The Foreign Exchange Market
Exchange Rates
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1/12/01
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German Mark:
Japanese Yen:
British Pound:
EMU Euro:
DM2.0554 per US dollar
¥118.53 per US dollar
$1.4778 per £
$0.95222 per €
European terms: the foreign currency prices of a
dollar
American terms: the dollar price of a unit of
foreign exchange
Appreciation and Depreciation
E$/¥ = the price of the yen in terms of
dollars
 A rise in E$/¥
Appreciation of the yen against the dollar;
Depreciation of the dollar against the yen
 A fall in E$/¥
Depreciation of the yen against the dollar;
Appreciation of the dollar against the yen
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Example
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In Munich, a bratwurst costs €2 = PB€
In Boston, a hot dog costs $1 = PH$
If E$/€ =1.5, then PB$ = E$/€ PB€ = 1.5 x 2 = $3.0.
So PB$/ PH$ =3.0/1.0 = 3.0 hot dog per bratwurst
If E$/€ =1.25, then PB$/ PH$ =(1.25 x 2)/1.0 = 2.5
hot dog per bratwurst
A hot dog become more expensive relative to a
bratwurst.
Euro €
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Jan. 1999 ~
EU: Austria, Belgium, Germany, Finland,
France, Greece, Ireland, Italy,
Luxembourg, Netherlands, Portugal,
Spain.
Not participate: Britain, Sweden, Denmark
2002: euro completely replaces national
currencies.
Appreciation and Depreciation
(cont’d)
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An appreciation of a country’s currency
makes its goods more expensive for
foreigners, and makes foreigners’ goods
less expensive for the country’s residents.
An appreciation of a country’s currency
raises the relative price of domestic goods
and lowers the relative price of foreign
goods.
Foreign Exchange (FX) Market
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The FX market is an over-the-counter market.
i.e. there is no physical location where traders
get together to exchange currencies. Rather
traders are located in the offices of major
commercial banks around the world and
communicate using computer terminals,
telephones, telexes, and other information
channels.
FX market (cont’d)
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The FX market is almost a 24 hour
market.
The major foreign exchange trading
centers are in
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London, New York, and Tokyo ---60%
Zurich, Singapore, and Hong Kong --- 20%
FX market (cont’d)
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Participants
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Importers and exporters, portfolio managers
Commercial banks
Foreign currency brokers
Central banks
Size: $1.5 trillion per day in 1998.
Market-makers
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Traders in the major money center banks
around the world who deal in two-way prices.
They announce bid and offer prices at which
they will exchange two currencies.
The difference between the two prices is
referred to as the bid/asked spread, which is
traders’ profits.
Bid (ask or offer) price = a price at which a
trader is willing to buy (sell).
Brokers
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Individuals who match up buy and sell
orders from two different parties.
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About 85% of all FX trading is between
market-makers.
Less than 15% is commercial business (by
companies engaged in trade, by tourists
etc.)
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FX trading
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Inter-bank traders are major players in FX
market.
90% of trading take place with respect to the US
dollars.
The reasons for quoting most exchange rates
against a common currency (a “vehicle
currency”)
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Avoid informational complexity
Avoid the possibility of triangular arbitrage
Three types of transactions
1.
2.
3.
Spot
Forward
Swap
Spot transaction
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An agreement on price today, with settlement
usually two business days later.
Settlement = actual delivery of currency for
currency
In the case of the US dollar for the Canadian
dollar (or the Mexican peso), settlement is on
the next day of the transaction.
Forward transaction
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An agreement on price today for
settlement at some date (called the “value
date”) in the future (one or two weeks, or 1
~ 12 months).
Example
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Exxon has a scheduled payment of £25
million in 8 months and buys that amount of
British pounds forward today. No money will
change hands now.
Swap
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A sale (purchase) of a foreign currency with a
simultaneous agreement to repurchase (resell) it
at some date in the future.
Usually in the inter-bank market
Example
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Citibank buys DM 2.5 million from Deutsch Bank for
$1 million, with a simultaneous agreement to sell the
DM back in 6 months for $1.05 million. $50,000 =
swap rate.
FX transaction
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65% of transactions: spot
33% of transactions : swap
2%
: (outright) forward
Spot against forward
Tomorrow next
Forward-forward
Forward Premium and Discount
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If the value of a foreign currency is greater (less)
forward than it is spot, the foreign currency is
said to be at a premium (discount).
Example
The spot DM is DM2.0554 = $1 in Jan. 12, 2001, and
the one-month forward DM is DM2.0536 = $1. So the
one-month forward DM is at a premium. It takes less
DM to buy $1 forward than it takes to buy $1 spot.
Futures Contract
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A bet on the direction of price (exchange rate) movement
of the underlying currency.
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If you buy (sell) a futures contract or go long (go short),
and the futures price goes up (down), you make money.
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If you stop an FX futures bet prior to the end of trading
on the last trade date, you do not have to buy or deliver
currency.
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Profits and losses are paid over every day at the end of
trading.
Futures Contract
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Example
Suppose a £62,500 futures contract is opened during Day1 at
a negotiated price of $1.4500/£ and the settlement prices are
Opening price:
$1.4500/£
Settlement price, Day 1:
$1.4460
Settlement price, Day 2:
$1.4510
then the cash flows for long and short positions are
_________Long
Short
Day1: (1.4460-1.4500)x62,500 = -$250
+$250
Day2: (1.4510-1.4460)x62,500 = +$312.50
-$312.50
Futures Contract (cont’d)
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The brokerage firm requires a certain amount of cash deposited with
it as a security bond (this is called margin). The brokerage firm will
in turn post margin with a clearing house, which will then
guarantee both sides of the futures contract against default by the
other party.
International Monetary Market (IMM) of Chicago Mercantile
Exchange (CME)
Trading on a floor for standardized contracts
4 value dates: the 3rd Wednesday of March, June, September,
and December.
Example: 125,000 marks, 100,000 Can dollars,
62,500 pounds, 12,500,000 yen.
Futures Contract (cont’d)
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Quotes are always in American terms.
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Prices not allowed to vary more than a certain amount in a given
day (limit moves).
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London International Financial Futures Exchange (LIFFE)
Differences between Forward contracts and
Futures contracts
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The daily cash flows take place on a futures contract. In
a forward contract, no money will change hands until the
contract expires.
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Because the time pattern of cash flow is different, your
opportunity cost is different.
To read futures price quotation:
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Open: the price of a contract at the beginning of the day
High: the highest price during the day
Low: the lowest price during the day
Settle: the price at which contracts are settled at the
close
Change: change from settlement price the previous day
Lifetime High (Low): the highest (lowest) price this
contract has ever traded
Open Interest: the number of contracts outstanding the
previous day
Hedging with futures
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Suppose you have accounts receivable denominated in
British pounds.
There is an exchange risk: The dollar value of the
account receivable will drop if the British pound loses
value with respect to the dollar.
To hedge this risk, you go short pound futures.
If the pound loses value in dollar terms, you will make
money, which will offset the loss in the value of your
account receivable.
Foreign Currency Options
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Option: The right (but not obligation) to buy or sell something at a
specified price (strike price). You want to use the contract if you
want to. Potential loss is limited.
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Option to buy: Call
Option to sell: Put
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At a specified date: European option
At any time prior to a specified date (expiration date, maturity):
American option
Foreign Currency Options (cont’d)
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Example
An importer has to make a 31,250 Br. pounds payment in 90 days.
He buys a call option at $.0422 per pounds in FILX. The strike price
is $1.975.
Thus, the importer pays $1,318.75 for the right to buy pounds any
time within 90 days at $1.975 per Br. Pound.
Suppose that at the end of 90 days the pound is at $2.05.
Then the importer saves
2.05 x 31,250 – 1,318.75 – 1.975 x 31,250 = $1,025
He makes a windfall profit.
Foreign Currency Options (cont’d)
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A Call (Put) on Futures
The call (put) buyers pays the premium to the writer in order to
acquire the right (but not obligation) to go long (short) an exchange
—traded FX futures at the strike price.
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Foreign currency options on spot and futures can be considered
types of insurance against adverse exchange rate movements.
What else?
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Central-Bank Intervention
To drive the value of their currencies to certain desirable levels, the
central banks sometimes buy or sell currencies in the FX market.
CBs often use swap arrangements for this purpose, which are
facilitated by the Fed in many cases.
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In developing countries, governments often restrict foreign
exchange transactions.  black market
The government allows a free market to coexist with the official
market.  parallel market