• The interbank market is the wholesale
market where the major banks trade with
one another. Most currency transactions
occur here. The interbank market is
generally referred to as the foreign
exchange market.
• Spot market: currencies trade for immediate
delivery (within 2 days of the trade)
• Forward market: contracts are made to buy
or sell currencies for future delivery.
Generally for 30,90,180,360 day periods.
• The participants in the foreign exchange
market are the large commercial banks,
foreign exchange brokers, the major
multinational corporate customers, and
central banks.
• The foreign exchange market is the largest
financial market in the world. In 1995 daily
volume was $1.2 trillion.
• Spot quotations
1. Direct quotes: DC/FC
e.g. $/DM
2. Indirect quotes: FC/DC
e.g. DM/$
• Bid-ask spread
Banks generally do not charge commissions
on foreign currency transactions. Instead,
they make their profit off the bid-ask
spread.
The bid price- the price the bank will pay for
FC
The ask price - the price the bank will sell FC
• The bid-ask spread is a function of the
breadth (number of market participants) and
depth (volume of purchases) of the market
for the currency as well as the currency’s
price volatility.
• % spread
= [(ask price-bid price)/ask price]*100
• The more widely the currency is traded, the
narrower the spread
• The forward bid-ask spreads are wider than
current spot spreads
• Financial press quotes are for interbank
market transactions. Local nonbank quotes
will be less favorable.
• Bid-ask spreads will also differ based on the
individual bank’s currency needs.
• Quotes are size related. The smaller the
transaction, the larger the spread
• Cross rates
The cross rate is the rate of exchange between
two non-U.S. currencies.
Suppose 1.7799 SF/$ and 2.2529 DM/$.
What is SF/$? 0.79005 SF/DM
• The forward market
Forward contracts between a bank and a
customer call for delivery of a specified
amount of a currency quoted against the
dollar on a specific future date. The
exchange rate is fixed at the time the
contract is entered into.
• Let’s say a U.S. bank must pay a Swiss
bank SF 100M in 90 days. The U.S. bank
has dollars now but needs future Swiss
francs, so the U.S. bank is in effect short the
Swiss franc. In order to offset this short
position risk, the U.S. bank will buy (go
long) the Swiss franc in the forward market.
• E.g.) A U.S bank is obliged to make a future
payment of SF 100,000 in 60 days. To
manage its exchange rate risk the firm
contracts to buy the SF 60 days in the future
at 1.7530 SF/$. The current exchange rate
is 1.7799 SF/$.
• At the time of payment the exchange rate fell to
1.6556 SF/$, the firm would have lost
(100,000/1.7530 -100,000/1.6556)= -$3,356.00
on its commitment on the spot market
• But, fortunately, the U.S. bank gets to buy the SF
at 1.7530 SF/$ rather than at the 1.6556 rate in
effect at the time the commitment must be met.
The actual loss on the commitment is exactly
offset by the gain on the forward contract
• If at the time of payment the exchange rate had risen
to 1.8250 SF/$, the bank would have gained
(100,000/1.7530 - 100,000/1.8250) = +$2,250.55 by
being able to pay off its commitment with cheap SF.
But unfortunately the bank must buy the SF at
1.7530 SF/$ on the forward market. Thus, the gain
on the commitment is exactly offset by the loss on
the forward contract.
• The interest rate parity (IRP)
Interest rate parity shows that there is a
relationship between the spot and forward
exchange rates and the domestic and foreign
interest rate in the countries represented by the
exchange rates.
• Forward (DC/FC) =
Spot (DC/FC) [(1+Rdomestic)/1+Rforeign)]
• Suppose that you can invest in DM at r =
5.127% or you can invest in SF at r = 5.5%. You
are a resident of Germany and the current spot
rate is 0.79005 DM/SF. Calculate the one-year
forward rate expressed in DM/SF.
Forward rate (DM/SF) =0.790059 (1.05127/1.055)
= 0.78726 DM/SF