chapter 6 the foreign exchange market

Multinational Business Finance
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The Foreign Exchange Market
• Foreign exchange means the money of a foreign
country; that is, foreign currency, bank balances,
banknotes, checks and drafts.
• A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount
of one currency will be delivered for some other
currency at a specified rate.
1 €
• The foreign exchange market spans the globe,
with currencies trading somewhere every hour of
every business day.
Exhibit 6.1 Measuring Foreign Exchange Market Activity: Average Electronic
Conversions Per Hour
Exhibit 6.2 Global Currency Trading:
The Trading Day
Start of the day
The Foreign Exchange Market
• The Foreign Exchange Market provides:
– the physical and institutional structure through
which the money of one country is exchanged for
that of another country;
– the determination of rate of exchange between
currencies, and
– is where foreign exchange transactions are
physically completed.
Functions of the Foreign Exchange
• 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
Market structure
• The foreign exchange market consists of two
– the interbank or wholesale market
(multiples of $1 trillion US or equivalent in
transaction size), and
– the client or retail market (specific,
smaller amounts).
Market Participants
Four broad categories of participants:
Bank and nonbank foreign exchange
Individuals and firms,
Speculators and arbitragers, and
Central banks and treasuries.
1. Bank and Nonbank Foreign Exchange Dealers
• Banks and a few nonbank foreign exchange dealers operate in
both the interbank and client markets.
• The profit from buying foreign exchange at a “bid” price and
reselling it at a slightly higher “offer” or “ask” price.
• Dealers in large international banks often function as “market
• 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.
Exhibit 6.8 Bid, Ask, and Mid-Point
2. Individuals and Firms
• Individuals (such as tourists) and firms (such as
importers, exporters and MNEs) conduct commercial
and investment transactions in the foreign exchange
• Their use of the foreign exchange market is
necessary for their underlying commercial or
investment purpose.
• Some of the participants use the market to “hedge”
foreign exchange risk.
3: Speculators and Arbitragers
• 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
• 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.
4: Central Banks and Treasuries
• Central banks and treasuries use the market
to acquire or spend their country’s foreign
exchange reserves as well as to influence the
price at which their own currency is traded.
• The motive is not to earn a profit
• central banks and treasuries differ in motive
from all other market participants.
Transactions in the Interbank Market
• A spot transaction in the interbank market is
the purchase of foreign exchange, with
delivery and payment between banks to take
place on the second following business day.
• The date of settlement is referred to as the
value date.
Exhibit 6.3 Foreign Exchange Settlement in Europe
Transactions in the Interbank Market
• An outright forward transaction (or a 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
Transactions in the Interbank Market
• 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 (settlement date).
• Both purchase and sale are conducted with the same
• Some different types of swaps are:
– spot against forward,
– forward-forward,
– nondeliverable forwards (NDF).
Market Size
• In April 2004, a survey conducted by the Bank
for International Settlements (BIS) estimated
the daily global net turnover in traditional
foreign exchange market activity to be $1.9
• This most recent period showed dramatic
growth in foreign exchange trading over that
seen in April 2001.
Exhibit 6.4 Global Foreign Exchange Market Turnover, 19892010 (average daily turnover in April, billions of U.S. dollars)
Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign
Exchange Market, 1991-2010 (average daily turnover in April)
Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair
(daily average in April)
Foreign Exchange Rates and
• A foreign exchange rate is the price of one
currency expressed in terms of another
• A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
Foreign Exchange Rates and
• Most foreign exchange transactions involve the
US dollar.
• Professional dealers and brokers may state
foreign exchange quotations in one of two ways:
– the foreign currency price of one dollar, or
– the dollar price of a unit of foreign currency.
• Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar.
Foreign Exchange Rates and
• Foreign exchange quotes:
direct or indirect quote
the home country of the currencies being discussed is critical.
• A direct quote is a home currency price of a unit of foreign
• An indirect quote is a foreign currency price of a unit of home
• The form of the quote depends on what the speaker regard as
Foreign Exchange Rates and
• For example, the exchange rate between US
dollars and the Swiss franc is normally stated:
– SF 1.6000/$ (European terms or direct quote)
• However, this rate can also be stated as:
– $0.6250/SF (American terms or indirect quote)
• most interbank quotations around the world
are stated in European terms.
Foreign Exchange Rates and Quotes
• Forward rates are typically quoted in terms of
points. 1 points typically corresponds to
0,0001 in value.
• Rather, it is the difference between the
forward rate and the spot rate.
Foreign Exchange Rates and Quotes
• Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate.
• This method of quotation makes it easier to
compare premiums or discounts in the forward
• If a currency increases in value in the future, it is
traded at a premium, if decreases, it is at a
discount against the other currency.
• For quotations expressed in foreign currency
terms (Indirect quotations) the formula
f ¥ = Spot – Forward x 360 x 100
• For quotations expressed in home currency
terms (Direct quotations) the formula
f ¥ = Forward – Spot 360
x 100
Exhibit 6.9 Exchange Rates: New York
Closing Snapshot
Exhibit 6.9 Exchange Rates: New York
Closing Snapshot (cont.)
Foreign Exchange Rates and Quotes
• Some currency pairs are only inactively
traded, so their exchange rate is determined
through their relationship to a widely traded
third currency (cross rate).
• Cross rates can be used to check on
opportunities for intermarket arbitrage.
• one bank’s (Dresdner) quotation on €/£ is not
the same as calculated cross rate between $/£
(Barclay’s) and $/€ (Citibank).
Intermarket Arbitrage
Citibank quote - $/€
Barclays quote - $/£
Dresdner quote - €/£
Cross rate calculation:
$1.5585/£ = € 1.1721/£
Because the rates are unequal, a triangular
arbitrage opportunity exists.
For another example, see Exhibit 6.11
Exhibit 6.10 Key Currency Rate
Calculations for January 3, 2012
Exhibit 6.11 Triangular Arbitrage by a
Market Trader
Foreign Exchange Rates
and Quotes
• Measuring a change in the spot rate for quotations expressed in
home currency terms (direct quotations):
%∆ =
Ending rate – Beginning Rate
x 100
Beginning Rate
Quotations expressed in foreign currency terms (indirect
Beginning rate –Ending rate
Beginning Rate
x 100
Exhibit 6.12 Spot and Forward Quotations for the
Euro and Japanese Yen

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