CHAPTER 7 THE FOREIGN EXCHANGE MARKET CHAPTER OVERVIEW I. II. INTRODUCTION ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. THE SPOT MARKET IV. THE FORWARD MARKET V. INTEREST RATE PARITY THEORY PART I. INTRODUCTION I. INTRODUCTION A. The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency. INTRODUCTION B. International Trade and Capital Transactions: - facilitated with the ability to transfer purchasing power between countries INTRODUCTION C. Location 1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications PART II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET A. Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level - business customers. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market: - transactions take place at a specified future date ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. FedWire - operated by the Fed - used for domestic transfers ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE MARKET A. Largest in the world 1995: $1.2 trillion daily ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily PART III. THE SPOT MARKET I. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes: a. b. c. d. spot price 30-day 90-day 180-day THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades: a. American terms example: $.5838/dm b. European terms example: dm1.713/$ THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. EXAMPLE: dm0.25/FF THE SPOT MARKET C. Transactions Costs 1. Bid-Ask Spread used to calculate the fee charged by the bank Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency THE SPOT MARKET 4. Percent Spread Formula (PS): Ask Bid PS x100 Ask THE SPOT MARKET D. Cross Rates 1. The exchange rate between 2 non - US$ currencies. THE SPOT MARKET 2. Calculating Cross Rates When you want to know what the dm/ cross rate is, and you know dm2/US$ and .55/US$ then dm/ = dm2/US$ .55/US$ = dm3.636/ THE SPOT MARKET E. Currency Arbitrage 1. If cross rates differ from one financial center to another, and profit opportunities exist. THE SPOT MARKET 2. Buy cheap in one int’l market, sell at a higher price in another 3. Role of Available Information THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due 2. 2nd Working day after date of original transaction. THE SPOT MARKET G. Exchange Risk 1. Bankers = middlemen a. Incurring risk of adverse exchange rate moves. b. Increased uncertainty about future exchange rate requires THE SPOT MARKET 1.) Demand for higher risk premium 2.) Bankers widen bid-ask spread MECHANICS OF SPOT TRANSACTIONS SPOT TRANSACTIONS: An Example Step 1. Currency transaction: verbal agreement, U.S. importer specifies: a. Account to debit (his acct) b. Account to credit (exporter) MECHANICS OF SPOT TRANSACTIONS Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1. MECHANICS OF SPOT TRANSACTIONS Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date. U.S. bank debits importer’s account. PART III. THE FORWARD MARKET I. INTRODUCTION A. Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate. THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk. THE FORWARD MARKET B. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market as a discount or premium. THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract THE FORWARD MARKET C. Forward Contract Maturities 1. Contract Terms 2. a. 30-day b. 90-day c. 180-day d. 360-day Longer-term Contracts PART IV. INTEREST RATE PARITY THEORY I. INTRODUCTION A. The Theory states: the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries. INTEREST RATE PARITY THEORY 2. The forward premium or discount equals the interest rate differential. (F - S)/S = (rh - rf) where rh = the home rate rf = the foreign rate INTEREST RATE PARITY THEORY 3. In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S INTEREST RATE PARITY THEORY B. Covered Interest Arbitrage 1. Conditions required: interest rate differential does not equal the forward premium or discount. 2. Funds will move to a country with a more attractive rate. INTEREST RATE PARITY THEORY 3. Market pressures develop: a. As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates. INTEREST RATE PARITY THEORY C. Summary: Interest Rate Parity states: 1. Higher interest rates on a currency offset by forward discounts. 2. Lower interest rates are offset by forward premiums.