Chapter 6

The Foreign Exchange Market

The Goals of Chapter 6

Introduce the foreign exchange markets, including
Geographical extent Functions performed Market participants Types of transactions (spot, forward, and swap) Analysis of the market condition over the last two decades

Introduce the quotation methods of foreign exchange rates in detail Discuss the relationship of cross exchange rates and the possibly international arbitrages among them

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Foreign Exchange Markets

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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 exchange rate between currencies is determined foreign exchange transactions are physically completed

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, e.g., spot, forward, and swap transactions discussed later or other kinds of currency derivatives
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Geographical Extent of the Foreign Exchange Market

The foreign exchange market spans the globe, with prices moving and currencies trading somewhere every hour of every business day (see the exhibit on the next slide) Many large international banks operate foreign exchange trading rooms in each major geographic trading center in order to serve important commercial customers on a 24-hour-a-day basis Banks engaged in foreign exchange trading are connected by highly sophisticated telecommunications system
Reuters, Telerate, and Bloomberg are the leading suppliers of foreign exchange rate information systems
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Exhibit 6.1 Measuring Foreign Exchange Market Activity: The Trading Volume of Currency Transactions Per Hour

This exhibit illustrates the trading volume of currency transactions ebbs and flows as the major currency trading centers across the globe open and close throughout the day The per-hour trading volume data suggests that Europe is the major center for foreign exchange transactions, the U.S. is the next, and Asia is the third

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Functions of the Foreign Exchange Market

The foreign exchange market is the mechanism by which participants can:
transfer purchasing power between countries (the currency exchange is in essence to transfer purchasing power between two parties of different countries) facilitate the international trade (without currency exchange, the international trade is difficult to be conducted) minimize exposure to the risks of exchange rate changes (the foreign exchange market provides hedging facilities of transferring foreign exchange risk to someone more willing to carry)

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Market Participants
The foreign exchange market consists of two tiers:
Interbank or wholesale markets
The size (or notional principal) for each contract is multiples of 1 million US$ or the equivalent value in other currencies

Client or retail markets

There is a specific amount for each transaction, which is relatively smaller than the size in the wholesale market The number of transactions in the retail market is far larger than that in the wholesale market

Four broad categories of participants operate within these two tiers:

Bank and nonbank foreign exchange dealers Individuals and firms Speculators and arbitragers Central banks and treasuries

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Market Participants: Bank and Nonbank Foreign Exchange Dealers

Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets Their profits are from buying foreign exchange at a bid price and reselling it at a slightly higher ask price (or offer price) Competition among dealers narrows the spread between bid and offer and thus contributes to making the foreign exchange market efficient Dealers in the foreign exchange department of large international banks often function as market makers in the interbank market
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Market Participants: Bank and Nonbank Foreign Exchange Dealers

Market makers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an inventory position in those currencies (therefore, they provide the liquidity for the markets of those currencies) Currency trading is quite profitable for commercial and investment banks. Many of the major currency-trading banks in the U.S. derive between 10% to 20% on average of their annual net income from currency trading Small- to medium-size banks are likely to participate but not be market makers in the interbank market, so they buy from and sell to larger banks to offset retail transactions with their own customers
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Market Participants: Individuals and Firms

Individuals (such as tourists) and firms (such as importers, exporters, and MNEs) use the foreign exchange market to facilitate execution of commercial or investment transactions They do not intend to make profit in the foreign exchange market. Their use of the foreign exchange market is only for their underlying commercial or investment purpose Sometimes, individuals and firms use the exchange market to hedge foreign exchange risk of their investment or incomes in foreign currencies
How to hedge various foreign exchange risks is discussed in Ch 11 to Ch 13
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Market Participants: Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading in the market for their own interest While dealers seek the bid/ask spread, speculators seek the profit from the expectations about exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets, e.g., the triangle arbitrage for cross exchange rates discussed later
Arbitragers exploit price distortions in different markets to make profit, so they can eliminate these unreasonable distortions in markets and provide some liquidity meanwhile

A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks
Thus banks could act both as dealers and as speculators and arbitragers
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Market Participants: Central Banks and Treasuries

Central banks and treasuries use the foreign exchange market to acquire or spend their countrys foreign exchange reserves as well as to influence the price at which their own currency is traded They may act to support the value of their own currency because of policies adopted at the national level The motive is not to earn a profit, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens As willing loss takers, central banks and treasuries differ in motive from all other market participants
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Transactions in the Interbank Market

Foreign exchange transactions in the interbank market can be executed on a spot, forward, or swap basis A spot currency transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place, normally, on the second following business day, i.e., the T+2 rule
The date of settlement (for delivery and payment) is referred to as the value date
On the other hand, however, a spot currency transaction between a bank and it commercial customers (in the retail market) would not necessarily involve a wait of two days for settlement
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Transactions in the Interbank Market

An outright forward transaction (usually called foreign exchange forward or FX forward) requires delivery a specified amount of one currency for a specified amount of another currency at a future value date The exchange rate is established at the time of the agreement, i.e., today (the agreed exchange rate is called the forward exchange rate), but payment and delivery are not required until maturity For example, you agree to purchase US$1,000,000 from a bank after one month at the one-month forward exchange rate NT$34/US$ today
After one month, you have both the right and the obligation to fulfill the forward contract
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Transactions in the Interbank Market

In interbank markets, forward exchange rates are usually quoted for value dates of 1, 2, 3, 6, and 12 months Buying FX forward and selling FX forward describe the same transaction (the only difference is the order in which currencies are referenced)
A FX forward contract to deliver dollars for Euros in six months is buying Euros forward with dollars or selling dollars forward for Euros

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Transactions in the Interbank Market

A foreign exchange swap transaction (FX swap) in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates with the same counterparty Swap transactions and outright forwards combined made up 57% of all foreign exchange market activities in April 2004 Some different types of FX swaps are:
Spot against forward
The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market

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Transactions in the Interbank Market

For example, if a Taiwanese firm needs US$1 million for the following 3 months, it can enter into a spot against forward swap, in which this firm buys US$ 1 million at the spot exchange rate today (e.g., NT$34/US$) from a bank, and this firm agrees to sell US$ 1 million back to the bank after three months at the 3-month forward exchange rate (e.g., NT$32/US$) Because these two transactions are in a single contract with one counterparty, it can save some transaction costs A swap can be viewed as a technique for borrowing another currency on a fully collateralized basis (in the above example, the NT$ is the cash collateral for borrowing US$ 1 million)

Forward-forward
For example, a dealer sells 1,000,000 forward for US dollars for delivery in two months at $1.842/ (two-month forward exchange rate) and simultaneously buys 1,000,000 forward for delivery in three months at $1.84/ (three-month forward exchange rate)

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Transactions in the Interbank Market

In addition to traditional spot, forward, or swap foreign exchange transactions, there are new types of transactions, e.g., nondeliverable forwards Nondeliverable forwards (NDF)
Created in the early 1990s, NDF is now a relatively common derivative in the interbank market Similar to traditional FX forward contracts, except that they are cash-settled (in domestic currency) and the foreign currency being sold forward or bought forward is not delivered physically on the maturity date The profit or loss of the NDF at the time of the maturity date is calculated by taking the difference between the agreed forward exchange rate and the spot exchange rate at that time point, for an agreed notional amount of funds
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Transactions in the Interbank Market

For example, consider a NDF of buying US$1,000,000 with NT$ after one month and the one-month forward exchange rate is NT$34/US$. After one month, if the spot exchange rate becomes NT$35/US$, the holder of the NDF can earn (NT$35/US$ NT$34/US$) US$1,000,000 = NT$1,000,000 Note that it is not necessary to buy foreign currency (US$1,000,000) with the domestic currency (NT$34,000,000) after one month
Comparing to the traditional forward contracts, on the maturity date, the holder should buy US$1,000,000 with NT$34,000,000 physically and resale US$1,000,000 in the market to exchange for NT$35,000,000

Another advantage of using NDFs is for emerging market currenciescurrencies that typically do not have liquid money markets, because it is not necessary to buy or sell the foreign currency physically

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Foreign Exchange Market Condition

Every three years, the Bank for International Settlements (BIS) conducts a survey to estimate the global trading activity of traditional foreign exchange transactions The BIS data for surveys from 1989 to 2007 is shown in Exhibits 6.2 to 6.4 For the market size in Exhibit 6.2
In the surveys of 2004 and 2007, the daily global trading amount in traditional foreign exchange market activities are $1.9 trillion and $3.2 trillion, respectively Those results imply a massive increase of nearly 70% for the foreign exchange trading from 2004 to 2007

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Exhibit 6.2 Global FX Market Turnover (daily averages in April, billions of US$)

Generally speaking, all three categories of traditional currency transactions have rising trends from 1989 to 2007 The only exception is that trading activities diminished in two of the three categories (spot and swaps) between the 1998 and 2001 surveys

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Exhibit 6.3 Geographic Distribution of FX Market Turnover (daily averages in April, billions of US$)

The U.K. continues to be the worlds major foreign exchange market with $1,359 billion in average daily turnover and 34% of daily global transactions in 2007 The U.S. makes 16.6% of global trading in 2007 The growth of the H.K. market can contribute to its role as a key economic and financial linkage to the rapidly rising Chinese economy Australia has grown considerably in recent years reflecting the demand for the carry trade, in which capital flows into the country in pursuit of high interest rate returns 6-23

Currency Distribution of Global FX Market Turnover (percentage shares of average daily turnover in April)
Because all exchange transactions involve two currencies, percentage shares total 200% 90 80 70 60 50 40 30 20 10 0 1989 1992 1995 1998 2001 2004
US Dollar Euro Deutsche Mark French Franc EMS Currencies Japanese Yen Pound Sterling Swiss Franc

For each transaction, it involves two currencies, and the percentage shares are calculated as the ratio between the number of appearance of one currency in all transactions and the number of all transactions, e.g., there are 40 currencies for 20 contracts, and if US$ appears 18 times, the percentage share is 18/20 = 90% Net global turnover since 1999 was dominated by trading in U.S. dollars, Euros, and Japanese yen, which are often called the big three About 80-90% of foreign exchange transactions are associated with the U.S. dollar It is obvious that the US$ is still the most important currency in the foreign exchange rate market, even after the emergence of Euros

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Exhibit 6.4 Distribution of US$-related contracts over different currencies

The US$/euro and US$/Japanese yen contracts have been slowly trending downward The US$/Australian dollar have increased in their volume since 2001
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Quotations of Foreign Exchange Rates

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Foreign Exchange Rates and Quotations

A foreign exchange rate is the price of one currency expressed in terms of another currency
1. One foreign dollar expressed in terms of domestic dollars 2. One domestic dollar expressed in terms of foreign dollars

A foreign exchange quotation (or quote) is an announced rate of willingness to buy or sell foreign currencies In the retail market (including newspapers or foreign exchange booths at airports), quotes are often given as the domestic currency price of the foreign currency, i.e., one foreign dollar = S domestic dollars
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Foreign Exchange Rates and Quotations

Most foreign exchange transactions involve the US dollar (see Slide 6-24) Therefore, professional dealers and brokers in the interbank markets may state foreign exchange quotations in one of two ways:
1. European terms: The foreign currency price of one dollar (from the viewpoints of non-U.S. nations)
For example, the exchange rate between US dollars and the Swiss franc is stated as SF1.6000/$ European terms is a generic name. SF1.6000/$ (110.00/$) is also called Swiss terms (Japanese terms)

2. American terms: The dollar price of a unit of foreign currency (from the viewpoint of the U.S.)
The exchange rate between US dollars and the Swiss franc can also be stated as $0.6250/SF
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Foreign Exchange Rates and Quotations

Since 1978, in order to facilitate worldwide currency trading through telecommunications, most foreign currencies in the world are stated in European terms except two important currencies The two important exceptions are quotes for the Euro and U.K. pound sterling, which are both normally quoted in American terms Although most foreign currencies are quoted in European terms for spot transactions, American terms are utilized in quoting rates for most foreign currency options and futures

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Foreign Exchange Rates and Quotations

Foreign exchange quotes are also described as either direct or indirect A direct quote is a home currency price of a unit of foreign currency
$0.6250/SF and $0.009091/ are direct quotes for Americans

An indirect quote is a foreign currency price of a unit of home currency

SF1.600/$ and 110.00/$ are indirect quotes for Americans

In this pair of definitions, the home or base country of the currencies being discussed is critical The form of the quote depends on what the speaker regards as the home country
For example, SF1.600/$ is a direct quotation in Switzerland as well as a indirect quotation in the U.S. 6-30

Foreign Exchange Rates and Quotations

Since the interbank currency market is a dealer market, where dealers purchase foreign currencies for their own accounts and sell them later at a higher price for a profit, interbank quotations are given as a bid and ask (also referred to as offer)
A bid is the price (i.e., exchange rate) in one currency at which a dealer will buy another currency An ask is the price (i.e., exchange rate) at which a dealer will sell the other currency Dealers bid (or buy) at one price and ask (or sell) at a slightly higher price such that they can make profit between the buying and selling transactions

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Foreign Exchange Rates and Quotations

A bid price for one currency is also the ask price for the opposite currency
Yen (/$) Spot rate Bid (/$) 118.27 Ask (/$) 118.37

The bank would buy dollars with Japanese yen (equivalent to selling Japanese yen) at the bid price of 118.27/$, so the bid price of 118.27/$ to purchase US$ is also the ask price to sell Japanese yens for US$ Similarly, the bank will sell dollars for Japanese yen (equivalent to buying Japanese yen) at the ask price of 118.37/$, so the ask price of 118.37/$ to sell US$ is also the bid price to buy Japanese yens with US$

In practice, traders tend to abbreviate the above outright quotations as 118.27-37 when talking on the phone or putting quotations on a video screen 6-32

Foreign Exchange Rates and Quotations

Forward exchange rates are typically quoted in terms of points
A point is the last digit of a quotation. Most currencies against the US$ (in European terms) are expressed to four decimal points, so a point is equal to 0.0001 However, some currencies, such as the Japanese yen, are quoted only to two decimal points. For these currencies, a point is equal to 0.01

In addition, a forward quotation is expressed as the difference between the forward and the spot exchange rates See Exhibit 6.5 on the next slide for the spot and forward quotations for the Euro and Japanese yen
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Foreign Exchange Rates and Quotations

The three month point-quotations for the Japanese yen are 143 points for bid and 140 points for ask, which means the quotations for the 3-month forward exchange rate are 116.84/$ (=118.27 1.43) for bid and 116.97/$ (=118.37 1.40) for ask

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Foreign Exchange Rates and Quotations

Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate This method of quotation facilitates comparing premiums or discounts in the forward market with interest rate differentials
In other words, this percent-per-annum quotation makes it easier to distinguish whether the spot and forward exchange rate quotations satisfy the interest rate parity (discussed in Ch 7)

Consider the following spot and forward quotations, where the US dollar is the home currency
Foreign currency/ home Home currency/Foreign currency (indirect quote) currency (direct quote)
Spot 3-mon forward Premiums or Discounts 105.65/$ 105.04/$ 2.32% $0.009465215/ $0.009520183/ 2.32%
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Foreign Exchange Rates and Quotations

For quotations expressed in direct quotations for the U.S., the formula to calculate forward premium or discount is: +: FC is expected to be stronger (at
f
premiums) Forward Spot 360 100% : FC is expected to be weaker (at Spot n days discounts) (0.009520183 0.009465215) 360 100% 2.32% per annum 0.009465215 90

For quotations expressed in indirect quotations for the U.S., the formula to calculate forward premium or discount is:
360 Spot-Forward premiums) f 100% : FC is expected to be weaker (at Forward n days discounts) (105.65-105.04) 360 100% 2.32% per annum 105.04 90
+: FC is expected to be stronger (at

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Measure a Change in Spot Exchange Rates

A similar way can be applied to measure the percentage change in spot foreign exchange rates Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations):
Ending rate Beginning rate % 100% Beginning rate
+: FC appreciates against DC : FC depreciates against DC

For quotations expressed in foreign currency terms (indirect quotations):

Beginning rate Ending rate % 100% Ending rate
+: FC appreciates against DC : FC depreciates against DC

Note that, in practice, it is often to annualize the above results to obtain the annual percentage changes of spot foreign exchange rates 6-37

Measure a Change in Spot Exchange Rates

Suppose that the Swiss franc, quoted at SF1.6351/$, suddenly strengthens to SF1.5000/$. What is the percent increase in the Swiss franc relative to the US$, and thus in the value of Swiss franc-denominated accounts receivable or payable held by Americans? (for Americans, SF1.6351/$ and SF1.5000/$ are indirect quotations)
SF1.6351/$ SF1.5000/$ % 100% 9.008% SF1.5000/$

Since the Swiss franc is 9.008% stronger on the ending date, holders of Swiss receivables will receive 9.008% more dollars, but those who owe Swiss francs (who with the accounts payable) will have to pay 9.008% more for them (we will discuss this FX risk in detail in Ch 11)

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Cross Exchange Rates

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Cross Rate
Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate) For example, a Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and the Japanese yen () are commonly quoted against the US$:
Japanese yen Mexican peso 110.73/$ Ps11.4456/$

The cross-rate calculation would be

Japanese yen/US$ 110.73 / $ 9.6745/Ps Mexican peso/US$ Ps11.4456/$
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Exhibit 6.7 Key Currency Cross Rate

This table shows the cross rates for any combinations of these 7 currencies Each column shows that the amount of each currency (listed on the left of the table) needed to buy a unit of the currency at the top For example, it costs 110.73 Japanese yen or 1.2506 Swiss franc to buy one U.S. dollar

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Intermarket Arbitrage
Cross rates can be used to check on opportunities for intermarket arbitrage This situation arose because one banks (Dresdner) quotation on / is not the same a calculated cross rate between $/ (Barclays) and $/ (Citibank)
Citibank quote - $/ Barclays quote - $/ Dresdner quote - / Cross rate calculation: $1.2223/ $1.8410/ 1.5100/

$1.8410 / 1.5062 / $1.2223 /

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Exhibit 6.8A Triangular Arbitrage

Citibank, New York
End with $1,002,538 Start with $1,000,000 (1) Exchange $1,000,000 with Barclays Bank for pounds at $1.8410/ 820,206 $1.2223/ = $1,002,538 $1,000,000 / $1.8410/ = 543,183

Dresdner Bank, Frankfurt

(3) Exchange 820,206 with Citibank for US$ at $1.2223/

Barclays Bank, London

(2) Exchange 543,183 with Dresdner bank for Euros at 1.5100/
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543,183 1.5100/ = 820,206

Intermarket Arbitrage
Three things should be noted for the triangular arbitrage
Such arbitrage is practical only if the participants have instant access to quotes and executions. Hence, such arbitrage is conducted only by institutional investors, and is almost infeasible for individual investors The institutional investors usually use a computer program to monitor the cross rates among major currencies continuously. Once there is an arbitrage opportunity, these transactions are executed by computers automatically Bank traders can conduct such arbitrage without initial money, because the traders are entered into and subsequently washed (i.e., offset) by electronic means before the normal settlement two days later
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