The Foreign Exchange

Market
Chapter 6
2
The Foreign Exchange
Markets
I. INTRODUCTION
A. The Market:
the anyplace where money
denominated in one currency is
bought and sold with money
denominated in another
currency.
3
INTRODUCTION
B. International Trade and
Capital Transactions:
facilitated with the ability
to transfer purchasing
power between countries

4
INTRODUCTION
C. Location
1. OTC-type: no specific
location
2. Most trades by phone or
SWIFT*

*SWIFT: Society for Worldwide Interbank
Financial Telecommunications
5
PART II.
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
I . PARTICIPANTS IN THE
FOREIGN EXCHANGE MARKET
A. Participants at 2 Levels
1. Wholesale Level (95%)
- major commercial
banks
2. Retail Level
- banks dealing for
business customers.

6
Mondays Direct Quote
7
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
B. Two Sub markets of Currency
Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business
day
2. Forward Market:
- transactions take place at
a specified future date
8
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial
banks
d. central banks
9
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
(hold currency)
b. speculators
c. hedgers
10
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET
II. SIZE OF THE CURRENCY MARKET
A. Largest in the world
2005: $1.9 trillion daily
B. Market Centers (1998):
London = $637 billion daily
New York= $351 billion daily
Tokyo = $149 billion daily
C. Benchmark: 1999 USGDP = $9.1
trillion
11
PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have
four different quotes:
a. spot price
b. 30-day
c. 90-day
d. 180-day
12
THE SPOT MARKET
B. For nonbank customers:
Direct quote
gives the home currency
price of one unit of
foreign currency.
EXAMPLE in France :
.80/US$
Indirect quote is the reciprocal
of the direct quote

13
THE SPOT MARKET
C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee
charged by the broker

2. Bid = the price at which
the broker is willing to buy

3. Ask = the price the broker will sell
the currency

14
THE SPOT MARKET
Sample bid-ask quote:

.7353-75/$ or .7375/$
If you are selling
dollars for euros, this
is the rate at which the
broker will buy them
from you
If you want to buy
dollars wit euros, this
is the rate at which the
broker will sell them to
you
15
THE SPOT MARKET
4. Percent Spread Formula:

Percent Spread = {(Ask-Bid)/Ask} x 100

16
Sample Problem
Suppose the spot quote for the Swedish
krona is $.1395-99, what is the
percent spread?
PS = Ask Bid x 100
Ask

= .1399 - .1395 x 100
.1399
= .29% or 29 basis
points
17
THE SPOT MARKET
D. Cross Rates

1. The exchange rate
between 2 non-US$
currencies.

2. Purpose: to identify
arbitrage opportunities
18
Sample Problem
Suppose the spot quote for the Swedish
Krona and the Swiss franc are
$.1395/kr and $.1133/SF, what is the
quote for the krona in Geneva?

$.1133
SF = _SF_ = 8.826 x US$ =8.826
kr $.1395 US$ 7.168 7.168
kr
= SF1.23/kr
19
The Impact of Arbitrage

20
THE SPOT MARKET
E. Currency Arbitrage
1. When cross rates differ from
one financial center to another,
arbitrage profit opportunities
exist.
2. Strategy: Buy cheap in one
intl market,
Sell at a higher price in
another

21
CURRENCY ARBITRAGE

What is The Critical Role of Arbitrage in
the Global Financial Markets?
22
PART III.
THE FORWARD MARKET
I. INTRODUCTION
A. Definition of a Forward Contract
an agreement between a bank and
a customer to buy or sell
1. a specified amount of currency
against another currency
2. at a specified future date and
3. at a fixed exchange rate.
23
THE FORWARD MARKET
2. Purpose of a Forward:
Hedging
the process of reducing or
mitigating exchange
rate risk.
24
Hedging Tools
Type Contract Features

Forward 1. Fixed currency
amount
Future 2. Fixed exchange rate

Option 3. Fixed expiration
date
25
THE FORWARD MARKET
C. Forward Contracts
Require performance by
both parties

1. Contract Terms may be
a. 30-day
b. 90-day
c. 180-day
d. 360-day
2. Longer-term Contracts possible

26
CALCULATING THE FORWARD PREMIUM
OR DISCOUNT

P or D = F-S x 12 x 100
S n

Alternate= F-S x 360 x 100
S n
where
F = the forward rate of exchange

S = the spot rate of exchange

n = the number of months or
days in the forward contract
27
Sample Problem
What is the forward discount or
premium if the 3 month forward rate
is $1.4511/ and the spot is $1.4487?

12
100
1.4511 1.4487 12
100
1.4487 3
.66%
F S
x x
S n
x x

28
Sample Problem
What is the forward discount or
premium if the 30 day forward rate is
$1.4498/ and the spot is $1.4487/ ?


360
100
1.4498 1.4487 360
100
1.4487 30
.91%
F S
x x
S n
x x