Foreign Exchange Markets
Market makers,
Market participants
March 22, 2016
Foreign Exchange Market
1
Foreign exchange risk
• liquidity in terms of a different currency for
international transactions
• lags involved (credit transactions)
• exposure from a position in a currency
•
•
an importer holding a payable denominated in a
different currency
an exporter holding a receivable denominated in
a different currency
• http://www.oanda.com/convert/fxhistory
March 22, 2016
Foreign Exchange Market
2
Market Participants
• market makers
• banks, foreign exchange dealers, foreign
exchange brokers
• firms
• exporters, importers
• individuals (investors)
• speculators and arbitragers
• central banks & treasuries
March 22, 2016
Foreign Exchange Market
3
Market Makers
•
Chartered banks – the main market




Hold positions in foreign exchange
Buy and sell spot and forward
Sell over-the-counter options
Hedge open positions buy buying and selling
•
Exchange traded options and futures
 Make money on the bid-ask spread
•
Exchange dealers
 Hold positions specialize in specific currencies
 Make money on the bid-ask spread
•
Exchange brokers
 Broker deals paid commissions
March 22, 2016
Foreign Exchange Market
4
Demanders and suppliers of
foreign exchange
•
Firms (primary demanders)
• Exporters paid in foreign currency want home
currency
 When you buy foreign, sellers usually demand payment
in their own currency
•
Some exceptions (all oil transactions denominated in us
dollars)
 Buying home currency both spot and forward
•
•
Individuals (travelers)
• Buying foreign currency spot or forward (traveler’s
checks)
Individuals (investors)
• Buying foreign currency spot
March 22, 2016
Foreign Exchange Market
5
Wild Cards in the Market
• Speculators - create volatility?
•
Trying to profit from a perceived miss-valuation
of a currency
 If currency is perceived overvalued
•
More of it will be needed in the future to buy
another currency
• It will be shorted (puts for example)
• Arbitrageurs - create stability?
•
Profiting from a riskless arbitrage
 Triangular arbitrage
•
March 22, 2016
Direct price different than price through another
currency
Foreign Exchange Market
6
Wild Cards in the Market
•
Central banks
•
May try to influence the trend of the value of a
currency
 Buying foreign exchange to prevent depreciation
 Selling foreign exchange to prevent appreciation
 Trying to prevent appreciation or depreciation of the
currency
•
May try to reduce volatility in the markets
 The direction of the trend line is not important
 But the volatility around the trend line is important
 Reduce the costs of hedging to exporters and
importers
March 22, 2016
Foreign Exchange Market
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Thickness of the market
• 1.19 trillion per day (2004)
•
spot, forward, and swap transactions
• major centers
•
•
•
London
New York
Japan
700 billion/day
450 billion/day
200 billion/day
• major currencies
•
•
•
usd
Euro
yen
March 22, 2016
45%
20%
10%
Foreign Exchange Market
8
Contracts
 spot
 Delivery and payment on 2nd business
day
 forwards
 Quotes for 1, 2, 3, 6, 12 month
increments
 Contracts however are negotiable
March 22, 2016
Foreign Exchange Market
9
The Spot Exchange rate
• Price of one currency in terms of
another
• For delivery today (four business
days)
• Price fluctuates constantly to reflect
market conditions
March 22, 2016
Foreign Exchange Market
10
Spot rate
•
e0 , cd, terms = cd/usd = 1.1522
• cd cost of the usd
• Canadian terms, European terms, direct
• interbank quotes usually in European
terms
•
e0 , usd
terms
= usd/cd = 0.8679
• usd cost of the cd
• American terms, indirect
http://www.x-rates.com/htmlgraphs/CAD30.html
March 22, 2016
Foreign Exchange Market
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Bid/ask (Offer) quotations
• bid - what the dealer will buy for
• ask (offer) - what the dealer will sell for
• spread
 a function of increased volatility (risk)
 Individual firm risk
 Increased market risk
 Forward exchange rates far into the future
 dealers and banks generate revenues from the
spread
March 22, 2016
Foreign Exchange Market
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Example -
spot rates
Canadian terms, European terms, direct terms
e0 , cd , usd
11522
.
cd

1 usd
American terms, indirect terms
e0, usd , cd
March 22, 2016
1 usd
0.8679 usd


11522
.
cd
1 cd
Foreign Exchange Market
13
Equilibrium Spot Rate
determinants
• Demand for CD by holders of foreign
currency
• foreigners want to buy something
Canadian
 goods, services, securities, etc.
• Supply from Canadians holding CD
demanding foreign exchange
• Canadians want to buy something
foreign
 goods, services, securities, etc
March 22, 2016
Foreign Exchange Market
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Equilibrium Spot Rate
Supply of cd - Canadians buying foreign
usd/cd
e0
Demand for cd - foreigners buying Canadian
March 22, 2016
Q
Foreign Exchange Market
0
Qcd
15
Efficiency of foreign exchange
 Thick (more than 1 billion US/day
 Many traders on both sides
 Opportunities for speculators (returns)
 Information incorporated into price more quickly
 Less opportunity to arbitrage
 Expected returns compensate for high risk taken
 Opportunities for hedgers (costs)
 More instruments
 Cost prices risks appropriately
March 22, 2016
Foreign Exchange Market
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Contract
 Quantity of goods
 Quality of goods
 Price of goods
 Denominated in which currency
 Time of delivery of goods to importer
 Time of payment by importer for
goods
March 22, 2016
Foreign Exchange Market
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Source of exchange-rate
exposure
 Lags
 Time lag between contract and production
 Variable on production schedule
 Time lag between production and delivery
 Variable relative to distance and mode of
delivery
 Time lag between delivery and payment
 Variable on credit terms
 Exposure directly related to length of lag
March 22, 2016
Foreign Exchange Market
18
Swaps –
 Simultaneously purchase and sale on two
different value dates
 Spot-forward swap
 Buy (sell) spot, Sell (buy) forward
 Same counter party
 Borrowing a currency fully collateralized
 Reflects interest rate parity between the two
currencies
 Essentially adjusts for relative inflation
 Forward-forward swaps
 Buy (sell) forward, sell (buy) further forward
March 22, 2016
Foreign Exchange Market
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Mechanics of exchange markets
 transactions confirmed by
 telephone
 telex
 SWIFT
 Society for Worldwide Interbank Financial
Communications
 provides liquidity
 goods & service flows
 capital flows - 95%
March 22, 2016
- 5%
Foreign Exchange Market
20
The clearing system
 clearing house interbank pymts sys (chips)
 fedwire
 electronic trading -
direct trading
 EBS
 Telerate
 Quotron
 efficiency of the markets increasing
 more pricing information
 competition has brought transaction costs down
March 22, 2016
Foreign Exchange Market
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cross rates
 calculating the pound price of the usd
going through the cd
 check for arbitrage possibilities
 arbitrage involves trading gains from a
riskless series of instantaneous
transactions
cd
usd
 dm
cd
dm
usd
March 22, 2016
Foreign Exchange Market
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Arbitrage
 assume crcd. Usd > ecd. Usd through
the Euro
 buy US dollars
 sell US dollars for the Euro
 sell the Euro for Canadian dollars
March 22, 2016
Foreign Exchange Market
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Change in the value of the CD
e 
March 22, 2016
et
 e0
e0
Foreign Exchange Market
24
Forward contracts
 contract today for future delivery of
exchange
 amount contracted, term contracted, rate
contracted
 quotations in points basis
 points added to or subtracted from spot bid/ask
spread
 if bid points larger than ask points, subtract
 trading at discount
 if bid points smaller than ask points, add
 trading at premium
March 22, 2016
Foreign Exchange Market
25
Factors affecting money &
exchange rates
1. economic growth
 economic growth increases demand for base
2. inflation
 CB controls the supply of base money
3. interest rates
 CB controls the bank rate directly
 CB influences term structure of interest rates
indirectly
4. political risk
March 22, 2016
Foreign Exchange Market
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