The Foreign Exchange Market

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12/12/17

Fundamentals of Multinational Finance Sixth Edition

Chapter 5 The Foreign Exchange

Market

Learning Objectives 5.1 Explore the multitude of functions of the foreign exchange market

5.2 Detail how the structure of the global foreign exchange market has evolved

5.3 Describe the financial and operational transactions conducted in the foreign exchange market

5.4 Examine the forms of currency quotations used by currency dealers, financial institutions, and agents of all kinds when conducting foreign exchange transactions

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Functions of the Foreign Exchange Market

• The foreign exchange market is the mechanism by which participants:

– transfer purchasing power between countries

– obtain or provide credit for international trade transactions

– minimize exposure to the risks of exchange rate changes

Structure of the Foreign Exchange Market (1 of 8)

• The Global Trading Day – The foreign exchange market spans the globe, with

currencies trading somewhere every hour of every business day

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Exhibit 5.1 Global Currency Trading: The Trading Day

Structure of the Foreign Exchange Market (2 of 8) • Market Participants – The Players

– Participants in the foreign exchange market include liquidity seekers and profit seekers.

– Five broad categories of institutional participants operate in the market § Bank and nonbank foreign exchange dealers

– Profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price

§ Individuals and firms conducting commercial or investment transactions

– Use the foreign exchange market to facilitate execution of commercial or investment transactions

§ Speculators and arbitragers – Seek to profit from trading within the market itself

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Structure of the Foreign Exchange Market (3 of 8) • Market Participants – The Players

– Five broad categories of institutional participants operate in the market (continued) § Central banks and treasuries

– Use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded

§ Foreign exchange brokers – Facilitate trading between dealers without

themselves becoming principals in the transaction

Structure of the Foreign Exchange Market (4 of 8)

• Evolution of the Market – How currency rates are quoted, prices posted, and

trades consummated, confirmed, and settled—across borders, time zones, and oceans—has all changed very quickly

– The foreign exchange market is the world’s largest financial market

– It is a market without a single dealer, a single exchange, a single global regulator, or even a single price

– It is today considered to be the world’s most pure competitive market

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Exhibit 5.2 Evolution of the Modern Currency Trading Marketplace

Structure of the Foreign Exchange Market (5 of 8) • The Evolution of FX Trading

– 1985

§ Limited price discovery capability

§ Trades conducted over the phone

– 1990’s

§ Instantaneous access to market data via computer

§ Market only accessible by intermarket dealers

– 2010

§ Trades are conducted electronically

§ Separation of the interdealer and customer markets has effectively broken down

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Exhibit 5.4 The Foreign Exchange Market Today

Structure of the Foreign Exchange Market (6 of 8)

• The Three Components of FX Trades – The foreign exchange trade transaction agreement—

the interaction of dealers, brokers, and aggregators – Electronic communication and notification for payment

settlement – Final settlement of the currency trade

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Structure of the Foreign Exchange Market (7 of 8) • The Three Components of FX Trades

– Instructions for foreign exchange trades are executed through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) § The SWIFT network sends payment orders, but it does not facilitate

the actual settlement § Settlement of a foreign exchange trade is made by correspondent

accounts that the banks and institutions have with each other – Continuous Linked Settlement (CLS)

§ Specialist bank provides settlement services to its members for foreign exchange trades

– Payment versus Payment § settlement service where both sides’ payment instructions for an FX

transaction are settled simultaneously

Structure of the Foreign Exchange Market (8 of 8) • FX Market Manipulation: Fixing the Fix

– London fix § The 4 p.m. daily benchmark rate used by a multitude of

institutions and indices for marking value § Market analysts had noted steep spikes in trading just prior to

the 4 p.m. fix, spikes that were not sustained in the hours and days that followed

§ Traders were alleged to be exchanging emails, using social networking sites, and even phone calls, to collaborate on market movements and price quotes at key times

§ With more and more of the market’s transactions executed electronically, computer algorithms were believed to be less likely to pursue fraudulent trading for fixing given the speed and frequency of transactions

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Transactions in the Foreign Exchange Market (1 of 6) • Spot Transactions

– The purchase of foreign exchange with delivery and payment between banks taking place normally on the second following business day.

– Value Date § The date of settlement

– Clearing House Interbank Payments System (CHIPS) § Most dollar transactions in the world are settled through the

computerized CHIPS in New York § Calculates net balances owed by any one bank to another and

which facilitates payment of those balances by 6:00 p.m. that same day in Federal Reserve Bank of New York funds

Exhibit 5.5 Foreign Exchange Transactions and Settlements

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Transactions in the Foreign Exchange Market (2 of 6)

• Forward Transactions aka Outright Forward Transactions

– Requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency

– The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity

Transactions in the Foreign Exchange Market (3 of 6) • Swap Transactions

– Spot Against Forward

§ A dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market

– Forward-Forward Swaps

§ Example: A dealer sells £20,000,000 forward for dollars for delivery in two months at $1.8420/£ and simultaneously buys £20,000,000 forward for

delivery in three months at $1.8400/£

§ This swap can be viewed as a technique for borrowing another currency on a fully collateralized basis

– Nondeliverable Forwards (NDFs)

§ Possess the same characteristics and documentation requirements as traditional forward contracts, except that they are settled only in U.S. dollars

§ The foreign currency being sold forward or bought forward is not delivered

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Transactions in the Foreign Exchange Market (4 of 6)

• Size of the Foreign Exchange Market

– A 2016 survey estimated daily global net turnover in the foreign exchange market to be $5.1 trillion, a 5% decline from its peak in 2013

Exhibit 5.6 Global Foreign Exchange Market Turnover, 1989–2016

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Transactions in the Foreign Exchange Market (5 of 6)

• Geographical Distribution

– London continues to be the world’s major foreign exchange market in traditional foreign exchange market activity with 37% of the global market, followed by the New York with 19%

– Currency trading in Asia is growing due to the growth of the Asian economies, markets, and currencies

Exhibit 5.7 Top 6 Geographic Trading Centers in the FX Market

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Transactions in the Foreign Exchange Market (6 of 6)

• Currency Composition

– The currency composition of trading indicates a number of global shifts

§ The U.S. dollar increased its presence in global currency trades

§ The Japanese yen and the European euro both showed declines

§ The Chinese renminbi’s proportion, although small, has recently doubled

Exhibit 5.8 Daily FX Trading by Currency Pair (percent of total) (1 of 2)

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Exhibit 5.8 Daily FX Trading by Currency Pair (percent of total) (2 of 2)

Foreign Exchange Rates and Quotations (1 of 10) • Foreign Exchange Rate

– The price of one currency expressed in terms of another currency.

• Foreign Exchange Quotation (Quote) – A statement of willingness to buy or sell at an announced rate

• Currency Symbols – Quotations may be designated by traditional currency symbols or by ISO codes

Currency Traditional Symbol ISO 4217 Code

U.S. dollar $ USD

European euro € EUR

Great Britain pound £ GBP

Japanese yen ¥ JPY Mexican Peso Ps MXN

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Foreign Exchange Rates and Quotations (2 of 10) • Exchange Rate Quotes

– Every currency exchange involves two currencies: the base or unit currency (CUR1), and the price or quote currency (CUR2):

CUR1/CUR2 – The quotation indicates the number of units of CUR2

required in exchange for receiving one unit of CUR1 – Example:

EUR/USD1.2174 – Designates the euro (EUR) as the base currency, the dollar

(USD) as the price currency § The exchange rate is USD 1.2174 = EUR 1.00

Exhibit 5.9 Foreign Currency Quotations

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Foreign Exchange Rates and Quotations (3 of 10) • Market Conventions

– European Terms § Quoting of the quantity of a specific currency per one U.S. dollar § Market practice for most of the past 60 years or more

– American Terms § Quoting the quantity of U.S. dollars per one unit of a specific currency § Exceptions that use American Terms

– Euro – U.K. pound sterling – Australian dollar – New Zealand dollar

Foreign Exchange Rates and Quotations (4 of 10) • Market Conventions

– Currency Nicknames § Cable

– Exchange rate between U.S. dollars and U.K. pounds sterlin § Loonie

– Canadian dollar § Kiwi

– New Zealand dollar § Aussie

– Australian dollar § Swissie

– Swiss francs § Sing dollar

– Singapore dollar

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Foreign Exchange Rates and Quotations (5 of 10) • Market Conventions

– Direct and Indirect Quotations § Direct Quote

– Price of a foreign currency in domestic (home) currency units • In Paris, a direct quote might be EUR 0.8214/USD 1.00

• The euro is the home currency • In New York, the same “quote” would be USD 1.2174/EUR

1.00 • The dollar is the home currency

§ Indirect Quote – Price of the domestic currency in foreign currency units

• In New York, the indirect quote would be EUR 0.8214/USD 1.00

• In Paris, the indirect quote would be USD 1.2174/EUR 1.00

Foreign Exchange Rates and Quotations (6 of 10)

• Market Conventions – Direct and Indirect Quotations

§ The two quotes are equivalent, one being the reciprocal of the other

= 1 USD1.2174

EUR 0.8214/USD EUR

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Foreign Exchange Rates and Quotations (7 of 10)

• Market Conventions – Bid and Ask Rates

§ Bid – The price in one currency at which a dealer will

buy another currency § Ask

– The price in one currency at which a dealer will sell the other currency

§ Bid-Ask Spread – Ask price is slightly higher than bid price

Exhibit 5.10 Bid, Ask, and Mid-Point Quotation

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Exhibit 5.11 Exchange Rates: New York Closing Snapshot (1 of 2)

Exhibit 5.11 Exchange Rates: New York Closing Snapshot (2 of 2)

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Foreign Exchange Rates and Quotations (8 of 10) • Market Conventions

– Cross Rates § Many currency pairs are only inactively traded, so their exchange rate

is determined through their relationship to a widely traded third currency

– Example: The JPY/MXN exchange rate may not be directly observable, but both are actively quoted versus the U.S. dollar

Currency per USD

Japanese yen USD/JPY 101.29 Mexican Peso USD/MXN 18.2692

– Cross-Rate Calculation

= JPY101.29/USD

JPY5.5443/Ps Ps18.2692/USD

Foreign Exchange Rates and Quotations (9 of 10) • Intermarket Arbitrage

– Cross rates can be used to check on opportunities for intermarket arbitrage § Example

Citibank quotes U.S. dollars per euro USD1.3297 = 1 EUR Barclays Bank quotes U.S. dollars per pound sterling USD1.5585 = 1 GBP

Dresdner Bank quotes euros per pound sterling EUR1.1722 = 1 GBP

– Cross rate Calculation

= USD1.5585/GBR

EUR5.5443/GBP USD1.3297/EUR

– The calculated cross rate of EUR 1.1721/GBP is not the same as Dresdner Bank’s quotation, so triangular arbitrage opportunity exists

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Exhibit 5.12 Triangular Arbitrage by a Market Trader

Foreign Exchange Rates and Quotations (10 of 10) • Forward Quotations

– Spot rates are typically quoted on an outright basis (all digits expressed) – Forward rates are typically quoted in terms of points or pips

Bid Ask

Outright spot JPY118.27 JPY118.37

Plus points (3 months) 1.43 1.40

Outright forward JPY116.84 JPY116.97

§ Cash Rates – Forward rates of one year or less maturity

§ Swap Rates – Forward rates for longer than one year maturity

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Exhibit 5.13 Spot and Forward Quotations for the Euro and Japanese Yen