CHAPTER 6 THE FOREIGN EXCHANGE
MARKET
Multinational Business Finance
723g33
Yinghong.chen@liu.se
6-1
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 €
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Geography
• The foreign exchange market spans the globe,
with currencies trading somewhere every hour of
every business day.
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Exhibit 6.1 Measuring Foreign Exchange Market Activity: Average Electronic
Conversions Per Hour
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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.
6-6
Functions of the Foreign Exchange
Market
• 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
changes.
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Market structure
• The foreign exchange market consists of two
tiers:
– the interbank or wholesale market
(multiples of $1 trillion US or equivalent in
transaction size), and
– the client or retail market (specific,
smaller amounts).
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Market Participants
Four broad categories of participants:
1.
Bank and nonbank foreign exchange
dealers,
2.
Individuals and firms,
3.
Speculators and arbitragers, and
4.
Central banks and treasuries.
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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
makers.”
• 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.
6-10
Exhibit 6.8 Bid, Ask, and Mid-Point
Quotation
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
market.
• 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.
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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
market.
• 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.
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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.
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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.
6-15
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
months.
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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
counterparty.
• Some different types of swaps are:
– spot against forward,
– forward-forward,
– nondeliverable forwards (NDF).
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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 $1.9
trillion.
• This most recent period showed dramatic
growth in foreign exchange trading over that
seen in April 2001.
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Exhibit 6.4 Global Foreign Exchange Market Turnover, 19892010 (average daily turnover in April, billions of U.S. dollars)
Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign
Exchange Market, 1991-2010 (average daily turnover in April)
Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair
(daily average in April)
Foreign Exchange Rates and
Quotations
• A foreign exchange rate is the price of one
currency expressed in terms of another
currency.
• A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
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Foreign Exchange Rates and
Quotations
• Most foreign exchange transactions involve the
US dollar.
• Professional dealers and brokers may state
foreign exchange quotations in one of two ways:
– the foreign currency price of one dollar, or
– the dollar price of a unit of foreign currency.
• Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar.
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Foreign Exchange Rates and
Quotations
• Foreign exchange quotes:
direct or indirect quote
the home country of the currencies being discussed is critical.
• A direct quote is a home currency price of a unit of foreign
currency
• An indirect quote is a foreign currency price of a unit of home
currency.
• The form of the quote depends on what the speaker regard as
“home.”
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Foreign Exchange Rates and
Quotations
• For example, the exchange rate between US
dollars and the Swiss franc is normally stated:
– SF 1.6000/$ (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.
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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.
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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
market
• 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.
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Percent-per-annum
• For quotations expressed in foreign currency
terms (Indirect quotations) the formula
becomes:
f ¥ = Spot – Forward x 360 x 100
n
Forward
• For quotations expressed in home currency
terms (Direct quotations) the formula
becomes:
f ¥ = Forward – Spot 360
x
Spot
n
x 100
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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).
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Intermarket Arbitrage
•
•
•
•
Citibank quote - $/€
$1.1.3297/€
Barclays quote - $/£
$1.5585/£
Dresdner quote - €/£
€1.1722/£
Cross rate calculation:
=
$1.5585/£ = € 1.1721/£
$1.3297/€
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
quotations):
Beginning rate –Ending rate
Beginning Rate
x 100
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Exhibit 6.12 Spot and Forward Quotations for the
Euro and Japanese Yen