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The Market for Foreign Exchange

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					The Market for Foreign Exchange


           A summary
                 Objective


Getting acquainted with the environment in which
        currencies are traded world-wide
                          Outline



•   Definitions
•   The players
•   The mechanisms
•   The functions
•   Types of quotations
             Foreign exchange rate



The price of one currency expressed in terms of another
currency
             Foreign exchange: Glossary of terms

• convertibility = exchanging paper money for gold
• fixed exchange rate system = a system in which governments
  maintain a fixed exchange rate for long periods of time
• floating exchange rate system = a system in which exchange rates
  are determined by the market
• devaluation = decrease in the price of a currency under a fixed
  exchange rate system
• revaluation = increase in the price of a currency under a fixed
  exchange rate system
• weakening (depreciation) = decrease in the price of a currency under
  a floating exchange rate system
• strengthening (appreciation) = increase in the price of a currency
  under a floating exchange rate system
                   Current Currency Arrangements


Pegged to another currency
•   to the US$: Argentina, Bahamas, Barbados, etc.



Pegged to a basket of currencies
•   to the SDR: Libya, Rwanda

•   to other baskets: Algeria, Burundi, Morocco, etc.



Managed float (dirty float)‫‏‬
•   China, Egypt, Indonesia, Israel, Tunisia, etc.



Independently floating

•   New Zealand, S. Africa, Australia, Canada, India, Japan, Switzerland, Russia, US
                     Change is relative


s0 = C$ 1.35/US$
s1 = C$ 1.37/US$

The US$ appreciated by (1.37-1.35)/1.35 = 1.48 % against the C$
(the price of US$ in terms of C$ increased by 1.48%)‫‏‬


Conversely, the C$ depreciated by (1/s1 -1/s0)/(1/s0) = (s0 - s1)/s1 =
-1.46 % against the US$
                    Participants

•   Central banks
•   Commercial banks
•   MNC
•   Foreign exchange brokers
•   Dealers
• Speculators (arbitrageurs)
              Size of the Forex




Over US $1,600 billion/day worldwide (late 1990s)‫‏‬
            About $ 1.2 trillion (today)
Top foreign exchanges



       London

      New York


       Tokyo
         Functions



 Transfer of purchasing power


Minimizing foreign exchange risk
                    Clearing systems


The Clearing House Interbank Payments System (CHIPS)‫‏‬

The Society for Worldwide Interbank Financial Telecommunications
(SWIFT)‫‏‬

Continuing Link Settlement Services (CLSS)
Types of transactions




        Spot


      Forward
                Spot transactions



Immediate purchase or sale of foreign exchange

Cash settlement is made two days after the transaction
(one day for North American currencies).
Spot rates: Quotations



   Direct vs. Indirect
          and
 American vs. European
          Spot rates: Direct quotation

The price of foreign currency in terms of domestic currency

If you are in Paris, the Swiss franc is at:
s = € 1.51

If you are in Frankfurt, the Euro is at:
s = Chf 0.66
          Spot rates: Indirect quotation

The price domestic currency in terms of foreign
currency

In Toronto, the US$ is at:
s = US$ 0.65

In New York, the C$ is at:
s = C$ 1.538
            Spot rates: European terms



For US$ only, the dollar is at:



s = € 1.1
(indirect from US perspective)
           Spot rates: American terms



For US$ only, the Euro is at:

s = US$ 0.909
(direct from US perspective)
                         Bid-ask spread

The form in which foreign exchange prices are quoted by dealers
and market-makers.
                        C$ 1.5321 - 1.5332

It shows the price at which the dealer is willing to buy and sell
foreign currency

Big figure: it is assumed known by all traders
C$ 1.5321 - 1.5332

Small figure: the one that is referred to when quoting and
negotiating: 21 - 32
How to convert a direct into an indirect quote




         In Montreal: C$1.5555 - 60



          In Miami: US$0.6427 - 29
                       Cross-rates


Some currency pairs are rarely traded
Ex: A$ and Dkr

Their exchange rate is determined through a widely traded
third currency:
s(1) = A$1.3806/US$
s(2)= Dkr6.468/US$


cross rate: A$0.2135/DKr or Dkr4.685/A$
          Triangular Currency Arbitrage




Taking advantage of exchange rate "inconsistencies"

Quoted exchange rates:
Frankfurt: s = € 1.1/US$
London: s = € 1.5/£
New-York: s = US$ 1.7/£

The cross rate between the US$ and the British pound
is USD 1.37 or £ 0.73
                             The arbitrage (1)‫‏‬




Start in Frankfurt with $1

Buy 1.1 Euros in Frankfurt

With 1.1 Euros buy £ 0.73 in London

With £ 0.73 buy US$1.24 in New York
                 The arbitrage (2)‫‏‬




Start in London with E1


Buy £0.667 in London


With £0.667 buy US$1.13 in NY


With US$1.13 buy E1.24 in Frankfurt
The arbitrage (3)‫‏‬




      ETC.
Shortcut to assessing a triangular arbitrage
                opportunity




    (1.1)€/US$ x (0.667) £ /€ x (1.7)US$/ £ = 1.24

   Since 1.24 > 1, there is an arbitrage opportunity.
                    Arbitrage: Question


What if instead of making money you are loosing money?



Maybe transactions costs more than offset any gains

or

Maybe‫‏‬you’re‫‏‬going‫‏‬the‫‏‬wrong‫‏‬way….
Transaction costs



   Bid-ask spread


Commissions and fees
             Forward exchange rates


Forward contract
A contract between a bank and a customer calling for
the delivery of a foreign currency at a fixed future date
and at an agreed-upon rate.
Quotation of forward rates



           Explicit

   Forward point quotation
       Explicit quotation


             US$
spot         C$ 1.5450 - 54
30 day       C$ 1.5465 - 74
90-day       C$ 1.5469 - 80
180-day      C$ 1.5477 - 82
             Forward point quotation

Points are added to or subtracted from the last two
digits of the spot bid-ask quotation


                           US$
              spot         C$ 1.5450 - 54
              30 day       15 - 20
              90-day       19 - 26
              180-day      27 - 28
               Forward contract: What for?




Hedging
Reducing the foreign exchange risk of doing business

Speculating
Betting on foreign exchange fluctuations in the hope of making a
profit
               Hedging using forward contracts

Assume Corel sells US$25 m worth of WordPerfect to Stack-Rack, a
Roanoke Va. based company. Shipment of the software and payment will
take place in one month.

Corel has two options:

It can wait until payment date, receive US$ 25 m from Stack-Rack, and
buy C$ in the spot market (go unhedged)‫‏‬

It can lock in a forward rate of C$1.5465, and receive C$38.66 m,
regardless of the spot rate one month from now (hedge)‫‏‬
             Speculating using forward contracts

Assume an American trader buys C$10 m three-month forward in the
hope that the US$ will weaken against the C$.
                                   US$
                    spot           C$ 1.5450 - 54
                    30 day         15 - 20
                    90-day         19 - 26
                    180-day        27 - 28


In three months, the spot rate turns to be: s = C$1.5325 - 43.

Our trader delivers on the C$10 m forward contract and immediately sells
the C$10 m on the spot
                 US$profit = 10 m/1.5343 - 10 m/1.5469

				
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