Finance 4328 (Moore)
Chapter 7 Lecture Notes
Chapter 7
The Foreign Exchange Market
The Foreign Exchange Markets
I. INTRODUCTION
A. The Market:
Place where money denominated in one currency is bought and
sold with money denominated in another currency.
B. International Trade and Capital Transactions:
- facilitated with the ability to transfer purchasing power
between countries
C. Location
1. OTC-type: no specific location
2. Most trades by phone 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 commercial banks
2. Retail Level
- banks dealing for business customers.
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Finance 4328 (Moore)
Chapter 7 Lecture Notes
B. Two Types of Currency Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business day
2. Forward Market:
- transactions take place at a specified future date
C. Participants by Market
1. Spot Market
a. Commercial banks
b. Brokers
c. Customers of commercial banks
d. Central banks
2. Forward Market
a. Arbitrageurs (holds currency)
b. Speculators
c. Hedgers
II.
SIZE OF THE CURRENCY MARKET
A. Largest in the world (2005): $2.2 trillion daily
B. Market Centers (1998):
London = $637 billion daily
New York= $351 billion daily
Tokyo = $149 billion daily
C.
Benchmark: 1999 USGDP = $9.1 trillion
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Finance 4328 (Moore)
Chapter 7 Lecture Notes
PART III. THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have four different quotes:
a. spot price
b. 30-day
c. 90-day
d. 180-day
3. The Internet
a. http://finance.yahoo.com
b. http://fxtrade.oanda.com
B. For nonbank customers:
Direct quote gives the home currency price of one unit of foreign
currency.
EXAMPLE in France: €.8075/US$
Indirect quote is the reciprocal
C. Transactions Costs
1. Bid-Ask Spread used to calculate the fee charged by the bank
2. Bid = the price at which the bank is willing to buy
3. Ask = the price it will sell the currency
4. Percent Spread Formula:
Percent Spread = (Ask-Bid)/Ask x 100
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Finance 4328 (Moore)
Chapter 7 Lecture Notes
Sample Problem
Suppose the spot quote for the Swedish Krona is $.1395-99, what is
the percent spread?
Percent Spread = PS =
PS 
Ask - Bid
 100
Ask
.1399  .1395
 100  .29%  29bips
.1399
D. Cross Rates
1. The exchange rate between 2 non-US$ currencies.
2.
Purpose: to identify arbitrage opportunities
Sample Problem
Suppose the spot quote for the Swedish Krona and the Mexican Peso
are $.1395/kr and $.1133/MP, what is the quote for the Krona in
Mexico City?
$.1133
MP
8.826 US $ 8.826
MP
 MP 


 1.23
$.1395 US $ 7.168 7.168
kr
kr
kr
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Finance 4328 (Moore)
Chapter 7 Lecture Notes
E. Currency Arbitrage
1. When cross rates differ from one financial center to another,
profit opportunities exist.
2. Buy cheap in one int’l market, sell at a higher price in another
3. Importance of Arbitrage
Suppose the euro is quoted in London at £.6064-80 and the £ is quoted
in Frankfurt at € 1.6244-59. Is there a profitable arbitrage situation?
What is The Critical Role of Arbitrage in the Global Financial Markets?
Sample Problem
London
£.6064-80/€
Frankfurt
€1.6244-59/£
London
Frankfurt
Bid
£.6064/€
£.6150/€
Ask
£.6080/€
£.6156/€
1. Buy euros for £ .6080 / € in London.
2. Use them in Frankfurt to buy pounds at €1.6259 (same as selling
euros at £.6150).
3. This is a net profit is .6150-.6080= £.0070 per euros
4. A yield of 1.16% (.0070/.6080)
Compute the percent spread
Pound spread = (1.6259-1.6244)/1.6259 = .09%
Euro spread = (.6080-.6064)/.6080 = .26%
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Finance 4328 (Moore)
Chapter 7 Lecture Notes
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.
B. Purpose of a Forward:
Hedging: the act of reducing exchange rate risk.
C. Forward Contract Maturities
1. Contract Terms
a. 30-day
b. 90-day
c. 180-day
d. 360-day
2. Longer-term Contracts
3. Require performance
CALCULATING THE FORWARD PREMIUM OR DISCOUNT

F  S 12
  100
S
n
F = Forward Rate
S = Spot Rate
n = number of months for forward contract
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Finance 4328 (Moore)
Chapter 7 Lecture Notes
Sample Problems
What is the forward discount or premium if the 30 day forward rate is
$1.4498/£ and the spot is $1.4487?
What is the forward discount or premium if the 3 month forward rate is
$1.4511/£ and the spot is $1.4487?
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