FIN 456 International financial management

Chapter 5
The market for foreign exchange

FIN 456 – Qin Lian

5-1
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FX Market Participants

The FX market is a two-tiered market:

Interbank market (wholesale)
About 100-200 banks worldwide stand ready to make a market in
foreign exchange.
Nonbank dealers account for about 40% 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.
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Correspondent Banking Relationships

Large commercial banks maintain demand

deposit accounts with one another, which
facilitates the efficient functioning of the FX
market.

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Correspondent Banking Relationships
Bank A is in London. Bank B is in New York.
The current exchange rate is £1.00 = $2.00.
A currency trader employed at Bank A buys
£100m from a currency trader at Bank B for
$200m settled using its correspondent
relationship.

Bank A $200 Bank B

London £100 NYC

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Correspondent Banking Relationships
Bank A buys £100m from Bank B for $200m
Bank A $200 Bank B
London £100 NYC

Assets Liabilities Assets Liabilities

£ deposit at B £300m B’s Deposit $1,000m $ deposit at A $1000m A’s Deposit £300m
£400m $1,200m $1200m £400m
$ deposit at B $800m B’s Deposit £200m £ deposit at A £200m A’s Deposit $800m
$600m £100m £100m $600m
Other Assets £600m Other L&E £600m Other Assets $800m Other L&E $800m
Total Assets £1,300m Total L&E £1,300m Total Assets $2,200m Total L&E $2,200m
You can check your work: make sure that
£1,300m = $1,200x(£1/$2) +£100 + £600
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Correspondent Banking Relationships
International commercial banks communicate
with one another using:
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 FX transactions.

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Spot Rate Quotations
A direct quotation is:
The price of one unit of the foreign currency
in U.S. dollar.
E.g., “a Japanese Yen is worth about a
penny.”
An indirect quotation is:
The price of one U.S. dollar in the foreign
currency.
E.g., “you get 100 yen to the dollar.”
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Spot Rate Quotations
European terms is:
The price of one U.S. dollar in the foreign
currency.
An indirect quote from the U.S. perspective.
American term is:
The price of one unit foreign currency in the
U.S. dollar.
A direct quote from the U.S. perspective.

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 Spot Rate Quotations 1
.5072 =1.9717
Currencies
Currencies
U.S.-dollar
U.S.-dollarforeign-exchange
foreign-exchangerates
ratesininlate
lateNew
NewYork
Yorktrading.
trading.
--------Friday------- --------Friday-------
--------Friday-------
The direct quote
Country/currency
for theper US$
in US$ Country/currency
Country/currency in
inUS$
US$ per
perUS$
US$
pounddollar
Canadian is: £1 = .9984
$1.97171.0016 Euro
Euroarea
areaeuro
euro 1.4744
1.4744 .6783
.6783
Theforward
1-mos indirect
quote
.9986 for the
1.0014 1-mos
1-mosforward
forward 1.4747
1.4747 .6781
.6781
3-most forward .9988
pound is: £.5072 = $1 1.0012 3-most
3-mostforward
forward 1.4744
1.4744 .6782
.6782
6-mos forward .9979 1.0021 6-mos
6-mosforward
forward 1.4726
1.4726 .6791
.6791
Note yen
Japanese that the direct
.009220quote is
108.46 British
Britishpound
pound 1.9717
1.9717 .5072
.5072
theforward
1-mos reciprocal of the indirect
.009250 108.11 1-mos
1-mosforward
forward 1.9700
1.9700 .5076
.5076
quote:
3-most forward
=
1
.009306 107.46 3-most
3-mostforward
forward 1.9663
1.9663 .5086
.5086
1.9717
6-mos forward .5072
.009378 106.63 6-mos
6-mosforward
forward 1.9593
1.9593 .5104
.5104
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The Bid-Ask Spread
The bid price is the price a dealer is willing to
pay you for something.
The ask price is the amount a dealer wants you
to pay for something.
It doesn’t matter if we’re talking used cars or
used currencies: the bid-ask spread is the
difference between the bid and ask prices.

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The Bid-Ask Spread

A dealer could offer:

A bid price of $1.4739 per €.
An ask price of $1.4744 per €.
While there are a variety of ways to quote the
above, the bid-ask spread represents the
dealer’s expected profit.
Ask Price – Bid Price
Percent Spread = × 100
Ask Price
$1.4744 –
0.0339% $1.4739
= x
100 $1.4744
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The Bid-Ask Spread

USD Bank American Terms European Terms

Quotations Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

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The Bid-Ask Spread
USD Bank American Terms European Terms
Quotations Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Notice that the reciprocal $1,971
of the S($/£) bid is the Dealer Customer
£1,000
S(£/$) ask.
$1,000
£.5073 £1.00 Dealer Customer
= £507.3
$1.00 $1.9712
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Currency Conversion with Bid-Ask Spreads

A speculator in New York wants to take a $10,000

position in the pound.
After his trade, what will be his position?

Bid Ask
Dealer will pay $1.9715
S($/£) 1.9715 – 20
for 1 GBP; he is asking
S(£/$) .5071 – 72 $1.9720.
He will pay £.5071 for
$1 and will charge
£1
£.5072 for $1 = £5,071
$10,000
×$1.972 5-14
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 Sample Problem
A businessman has just completed transactions in Italy
and England. He is now holding €250,000 and
£500,000 and wants to convert to U.S. dollars.
His currency dealer provides this quotation:
GBP/USD 0.5025 – 76
USD/EUR 1.4739 – 44

 What are his proceeds from conversion?

He sells €250,000 at the dealer’s bid price:
€250,000 $1.4739 =$368,475
x €1.00
He sells £500,000 at the dealer’s
ask price: £500,000 $1.00 =$985,027.5
£.5076
x 8
$1,353,502.58
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Spot FX trading

In the interbank market, the standard size trade

is about U.S. $10 million.
A bank trading room is a noisy, active place.
The stakes are high.
The “long term” is about 10 minutes.

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Cross Rates
Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00) and that S($/£) = 2.00
(i.e., £1.00 = $2.00).
What must the €/£ cross rate be?

$1.50£1.00 £0.75
× =
€1.00$2.00 €1.00
€1.00 = £0.75
£1.00 =€1.33
Pay attention to your “currency
algebra”!
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Cross Rates with Bid-Ask Spreads
USD Bank American Terms European Terms
Quotations Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Euros 1.4738 1.4742 .6783 .6785
To find the €/£ cross bid rate, consider a retail customer who:
Starts with £10,000, sells £ for $, and buys €:
$1.9712 €.6783
£10,000 × × = €13,370.65
£1.00 $1.00
He has effectively sold £ at a €/£ bid price of €1.3371/£.
$19,712
b uy € at ask €13,371
sell £ at bid
£10,000
Or sell $ at bid 1-18
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Cross Rates with Bid-Ask Spreads
USD Bank American Terms European Terms
Quotations Bid Ask Bid Ask

Pounds 1.9712 1.9717 .5072 .5073

Euros 1.4738 1.4742 .6783 .6785
To find the €/£ cross ask rate, consider a retail customer
who starts with €10,000, sells € for $, and buys £:
$1 £1.00
€10,000 × ×
€0.6785 $1.9717 = £7,474.77
He has effectively bought £ at a €/£ ask price of €1.3378/£.
€10,000
sell € at bid$14,738buy £ at ask £7,475
Or buy $ at ask Or sell $ at bid 1-19
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 Triangular Arbitrage
Bank Quotations Bid Ask
Deutsche Bank $:£ $1.5400 $1.5405
Credit Lyonnais $:€ $1.3087 $1.3092
Credit Agricole €/£ €1.1764 €1.1770
“No Arbitrage” €/£ €1.1763 €1.1771
Suppose we observe these banks posting these exchange
rates. As we have calculated the “no arbitrage” €/£ cross
bid and ask rates, we can see that there may be an
arbitrage opportunity: Credit Agricole’s bid is too high and
their ask is too£1
low. $1.5400 €1.00
× × = €1.1763
£1.00 $1.3092
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 Triangular Arbitrage
Bank Quotations Bid Ask
Deutsche Bank $:£ $1.5400 $1.5405
Credit Lyonnais $:€ $1.3087 $1.3092
Credit Agricole €/£ €1.1758 €1.1760
“No Arbitrage” €/£ €1.1763 €1.1771
By going through Deutsche Bank and Credit Lyonnais, we can sell
pounds for €1.1763.
$1.5400 €1.00
£1 × × = €1.1763
£1.00 $1.3092
The arbitrage is to buy the pounds from Credit Agricole for €1.1760.

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 Triangular Arbitrage
Bank Quotations Bid Ask
Deutsche Bank $: £ $1.5400 $1.5405
Credit Lyonnais $: € $1.3087 $1.3092
Credit Agricole €: £ €1.1758 €1.1760
Start with £1m. Sell £ to Deutsche Bank for $1,540,000:
$1.5400
£1,000,000 × = $1,540,000.
£1.00
Buy € from Credit Lyonnais, receive €1,176,291:
€1.00
$1,540,000 × = €1,176,291.
$1.3092
Buy £ from Credit Agricole, receive £1,000,247.
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5-23
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Spot Foreign Exchange Microstructure
Market microstructure refers to the mechanics of
how a marketplace operates.
The bid-ask spreads in the spot FX market:
Increase with FX exchange rate volatility.
Decrease with dealer competition.
Private information is an important determinant
of spot exchange rates.

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Forward Rate Quotations

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.

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 Forward Rate Quotations

Consider the exchange Country/currency in US$ per US$

rates shown to the right. UK pound 1.9717 .5072
For British pounds, the 1-mos forward 1.9700 .5076
spot exchange rate is 3-most forward 1.9663 .5086
$1.9717 = £1.00 while 6-mos forward 1.9593 .5104
the 180-day forward rate
is $1.9593 = £1.00
Clearly market participants
What’s up with that? expect that the pound will be
worth less in dollars in six
months.
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Forward Rate Quotations
Consider the (dollar) holding period return of a
dollar-based investor who buys £1 million at the
spot exchange rate and sells them forward:

gain $1,959,300 – $1,971,700 –$12,400

$HPR = = =
pain $1,971,700 $1,971,700

$HPR = –0.00629
Annualized dollar HPR = –1.26% = –0.629% ×
2
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Forward Premium
The interest rate differential implied by forward
premium or discount.
For example, suppose the € is appreciating from
S($/€) = 1.55 to F180($/€) = 1.60.
The 180-day forward premium is given by:

F180($/€) – S($/€) 360 1.60 – 1.55

f180,€v$ = × = ×2
S($/€) 180 1.55
= 0.0645, or 6.45%

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Long and Short Forward Positions

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.”
Sp, if you have agreed to sell an FX forward, you
are short, and if you have agreed to buy an FX
forward, you are long.

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 ng
l o 00
Payoff Profiles m 0
rf o 10,
ff n£
o i
profit

y
Pa tion
s i Consider the payoffs at
po
maturity to a long position
$1,407 in a six month forward
contract on £10,000.

$1.90/£
Spot exchange in 6 months $/£
$2.10/£
Country/currency in US$ per US$
−$593 $1.9593/£
UK pound 1.9717 .5072
1-mos forward 1.9700 .5076
3-most forward 1.9663 .5086
loss

6-mos forward 1.9593 .5104

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 Forward Cross Rates
Currencies
U.S.-dollar foreign-exchange rates in late New York trading.
--------Friday-------
The 3-month forward €/£ Country/currency in US$ per US$
cross rate is: Euro area euro 1.4744 .6783

$1.4744 £0.5086 £0.7498 1-mos forward 1.4747 .6781

× = 3-mos forward 1.4744 .6782
€1.00 $1.00 €1.00
6-mos forward 1.4726 .6791
UK pound 1.9717 .5072
£1.00 =€1.3337 1-mos forward 1.9700 .5076
3-mos forward 1.9663 .5086
6-mos forward 1.9593 .5104

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forward points example

Restate the following one-, three-, and six-month outright forward

European term bid-ask quotes in forward points.
Spot 1.3431-1.3436
One-Month 1.3432-1.3442
Three-Month 1.3448-1.3463
Six-Month 1.3488-1.3508

If the second number in a forward point “Pair” is smaller than the

first, the forward points are subtracted from the spot bid and ask
prices to obtain the outright forward rates.

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Currency Symbols

In addition to the familiar currency symbols (£, ¥,

€, $) there are three-letter codes for all
currencies.
It is a long list, but selected codes include:
CHF Swiss francs
GBP British pound
ZAR South African rand
CAD Canadian dollar
JPY Japanese yen

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Swaps
A swap is an agreement to provide a counterparty
with something he or she wants in exchange for
something that you want.
Often on a recurring basis, e.g., every six
months for five years.
Swap transactions account for approximately 56
percent of interbank FX trading, whereas
outright trades are 11 percent.
Swaps are covered fully in Chapter 14.

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Exchange-Traded Currency Funds
Individual shares are denominated in the U.S.
dollar and trade on the New York Stock
Exchange.
Consider an ETF where each share represents
100 euros. The price of one share at any point
in time will reflect the spot dollar value of 100
euros plus accumulated interest minus
expenses.
Six additional currency trusts exist on the
Australian dollar, British pound sterling,
Canadian dollar, Mexican peso, Swedish krona,
and the Swiss franc.
Currency is now recognized as a distinct asset
class, like stocks and bonds. Currency ETFs 5-35
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