 • customer hold 1000000 DM, • New. York 1000000/1. 503=＄665336 • New. York＄665336*0. 5875=£ 390885 • London£ 390885*2. 5610=DM 1001056 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 25

2. 3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits The Interbank Market: Overview • Introduction • Bid-Ask Spreads • The difference between the ask rate and the bid rate • The Magnitude of Bid-Ask Spreads • Bid-Ask Spreads All Day Around the Work Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 26

2. 3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits • Introduction • Bid rate • Ask Rate • Bid-Ask Spreads • Offer Price Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 27

2. 3 Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits • The Magnitude of Bid-Ask Spreads • Pip • Fourth decimal place in a dealer’s quote • percentage spread=100*(ask-bid)/ask • ask rate is ＄1. 1895/*, bid rate is ＄1. 1891/* • the spread is 100*1. 18951. 1891/1. 1895=0. 03% • Bid-Ask Spreads • The difference between the bid and the ask rates Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 28

2. 4 Inside the Interbank Market II: Communications and Fund Transfers • Communication Systems • Society of Worldwide Interbank Financial Telecommunications (SWIFT) • Clearing House Interbank Payments System (CHIPS) • Trans-European Automated Real-time Gross Settlement Express Transfer (TARGET) • Fedwire • Cross-Currency Settlement (Herstatt Risk) Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 29

Exhibit 2. 9 The Reciprocal Nature of Bid and Ask Exchange Rates Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 30

the reciprocal nature of bid ask spread • from the picture, we can see in selling yen for dollars , the seller will receive the bid price of ＄/¥ which is the reciprocal of the bank's ask yen price per dollar 1/(¥/＄), in selling dollar for yen, receive bank' s bid price of yen to dollar is the reciprocal of bank's ask price of dollars for yen. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 31

Exhibit 2. 10 Communication Systems in the Forex Market Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 32

2. 4 Inside the Interbank Market II: Communications and Fund Transfers • Cross-Currency Settlement (or Herstatt) Risk • The risk that a financial institution may not deliver the currency on one side of a completed transaction Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 33

2. 5 Describing Changes in Exchange Rates • Introduction • Appreciation • Devaluations • Revaluations • Rates of Appreciation and Depreciation are used to describe changes in exchange rates when exchange rates are allowed to be flexible Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 34

• devalution and revaluation means some country use fixed or peg exchange rate system if the monetary authorities increase the demestic currency price of foreign exchange , they are devaluating their money , or is revaluating • P 61 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 35

Exhibit 2. 11 Netting Arrangements Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 36

Exhibit 2. 11 Netting Arrangements Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 37