Vicentiu Covrig International Financial Management The Market for

Vicentiu Covrig International Financial Management The Market for Foreign Exchange (chapter 4) 1

Vicentiu Covrig International Financial Management FOREX Market Participants l. FX market involves participants buying and selling currencies all over the world l. It includes trading currencies spot and forward; bank deposits of foreign currencies; foreign trade financing; trading in currency options, futures and swaps l FOREX market is a global over-the-counter market l. Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks 2

Vicentiu Covrig International Financial Management Size of the FX market Largest in the world (1995): $1. 2 trillion daily Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily Trading systems: - Screen based dealing using a phone or an e-mail type system - EBS: Electronic Brokerage System 3

Vicentiu Covrig International Financial Management FOREX Market Participants n The FOREX market is a two-tiered market: - Interbank Market (Wholesale) u. About 700 banks worldwide stand ready to make a market in Foreign exchange. u. Nonbank dealers account for about 20% of the market. u. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. - Client Market (Retail) l Why is the trading volume so large in the FOREX market? 4

Vicentiu Covrig International Financial Management The Spot Market l. The spot market involves immediate purchase or sale of foreign exchange l. Direct quotation from US perspective nthe l U. S. dollar equivalent price of one unit of the foreign currency in US Dollars Indirect Quotation from US perspective nthe ne. g. l. The price of a U. S. dollar in the foreign currency “you get 100 yen to the dollar” direct quote is the reciprocal of the indirect quote 5

Vicentiu Covrig International Financial Management The Bid-Ask Spread n n In general, banks do not charge commissions on foreign currency transactions. They profit from bid-ask spread The bid-ask spread is the difference between the bid and ask prices The bid price is the price a dealer is willing to pay you for something (our case foreign currency); always listed first The ask price is the amount the dealer wants you to pay for the thing (our case foreign currency); listed second 6

Vicentiu Covrig International Financial Management The Bid-Ask Spread Interbank dealer quotes: - American terms: Euro, British Pound, Australian Dollar - European terms: all others Ex: You want to transact with a dealer that gives you the following quotations: $1. 6625(bid) - 1. 6635(ask)/£. The dealer buys (gets) one pound from you for $1. 6625 The dealer sells (gives) one pound to you for $1. 6635 The bid-ask spread is a function of liquidity of the market, the XR volatility as well as dealers’ inventory The retail bid-ask spread is wider than interbank spread 7

Vicentiu Covrig International Financial Management Cross Rates The cross rate is the rate of exchange between two non-US currencies Suppose that S($/Euro) = 1. 25 and that S(Yen/$) = 110 Yen What must the Yen/Euro cross rate be? Yen/Euro= (Yen/$)x($/Euro) = 110 x 1. 25= 137. 5 n Suppose that S($/Euro) = 1. 25 and that S($/AUD) = 0. 5 What must the AUD/Euro cross rate be? 8

Vicentiu Covrig International Financial Management The Forward Market n n A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract The forward market for FOREX 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 are readily available forward contracts 9

International Financial Management Vicentiu Covrig Forward Rate Quotations S (USD/CAD)= 0. 7537 S(CAD/USD)= 1. 3268 F 30 (USD/CAD)= 0. 7528 This is 1 month forward rate F 90 (USD/CAD)= 0. 7512 This is 3 month forward rate F 180 (USD/CAD)= 0. 7492 This is 6 month forward rate Market expects that USD will appreciate (CAD depreciate) A forward currency is at a forward discount if the forward rate expressed in USD ($/FC) is below the spot rate A forward currency is at a forward premium if the forward rate expressed in USD is above the spot rate What about CAD? 10

Vicentiu Covrig International Financial Management Long and Short Forward Positions n n 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”. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long. 11

Vicentiu Covrig International Financial Management Payoff Profiles: $/FC profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. S 180($/CAD) 0 F 180($/CAD) =. 7492 If you agree to sell anything in the future at a set price and the spot loss price later rises then you lose. Short position 12

Vicentiu Covrig International Financial Management Payoff Profiles: $/FC profit When the short entered into this forward contract, he agreed to sell CAD in 180 days at F 180($/CAD) = 0. 7492 If, in 180 days, S 180($/CAD) = 0. 6, the short will make a profit by buying spot CAD at S 180($/CAD) = 0. 6 and delivering/selling CAD at F 180($/CAD) = 0. 7492 S 180($/CAD) 0 F 180($/CAD) =. 7492 loss Short position 13

Vicentiu Covrig International Financial Management Profit and losses of forward positions: examples The following quotations exist for the Australian dollar (AUD): Present spot rate($/AUD) $0. 50 90 -day forward rate $0. 52 Your expectation of the spot rate in 90 days $0. 55 If your expectations prove correct, what would be your US dollar profit or loss from investing $4, 000 in the spot market? If your expectations prove correct, what would be your US dollar profit or loss from investing $4, 000 in the forward market? 14

Vicentiu Covrig International Financial Management Forward Premium/Discount For example, for CAD, we have S($/CAD) =. 7537 and F 180($/CAD) =. 7492 n The annualized percentage forward premium/discount is given by: n n The CAD sells at a discount 15

Vicentiu Covrig International Financial Management The following sections in chapter 4 are not required for the exam: - Triangular Arbitrage -Spot Foreign Exchange Microstructure - Swap transactions 16

Vicentiu Covrig International Financial Management Learning outcomes • Know the structure of the FX market • Know the difference between wholesale (interbank) market and retail market • Who are the participants in the FX market? • Explain how are foreign exchange transactions between international banks settled • Know how to read/use spot and forward quotes; direct and indirect method • Calculate currency cross-rates, without bid-ask quotes, when given two spot or forward FX quotations involving three currencies • Calculate the profit or loss of short and long forward positions • Define and calculate the forward discount or premium, both as the difference and as an annualized % from the spot • Recommended end-of-chapter questions: 1, 2, 3, 4, 5 • Recommended end-of-chapter problems: 1, 6, 9 17