CHAPTER 7

THE FOREIGN
EXCHANGE
MARKET
CHAPTER OVERVIEW

I. INTRODUCTION
II. ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
III. THE SPOT MARKET
IV. THE FORWARD MARKET
V. INTEREST RATE PARITY
THEORY
PART I. INTRODUCTION

I. INTRODUCTION
A. The Currency Market:
where money
denominated in one
currency is bought and
sold with money
denominated in another
currency.
INTRODUCTION

B. International Trade and

Capital Transactions:
- facilitated with the ability
to transfer purchasing power
between countries
INTRODUCTION

C. Location
1. OTC-type: no specific
location
2. Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide
Interbank Financial
Telecommunications
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 banks
2. Retail Level
- business
customers.
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. Two Types of Currency

Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd
business day
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

2. Forward Market:
- transactions take place at a
specified future date
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

C. Participants by Market
1. Spot Market
a. commercial banks
b. brokers
c. customers of commercial
and central banks
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

2. Forward Market
a. arbitrageurs
b. traders
c. hedgers
d. speculators
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

II. CLEARING SYSTEMS

A. Clearing House Interbank
Payments System
(CHIPS)
- used in U.S. for electronic
fund transfers.
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. FedWire
- operated by the Fed

- used for domestic transfers

ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

III. ELECTRONIC TRADING

A. Automated Trading
- genuine screen-based
market
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. Results:
1. Reduces cost of trading
2. Threatens traders
oligopoly of information
3. Provides liquidity
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET

A. Largest in the world
1995: $1.2 trillion daily
ORGANIZATION OF THE
FOREIGN EXCHANGE MARKET

B. Market Centers (1995):

London = $464 billion
daily
New York= $244 billion
daily
Tokyo = $161 billion
daily
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
THE SPOT MARKET

B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $.5838/dm
b. European terms
example: dm1.713/$
THE SPOT MARKET

2. For nonbank customers:

Direct quote
gives the home currency
price of one unit of foreign
currency.
EXAMPLE: dm0.25/FF
THE SPOT MARKET

C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee
charged by the bank
Bid = the price at which
the bank is willing to buy
Ask = the price it will sell
the currency
THE SPOT MARKET

4. Percent Spread Formula (PS):

Ask Bid
PS x100
Ask
THE SPOT MARKET

D. Cross Rates
1. The exchange rate
between 2 non - US$
currencies.
THE SPOT MARKET

2. Calculating Cross Rates

When you want to know
what the dm/ cross rate
is, and you know
dm2/US$ and .55/US$

then dm/ = dm2/US$

.55/US$
= dm3.636/
THE SPOT MARKET

E. Currency Arbitrage
1. If cross rates differ from
one financial center to
another, and profit
opportunities exist.
THE SPOT MARKET

2. Buy cheap in one intl market,

sell at a higher price in
another

3. Role of Available Information

THE SPOT MARKET

F. Settlement Date Value Date:

1. Date monies are due

2. 2nd Working day after date of

original transaction.
THE SPOT MARKET

G. Exchange Risk
1. Bankers = middlemen
a. Incurring risk of adverse
exchange rate moves.
b. Increased uncertainty
about future exchange
rate requires
THE SPOT MARKET

1.) Demand for higher risk

premium

2.) Bankers widen bid-ask

spread
MECHANICS OF SPOT
TRANSACTIONS

SPOT TRANSACTIONS: An
Example
Step 1. Currency transaction:
verbal agreement, U.S.
importer specifies:
a. Account to debit (his acct)
b. Account to credit
(exporter)
MECHANICS OF SPOT
TRANSACTIONS
Step 2. Bank sends importer
contract note including:
- amount of foreign
currency
- agreed exchange rate
- confirmation of Step 1.
MECHANICS OF SPOT
TRANSACTIONS
Step 3. Settlement
Correspondent bank in Hong
Kong transfers HK$ from
nostro account to exporters.
Value Date.
U.S. bank debits importers
account.
PART III.
THE FORWARD MARKET
I. INTRODUCTION
A. Definition of a Forward
Contract
an agreement between a bank and
a customer to deliver a specified
amount of currency against
another currency at a specified
future date and at a fixed exchange
rate.
THE FORWARD MARKET

2. Purpose of a Forward:
Hedging
the act of reducing exchange
rate risk.
THE FORWARD MARKET

B. Forward Rate Quotations

1. Two Methods:
a. Outright Rate: quoted to
commercial customers.
b. Swap Rate: quoted in the
interbank market as a
discount or premium.
THE FORWARD MARKET

CALCULATING THE FORWARD

PREMIUM OR DISCOUNT

= F-S x 12 x 100
S n
where F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the
forward contract
THE FORWARD MARKET

C. Forward Contract Maturities

1. Contract Terms
a. 30-day
b. 90-day
c. 180-day
d. 360-day
2. Longer-term Contracts
PART IV.
INTEREST RATE PARITY THEORY

I. INTRODUCTION
A. The Theory states:
the forward rate (F) differs
from the spot rate (S) at
equilibrium by an amount
equal to the interest
differential (rh - rf) between
two countries.
INTEREST RATE PARITY
THEORY
2. The forward premium or
discount equals the interest
rate differential.
(F - S)/S = (rh - rf)
where rh = the home rate
rf = the foreign rate
INTEREST RATE PARITY
THEORY
3. In equilibrium, returns on
currencies will be the same
i. e. No profit will be realized
and interest parity exists
which can be written
(1 + rh) = F
(1 + rf) S
INTEREST RATE PARITY
THEORY
B. Covered Interest Arbitrage
1. Conditions required:
interest rate differential does
not equal the forward
premium or discount.
2. Funds will move to a country
with a more attractive rate.
INTEREST RATE PARITY
THEORY
3. Market pressures develop:
a. As one currency is more
demanded spot and sold
forward.
b. Inflow of fund depresses
interest rates.
INTEREST RATE PARITY
THEORY
C. Summary:
Interest Rate Parity states:
1. Higher interest rates on a
currency offset by
forward discounts.
2. Lower interest rates are
offset by forward
premiums.