Ch 5 Foreign Exchange Market

Chapter 5 The Market for Foreign FX Market Participants

Exchange • The FX market is a two-tiered market:
– Interbank market (wholesale)
• Function and Structure of the FX Market • About 100-200 banks worldwide stand ready to make a
• The Spot Market market in foreign exchange.
• Nonbank dealers account for about 40% of the market.
• The Forward 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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Circadian Rhythms of the FX Market Correspondent Banking Relationships

Electronic Conversations per Hour • Large commercial banks maintain demand
45000
average peak
deposit accounts with one another, which
facilitates the efficient functioning of the
40000
35000
30000
25000
20000 FX market.
15000
10000
5000
0
1:00 3:00 5:00 7:00 9:00 11:00 1:00 15:00 5:00 19:00 9:00 11:00
10 am in Lunch Europe Asia Lunch Americas London New 6 pm in
Tokyo hour in coming in going out hour in coming in going out Zealand NY
Tokyo London coming in
Source: Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York,
www.newyorkfed.org.

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Correspondent Banking Relationships Correspondent Banking Relationships

Bank A buys £100m from Bank B for $200m
• Bank A is in London. Bank B is in New York. Bank A Bank B
$200m
• The current exchange rate is £1.00 = $2.00. London £100m NYC
• A currency trader employed at Bank A buys
Assets Liabilities Assets Liabilities
£100m from a currency trader at Bank B for
$200m settled using its correspondent £ deposit at B £300m B’s Deposit $1,000m $ deposit at A $1000m A’s Deposit £300m
relationship. £400m $1,200m $1200m £400m
£ deposit at A £200m A’s Deposit $800m
$ deposit at B $800m B’s Deposit £200m
$600m £100m £100m $600m
Bank A $200m Bank B 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
London £100m NYC
You can check your work: make sure that £1,300m = $1,200x(£1/$2) +£100 + £600
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1
Ch 5 Foreign Exchange Market

Practice Problem Bank X

buys
Practice Problem
£100m €110m
• Bank X is in Milan. Bank Y is in London. from Y for
Bank X Bank Y €1.10 =
£100m £1.00
• The current exchange rate is €1.10 = £1.00. €110m Milano London

• Show the correct balances in each account if a Bank X Bank Y

Assets Liabilities Assets Liabilities
currency trader employed at Bank X buys
£100,000,000 from a currency trader at Bank Y £ deposit at Y £300m Y’s deposit €1,210m € deposit at X€1,210m X’s deposit £300m
for €110,000,000. £400m €1,320m €1,320m £400m
€ deposit at Y €880m Y’s deposit £200m £ deposit at X £200m X’s deposit €880m
– (The balance sheets are shown on the next slide.) €770m £100m £100m €770m
Other Assets £600m Other L&E £400m Other Assets €590m Other L&E €810m
Total Assets £1,700m Total L&E £1,700m Total Assets €2,020m Total L&E €2,020m
£1.00 Check: €2,020m = £400m x € 1.10 + € 770 + €810
Check: £1,700m = €1,320m x +£100 + £400
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Correspondent Banking Relationships Spot Rate Quotations

• International commercial banks • A direct quotation is:
communicate with one another using: – The U.S. dollar equivalent.
– E.g., “a Japanese Yen is worth about a penny.”
– SWIFT: The S ociety for Worldwide I nterbank
F inancial T elecommunications. • An indirect quotation is:
– The price of a U.S. dollar in the foreign currency.
– CHIPS: C learing H ouse I nterbank P ayments
S ystem. – E.g., “you get 100 yen to the dollar.”

– ECHO: E xchange C learing H ouse Limited, • See Exhibit 5.4 in the textbook.
• http://www.x-rates.com/table/?from=USD&amount=1
the first global clearinghouse for settling • http://www.exchangerates.org.uk/US-Dollar-USD-currency-table.html
interbank FX transactions.
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Spot Rate Quotations The Bid-Ask Spread

Currencies
Currencies
U.S.-dollar
U.S.-dollarforeign-exchange
foreign-exchangerates
ratesininlate
lateNew
NewYork
Yorktrading.
trading.
• The bid price is the price a dealer is willing
------Wednesday------ ----------Friday-------
--Wednesday--- to pay you for something.
The direct quote for theper US$
Country/currency in US$
pound is: £1 = .9984
$1.54051.0016
Country/currency
Country/currency in
inUS$
US$ per
perUS$
US$
• The ask price is the amount a dealer
wants you to pay for something.
Canadian dollar Euro
Euroarea
areaeuro
euro 1.3092
1.3098 .7638
.6783
1-mos
Theforward
indirect .9986 for the
quote 1.0014 1-mos
1-mosforward
forward 1.3093
1.3093 .7638
.7638
3-most forward .9988
pound is: £.6491 = $1 1.0012 3-most
3-mostforward
forward 1.3098
1.3098 .7635
.7635 • It doesn’t matter if we’re talking used cars
6-mos forward
Note yen
that the direct
.9979 1.0021 6-mos
6-mosforward
forward 1.3107
1.3107 .7630
.7630
or used currencies: the bid-ask spread is
.010094quote is
the difference between the bid and ask
Japanese 99.07 British
Britishpound
pound 1.5405
1.5405 .6491
.6491
theforward
1-mos reciprocal of the indirect
.010095 99.06 1-mos
1-mosforward
forward 1.5402
1.5402 .6493
.6493
quote:
3-most forward 1
=.010099 99.02 3-most
3-mostforward
forward 1.5396
1.5396 .6495
.6495 prices.
1.9717
6-mos forward .5072
.010106 98.95 6-mos
6-mosforward
forward 1.5389
1.5389 .6498
.6498
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2
Ch 5 Foreign Exchange Market

The Bid-Ask Spread The Bid-Ask Spread

• A dealer could offer: A dealer pricing pounds in terms of dollars would likely
– A bid price of $1.3090 per €. quote these prices as 00–05.
– An ask price of $1.3092per €. Anyone trading $10m knows the “big figure.”
• While there are a variety of ways to quote the above, the
bid-ask spread represents the dealer’s expected profit. USD Bank American Terms European Terms
Quotations Bid Ask Bid Ask
Ask Price – Bid Price
Percent Spread = × 100 Pounds 1.5400 1.5405 .6491 .6494
Ask Price
$1.3092– $1.3090
0.0153% = x 100
$1.3092
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The Bid-Ask Spread Currency Conversion with

USD Bank
Quotations
American Terms European Terms Bid-Ask Spreads
Bid Ask Bid Ask • A speculator in New York wants to take a
Pounds 1.5400 1.5405 .6491 .6494 $10,000 position in the pound.
• After his trade, what will be his position?
Notice that the reciprocal $1,540 Bid Ask Dealer will pay $1.5400 for 1 GBP;
of the S($/£) bid is the Dealer Customer he is asking $1.5405.
S(£/$) ask.
£1,000 S($/£) 1.5400 – 05
Customer sells pounds to dealer at direct bid He will pay £.6491 for $1 and will
£.6494 £1.00 $1,000 S(£/$) .6491– 94 charge £.6494 for $1
= Dealer Customer £1
$1.00 $1.5400
£649.40
£0.6491 $10,000 × = £6,491
Buy USD from dealer at indirect ask $10,000 × = £6,491 $1.5405
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Sample Problem Another Sample Problem

• A businessman has just completed transactions in Italy • An Italian has just completed transactions in America and England.
and England. He is now holding €250,000 and £500,000 – He is now holding $100,000 and £500,000, and wants to convert
and wants to convert to U.S. dollars. both amounts to the euro.
• His currency dealer provides this quotation:
• His currency dealer provides this quotation:
GBP/USD 0.6488 – 93
GBP/USD 0.6488 – 93 USD/EUR 1.3095 – 98
USD/EUR 1.4739 – 44 • What are his proceeds from conversion?
• What are his proceeds from conversion?
He sells €250,000 at the dealer’s bid price: $770,060.06 = £500,000 x $1.00
€250,000 x$1.4739 =$368,475
£.6493
€1.00
He sells £500,000 at the dealer’s ask price: €1.00
£500,000 x $1.00 =$770,060.06 ($770,060.06 + $100,000) x = €664,269.40
£.6493 $1.3098
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3
Ch 5 Foreign Exchange Market

Spot FX Trading Cross Rates

• In the interbank market, the standard size • Suppose that S($/€) = 1.50 (i.e., $1.50 = €1.00)
trade is about U.S. $10 million. and that S($/£) = 2.00 (i.e., £1.00 = $2.00).
• What must the €/£ cross rate be?
• A bank trading room is a noisy, active
place.
$1.50 £1.00 £0.75
• The stakes are high. × = €1.00 = £0.75
€1.00 $2.00 €1.00
• The “long term” is about 10 minutes.
€1.00 $2.00 € 2.00
× = £1.00 = € 1.33
$1.50 £1.00 £ 1.5
Pay attention to your “currency algebra”!
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£10,000 sell £ at bid $15,400 buy € at ask €11,763 €10,000 sell € at bid $13,087 buy £ at ask £8,495

Cross Rates with Bid-Ask Spreads Cross Rates with Bid-Ask Spreads
USD Bank American Terms European Terms USD Bank American Terms European Terms
Quotations Bid Ask Bid Ask Quotations Bid Ask Bid Ask
Pounds 1.5400 1.5405 .6491 .5073 Pounds 1.5400 1.5405 .6491 .5073
Euros 1.3087 1.3092 .7638 .7641 Euros 1.3087 1.3092 .7638 .7641
€/£ €1.1763 £0.8501 €/£ €1.1763 €1.1771 £0.8495 £0.8501
To find the €/£ cross bid rate, consider a retail customer who:
To find the €/£ cross ask rate, consider a retail customer
Starts with £10,000, sells £ for $, and buys €: who starts with €10,000, sells € for $, and buys £:
1 $1.3087 £1.00
$1.5400 €1.00 1
£10,000 × = €11,763 €10,000 × × = £8,495 €1/£0.8495 = €1.1771/£
£1.00 × $1.3092
€1.1763/£
€1.00 $1.5405
He has effectively sold £ at a €/£ bid price of €1.1763/£. He has effectively bought £ at a €/£ ask price of €1.1771/£.
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Cross Rates with Bid-Ask Spreads

direct indirect
Triangular Arbitrage
Bank American Terms European Terms Bank Quotations Bid Ask
Quotations Bid Ask Bid Ask Deutsche Bank $/£ $1.5400 $1.5405
$/£ $1.5400 $1.5405 £.6491 £.6494 Credit Lyonnais $/€ $1.3087 $1.3092
$/€ $1.3087 $1.3092 €.7638 €.7641 Credit Agricole €/£ €1.1758 €1.1760
€/£ €1.1763 €1.1771 £0.8495 £0.8501 “No Arbitrage” €/£ €1.1763 €1.1771
Suppose we observe these banks posting these exchange rates.
Recall that the reciprocal of €1.1763 €1.00 As we have calculated the “no arbitrage” €/£ cross bid and ask
the S(£/€) bid is the S(€/£) ask. = rates, we can see that there is an arbitrage opportunity: Credit
£1.00 £0.8501
He has bought £ at a €/£ ask price of €1.1771/£ Agricole’s bid is too high and their ask is too low.
$1.5400 €1.00
Bid-ask quote would be €/£: 1.1763-71 £1 × £1.00 × $1.3092 = €1.1763
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4
Ch 5 Foreign Exchange Market

Triangular Arbitrage Triangular Arbitrage

Bank Quotations Bid Ask Bank Quotations Bid Ask
Deutsche Bank $/£ $1.5400 $1.5405 Deutsche Bank $/£ $1.5400 $1.5405
Credit Lyonnais $/€ $1.3087 $1.3092 Credit Lyonnais $/€ $1.3087 $1.3092
Credit Agricole €/£ €1.1758 €1.1760 Credit Agricole €/£ €1.1758 €1.1760
“No Arbitrage” €/£ €1.1763 €1.1771 Start with £1m. Sell £ to Deutsche Bank for $1,540,000:
$1.5400
By going through Deutsche Bank and Credit Lyonnais, we can sell pounds £1,000,000 × £1.00 = $1,540,000.
for €1.1763. Buy € from (i.e. Sell $ to) Credit Lyonnais, receive €1,176,291 :
$1.5400 €1.00 €1.00
£1 ×
£1.00 × $1.3092 = €1.1763 $1,540,000 × = €1,176,291.
$1.3092
Buy £ from (i.e. Sell € to) Credit Agricole, receive £1,000,247:
The arbitrage is to buy the pounds from Credit Agricole for €1.1760.
= €1,176,291 x (£1.00/ €1.1760) = £1,000,247.
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Spot Foreign Exchange Microstructure The Forward Market

• Market microstructure refers to the mechanics of • Forward Rate Quotations
how a marketplace operates.
• Long and Short Forward Positions
• The bid-ask spreads in the spot FX market:
– Increase with FX exchange rate volatility.
• Non-Deliverable Forward Contracts
– Decrease with dealer competition. • Forward Cross Exchange Rates
• Private information is an important determinant • Forward Premium
of spot exchange rates.

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Forward Rate Quotations Forward Rate Quotations

• The forward market for FX involves Consider the exchange Country/currency in US$ per US$
rates shown to the right.
agreements to buy and sell foreign For British pounds, the
UK pound 1.5405 .6491
currencies in the future at prices agreed spot exchange rate is 1-mos forward 1.5402 .6493

upon today. $1.5405 = £1.00 while the 3-most forward 1.5396 .6495
180-day forward rate is 6-mos forward 1.5389 .6498
• Bank quotes for 1, 3, 6, 9, and 12 month $1.5389 = £1.00
maturities are readily available for forward •What’s up with that? Clearly market participants
contracts. expect that the pound will be
worth less in dollars in six
• Longer-term swaps are available. months.

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5
Ch 5 Foreign Exchange Market

Forward Rate Quotations Forward Premium

• Consider the (dollar) holding period return of a • The interest rate differential implied by
dollar-based investor who buys £1 million at the forward premium or discount.
spot exchange rate and sells them forward:
• For example, suppose the € is
F-S $1,538,900 – $1,540,000 –$1,100 appreciating from S($/€) = 1.55 to F180($/€)
$HPR =
S
=
$1,540,000
=
$1,540,000 = 1.60.
• The 180-day forward premium is given by:
$HPR = –0.0007 F180($/€) – S($/€) 360 1.60 – 1.55
f180,€v$ = ×
Annualized dollar HPR = –0.14% = –0.07% × 2 S($/€) 180 = 1.55 ×2
= 0.0645, or 6.45%
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Long and Short Forward Positions Payoff Profiles

profit

• If you have agreed to sell anything (spot or Consider the payoffs at

forward), you are “short.” $611
maturity to a long position in a
six month forward contract on
• If you have agreed to buy anything £10,000.

(forward or spot), you are “long.”

• So, if you have agreed to sell an FX $1.50/£
$1.60/£
Spot exchange in 6 months $/£
−$389
forward, you are short, and if you have
Country/currency in US$ per
$1.5389/£ US$
agreed to buy an FX forward, you are UK pound 1.5405 .6491
long. 1-mos forward 1.5402 .6493
loss

3-most forward 1.5396 .6495

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6-mos forward Copyright © 20141.5389 .6498
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Non-Deliverable Forward Contracts Forward Cross Rates

Currencies
• Due to government-initiated capital controls, the
U.S.-dollar foreign-exchange rates in late New York trading.
currencies of some emerging market countries are not
freely traded.
--------Friday-------
The 3-month forward £/€ Country/currency in US$ per US$
• For many of these currencies, trading in non-deliverable cross rate is:
forward (NDF) contracts exists.
Euro area euro 1.3092 .7638
1-mos forward 1.3093 .7638
• A non-deliverable forward contract is settled in cash, $1.3098 £1.00 £0.8507
× = 3-mos forward 1.3098 .7635
usually U.S. dollars. €1.00 $1.5396 €1.00 6-mos forward 1.3107 .7630
– Settlement is calculated by the difference between the forward
price agreed to in the contract and the spot price at maturity of UK pound 1.5405 .6491
the contract multiplied by the contract size. 1-mos forward 1.5402 .6493
3-mos forward 1.5396 .6495
6-mos forward 1.5389 .6498
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