Foreign Exchange Market

Reading: Chapter 6
 Lecture Outline

Describe the FX market

Identify participants and currencies
Understand spot and forward rates
Calculate & use cross and forward rates
Triangular arbitrage
Changes in exchange rates

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 Functions of FX Market

The foreign exchange market is the mechanism by

which participants:
transfer purchasing power between countries;
obtain or provide credit for international trade
transactions, and
minimize exposure to the risks of exchange rate
changes.

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 Characteristics of FX Market
Largest of all financial markets with average daily
turnover of over $2 trillion!
66% of all foreign exchange transactions involve
cross-border counterparties.
Only 11% of daily spot transactions involve non-
financial customers.
London is the largest FX market.
US dollar involved in 87% of all transactions.

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Market Activity 24hrs

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 Increasing Turnover

Daily foreign exchange market turnover in billions of US dollars

(Bank for International Settlements Triennial Central Bank Survey 2004)

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Important Currencies

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 Types of Transactions

A Spot 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.
The date of settlement is referred to as the
value date.

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 Types of Transactions
An outright forward transaction (usually called just
forward) requires delivery at a future value date of a
specified amount of one currency for a specified amount of
another currency.
The exchange rate is established at the time of the
agreement, but payment and delivery are not required until
maturity.
Forward exchange rates are usually quoted for value dates of
one, two, three, six and twelve months.
Buying Forward and Selling Forward describe the same
transaction (the only difference is the order in which
currencies are referenced.)

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 Types of Transactions
A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount
of foreign exchange for two different value dates.
Both purchase and sale are conducted with the
same counterparty.
Some different types of swaps are:
spot against forward,
forward-forward,
nondeliverable forwards (NDF).

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Types of Transactions

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 Market Participants
The foreign exchange market consists of two tiers:
the interbank or wholesale market (multiples of $1M US or
equivalent in transaction size), and
the client or retail market (specific, smaller amounts).

Five 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, and foreign
exchange brokers.

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 Market Participants

Banks and a few nonbank foreign exchange dealers

operate in both the interbank and client markets.
They profit from buying foreign exchange at a bid
price and reselling it at a slightly higher offer or
ask price.
Dealers in the foreign exchange department of large
international banks often function as market makers.
These dealers stand willing at all times to buy and sell
those currencies in which they specialize and thus
maintain an inventory position in those currencies.
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 Market Participants

Individuals (such as tourists) and firms (such as

importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
market.
Their use of the foreign exchange market is necessary
but nevertheless incidental to their underlying
commercial or investment purpose.
Some of the participants use the market to hedge
their foreign exchange risk.

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 Market Participants

Speculators and arbitragers seek to profit from

trading in the market itself.
They operate in their own interest, without a need
or obligation to serve clients or ensure a
continuous market.
While dealers seek the bid/ask spread, speculators
seek all the profit from exchange rate changes and
arbitragers try to profit from simultaneous
exchange rate differences in different markets.

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 Market Participants
Central banks and treasuries use the 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 or because
of commitments entered into through membership in joint
agreements such as the European Monetary System.
The motive is not to earn a profit as such, 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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 Types of Activities
Speculation
An activity that leaves one open to exchange rate
fluctuations where one aims to make a profit.
Hedging
Allows the firm to transfer exchange rate risk inherent in
foreign currency transactions or positions.
Arbitrage take advantage of inconsistent prices to
make risk-free profits. These profits are unlikely to last
long.
Spatial (or Locational) Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage Lecture 3
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Foreign Exchange Rates & Quotations
A foreign exchange rate is the price of one currency
expressed in terms of another currency.

A foreign exchange quotation (or quote) is a

statement of willingness to buy or sell at an
announced rate.

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 Bid & Ask Quotes
Foreign currency dealers provide two quotes:
Bid Price: Price at which the dealer is willing to buy
foreign currency from you.
Ask Price: Price at which the dealer is willing to sell
foreign currency to you.
It is always the case that the Ask Price > Bid Price. The
difference is the Bid-Ask spread.
The less traded and more volatile a currency, the greater
is the spread.

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 Direct & Indirect Quotes
Direct Quote: Home currency per unit of Foreign currency
(FC) - e.g. AUD/ quote is 1.6003 1.6499
Indirect Quote: Foreign currency per unit of Home currency
- e.g. /AUD quote of 0.6061 0.6249
Note that in all cases, the reciprocal of a direct quote is an
indirect quote:
AUD 1

EUR EUR
AUD
Also, you might encounter an exchange rate quotation in
American terms (US$/FC) or European terms (FC/US$).

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 Example

Bid Ask
$/ 1.4482 1.4484

Bid: Dealer buys for $ at the Bid, Client

sells for $ (i.e., dealer will buy 1,000,000
for $1,448,200).

Ask: Dealer sells for $ at the Ask, Client

buys with $ (i.e., dealer will sell 1,000,000
for $1,448,400).

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 Bid Ask Spread
Banks act as market makers and realise their profits
from the spread:
Bid-Ask Spread = (Ask-Bid)/Ask

Consider the DIRECT quote of $ 1.4482 1.4484/

% spread
1.4484 1.4482
100 1.38%
1.4484

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 Forward Quotes
Forward rates can be quoted as either as an outright quote,
points or as an annualised % forward premium or discount.

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 Forward Quotes Points
A forward quotation expressed in points is not a foreign
exchange rate as such. It is the difference between the
forward rate and the spot rate.

When the Bid Points > Ask Points, you subtract the
points from the spot rate to get the outright forward
quote.
If the Bid Points < Ask Points, you add the points to
the spot rate to get the outright forward quote

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 Forward Quotes Percentage

For quotations expressed in foreign currency terms

(Indirect quotations) the formula becomes:
f = Spot Forward 360
x n x 100
Forward
For quotations expressed in home currency terms
(Direct quotations) the formula becomes:
f = Forward Spot 360
Spot x n x 100

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 Cross Rates
Many currency pairs are inactively traded, so their exchange
rate is determined through their relationship to a widely
traded third currency.
For example, an Australian importer needs Danish currency
to pay for purchases in Copenhagen.
The Australian dollar (symbol A$) is not widely quoted
against the Danish kroner (symbol DKr).
However, both currencies are quoted against the U.S. dollar.
Assume the following quotes:
Australian dollar A$1.5431/US$
Danish kroner DKr7.0575/US$

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 Cross Rates
The Australian importer can buy one U.S. dollar
for A$1.5431 and with that dollar buy
DKr7.0575. The cross-rate calculation would
be:
Australian dollar/U.S . dollar A$1.5431/US$
0.2186 A$/DKr
Danish kroner/U.S. dollar DKr7.0575/US$

However, calculating cross-rates is usually

not as easy as this!

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 Cross Rates Example

We have the following rates:

US$1.4419 36 / GBP
US$0.6250 67 / CHF

Calculate the CHF / GBP rate!

= CHF 2.3008 98 / GBP.

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 Cross Rates Example
First: How do I get CHF/GBP from the two rates?
CHF/GBP = (US$/GBP)/(US$/CHF)

Second: Bid = go from bottom (GBP) to top (CHF) (use

GBP to buy US$, then US$ to buy CHF)

Third: Ask = go from top (CHF) to bottom (GBP) (use CHF

to buy US$, then US$ to buy GBP)

Fourth: Apply rule from part one to currency rate pairs.

Therefore, CHF 2.3008 98 / GBP.

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 Cross Rates Tips
As you do more cross rate questions you
will start to see patterns emerging.
For example if both rates are something
per USD or USD per something then you
will have to divide the rates somehow and
you will be matching bids with asks.
Or if the rates are in different forms (USD
is in different places) then you will be
multiplying and you will match bid with
bid and ask with ask.
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 Triangular Arbitrage
Cross rates can be used to check on opportunities for
inter-market arbitrage. Suppose the following exchange
rates are available:
Bank of America: Dutch guilders (fl) per U.S. $ fl1.9025/U.S.$
Dominion Bank: Canadian dollars per U.S. $ C$1.2646/U.S.$
ABN Amro Bank: Dutch guilders per Canadian $ fl1.5214/C$

The synthetic cross rate between Dutch You get more

guilders from
guilders and Canadian dollars is: ABN Amro

Dutch guilders/U .S. dollar fl1.9025/US$

1.5044fl/C$
Canadian dollars/U. S. dollar C$1.2646/US$
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 Triangular Arbitrage Example

Netherlands
fl1,011,281 fl1,000,000
(End) (Start)
Profit = fl 11,281
Multiplied by Divided by
1.5214 fl/C$ 1.9025 fl/US$

C$664,704 Multiplied by US$525,624

Canada 1.2646 C$/US$ United States

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 Measuring a Change in the Spot Rate

Measuring a change in the foreign currency for

quotations expressed in home currency terms
(direct):
% = Ending rate Beginning Rate
Beginning Rate x 100

Quotations expressed in foreign currency terms

(indirect):
% = Beginning Rate Ending Rate
Ending Rate x 100

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 Example

The Australian dollar was quoted at A$1.8445/US$ on

Aug 19, 2002, while on March 2, 2004 it was quoted at
A$1.335/US$.

What is the appreciation/depreciation of the US$?

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 Example
Thus, the appreciation/depreciation of the US$, relative
to the A$ from t-1 to t is:

St St 1 A$1.335/$ A$1.8445 /$
Rt 1,t 27.6%
St 1 A$1.8445 /$

Thus, the U.S.$ has depreciated

relative to the A$ by 27.6%

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 Example
To calculate the appreciation/depreciation of the
Australian dollar, relative to the US dollar, we want the
denominator currency to be the A$:
At t-1: A$1.8445/US$ = US$0.5422/A$
At t: A$1.335/US$ = US$0.7491/A$

St St 1 $0.7491 $0.5422 / A$
Rt 1,t 38.2%
St 1 $0.5422 / A$

Thus, the A$ has appreciated

relative to the US $ by 38.2%

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$ depreciation, A$ appreciation not equal
In general, the percentage appreciation in one currency
is not equal to the percentage depreciation in the other
currency. Instead

1
________________________

1 + RA$ = (1 + RUS$)

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