CHAPTER 6 THE FOREIGN EXCHANGE MARKET Multinational Business

CHAPTER 6 THE FOREIGN EXCHANGE MARKET Multinational Business Finance 723 g 33 Yinghong. chen@liu. se 6 -1

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 € 6 -2

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. 6 -6

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. 6 -7

Market structure • The foreign exchange market consists of two tiers: – the interbank or wholesale market (multiples of $1 trillion US or equivalent in transaction size), and – the client or retail market (specific, smaller amounts). 6 -8

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. 6 -9

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. 6 -12

3: 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. 6 -13

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. 6 -14

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, – nondeliverable forwards (NDF). 6 -18

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. 6 -19

Exhibit 6. 4 Global Foreign Exchange Market Turnover, 19892010 (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. 6 -23

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. 6 -24

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 • An indirect quote is a foreign currency price of a unit of home currency. • The form of the quote depends on what the speaker regard as “home. ” 6 -25

Foreign Exchange Rates and Quotations • For example, the exchange rate between US dollars and the Swiss franc is normally stated: – SF 1. 6000/$ (European terms or direct quote) • However, this rate can also be stated as: – $0. 6250/SF (American terms or indirect quote) • most interbank quotations around the world are stated in European terms. 6 -26

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. 6 -27

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. 6 -28

Percent-per-annum • For quotations expressed in foreign currency terms (Indirect quotations) the formula becomes: f ¥ = Spot – Forward x 360 x 100 n Forward • For quotations expressed in home currency terms (Direct quotations) the formula becomes: f ¥ = Forward – Spot 360 x Spot n x 100 6 -29

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). 6 -32

Intermarket Arbitrage • • Citibank quote - $/€ $1. 1. 3297/€ Barclays quote - $/£ $1. 5585/£ Dresdner quote - €/£ € 1. 1722/£ Cross rate calculation: = $1. 5585/£ = € 1. 1721/£ $1. 3297/€ Because the rates are unequal, a triangular arbitrage opportunity exists. For another example, see Exhibit 6. 11

Exhibit 6. 10 Key Currency Rate Calculations for January 3, 2012

Exhibit 6. 11 Triangular Arbitrage by a Market Trader

Foreign Exchange Rates and Quotes • Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations): %∆ = Ending rate – Beginning Rate x 100 Beginning Rate Quotations expressed in foreign currency terms (indirect quotations): Beginning rate –Ending rate Beginning Rate x 100 6 -36

Exhibit 6. 12 Spot and Forward Quotations for the Euro and Japanese Yen