INTERNATIONAL FINANCE

Unit 2: The Foreign Exchange Market and Exchange Rate Determination

International Finance

• FX Market and FX Market participants • Spot rate quotations

– Direct and indirect quotes – Bid and ask prices

• Cross Rates – Triangular arbitrage

• Forward Rate Quotations – Forward premium (discount) – Forward points

Summary

• YOU BID / ASK

• CLIENT BID / ASK

FX Market: where money denominated in one currency is bought and sold with money denominated in another

currency.

• The FX market can be viewed as a two-tiered market: – Interbank Market (Wholesale)

• Approximately 100 to 200 banks worldwide stand ready to make a market in foreign exchange.

• “make a market” meaning they stand willing to buy or sell foreign currency for their own account

• Nonbank dealers account for about 14% of the market. • There are FX brokers who match buy and sell orders but do not carry

inventory and FX specialists. – Client Market (Retail)

• Market participants include international banks, their customers, nonbank dealers, FX brokers, and central banks.

FX Market Participants

• Interbank trading: either to adjust inventory positions they hold in various foreign currencies or speculative or arbitrage transactions

• FX brokers match dealer orders to buy and sell currencies for a fee, but do not take positions themselves – Because the extensive electronic trading platforms, few specialized

broking firms still exist in the FX market (Thomson Reuters or ICAP platforms)

• Central Banks through Intervention: using foreign currency reserves to buy one´s own currency for foreign currency in order to increase its supply and lower its price

FX market participants

• Interbank market is a network or correspondent banking relationships, with large commercial banks

• Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the FX market. – US importer desire purchase merchandise from Dutch Exporter invoiced in

EUR – Costs 750,000 EUR – US importer inquire his US bank about the $/E exchange rate – US bank offers a price $1.2238 / E 1.00 – US importer accepts price, so US Bank debit US importer´s demand deposit

account $917,850 (750,000 x 1.2238) for the purchase of the euros – US Bank instruct its correspondent bank in the EUR zone (EZ Bank) to debit its

correspondent Bank Account Eur 750,000 and to credit that amount to Dutch exporter´s bank account

– US Bank will then credit its books $917,850 as an offset to the $917,850 debit to US importer´s account to reflect the decrease in its correspondent bank account balance with EZ bank

Correspondent Banking Relationships

• International commercial banks communicate with one another with: – SWIFT: The Society for Worldwide Interbank Financial

Telecommunications., allows international commercial banks to communicate instructions to one another

– CHIPS: Clearing House Interbank Payments System, provides a clearinghouse for the interbank settlement for over 95% of $ payments between international banks

– ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FX transactions.

Correspondent Banking Relationships

• Almost immediate purchase or sale or foreign exchange • Direct quotation

– the U.S. dollar equivalent – e.g. “a Japanese Yen is worth about 1 US cent”

• Indirect Quotation – the price of 1 U.S. dollar in the foreign currency – e.g. “you get 100 yen to the dollar”

Spot Rate Quotations

• Most currencies in the interbank market are quoted in European terms, that is the $ priced in terms of the foreign currency (an indirect quote from the US perspective)

• By convention, it is standard practice to price certain currencies in terms of the $, or in what is referred to as American terms (a direct quote from the US perspective).

• Settlement Date Value Date: – Date monies are due – 2nd Working day after date of original transaction.

The Spot Market

Spot Market quotes

FX Market Overview

Country USD equiv Friday

Currency per USD Friday

Britain (Pound) 1.4655 0.6824

• The direct quote for British pound is: – £1 = $1.4655

• The indirect quote for British pound is: – £.6824 = $1

• Note that the direct quote is the reciprocal of the indirect quote: – $1.4655 =( 1/ £.6824 )

Spot Rate Quotations

Indirect Quotes

Direct quotes

• The bid price is the price a dealer is willing to pay you for something. • The ask price is the amount the dealer wants you to pay for the

thing. • The bid-ask spread is the difference between the bid and ask prices. • A dealer could offer

– bid price of $1.25 per € – ask price of $1.26 per € – While there are a variety of ways to quote that,

• The bid-ask spread represents the dealer’s expected profit. • Percent Spread Formula (PS)

The Bid-Ask Spread

PS = Ask −Bid Ask

x100

• A dealer would likely quote these prices as 50-55. • It is presumed that anyone trading $10m already knows the “big

figure”.

The Bid-Ask Spread

Bid Ask

1.4650

.6824

S($/£)

S(£/$)

1.4655

.6826

big figure small figure

• Suppose that S($/€) = 1.50 – i.e. $1.50 = €1.00

• and that S(¥/€) = 50 – i.e. €1.00 = ¥50

• What must the $/¥ cross rate be?

Cross Rates

$1.50 ¥50=

$1.50 €1.00 €1.00 ¥50×

$1.00 = ¥33.33 $0.0300 = ¥1

American Terms

European Terms

Bank Quotations

Bid Ask Bid Ask

British Pounds 1.4650 1.4655 .6824 .6826

Euros 1.2233 1.2238 .8171 .8175

Cross Rate

• Bank customer wants to sell 1 MM gbp for EUR. • Bank will sell USD (to buy gbp) for $1.4650. The sale yields Bank Customer:

1,000,000 gbp x 1.4650 = $1,465,000 • The bank will buy $ (sell EUR) for .8171. The sale of $ yields Bank customer:

$1,465,000 x .8171 = 1,197,052 EUR • Bank cutomer has effectively sold GBP at a EUR / GBP bid price of EUR

1,197052/ GBP 1,000,000 = EUR 1.1971 / GBP 1

• Certain banks specialize in making a direct market between nondollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread.

• If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible.

• Triangular arbitrage is the process of trading out of the USD into a second currency, then trading if for a third currency, which is in turn traded for USD.

• Purpose is to earn an arbitrage profit via trading from the second to the third currency when direct exchange rate between the two is not in alignment with the cross-exchange rate.

Triangular Arbitrage

Triangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate any implied cross rate to see if an arbitrage exists.

£1.00

¥80 =

£1.50 $1.00

$1.00 ¥120 ×

Triangular Arbitrage

$ Credit

Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

The implied S(¥/£) cross rate is

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

So, how can we make money?

¥ £

£1.00

¥80 =

£1.50 $1.00

$1.00 ¥120 ×

Buy the £ @ ¥80; sell @ ¥85.

Triangular Arbitrage

$

Credit Lyonnais

S(£/$)=1.50 Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell our $ for £,

2. Sell our £ for ¥,

3. Sell those ¥ for $.

¥ £

1

2

3

$

Triangular Arbitrage

$

Credit Lyonnais

S(£/$)=1.50 Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Here we have to go “clockwise” to make money—but it doesn’t matter where we start.

¥ £ 1

2 3

$

If we went “counter clockwise” we would be the source of arbitrage profits, not the recipient!

Triangular Arbitrage

Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000 Sell our £150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥12,750,000 for $ at S(¥/$) = 120 receive $106,250

profit per round trip = $106,250 – $100,000 = $6,250

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.

• The forward market for FX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.

• Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

• Longer-term swaps are available. • Hedging, Speculating or Arbitraging

Forward Rate

• The forward exchange rate is an unbiased predictor of the expected spot exchange rate N months into the future. – American terms: Spot ($/SF) = .8662 F6 ($/SF) = .8715 where SF is

trading at a premium to the $. That premium increase out to 6 months so market expects $ to depreciate relative to the SF

– European terms: Spot (SF/$) = 1.1545 F6(SF/$) = 1.1474 where $ is trading at a discount to the SF. That discount increase out to 6 months so market expects SF to appreciate relative to the $

Forward Rate

Country USD equiv Friday

Currency per USD Friday

Britain (Pound) 1.4655 0.6824

1 Month Forward 1.4655 0.6824

3 Months Forward 1.4658 0.6822

6 Months Forward 1.4661 0.6821

Forward Rate

• Interest Rate Parity Theory – the forward rate (F) differs from the spot rate (S) at equilibrium by an

amount equal to the interest differential (rh - rf) between two countries.

– Convert GBP into USD • 1. Invest GBP at the risk free rate, and simultaneously enter into a forward

rate agreement to convert the proceeds from the investment into USD at the end of the investing period

• 2. Convert GBP to USD at the spot then invest the USD for the same amount of time in previous option 1 at the USD risk free rate. No arbitrage exist if both cashflows are equal.

Country USD equiv Friday

Currency per USD Friday

Britain (Pound) 1.9077 0.5242

1 Month Forward 1.9044 0.5251

3 Months Forward 1.8983 0.5268

6 Months Forward 1.8904 0.5290

Canada (Dollar) 0.8037 1.2442

1 Month Forward 0.8037 1.2442

3 Months Forward 0.8043 1.2433

6 Months Forward 0.8057 1.2412

GBP1.00

CAD2.3464 =

GBP1.00 USD1.00

USD1.8904 CAD1.2412 ×

pound-Canadian dollar cross rate

The forward

Forward Cross Exchange Rates

In generic terms

Forward Cross Exchange Rates

)/($ )/($

)/(

and )/($ )/($

)/(

kF jF

jkF

jF kF

kjF

N

N N

N

N N

=

=

Notice that the “$”s cancel.

• Consider the (dollar) holding period return of a dollar-based investor who buys EUR 1 million at the spot and sells them forward: – USD 1.25 invested at 1% for 91 days we will receive 1.25316 – EUR 1 invested at 2% for 91 days we will receive 1.005056

• FX Spot rate 1.25/1.00 = 1.25 • FX Forward rate 1.25316/1.0056 = 1.246856

Forward Rate Quotations

Forward Quotes

• The interest rate differential implied by forward premium or discount. • The forward premium is given by:

Forward Premium (or discount)

FN,€v$ FN($/€) – S($/€)

S($/€) = ×

360

Days

• Depending on the differences in interest rates between the currencies, there are three possibilities: – the interest rate for the base currency is lower than that for the quoted

currency: The forward rate is then higher than the spot rate. The base currency is said to trade at a premium

– the interest rate for the base currency is higher than that for the quoted currency. The forward rate is lower than the spot rate. The base currency is said to trade at a discount

– the interest rates of both relevant currencies are equal. The forward rate is the same as the spot rate and this is called parity.

Forward rate premium

Forward Rate Discount

Country USD equiv Friday Currency per USD Friday

EUR 1.2238 0.8171

1 Month Forward 1.2242 0.8169

3 Months Forward 1.2251 0.8163

6 Months Forward 1.2260 0.8157

• 3 month fwd premium (1.2251 – 1.2238)/(1.2238) x 360/94 = .0041 • 3 month forward premium is .0041 or .41 percent. So, EUR is trading at a .41

percent premium versus the $ for delivery in let´s say 94 days • In European terms fwd premium (.8163 - .8171)/(.8171) x 360/94 = -.0037

• 3 month forward discount is -.0037 or -.37 percent. So, the $ is trading versus the EUR at a .37 percent discount for delivery in 94 days.

• If you have agreed to sell anything (spot or forward), you are “short”.

• If you have agreed to buy anything (forward or spot), you are “long”. – If you have agreed to sell FX forward, you are short. – If you have agreed to buy FX forward, you are long.

Long and Short Forward Positions

Payoff Profiles

0 S180($/¥)

F180($/¥) = .009524

Short positionloss

profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain.

If you agree to sell anything in the future at a set price and the spot price later rises then you lose.

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

120

If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105.

15¥

profit Long position

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

Short position-F180(¥/$)

F180(¥/$) Long position profit Since this is a zero-sum game, the long position

payoff is the opposite of the short.

• June 2, 2010. $/SF trader believe $ will likely appreciate against SF over the next 3 months – Trader will short 3 months $/SF contract: sells SF 5,000,000 forward

against $.8686 • September 2, 2010, spot $/SF trading at $.8616

– Trader can buy SF spot at .8616 and deliver it under the forward contract at a price of $.8686

– Profit would be (.8686 – 86.16) = .0070 per unit – Total profit is SF5,000,000 x $.0070 = $35,000 – If $ depreciated and spot instead would be .7816, would have lost

($.8686 - $.8716) = -$.0030 for a total loss of SF5,000,000*(- $.0030)=$15,000

Speculative Forward Position