Chapter 2

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Chapter 3
Foreign Exchange Market and
Foreign Exchange Rate
Foreign Exchange Market

Foreign exchange is another country’s money.
The dynamic meaning of the foreign exchange
refers to the act of trading different
country’s currencies.

Convertibility means a currency can be
freely exchanged for another currency. This
is the most important characteristic of the
foreign exchange.

Foreign exchange rate is the price of one
currency in terms of another.

Foreign exchange market is the place where
currencies are bought and sold.

The foreign exchange market is by far the
largest financial market in the world.

Foreign exchange market has two functions:
the first is to convert one currency into
another (the spot exchange market); the
second is to provide insurance against
foreign exchange risk (the forward exchange
market).

The foreign exchange market is an informal,
over-the-counter and around-the-clock
market.

It has no centralized meeting-place and no
formal requirements for participation.

The market never sleeps. Tokyo, London, and
New York are all shut for only 3 hours out of
every 24. During these three hours, trading
continues in a number of minor centers,
particularly San Francisco and Sydney.
Measuring foreign exchange market activity:
Average electronic conversions per hour

As of 2009, more than $3 trillion are traded
in this market on a daily basis. This was a
massive increase of nearly 70% over the 2004
survey’s estimate of $1.9 trillion.

The U.S. dollar was involved in more than 90%
of all foreign exchange transactions,
followed by the euro (38%), yen (23%), and
British pound sterling (13%).

London is the largest world foreign exchange
market, followed by New York and Tokyo.
London accounts for 34.1% of daily world
exchange. New York is about 16%.
Global foreign exchange market turnover, 1998 2010 (daily averages in April, billions of U.S. dollar)
$2,000
$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
1998
2001
2004
Spot
Forwards
2007
Swaps
2010
Top 10 geographic trading center in the foreign exchange
market, 1992-2007 (daily averages in April, billions of $)

Foreign exchange
market structure
Customers buy $
with ¥
Local banks
Foreign exchange
brokers
Major banks
Interbank markets
Local banks
Customers buy ¥
with $
MNCs
& Others
Participants in the foreign exchange
market

Retail customers are made up of individuals,
international investors, small businesses,
speculators or the like who need foreign
exchange.

Commercial banks (market dealers) carry out
buy/sell orders from their retail clients and
buy/sell currencies on their own account.

Dealers often function as market makers who
stands ready to buy and sell at quoted
exchange rates, earning their profit by the
difference of the bid and ask price.

Small- to medium-size banks are not market
makers in the interbank market. They buy
from and sell to larger banks to offset retail
transactions with their own customers.

Foreign exchange brokers do not put their
own money at risk. They serve three purposes
in the market. First, they are the sources of
information. Second, they bring buyers and
sellers together and contributes to market
efficiency. Third, they make it possible for
traders to remain anonymous.

Businesses such as MNCs are the major nonbank participants in the market.

Central banks buy and sell currencies in a
bid to influence the exchange rate.
Spot Exchange Market and Exchange Rate
Quotations

The spot exchange market is a market that
deals in foreign exchange for immediate
delivery. Immediate delivery in foreign
currencies usually means within two
business days.

A spot exchange rate is the current market
price, the rate at which a foreign exchange
dealer converts one currency into another
currency on a particular day.
Foreign exchange rate quotations on the U.S.
Dollar/British Pound in the Financial Press

An exchange of currencies involves two
currencies. Either of which may be placed in
the denominator. The quotation of the
exchange rates follows conventions.

Direct quote is the amount of domestic
currency per unit of foreign currency.
In Japan ¥115 = €1
In Canada C$1.50 = ₤1

Indirect quote is the amount of foreign
currency per unit of domestic currency.
In England $1.60 = ₤1

American quote is the dollar per currency
quote, i.e. the price of other currencies in
terms of the dollar.
Example: US$ 1.57 = £1
US$ 1.35 = €1

European quote is the currencies per dollar
quote, i.e. the price of the dollar in terms of
the other currencies.
Example: A$ 1.02 = US$ 1
€ 0.74 = US$ 1

Bid and ask quotes are the prices at which a
bank likes to buy and sell standard amounts
of foreign currency.
Example: $1.0206/SFr Bid
$1.0217/SFr Ask

When bid is lower than ask, the bank is
buying or selling the currency in the
denominator of the quote.

When bid is higher than ask, the bank is
buying or selling the currency in the
numerator of the quote.

Example: SFr0.9798/$ Bid
SFr0.9787/$ Ask
The bank spends one dollar to buy SFr0.9798;
It sells SFr0.9787 for one dollar.

Bid-ask spread is the difference between the
bid and ask price. It is usually expressed by
“point”.

Example: SFr1.0206/$ Bid
SFr1.0217/$ Ask
Here bid-ask spread is SFr 0.0011/$
or 11 basis points.

one basis point = 1% of 1% = 0.0001

When the spread is expressed as a percent of
the ask price, it is called bid – ask margin.

Bid – ask margin = (ask – bid)/ask x 100

Example: SFr1.0206/$ Bid
SFr1.0217/$ Ask
Bid – ask margin = [(1.0217 – 1.0216) / 1.0217]
x 100 = 0.1077%

A cross rate is the rate which is calculated
from two other bilateral exchange rate.
S(x/y) = S(x/z) / S(y/z)

Example: Suppose ¥/$ 6.6766 and SFr/$ 0.9644,
applying the above formula,
¥/SFr = 6.6766/0.9644 = 6.9230

The following formula is available when both
the bid and ask prices are calculated:
Sa(x/y) = Sa(x/z) / Sb(y/z)
Sb(x/y) = Sb(x/z) / Sa(y/z)

Examples:
If J¥/$ = 85.01 – 08 and SFr/$ = 0.9855 – 65
J¥/SFr (bid) = 85.01/0.9865 = 86.17
J¥/SFr (ask) = 85.08/0.9855 = 86.33

If $/₤ = 1.6000 – 10 and J¥/$ = 85.01 – 08
J¥/₤ (bid) = 1.6000 x 85.01 = 136.01
J¥/₤ (ask) = 1.6010 x 85.08 = 136.21
Foreign exchange cross rates at close of business,
4 January 2005
The Value of a Currency

When a currency gains value relative to
another, the currency appreciates. Otherwise,
it depreciates. In foreign exchange market,
if the demand for dollar is more than the
supply of the dollar, the dollar appreciates.

Percentage change in foreign currency value:
(Ending rate – Beginning rate)
(Beginning rate)

Example: 6 months ago: CHF/USD 1.0235
right now: CHF/USD 0.9644
Percentage change in the value of the dollar:
(0.9644 – 1.0235) / 1.0235 x 100 = -5.77%
The dollar depreciated against the franc by
5.77%. Annual depreciation rate: 11.54%.

Percentage changes in currency values are
asymmetric. When the dollar is depreciated
against franc by 11.54% p.a., it does not mean
the franc is appreciated against the dollar
by 11.54% p.a.

To calculate the percentage change in Swiss
franc, we can use the following formula:
(Beginning rate – Ending rate )
(Ending rate)

Applying the formula, the change in Swiss
franc is:
(1.0235 – 0.9644) / 0.9644 = 6.13%
The Swiss franc appreciates against the
dollar by 12.26% annually.
Foreign Exchange Arbitrage

Arbitrage means a profitable position
obtained with no net investment and no risk.

Foreign exchange arbitrage refers to buying
one currency in one place and selling it in
another place at the same time.

Spatial arbitrage refers to arbitrage
activities conducted across two different
geographical markets.

Suppose $/Dkr = 0.1584 – 0.1594 in New York,
and the exchange rate (Dkr/$) is 6.3520 –
6.3540 in London, what should the foreign
exchange trader do to make profit?

Assume the trader has $1 million line of
credit and both markets are open without any
restrictions against buying and selling
currencies. The trader should buy Danish
krone in London and sell the krone for dollar
in New York.

Buying Kroner in London:
$1m x 6.3520 = Dkr6.3520m (in London)

Selling Kroner in New York:
Dkr6.3520m x 0.1584 = $1.006157m (in New York)

Profit: $1.006157m - $1m = $6,157

Such arbitrage is practical only if the
participants have instant access to quotes
and executions. Bank traders can conduct
such arbitrage without an initial sum of
money, other than their bank’s credit
standing.

When the process is taking place in three
places, it is called Triangular Arbitrage.

The no-arbitrage condition for triangular
arbitrage in the currency markets is: (three
currencies d, e, f, are involved)
Sd/e· Se/f·Sf/d = 1

If the product of the three exchange rates is
not equal to one. An arbitrage opportunity
exists. A rule for determining which
currencies to buy and sell in triangular
arbitrage.

If Sd/e· Se/f·Sf/d < 1, buy the currencies in the
denominators with the currencies in the
numerators.

If Sd/e· Se/f·Sf/d > 1, sell the currencies in the
denominators for the currencies in the
numerators.

Example. If in New York $/¥ = 0.00960984, in
Tokyo ¥/SFr = 60.75, in Zurich SFr/$ = 1.7125,
is there an arbitrage opportunity?

The product of these exchange rates is
Sd/e·Se/f·Sf/d = S$/¥·S¥/SFr·SSFr/$

Since 0.00960984 x 60.75 x 1.7125 = 0.999754 < 1
then,
Buy ¥ with $, (1m)/0.00960984 = ¥104.06 m
Buy SFr with ¥, 104.06/60.75 = SFr 1.712922 m
Buy $ with SFr, 1.712922/1.7125 = $ 1.000246 m

Profit: 1.000246m – 1m = $246.00
The Forward Foreign Exchange Market

Forward foreign exchange market is for
forward foreign exchange transactions. It
means the rates and the amounts of the deal
are agreed on today but settlement occurs
sometime in the future.

Forward exchange rate is defined as the rate
to be paid for delivery of specific currency
at some future date.
Forward Premium and Discount
Spot:
Forward: (90 days)
Spot:
Forward: (90 days)
basis points
Bid
Ask
¥120.25/€
¥118.84/€
¥120.45/€
¥118.97/€
Bid
¥120.25/€
-141
Ask
¥120.45/€
-148

Forward premium: a currency is trading at a
forward premium when the value of that
currency in the forward market is higher
than in the spot market.

Forward discount: a currency is trading at a
forward discount when the value of that
currency in the forward market is lower than
in the spot market.

Formula for forward premium/discount
(n) [(Ftd/f – S0d/f)] / (S0d/f)
n: number of compounding periods per year
Example

If S0$/SFr = 1.04 and F6$/SFr = 1.0000
Swiss franc is selling at a 6-month forward
discount $0.0400/SFr, or 400 basis points.
Annualized percentage deviation from the
spot rate is:
(n) [(Ftd/f – S0d/f)] / (S0d/f)
= (2) [(1.0000 – 1.0400)] / 1.0400
= -0.06923 = 6.923% discount rate annually
Foreign Exchange Risk

Foreign exchange risk refers to fluctuations
in the domestic value of assets, liabilities,
income or expenditure due to unanticipated
changes in exchange rates.

Risk exists when the future is unknown; that
is, whenever actual outcomes can deviate
from expected outcomes.

Foreign exchange exposure is what is at risk.

Transaction exposure is the extent to which
the income from individual transactions is
affected by fluctuations in foreign exchange
values.

Translation exposure is the impact of
currency exchange rate changes on the
reported financial statements of a company.
Translation exposure is basically concerned
with the present measurement of past events.

Economic exposure is the extent to which a
firm’s future international earning power is
affected by changes in exchange rates.
Economic exposure is concerned with longrun effect of changes in exchange rates on
future prices, sales, and costs.

Hedging is the act of offsetting exposure to
risk.

Long position in foreign currency means
foreign currency or a claim in foreign
currency is owned.

Short position in foreign currency means a
foreign currency liability is owed.

A Chinese exporting company expects to
receive the U.S. dollar in the near future.
The company takes long position on the
dollar. If a company will pay dollar, the
company takes short position on the dollar.

Hedging a long position refers to selling
foreign exchange forward.

Hedging a short position involves buying
foreign exchange forward.
company’s income
in RMB
Unhedged position
6.90m
6.85m
6.80m
Hedging with a
forward contract
6.80 6.85 6.90
¥/$ spot rate
company’s expenditure
in RMB
Unhedged position
6.90m
6.85m
6.80m
Hedging with a
forward contract
6.80 6.85 6.90
¥/$ spot rate
Real exchange rate and effective exchange
rate

Nominal exchange rate is the exchange rate
that prevails at a given date.

Real exchange rate is the nominal exchange
rate adjusted for relative changes in
domestic and foreign price levels. That is,
adjusted for inflation differential. So the
real exchange rate captures changes in the
purchasing power of a currency relative to
other currencies.
SR = Sd/f x (Pf/Pd)

Effective exchange rate is a measure of
whether or not the currency is appreciating
or depreciating against a weighted basket of
foreign currencies.

To construct an effective exchange rate, you
have to select:
a currency basket
a base year
the weights for each of the currencies in the
basket.
Nominal exchange rates and trade volume
to the United States
millions of U.S. dollar
Country S (2008) S(2009)
Canada
Japan
C$1.03/$ C$0.99/$
¥80/$
¥85/$
Exports Imports
to U.S. from U.S.
275
235
Total U.S. foreign trade:
(275 + 150) + (235 + 175) = $835m
150
175

Example:
2008 (base year)
Canadian dollar, Japanese yen
(currency basket)
Weight for C$: $425m / $835m = 50.90%
Weight for ¥: $410m / $835m = 49.1%

Compared to the Canadian dollar, the value
of the dollar in 2009 was 96.12% of the value
in 2008 (0.99/1.03).

Compared to the Japanese yen, the value of
the dollar in 2009 was 106.25% of the value in
2008 (85/80).

EER2009 = [(.509)(.9612) + (.491)(1.0625)] x 100
= 101.10%

The value indicates that the average value of
the U.S. dollar against the Canadian dollar
and the Japanese yen in 2009 was 101.10% of
the value in 2008. Therefore, the dollar was
“stronger”.
Nominal effective exchange rate indices
1980–2004 (annual averages)
Real effective exchange rate indices,
1980–2004
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