International Finance FINA 342
Dr. Angela Ng HKUST
Class Notes 4 THE FOREIGN EXCHANGE MARKET
I. THE FOREX MARKET WHAT, WHERE, WHEN An exchange rate is the relative price of two monies, like the Japanese yen price of the U.S. dollar (¥/$), or the U.S. dollar price of the British pound ($/£). Foreign exchange means the money of a foreign country – that is, foreign currency bank balances, banknotes, checks, and drafts. The foregin exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are completed. Functions of the FOREX market: Transfer of purchasing power Provision of credit Minimizing foreign exchange risk
A foreign exchange market is a very large over-the-counter market with an interbank and retail part. The traders are trading from “foreign exchange desks” in banks in major financial centers such as New York, Chicago, San Francisco, Tokyo, Hong Kong, Singapore, Bahrain, Frankfurt, Zurich, Paris, and London. There is almost 24 hour trading. (See Exhibits 4.1 & 4.2) MARKET PARTICIPANTS Importers, Exporters, International Portfolio Investors, Multinational Firms, and Tourists This group’s transactions result in commitments to make or receive payments in foreign currencies, and the need of this group for currency conversion that supplies the foreign exchange market’s basic justification for existence. Bank and Non-Bank Foreign Exchange Dealers (See Exhibits 4.3 & 4.4) Forex dealers derive income by buying currencies at lower prices than the prices at which they sell currencies. Dealers’ operations are divided into the wholesale (or interbank) and retail levels of operation. At the interbank level, dealers alter their currency inventories by transacting on a large scale, typically for more than $3 million per transaction. At the retail level, dealers cater to the need of customers wishing to buy or sell foreign exchange on a small scale. The bid-ask spread in retail transactions is much wider than that in interbank transactions.
Foreign Exchange Brokers Forex brokers bring buyers and sellers into contact with each other on a commission basis. They exist because they lower dealers’ costs, reduce their risks, and provide anonymity. For their services, brokers receive commissions, typically 0.01% of the transaction amounts in interbank trades. Speculators and Arbitrageurs Speculation In the broader sense, speculation means to accept an open/unhedged position denominated in foreign currency. In the narrower sense, speculation occurs when someone transacts in foreign exchange primarily or entirely because of an anticipated but uncertain gain as a result of an exchange rate change. Illustration: Barclays dealers in action On one Wednesday in 1987, the Barclays Bank in Britain speculated that the pound would rise that afternoon.
Arbitrage Arbitrageurs make gains by discovering price discrepancies that allow them to buy cheap and sell dear. Three types of arbitrage in the FOREX market: 1. Arbitrage between different quotes for same currency 2. Triangular arbitrage – dollar rates versus cross rates
¥ ¥ US $ £ US$ £
3. Covered interest arbitrage Central Banks or Governments Both political and economic considerations move governments to intervene in the forex market. Government intervention may be designed either to stabilize an exchange rate or to move it to a new level. SIZE OF THE MARKET Huge, recent estimates of daily turnover at over US$1 trillion. (See Exhibit 4.5) Up until a few years ago, the composition of trading activity was approximately as follows: Interbank: 85% Capital movements: 10-15% Trade flows: < 5% Recently, professional fund managers have become more important players. TYPES OF TRANSACTIONS
Spot – purchase of foreign exchange with delivery and payment between banks to be completed, normally, on the second business day. The settlement date is called value date. Forward – requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time the contract is agreed on, but payment and delivery are not required until maturity. The typical contracts are for a maturity of 1, 2, 3, 6, and 12 months. About 60% of foreign exchange transactions are in the forward market. Swap – simultaneous purchase and sale of foreign exchange for two different value dates. A common type of swap in the interbank market is spot against forward.
II. THE EUROCURRENCY MARKET Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issued the currency. For example, Eurodollars are deposits of US$ in banks located outside the US. Banks accepting Eurocurrency deposits are called Eurobanks. The Eurocurrency market is an external banking system that runs parallel to the domestic banking system of the country that issued the currency. Characteristics Few regulations No reserve requirements No interest rate regulations or caps No withholding taxes No deposit insurance requirements No regulations influencing credit allocation decisions Less stringent disclosure requirements Low risk Relatively short maturities Low interest rate risk Low default risk Highly competitive
The Eurocurrency market operates at the interbank and/or wholesale level. The majority of Eurocurrency transactions are interbank transactions. Banks making a market in Eurocurrencies quote bid rates at which they will take deposits and offer/ask rates at which they will make loans to other Eurobanks. The interbank spread is generally 1/8 of 1% for most major Eurocurrencies. London is the major Eurocurrency financial center. Consequently, the most frequently quoted rates are the London Interbank Bid Rate (LIBID) and the London Interbank Offer Rate (LIBOR). Eurobonds Eurobonds are bonds sold outside the countries in whose currencies they are denominated. Eurobonds are issued directly by the final borrowers. Eurocurrency Creation: Suppose that a Swedish firm sells medical equipment worth $1 million to a US hospital. It receives a check payable in $ drawn on Citibank in New York. Initially, the Swedish firm deposits the check in its Citibank checking account. To earn a higher interest rate on the $1 million account, the Swedish firm decides to place the funds in a time deposit with Barclays Bank in London. Barclays lends the $1 million to a German importer
III. FOREIGN EXCHANGE RATES AND QUOTATIONS SPOT EXCHANGE RATES “European” terms: FC/US$ American terms: US$/FC Illustrations: (See Exhibits 4.6-4.8) Asian Wall Street Journal – quotes SCMP – quotes Is the “U.S. $ equivalent” an American or European quote? Direct quotes: LC/FC Indirect quotes: FC/LC The convention in most countries is to use indirect quotes, while as a convenience to domestic customers, banks are willing to provide direct quotes. Bid-Ask Spreads Foreign exchange traders (such as banks) quote two-way prices in a bid-ask spread. Whenever a currency trader is buying one currency, it is simultaneously selling another. Bid price = buying price of a currency dealer Ask price = selling price of a currency dealer Examples: $1.6710/£ - $1.6720/£ ¥140.25/$ - ¥140.35/$
What would be the bid rate for $ in terms of pounds?
When the bid quote is lower than the ask quote, the bank is
buying and selling the currency in the denominator of the quote. When the bid quote is higher than the ask quote, the bank is buying and selling the currency in the numerator of the quote. It is standard practice to divide the amount of the spread by the ask price, that is, Percentage spread =
Ask - Bid 100 Ask
Suppose that the bid-ask spread of $/£ is equal to 0.06%, and that you started with US$1000 and bought pounds. Then you realized that you had made a mistake and decided to sell the pounds back. How much would you end up with, in terms of US$?
Bid-ask spreads in exchanges between leading currencies are ordinarily quite small. Volatile currencies tend to have wider per cent spreads. Why? Triangular Arbitrage and Foreign Currency Cross-Rates Triangular arbitrage keeps secondary exchange rates or “cross rates” (like HK$/¥) in line with primary exchange rates (usually quoted relative to the U.S. dollar).
Question: S$/£ = 3.00 £/US$ = 0.50 S$/US$ = 2.00 Suppose that you are Singaporean with 1 million Singaporean dollars on hand. How can you make a profit?
Example from the AWSJ: Using the recent AWSJ quotes, check whether triangular arbitrage holds the S$/£ in line with the dollar rates. FORWARD EXCHANGE RATES Outright forward quotations are just like spot quotations. Foreign exchange traders usually quote forward rates in terms of “points”, also referred to as swap rate. The swap rate is the difference between the forward rate and the spot rate. Are bid-ask spreads bigger or smaller in the forward market compared to the spot market? If the forward price of the dollar in terms of yen (i.e. ¥/$) is higher than the spot rate, the dollar is said to be at a forward premium in terms of the Japanese yen. If forward price of the dollar in terms of yen is less than the spot price of ¥/$, the dollar is said to be at a forward discount in terms of the yen.
The terms forward premium and discount are often expressed in per cent annum as
Ft$ / FC St$ / FC 360 100 St$ / FC N
StFC / $ Ft FC / $ 360 100 Ft FC / $ N
where N = 30 days, 60 days, 180 days, … Example: S$/FF = $0.20/FF F$/FF = $0.25/FF Exercise: Forward premium from AWSJ Country Canada Spot (FC/$) Forward (FC/$) (30) (90) (180) (30) (90) (180) Premium (% p.a.)
PERCENTAGE CHANGES IN EXCHANGE RATES Percentage change in the value of a foreign currency
$ S1$ / FC S0 / FC 100 $ S0 / FC
S0FC / $ S1FC / $ 100 S1FC / $
Example: S0FF/$ = FF5/$ S1FF/$ = FF8/$ What is the percentage change in the nominal value of the franc?
IV. EXPOSURE TO FOREIGN EXCHANGE RISK Example: A US company expects to receive FF40,000 in 90 days, and the expected exchange rate then is $0.25/FF. How will the profit of the US company be affected if the actual exchange rate, 90 days from now, is $0.20/FF (rather than $0.25/FF)?
Forward Contracts Definition: A forward contract is an agreement to buy or sell an asset (foreign currency) at an agreed-upon future date and at an agreed-upon price. Forward currency contracts can be used to reduce exposure to foreign exchange risk. How would you use forward contracts to hedge against currency risk in the above example for the US company expecting a receipt of FF40,000 in 90 days?
Source: The Economist, September 23, 1995
Exhibit 4.3 The Top 20 Foreign Exchange Dealers
Exhibit 4.4 Foreign Exchange Markets Top 30 by % share of forex market
97 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 96 1 4 24 9 2 10 5 14 3 7 8 12 19 6 11 28 17 13 25 26 27 22 16 15 Bank Citibank NatWest Merrill lynch Deutsche Morgan Grenfell Chase SBC Warburg JP Morgan Goldman Sachs HSBC Midland BZW Bank of America Credit Suisse First Boston Bank of Tokyo-Mitsubishi Union Bank of Switzerland ABN Amro Hoare Govett Commerzbank Sumitomo Bank Dai-Ichi Kangyo Bank Royal Bank of Canada Standard Chartered Morgan Stanley First Chicago AIG International Societe Generale Sanwa Bank Fuji Bank Bankers Trust S-E-Banken Dresdner Kleinwort Benson Banque Indosuez/Credit Agricole Estimated share (%) 8.30 5.62 5.18 4.79 4.65 4.43 4.40 3.82 3.24 3.14 2.56 2.39 2.14 1.87 1.82 1.78 1.69 1.68 1.64 1.60 1.43 1.41 1.33 1.32 1.19 1.17 1.16 1.08 1.07 1.03
Euromoney | May 1997
Exhibit 4.5 Major Foreign Exchange Trading Centers
(Average daily volume during April of 1989, 1992, 1995, 1998)
Exhibit 4.6 The Asian Wall Street Journal, February 22, 2000
Exhibit 4.7 The Asian Wall Street Journal, February 22, 2000
Exhibit 4.8 South China Morning Post, February 22, 2000