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IFLecture_1_full.pptxInternational Finance Lecture 1
Foreign Exchange Fundamentals
Learning Objectives
Gain knowledge of foreign exchange markets, exchange rates, and use of terminology
Understand how arbitrage may arise in these “multi-faceted” markets and how transaction costs reduce arbitrage opportunities
Be familiar with exchange rate regimes, regime changes and the effect on and implications of exchange rates in practice
Foreign Exchange Markets and Exchange Rates
A foreign exchange market is a market where a convertible currency is traded for other convertible currencies.
An exchange rate is the price of one currency in terms of another currency; it is the relative price of the two currencies.
| OTC foreign exchange turnover | ||||||
| Net-net basis,1 daily averages in April, in billions of US dollars | Table 1 | |||||
| Instrument | 2001 | 2004 | 2007 | 2010 | 2013 | 2016 |
| Foreign exchange instruments | 1,239 | 1,934 | 3,324 | 3,971 | 5,355 | 5,088 |
| Spot transactions | 386 | 631 | 1,005 | 1,488 | 2,046 | 1,654 |
| Outright forwards | 130 | 209 | 362 | 475 | 679 | 700 |
| Foreign exchange swaps | 656 | 954 | 1,714 | 1,759 | 2,239 | 2,383 |
| Currency swaps | 7 | 21 | 31 | 43 | 54 | 96 |
| Options and other products² | 60 | 119 | 212 | 207 | 337 | 254 |
| Memo: | ||||||
| Turnover at April 2016 exchange rates3 | 1,381 | 1,884 | 3,123 | 3,665 | 4,915 | 5,088 |
| Exchange-traded derivatives4 | 12 | 25 | 77 | 145 | 145 | 115 |
| 1 Adjusted for local and cross-border inter-dealer double-counting (ie “net-net” basis). 2 The category “other FX products” covers highly leveraged transactions and/or trades whose notional amount is variable and where a decomposition into individual plain vanilla components was impractical or impossible. 3 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2016 exchange rates. 4 Sources: Euromoney Tradedata; Futures Industry Association; The Options Clearing Corporation; BIS derivatives statistics. Foreign exchange futures and options traded worldwide. | ||||||
Location of FX Trading
| Geographical distribution of OTC foreign exchange turnover1 | ||||||||
| Net-gross basis,2 daily averages in April, in billions of US dollars and percentages | ||||||||
| Country | 2007 | 2010 | 2013 | 2016 | ||||
| Amount | % | Amount | % | Amount | % | Amount | % | |
| United Kingdom | 1,483 | 34.6 | 1,854 | 36.8 | 2,726 | 40.8 | 2,426 | 37.1 |
| United States | 745 | 17.4 | 904 | 17.9 | 1,263 | 18.9 | 1,272 | 19.4 |
| Total | 4,281 | 100.0 | 5,043 | 100.0 | 6,684 | 100.0 | 6,546 | 100.0 |
| 1 Data may differ slightly from national survey data owing to differences in aggregation procedures and rounding. The data for the Netherlands are not fully comparable over time due to reporting improvements in 2013. 2 Adjusted for local inter-dealer double-counting (ie “net-gross” basis). Source; Bank for International Settlements. | ||||||||
Foreign Exchange Market Participants and Activity
The FOREX market is a two-tiered market:
Interbank Market (Wholesale)
About 700 banks worldwide stand ready to make a market in Foreign exchange.
Nonbank dealers account for about 20% of the market.
There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.
Client Market (Retail)
Foreign Exchange Market Participants and Activity
Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.
Large commercial banks maintain demand deposit accounts with one another
This facilitates the efficient functioning of the forex market.
Foreign Exchange Market Participants and Activity
International commercial banks communicate with one another with:
SWIFT: The Society for Worldwide Interbank Financial Telecommunications.
CHIPS: Clearing House Interbank Payments System
ECHO: Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.
Foreign Exchange Quotations
Direct quotation: expressed as the number of units of the home/ domestic currency per foreign currency unit. (in blue on next page)
Indirect quotation: foreign currency units per home currency unit. (in black on next page)
| F\H | USD | GBP | CAD | EUR | AUD |
| USD | 1 | 0.76444 | 1.32118 | 0.89591 | 1.33526 |
| GBP | 1.30815 | 1 | 1.7283 | 1.17199 | 1.74671 |
| CAD | 0.7569 | 0.5786 | 1 | 0.67812 | 1.01065 |
| EUR | 1.11618 | 0.85325 | 1.47467 | 1 | 1.49038 |
| AUD | 0.74892 | 0.5725 | 0.98946 | 0.67097 | 1 |
Foreign Exchange Cross Rates
Foreign Exchange Quotations
We use direct quotations in our discussions.
Important to remember this
So an increase in the exchange rate
indicates depreciation of the home currency
or appreciation of the foreign currency.
Foreign Exchange Quotations
A cross exchange rate
refers to the amount of one foreign currency per unit of another foreign currency.
e.g., if the euro exchange rates against £ and $ are €1.1458/£ and €0.731/$ respectively,
then the dollar sterling exchange rate is
Cross Rates and Arbitrage
If the dollar sterling exchange rate <1.5673, euro holders can
Demand for $ (£); supply of £ ($)
The $/£ rate will be pushed up to settle at $1.5673/£
£1
$1.5673
€1.1458
Cross rate and Arbitrage
If the cross exchange rates are substantially different
Traders will be able to make profit through arbitrage trading
For example (check yourself against the table)
Take € 1 and exchange for Koruna 24.63
Take Koruna 24.63 with exchange rate of £ 0.036= Kr 1 (this is direct exchange rate, not the cross exchange rate we have calculated from the table)
Then take £ 0.887 with exchange rate of £ 0.8703 =€ 1
This gives € 1.019
So round trip trade generates a profit of nearly 2 %
Cross rate and Arbitrage
Banks provide foreign exchange services for a fee:
The bank’s bid (buy) quote for a foreign currency
Will be less than its ask (sell) quote.
This is the bid-ask spread
Bid-ask spread in percentage =
(ask rate – bid rate)/ask rate
What should be the bid-ask exchange rates be
For Norwegian Krone, kr against the Polish Zloty, Zl
using their respective quotes in Euros in the table?
Transaction Costs and Arbitrage
For bid price for the Krone (i.e. investor sells Kr) is:
Sell kr for € (i.e. bank sells €, taking ask quote) .
kr 7.7816 =€1
Sell € for Zl (i.e. bank buys €) .
Zl 4.3806 = €1
The bid price for the Krone against Zloty
kr 1.7763= Zl 1
The ask price for the Krone (i.e. investors buy Kr) is:
Sell Zl for € (i.e. bank sell €) .
Zl 4.3827= €1
Sell € for kr (i.e. bank buy €) .
Kr 7.7776 = €1
The ask price for the Krone
kr 1.7746= Zl 1
So the bid-ask quotes are
Kr 1.7763-1.7746/ ZI
Points to Note
The spread (below the bid price)
About 9 basis points
Usually more for retail transactions
Larger investment banks will trade much more cheaply
So arbitrage opportunities are usually slight
The floating, or flexible, exchange rate regime
A flexible, or floating exchange rate
Level is determined exclusively by supply and demand
for the currencies involved
Without government intervention
Determined by general economic factors, inflation, gdp etc
The UK operates a floating exchange rate
Exchange Rate Regimes
The fixed exchange rate regime
A fixed exchange rate
Level is fixed by the government
Through imposing legal restrictions
Or intervention in the foreign exchange market.
The government maintains target rates.
Central banks buy/sell currency if target rates are threatened.
Exchange Rate Regimes
Managed float or dirty float
The floating rate is the most common exchange rate regime today
Market forces set exchange rates under normal circumstances.
However, since central banks frequently intervene when markets are excessively volatile
Exchange Rate Regimes
Target zones
Upper and Lower levels are set for the exchange rate
Member states of the regime adjust their economic policies to maintain the target zone.
This was the process for the European Monetary System
Before the creation of the Euro
Exchange Rate Regimes
Business School
£
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5673
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$
$
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Sheet2
| EURO SPOT FORWARD AGAINST THE EURO | ||||||
| Closing | Change | Bid/offer | One year | |||
| Europe | mid-point | on day | spread | Rate | %PA | |
| CzechRep. | (Koruna) | 24.63 | 0.18 | 150-450 | 24.5 | 0.5 |
| Denmark | (DanishKrone) | 7.4469 | -0.0007 | 467-470 | 7.43 | 0.2 |
| Hungary | (Forint) | 291.175 | 4.335 | 020-330 | 299.29 | -2.7 |
| Norway | (Nor.Krone) | 7.7796 | 0.0746 | 776-816 | 7.9 | -1.5 |
| Poland | (Zloty) | 4.3817 | 0.0788 | 806-827 | 4.47 | -2.1 |
| Russia | (Rouble) | 42.5873 | 0.4736 | 718-027 | 44.93 | -5.2 |
| Sweden | (Krona) | 9.1649 | 0.0051 | 634-664 | 9.28 | -1.2 |
| Switzerland | (Fr) | 1.2052 | -0.0013 | 050-054 | 1.19 | 1.3 |
| Turkey | (NewLira) | 2.4609 | 0.0054 | 601-617 | 2.59 | -5.1 |
| UnitedKingdom | (£) | 0.8703 | -0.0025 | 700-705 | 0.87 | -0.3 |
EURO SPOT FORWARD AGAINST THE EURO
ClosingChangeBid/ask
Europemid-pointon day0.01%Rate%PA
CzechRep.(Koruna)24.630.18150-45024.50.5
Denmark(DanishKrone)7.4469-0.0007467-4707.430.2
Hungary(Forint)291.1754.335020-330299.29-2.7
Norway(Nor.Krone)7.77960.0746776-8167.9-1.5
Poland(Zloty)4.38170.0788806-8274.47-2.1
Russia(Rouble)42.58730.4736718-02744.93-5.2
Sweden(Krona)9.16490.0051634-6649.28-1.2
Switzerland(Fr)1.2052-0.0013050-0541.191.3
Turkey(NewLira)2.46090.0054601-6172.59-5.1
UnitedKingdom(£)0.8703-0.0025700-7050.87-0.3
One year
Sheet2
| EURO SPOT FORWARD AGAINST THE EURO | ||||||
| Closing | Change | Bid/ask | One year | |||
| Europe | mid-point | on day | 0.01% | Rate | %PA | |
| CzechRep. | (Koruna) | 24.63 | 0.18 | 150-450 | 24.5 | 0.5 |
| Denmark | (DanishKrone) | 7.4469 | -0.0007 | 467-470 | 7.43 | 0.2 |
| Hungary | (Forint) | 291.175 | 4.335 | 020-330 | 299.29 | -2.7 |
| Norway | (Nor.Krone) | 7.7796 | 0.0746 | 776-816 | 7.9 | -1.5 |
| Poland | (Zloty) | 4.3817 | 0.0788 | 806-827 | 4.47 | -2.1 |
| Russia | (Rouble) | 42.5873 | 0.4736 | 718-027 | 44.93 | -5.2 |
| Sweden | (Krona) | 9.1649 | 0.0051 | 634-664 | 9.28 | -1.2 |
| Switzerland | (Fr) | 1.2052 | -0.0013 | 050-054 | 1.19 | 1.3 |
| Turkey | (NewLira) | 2.4609 | 0.0054 | 601-617 | 2.59 | -5.1 |
| UnitedKingdom | (£) | 0.8703 | -0.0025 | 700-705 | 0.87 | -0.3 |
