the foreign exchange market Learning objectives To develop practice in dealing with foreign exchange To develop intuition regarding market forces including arbitrage Market Participants ID: 793921
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Slide1
A classroom exercise to simulatethe foreign exchange market
Learning objectives
To develop
practice
in dealing with foreign exchange
To develop
intuition
regarding market forces, including arbitrage
Market Participants
Dealers
make a market in fx; that is, quote
bid
and
offer
(or
ask
) prices
Traders
trade for their own account
Slide2Rules of the game
“Buy low and sell high”
One contract
º
One million U.S. dollars
Trades can be for up to 10 contracts
Record each transaction as a purchase or sale
Maximum bid-offer spread is 1 basis point
(1
bp
= €0.0001
/
$)
Dealer quotes are good for 2 minutes
Slide3Buy low and sell high
Bank A:
“
€0.8220/$ bid and €0.8221/$ ask”
Bank B:
“€0.8222/$ bid and €0.8223/$ ask”
€0.8223
/$
ask
€0.8222
/$
bid
€0.8221
/$
ask
€0.8220
/$
bid
Buy from A
Sell to B
Arbitrage profit€0.0001/$
Bank A
Bank B
Slide4Riskless arbitrage profit
Buy 1 million dollars from Bank A at their €0.8221
/€
ask price
Sell 1 million
dollars
to Bank B at their €0.8222/€ bid priceArbitrage Profit
= (€0.0001/$)($1 million) = €100 with…
Arbitrage Profit = no net investment and no risk
Slide5Sample foreign exchange ledger
$1 million €/$ Cumulative
Counterparty
contracts price
balance
1 Deutsche Bank BUY 1 0.8221 +1
2 Citi BUY 3 0.8222 +43 Barclays SELL 2 0.8223 +2
4 UBS AG SELL 4 0.8223 -2
5 . . .
Slide6Opening prices:
€0.8221/$
BID &
€0.8222/$
OFFER
News announcements
The European Central Bank announces that they are buying euros in an effort to stabilize the value of the euroThe European Central Bank announces that in an effort to stimulate economic activity it is lowering
short-term Eurozone interest ratesThe European Central Bank reports that Eurozone money supply increased by €1 billion more than expected in the most recent quarter
Slide7The Impact of News Events
The
ECB
announces
that they are buying euros in an effort to stabilize the value of the
euro
Supply and demand for the euro
As the demand for euros rises, the dollar will depreciate and the spot rate S€/$ will fall
P
€
P'
€
S
€
D'
€D€
Q€
Slide8The Impact of News Events
The
ECB
announces that in an effort to stimulate economic activity it is lowering short-term Eurozone interest rates
This makes it easier for European businesses to borrow and increases economic activity. If this also increases euro inflation, then the value of the euro should fall. This will result in
an appreciation of the dollar against the euro
.An increase in the domestic discount rate usually, but not always, leads to an increase in the value of the domestic currency.
Slide9The Impact of News EventsThe
ECB
reports
that Eurozone money supply increased by €1 billion more than expected in the most recent quarter
This would appear to result in a larger supply of euros and hence a lower value for the euro. However, the increase in the money supply has already occurred and should already be reflected in the market price of the euro.
On the other hand, if the ECB is likely to increase the discount rate to slow down the economy,
then the euro could rise in anticipation of this monetary policy.
If the euro rises against the dollar, then the dollar will fall against the euro.