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The Foreign Exchange Market The Foreign Exchange Market Cross Rate
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- 12/18/2010
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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
19 20 21
FX Market -- Direct and Brokered Trading FX Market -- Direct and Brokered Trading FX Market -- Direct and Brokered Trading
22 23 24
FX Market -- Direct and Brokered Trading FX Market -- Direct and Brokered Trading
25 26
