The Market for Foreign Exchange (FX or FOREX) - PowerPoint Presentation

Slide1

The Market for Foreign Exchange (FX or FOREX)

Chapter 5

Slide2

Announcement 1

Please organize

Group of 2 for team project

(news summary)

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(MNC)

Submit the list of members before September 21, 2017 11:59 PM

Team size is flexible (−1 or +1 member)

Please send me an e-mail if you cannot organize by yourself

Slide3

Announcement 2

The schedule for projects will be randomly assigned based on the submitted entry at September 28Extra credit opportunities for early presentersThose who want to present your team project earlier in October...

Date

Extra

Credit

October 5, 2017

(Obtained

Average)

×130%

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Average)

×120%

October 19, 2017

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Average)

×110%

Slide4

Lecture Objectives

Introduce the institutional framework within which exchange rates are determined

Lay the foundation for much of the discussion throughout the course

Slide5

Lecture Outline

Structure of the FX Market

The Spot Market

The Forward Market

Slide6

Related Video Clips

Bloomberg, The Retail FX Market

https://

youtu.be/skvsu2vGK10?t=5s

Slide7

Structure of the FX Market

The FX market

Involves market participants buying and selling of different currencies all over the world.

A worldwide network of traders, connected by telephone lines and computer screens – there is no central headquarters. Trading also occurs around the clock.

Includes trading currencies spot and forward, bank deposits of foreign currencies, foreign trade financing, trading in currency options, futures and swaps.

Slide8

What’s Happening Nowadays?

Central Bank Survey

Bank for Int’l Settlement (BIS)

Slide9

Size of the FOREX Market

Global Foreign Exchange Market Turnover (daily averages in April, billions of US dollars)

Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2016.

Slide10

World FX transactions

$5.1 trillion/day (2016)

Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2016.

Slide11

Distribution of FX Trading Centers

Source: Bank for International Settlements, “Triennial Central Bank Survey” April 2016.

Slide12

Major FX Trading Centers(Average daily volume ($b) during April of 1995-2010)

Source: Bank for International Settlements

, “Triennial Central Bank Survey” April 2010.

Slide13

Top 5 Most Traded Currencies (in terms of turnover)

Rank

Currency

Code

Symbol

1

United States

USD

$

2

Eurozone

EUR

€

3

Japanese Yen

Yen

¥

4

British Pound Sterling

GBP

£

5

Swiss Franc

CHF

Fr

Slide14

Top 10 currency traders

% of overall volume, May 2011

Source: Euromoney FX survey FX survey 2011: The Euromoney FX survey is the largest global poll of foreign exchange service providers.

Slide15

The FX market in the U.S. is the most active market in the U.S.

($1.27 trillion

turnover per day, in April 2016)

Slide16

The FX market in the U.S. is the most active market in the U.S.

$1.27 trillion

turnover

per day

, in April

2016

Comparisons with U.S. asset markets:

10 times the turnover of U.S. gov’t bonds

50 times the turnover of NYSE stocks

Comparisons with real activity in U.S.:

10 times U.S. daily GDP

30 times U.S. daily exports + imports

Slide17

Primary functions of FX Market

Currency conversions

associated with international payments process

Provision of credit

to clients

(also part of international payments process)

Managing exchange rate risk

Slide18

Structure of the FX Market

The FX market is a two-tiered market:

Client Market (Retail)

Non-financial

companies; account about

17.8%

in

2008.

Central banks, hedge funds, mutual funds, insurance companies, and pension funds account for 40.3%

Interbank Market (Wholesale)

About 100-200

banks worldwide stand ready to make a market in foreign exchange.

Dealers account for about 38.9% of the market in 2010.

There are FX brokers who match buy and sell orders but do not carry inventory.

Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

Slide19

Direct vs. brokered interbank trades

Direct dealing

Banks face another bank’s bid-ask spread, at which they can transact

immediately

Brokered trades

Get best price of all posted buys/sells

If

you

post an order, may not get executed

Electronic brokerage has become the primary method of trading interbank spot FX; drawback is that it covers only major currencies.

Slide20

Much (56%) of FX trading is in the interbank (wholesale) market

56% of all dealers’ trades are with other dealers

31% are with other financial institutions

(brokers, mutual funds, ...)

13% are with nonfinancial customers

66% of all trades are with foreign counterparties

Slide21

However, the retail orders are the important ones that determine exchange rates

Interbank traders

are

intermediaries

(

market makers

)

temporarily take positions intradaily,

but

work hard to zero out their positions regularly and by the end of the day

Slide22

The Spot Market

Spot Rate Quotations

The Bid-Ask Spread

Spot FX trading

Cross Rates

Slide23

Spot Rate Quotations

“Spot” - settlement happens on the second working day after the deal is done. The exceptions are US dollar trades against the Canadian Dollar and Mexican Peso, which are settled next day.

When looking at foreign exchange quotations, it is necessary to decide immediately which is the “home” currency and which the “foreign” currency.

For the purposes of this class, the dollar will always be the “home” currency.

Slide24

Spot Transaction

Day 0

Day 1

Day 2

Commit a

transaction

The currency

is settled

Exception

- Canadian Dollar (CAD), Mexican Peso (MXN)

- The currencies are settled on Day 1

Nowadays banks use their reserves of currencies to meet the needs

of customers immediately hence currencies are settled in advance

Slide25

Home Currency: In This Class...

Euro (€),

Yen (¥),Pound (£)...

I need...

We will assume US Dollar as home currency

Slide26

Spot Rate Quotations

There are two ways of quoting spot rates:

No of units of home currency per 1 unit of foreign currency

No of units of foreign currency per 1 unit of home currency

These are called, respectively, “Direct” and “Indirect” quotations. If the home currency is the dollar, they are sometimes called “American” and “European” quotations, respectively.

Direct quotation: the U.S. dollar equivalent

e.g.

“a Japanese Yen is worth about a penny”

Indirect Quotation: the price of a U.S. dollar in the foreign currency

e.g.

“you get 77 yen to the dollar”

Slide27

Spot Rate Quotations

For example:

US$1 = S$1.789 is equivalent to

S$

1 = US$0.559

Note: No different from any other price.

10 US dollar/One umbrella

1/10 umbrella/$

We will use the notation, for example, S$/US$ as the numbers of Singapore dollars per 1 dollar - that is an indirect quotation from an American perspective.

The Wall Street Journal gives both quotes.

Slide28

Direct/American Quotation: Walmart

Price ($) means: If you need one, you must pay this

Slide29

Indirect/European Quotation: Dollar Tree

Price (1 Downy=2 Lays=10 pencils=…):

Paying $1, you can get this amount

Slide30

Why Indirect?

It’s counterintuitive! Suppose that, in Walmart...Here, the direct quotation is: $2/Coke (like price tag)Indirect quotation is: 1/2 Coke/$ (true, but inconvenient)

Hey, now I have

just

$1 in

my pocket

...

Can

I

buy just

the

half

of

that bottle

?

Slide31

Spot Rate Quotations

CountryUSD equiv FridayUSD equiv ThursdayCurrency per USD FridayCurrency per USD ThursdayArgentina (Peso)0.23120.23214.32594.3083Australia (Dollar)1.04841.04190.95380.9598Brazil (Real)0.56530.56531.76891.7689Britain (Pound)1.55751.54890.64210.64561 Month Forward1.55711.54850.64220.64583 Months Forward1.55621.54760.64260.64626 Months Forward1.55481.54610.64320.6468

The

direct quote for British pound is: £1 = $1.5575

Slide32

The indirect quote for British pound is: £.6421 = $1

0.98

0.97

1.02237

1.02881783

6 Months Forward

0.97

0.96

1.03150

1.03800283

3 Months Forward

0.96

0.96

1.03816

1.04470783

1 Month Forward

0.9598

0.9538

1.0419

1.0484

Australia (Dollar)

0.6468

0.6432

1.5461

1.5548

6 Months Forward

0.6462

0.6426

1.5476

1.5562

3 Months Forward

0.6458

0.6422

1.5485

1.5571

1 Month Forward

0.6456

0.6421

1.5489

1.5575

Britain (Pound)

1.7689

1.7689

0.5653

0.5653

Brazil (Real)

1.0112

1.0132

0.9889

0.9869

Canada (Dollar)

4.3083

4.3259

0.2321

0.2312

Argentina (Peso)

Currency per

USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv Friday

Country

Spot Rate Quotations

Slide33

Note that the direct quote is the reciprocal of the indirect quote:

0.98

0.97

1.02237

1.02881783

6 Months Forward

0.97

0.96

1.03150

1.03800283

3 Months Forward

0.96

0.96

1.03816

1.04470783

1 Month Forward

0.9598

0.9538

1.0419

1.0484

Australia (Dollar)

0.6468

0.6432

1.5461

1.5548

6 Months Forward

0.6462

0.6426

1.5476

1.5562

3 Months Forward

0.6458

0.6422

1.5485

1.5571

1 Month Forward

0.6456

0.6421

1.5489

1.5575

Britain (Pound)

1.7689

1.7689

0.5653

0.5653

Brazil (Real)

1.0112

1.0132

0.9889

0.9869

Canada (Dollar)

4.3083

4.3259

0.2321

0.2312

Argentina (Peso)

Currency per

USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv Friday

Country

Spot Rate Quotations

Slide34

Is This Direct or Indirect Quotation?

Slide35

Is This Direct or Indirect Quotation?

Euro: 1.1982$/

€

Yen: 111.81

¥/$

Pound: 1.3538$/£

Swiss Franc:

0.9612CHF/$

Slide36

Calculate Matching (In)Direct Quotation

Euro

1.1876$/

€

Yen

110.51

¥/$

Pound

1.3204$/

£

Swiss

Franc

0.9644CHF/$

Slide37

The Bid-Ask Spread

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 a foreign currency.

The ask price is the amount the dealer wants you to pay for the foreign currency.

Slide38

Find “Bid” and “Ask” Prices Here

Slide39

The Bid-Ask Spread

Bank’s quote: US$/

£

1.794 - 1.796

1.794 is the “Bid” price. A bank will buy pounds for $

1.794/pound

; same as bank selling $

1.794

for

£

1.

1.796 is the “Offer” price. A bank will sell pounds for $1.796; same as bank buying $1.796 for

£

1 pound.

Bank’s

profit

= ASK-BID = “Bid-Ask Spread

”

Slide40

The Bid-Ask Spread

Bank’s quote: US$/

£

1.794 - 1.796

You pay US$1.796 for every pound you buy.

You receive US$1.794 for every pound

you

sell.

If you started with one million dollars and converted it into pounds, then back to dollars, how much would you have after the two conversions?

What’d be the bank quote for

£

/US$?

Slide41

The Bid-Ask Spread

Bank’s quote: €/US$ 1.0820 - 1.0826

What rate does the bank pay for every dollar you sell?

What rate does the bank receive for every dollar you buy?

What is the bank’s profit?

Slide42

Cross Rates

Suppose that S($/€) = .50 i.e. $1 = 2 € and that S(¥/€) = 50 i.e. €1 = ¥50What must the $/¥ cross rate be?

Slide43

Cross Rates

Suppose that S($/€) = 1.082 i.e. €1 = $1.082and that S(CHF/$) = 1.572i.e. $1 = CHF 1.572What must the €/CHF cross rate be?

Slide44

Cross Rates

Suppose that

S

($/€) = 1.20 and that

S

($/¥) = 0.009. What must the

S

(¥/€) cross rate be?

Suppose that

S

(AUD/$) = 2. What must the

S

(AUD/€) cross rate be?

Slide45

Intuition: Arbitrage?

Assume that bananas are homogeneous and transactions are unrestricted...

Buy @ Walmart & Sell @ Starbucks: Profit=$1.00−$0.52=$0.48

Slide46

Triangular Arbitrage

$

£

¥

Credit Lyonnais

S

($/£)=1.50

Credit Agricole

S

(¥/£)=185

Barclays

S

(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an

arbitrage

exists.

Slide47

Triangular Arbitrage

$

Credit Lyonnais

S

($/£)=1.50

Credit Agricole

S

(¥/£)=185

Barclays

S(¥/$)=120

The implied S(¥/£) cross rate is S(¥/£) = 180.

Credit Agricole has posted a quote of S(¥/£)=185 so there is an arbitrage opportunity.

So, how can we make money?

¥

£

Slide48

Cross Exchange Rate Equilibrium

S

(d/e)

S

(e/f)

S

(f/d) =

1

If

S

(d/e)

S

(e/f)

S

(f/d) < 1, then either

S

(d/e),

S

(e/f), or

S

(f/d) must rise.

Þ

Buy the currency in the denominator with the currency in the numerator of each spot rate.

If

S

(d/e)

S

(e/f)

S

(f/d) > 1, then either

S

(d/e),

S

(e/f), or

S

(f/d) must fall.

Þ

Sell the currency in the denominator for the currency in the numerator of each spot rate.

Slide49

Cross Exchange Rates and Triangular Arbitrage

Calculate

S

(d/e)

S

(e/f)

S

(f/d).

S

(¥/$) = 120

S

($/£)=1.50

S

(¥/£)=185

Then

S

(¥/$)

S

($/£)[1/

S

(¥/£)] = 0.973.

Þ

Sell the currency in the numerator for the

currency in the denominator of each spot rate.

Slide50

Recipe

 

We checked

 

Convert

$ to £

Convert

£

to ¥

Convert

¥ to $

Slide51

Triangular Arbitrage

$

Credit Lyonnais

S

($/£)=1.50

Credit Agricole

S(¥/£)=185

BarclaysS(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.

¥

£

1

2

3

$

Slide52

Triangular Arbitrage

Sell $150,000 for £ at S($/£) = 1.50 receive £100,000

Sell our £ 100,000 for ¥ at S(¥/£) = 185 receive ¥18,500,000

Sell ¥ 18,500,000 for $ at S(¥/$) = 120

receive $154,167

profit per round trip = $ 154,167- $150,000 = $4,167

Slide53

The Forward Market

Forward Rate Quotations

Long and Short Forward Positions

Forward Premium

Slide54

The Forward Market

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.

Slide55

The Forward Market (cont’d)

Day 0

1 Month Later

Order (contract):

No cash flow occurs,

No settlement occurs,

Determine/fix the price

(the price of one month

Forward F

30

)

Book Price

Today (S

0)

Price 1 MonthLater (S30)

Student:

Pay F

30(not S30)

Store:Give Himthe Book

Student w/o the contract:

Must pay S30 instead of F30To buy the book today

Slide56

Forward Rate Quotations

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 for forward contracts.

Slide57

Forward Rate Quotations

Consider the following example.

for British pound, the spot rate is

$1.5627

=

£

1.00

While the 180-day forward rate is

$1.5445

=

£

1.00

What’s up with that?

Slide58

Spot Rate Quotations

Clearly the market participants expect that the pound will be worth less in dollars in six months.

1.4975

1.5106

0.6678

0.662

6 Months Forward

1.4888

1.502

0.6717

0.6658

3 Months Forward

1.4835

1.4968

0.6741

0.6681

1 Month Forward

1.4813

1.4943

0.6751

0.6692

Canada (Dollar)

0.6461

0.6475

1.5477

1.5445

6 Months Forward

0.6423

0.6437

1.5568

1.5535

3 Months Forward

0.6398

0.6412

1.5629

1.5596

1 Month Forward

0.6386

0.6399

1.566

1.5627

Britain (Pound)

3.4734

3.4025

0.2879

0.2939

Brazil (Real)

1.6852

1.6932

0.5934

0.5906

Australia (Dollar)

3.0377

3.0221

0.3292

0.3309

Argentina (Peso)

Currency per

USD Thursday

Currency per USD Friday

USD equiv Thursday

USD equiv Friday

Country

Slide59

Forward Rate Quotations

S

(USD/CAD)= 0.6399

F

30

(USD/CAD)= 0.6391 This is 1 month forward rate

F

90

(USD/CAD)= 0.6376 This is 3 month forward rate

F

180

(USD/CAD)= 0.6352 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

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?

Slide60

Long and Short Forward Positions

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

s

ell forex forward, you are

s

hort.

If you have agreed to buy forex forward, you are long.

Slide61

Forward Premium and Discount

It’s just the interest rate differential implied by forward premium or discount.For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307The forward premium is given by:

€ is traded at a premium of 2.75%.

How about $?

Slide62

Forward Premium and Discount

Spot US$/

£

1.6000

6-mo Forward 1.5900

What is the forward premium/discount on the US$?

What about

£

, is it trading at a premium or

discount?

Slide63

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?

Know how to read/use spot and forward quotes; direct and indirect method

Know how to define and calculate the bid-ask spread

Calculate currency cross-rates, with and without bid-ask quotes, when

given two spot or forward FX quotations involving three currencies

Calculate the profit/loss on a triangular arbitrage opportunity given

three currency quotations, with and without bid-ask spread

Calculate the profit or loss of short and long forward positions

Define and calculate the forward discount or premium