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The Foreign Exchange Market The Foreign Exchange Market Cross Rate

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The Foreign Exchange Market The Foreign Exchange Market Cross Rate

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									                                                                          The Foreign Exchange Market                                         The Foreign Exchange Market
The Foreign Exchange Market                                                Geographical extent                                                Market participants (different motives)
                                                                                                                                               (1) Bank and nonbank FX dealers
                                                                                      Afternoon        London         Morning
                                                                                                                                                            Profit from spread
                                                                                                                                 Japan
                                                                                                                                Japan
                                                                                                                                               (2) Individuals and firms
                                                                              N.Y.
                                                                              N.Y.                                                H.K.
                                                                                                       Continuously              H.K.          (3) Central banks and treasuries
                                                                                                                                                            Monitor the market
                                                                                                   Frankfurt
                                                                                                  Frankfurt
                                                                                                     Zurich
                                                                                                    Zurich
                                                                                                                                                            Intervene for purpose of policy implementation
               Jerry T. Yang                                                                                                                                Profit on their FX reserves
                                                                           Three main functions                                                             Discourage speculation against their currencies
   National Tsing Hua University                                           (1) Transfer of purchasing power                                    (4) FX brokers
                                                                           (2) Provision of credit                                            Transaction Volume
                                                                           (3) Minimizing FX risk
                                                                     1                                                                    2     During the month of April 1995, $1.2 trill/business day                      3




 The Foreign Exchange Market                                             The Foreign Exchange Market                                          Spot Market
  Type or transactions
  (1) Spot transactions (43.4% )                                          Quotations                                                           Allows for the buying & selling of FX with
        Value date 2 business days                                                                                                             settlement in 2 business days (value date)
        ~ 70% of all transaction in London                                        SF 1.6395
                                                                                 SF 1.6395//$                        $ 0.60994
                                                                                                                    $ 0.60994//
                                                                                            $                                   SF
                                                                                                                               SF              Cross Rate
        ~ 60% of all transaction in N.Y.
  (2) (Outright)forward transactions (24% in April 98’)                                                                                                       Dealers buy   Dealers sell
        Value dates 1 2 3 6           12 months                            (1) European terms & American terms                                                  (sell $)     (buy $)       Dealer’
                                                                                                                                                                                           Dealer’s profit   Profit on $1b
                                                                                                                                                                  Bid         Offer           Spread         transaction
        8.5% of all FX transaction
                                                                                                                                                                                               50pts
  (3) Currency futures (24% in April 98’)                                            FX // $
                                                                                     FX $                              $ FX
                                                                                                                       $ // FX                   FF/$          6.6575        6.6625
                                                                                                                                                                                             (FF0.0050)
                                                                                                                                                                                                             FF 5 mile
        Smaller contract size                                                                                                                                                                  10pts
                                                                                                                                                 DM/$          2.0310        2.0320                          DM 1 mile
        Higher transaction costs                                           (2) Direct quotes & indirect quotes                                                                               (DM0.0010)
  (4) Options on spot currency/currency future                                                                                                 Cross rate      3.2763
                                                                                                                                                               3.2779        3.2804
                                                                                                                                                                             3.2788            41pts
  (5) Swap transactions (48% in April 98’)                                           home/FX
                                                                                     home/FX                          FX/home
                                                                                                                      FX/home
                                                                                                                                                (FF/DM)
                                                                                                                                                              Sell DM       Buy DM
        Simultaneous purchase and sell of a given amount of FX for 2
                                                                     4                                                                    5                                                                                  6
        different value dates




    Triangular Arbitrage-1                                                  Triangular Arbitrage-2                                                Triangular Arbitrage-3
          cross-
   If the cross-bid rate were actually FF3.3000/DM                         If the cross-bid rate were actually FF3.3000/DM
                                                                                  cross-                                                               cross-
                                                                                                                                                If the cross-offer rate were actually FF3.2500/DM
   then                                                                    then                                                                 then
                               overpriced”
   1) Sell DM 1,000,000 ( the “overpriced currency) at                                                                                                                     underpriced”
                                                                                                                                                1) Buy DM 1,000,000 ( the “underpriced currency) at
                                                                                                     underpriced”
                                                                          1) Buy FF 1,000,000 ( the “underpriced currency) at
       FF3.3000/ DM                   receive FF 3,300,000
                                                                                                                                                    FF3.2500/ DM                                 pay FF 3,250,000
                                                                              FF3.3000/ DM                            pay DM 303,030
                                                                                                                                                1) Sell DM 1,000,000 for US$ at                  DM    2.0320 / $
   1) Sell FF 3,300,000 for US$ at        FF   6.6625 / $                 1) Sell FF 1,000,000 for US$ at             FF   6.6625 / $
                                             receive $ 495,310                                                                                                                                   receive $ 492,126
                                                                                                                      receive $ 150,094
                                          DM                                                                                                    3) Sell $ 492,126 for FF at                      FF   6.6575 / $
   3) Sell $ 495,310 for DM at               2.0310 / $                                                               DM
                                                                          3) Sell $ 150,094 for DM             at          2.0310 / $
                                     receive DM 1,005,975                                                                                                                                  receive FF 3,276,329
                                                                                                                receive DM 304,841
        Profit : DM 5,975                                                     Profit : DM 1,811                                                       Profit : FF 26,329
                                                                     7                                                                    8                                                                                  9
Forward Market                                           1) Outright Basis                                               2) Points Basis
                                                                                                                          Quote forward premium (or discount) in terms of point
                                                          Ex    3-month forward
   Forward contracts are often negotiated against                                                                         A point is the last digit of a quotation
   dollars.                                                                    Bid        Ask        Spread
                                                                    /$                                10pts                                                      3-month
                                                                                                                                           Spot                                          Outright
   The most frequent forward contracts are 1,2,3,6             (Indirect)
                                                                             105.65      105.75
                                                                                         105.75
                                                                                                     (=0.10)                              (bid/ask)
                                                                                                                                                                 Forward
                                                                                                                                                                                       forward rate
                                                                                                                                                               (bid pts/ask pts)
   or 12 months
                                                                    /                                  9pts                  FF/$        7.7150/200               300/425              7.7450/7.7625
                                                                            0.009465    0.009456
                                                                                        0.009456
   Quotation                                                    (direct)                           (=0.000009)               DM/$        1.5625/35                175/169              1.5450/1.5466

  1) Outright Basis                                       Dollar premium forward dollars are at a premium                                  Forward             Forward            1.5625-0.0175 1.5635-0.0169
                                                                                                                                           premium             discount
  2) Points Basis                                         over spot (need more foreign currency to buy dollar
  3) Percentage Terms                                     forward than to buy dollar spot)                                The bid-ask spreads on forward contracts increase with maturity.
                                                                                                                          Not b/c it’s riskier
                                                          Dollar discount       forward dollars are at a discount         But b/c of the decreasing liquidity of longer-term forwards.
                                                    10
                                                          over spot                                                 11
                                                                                                                          (harder to find offsetting positions )
                                                                                                                                                                                                          12




3) Percentage Terms-1                                    3) Percentage Terms-2                                           3) Percentage Terms-3
 Quote forward premium (or discount) in                                                                                   Indirect
                                                          Direct                                                                                       S       F 12
 terms of percent-per-annum deviation from                                           F S 12                               Percent premium
                                                          Percent premium                                                                                  F      3
 spot rate                                                                            S   3                                    (or discount)
                                                               (or discount)                                                                          2.2605 2.2405 12
 Ex: 3-month forward                                                           = .4463 .4424       12                                                                                            3.53%
                                                                                                          3.53 %                                          2.2406     3
                                                                                       .4424        3
                     Direct          Indirect
                $/ DM (home/FX)
                      (home/FX    DM/$ (FX/home)
                                       (FX/home                                                                                                       1        1
   Spot (S)          .4424            2.2605              DM forward is selling at a 3.53% per annum premium                         F S              S        F          S        F
                                                                                                                               Note:
  Forward (F)        .4463            2.2406                                                        over the spot                     S                    1                  F
                                                                                                                                                           F
          DM forward sold at a premium
                                                    13                                                              14                                                                                    15
                                                                                                                                      Direct                           Indirect




Currency Future Market                                   Currency Future Market                                          Currency Future Market
(1st traded in IMM of CME in 1972)
                                                          4) Margin Account                                               – Settlement: only 5% of all futures are settled by
  Standardized contracts           Monetary market
                                                          i.e., initial margin on sterling :$2000 per contract              the physical delivery
 1) A few value dates: i.e., Chicago IMM                        maintenance margin on sterling :$1500 per                  Adv.: liquidity, gain can be taken as cash by
    most 3rd Wednesday in the months of March,                 contract                                                    selling back to the exchange (but for forward
    June, September, December.
                                                                                                                           contract, buy an offsetting contract for the
                                                               If the market value of the contract falls more
 2) Traded in whole units i.e.    62500, DM125,000                                                                         same maturity to lock in a profit)
                                                               than $500 then receive a “margin call”
    etc.
                                                               daily adjustment            marking to market                Disadv.:
                                                                                                                            Disadv.: flexibility, marking to market risk
 3) Clearing House

                                                    16                                                              17                                                                                    18
                                              FX Market -- Direct and Brokered Trading    FX Market -- Direct and Brokered Trading
Currency Future Market

  Daily volume: (during the month of April
  1995) < $4 billions

 But forward market   $97 billions




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FX Market -- Direct and Brokered Trading      FX Market -- Direct and Brokered Trading    FX Market -- Direct and Brokered Trading




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FX Market -- Direct and Brokered Trading      FX Market -- Direct and Brokered Trading




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