The Foreign

Exchange Market
Chapter 6

The Foreign Exchange

Markets
I. INTRODUCTION
A. The Market:
the anyplace where money
denominated in one currency is
bought and sold with money
denominated in another currency.

INTRODUCTION

B. International Trade and

Capital Transactions:
facilitated with the ability
to transfer purchasing
power between countries

INTRODUCTION

C. Location
1. OTC-type: no specific
2. Most trades by phone or

location
SWIFT*

*SWIFT: Society for Worldwide Interbank

Financial Telecommunications

PART II.
ORGANIZATION OF THE
FOREIGN EXCHANGE
IMARKET
. 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.

Mondays Direct Quote

ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
B. Two Sub markets of Currency
Markets
1. Spot Market:
- immediate transaction
- recorded by 2nd business day
2. Forward Market:
- transactions take place at a
specified future date
7

ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
C. Participants by Market
1.
Spot Market
a. commercial banks
b. brokers
c. customers of commercial
banks
d. central banks
8

ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
2. Forward Market
a. arbitrageurs
(hold currency)
b. speculators
c. hedgers
9

ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
II. SIZE OF THE CURRENCY MARKET
A. Largest in the world
2005: $1.9 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
10

PART III.
THE SPOT MARKET
I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have
different quotes:
a.
b.
c.
d.

four

spot price
30-day
90-day
180-day

11

THE SPOT MARKET

B. For nonbank customers:
Direct quote
gives the home currency
price
of one unit of foreign currency.

EXAMPLE in France : .80/US$

Indirect quote is the reciprocal
of the direct quote
12

THE SPOT MARKET

C.

Transactions Costs
1.
Bid-Ask Spread
used to calculate the fee
charged by the broker
2.

Bid = the price at which

the broker is willing to

3.

Ask = the price the broker

the currency

buy
will sell

13

THE SPOT MARKET

Sample bid-ask quote:
.7353-75/$ or .7375/$

If you are selling

dollars for euros,
this is the rate at
which the broker
will buy them from
you

If you want to buy

dollars wit euros,
this
is the rate at which
the broker will sell
them to you

14

THE SPOT MARKET

4. Percent Spread
Formula:
Percent Spread = {(Ask-Bid)/Ask} x
100

15

Sample Problem
Suppose the spot quote for the Swedish
krona is $.1395-99, what is the percent
spread?
PS = Ask Bid x 100
Ask
= .1399 - .1395 x 100
.1399
= .29% or 29 basis points
16

THE SPOT MARKET

D. Cross Rates
1. The exchange rate
2 non-US$ currencies.

between

2.
Purpose: to identify
arbitrage opportunities
17

Sample Problem

Suppose the spot quote for the Swedish

Krona and the Swiss franc are $.1395/kr
and $.1133/SF, what is the quote for
the krona in Geneva?

$.1133
SF = _SF_ = 8.826 x US$
=8.826
kr
$.1395
US$ 7.168
7.168
kr
= SF1.23/kr

18

The Impact of
Arbitrage

19

THE SPOT MARKET

E. Currency Arbitrage
1. When cross rates differ from
one financial center to another,
arbitrage profit opportunities
exist.
2. Strategy: Buy cheap in one
intl
market,
Sell at a higher price in another

20

CURRENCY ARBITRAGE
What is The Critical Role of
Arbitrage in the Global Financial
Markets?

21

PART III.
THE FORWARD
MARKET
I. INTRODUCTION
A. Definition of a Forward Contract
an agreement between a bank and
customer to buy or sell
1. a specified amount of currency
against another currency
2. at a specified future date and
3. at a fixed exchange rate.

22

THE FORWARD
MARKET
2. Purpose of a Forward:
Hedging
the process of reducing or
mitigating exchange
rate risk.

23

Hedging Tools
Type

Contract Features

Forward 1.
Future 2.

Fixed currency
amount
Fixed exchange rate

Option

Fixed expiration date

3.

24

THE FORWARD
MARKET
C. Forward Contracts Require
performance by both parties
1. Contract Terms may be
a.
b.
c.
d.
2.

30-day
90-day
180-day
360-day
Longer-term Contracts possible

25

CALCULATING THE FORWARD

PREMIUM OR DISCOUNT

P or D = F-S x 12 x 100
S
n
Alternate= F-S x 360 x 100
S
n
where
F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months or
days in the forward contract
26

Sample Problem

What is the forward discount or

premium if the 3 month forward
rate is $1.4511/ and the spot is
$1.4487?

F S 12

x
x100
S
n
1.4511 1.4487 12

x
x100
1.4487
3
.66%

27

Sample Problem
What is the forward discount or
premium if the 30 day forward rate
is $1.4498/ and the spot is
$1.4487/
?
F S 360

x100

S
n
1.4498 1.4487 360

x
x100
1.4487
30
.91%
28