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The Foreign Exchange Market
1 The Structure of the Market
The foreign exchange market is an example of a speculative auction market that trades the money of various countries continuously around the world. Trading of currencies takes place by telex, email, fax,etc. Majority of trading occurs among banks. Major banks trade with each other by selling and buying bank deposits or bank transfers of deposits denominated in foreign currency. The largest trading centers are in London, New York, and Tokyo, and these centers account for approximately 70% of the total exchange. The New York market opens about 5 hours after the opening of the London market, Tokyo market opens about 2 hours after the close of the New York market. For the time zones look at figure 13.2 in your textbook. Traders in the market in any participating bank are located in a trading room, where they have access to a telex, telephones and monitors that display a wide set of information, including economic news as it is released. Most of the trades are conducted over the phone and subsequently confirmed in writing. In case of errors/mistakes, traders customarily split the difference. Despite the growth of international trade, exchange of currencies for transactions of goods and services has become a distinctly secondary activity in the foreign exchange market. Unlike many other financial markets, e.g. the stock market, the actual transactions prices are generally unobserved. Instead, quotation prices in terms of bid ask rates are observed.
2 Spot Rate
The spot rate is the price of a currency that is transacted contemporaneously, that is traded in current time period. The market where currencies are traded in current time period is called spot market. Actually, deposits traded in the foreign exchange market generally take two working days to clear. The spot market constitutes about 70% of the exchange rate market transactions. The spot rate data are generally recorded at a particular point of time each day. The Wall Street Journal usually reports spot price information at 3:00pm or 4:00pm the previous working day from the Bankers Trust Company, Reuters, or other sources. The quotations are based on large trades of $ 1million and more in a basically wholesale market for money among major banks. In- deed, now data is also recorded at very high frequencies, say each one minutes intervals even. This type of data has become available to researcher in recent years. There are two types of quotations;American terms and European terms. American Terms refers to the quotation where spot rate is quoted in terms of the number of US dollars per unit of foreign currency, e.g. Franc-$(or $/Franc). The U.S. dollar is the numeraire currency. The Wall Street Journal refers to this method as ”Currency per U.S. $”. European Terms refers to the quotation where spot rate is quoted in terms of foreign currency units per U.S. dollar, e.g. $-L(or L/$). In this method of quotation, foreign currency(L) is the numeraire currency. The Wall Street Journal refers to this method as ’U.S. dollar equivalents’. Reciprocal Rates The choice of numeraire currency is a matter of convenience and alternative method of quotation is simply the reciprocal of the rate. For example, in American terms if Dutch Guilder-US dollar rate, S=9.517 on January 11, 2000, then the reciprocal rate, US Dollar-Dutch Guilder, 1§=0.4689. Note that all of the exchange rate quotes reported in the Wall Street Journal are market traded rates and hence are nominal, in the sense that they are in current prices and are not deflated for price differential across countries. The quoted rates are also
is known as arbitrage, will raise the exchange rate where it is too low and lower it where it is too high. Why? Since information flows in international markets fast and at lower costs, when it is known that a particular currency sells at lower rates then investors will tend to buy the currency from that market. As demand for the currency increases in that market this will increase the exchange rate. Similarly, if the currency is high in value in another market, then investor will tend to sell their holdings of the currency in that market causing an increase in the supply of the currency. This will lower the exchange rate in this market for the currency. Arbitrage occurs until the exchange rates in different markets are so close that it is not worth the costs incurred from any buying and selling. When this situation occurs, we say that the rates are transaction cost close, because any remaining deviation in rates will not cover the costs of additional arbitrage transactions, so the arbitrage activity ends and brings the exchange rates between different locations close to each other. Example: Suppose that in New York, the Japanese Yen is selling for $0.22 while in London the Yen is quoted at $0.25. A profit-seeking arbitrager would buy Yen in New York (where it is cheaper) and simultaneously sell in London (where Yen is expensive) and make 3 cents per Yen sold. Cross Rate is the third exchange rate implied by any two exchange rates involving three currencies. Example: Suppose that in London $/E=$ 1.5, while in Tokyo, $/L=$ 2. The im- plied cross rate between pounds and euro is the E/Lrate. If $/E=1.5 and $/L=$2 and E/L=($/L)/($/E)=2/1.5=4/3. The arbitrage opportunity arise if any of the three exchange rates considered in above example differs drastically from one other. Example: Three-way arbitrage: Suppose in London $/L=$1.90, in Zurich, L/SF=0.2, while in New York $/SF=0.4. A risk taking investor could start with dollars and buy say L1 million in London for $1,900,000. The pounds could be used to buy francs at L/SF=0.2 in Zurich, so that L1,000,000=SF5,000,000. The SF5 million could
then be used in New York to buy dollars at $/SF=$0.40, so that SF5,000,000=$ 2,000,000. Thus the initial $1.9 million could be turned into $2 million with the tri- angular arbitrage. Note that we are assuming here costs of transaction is zero. Oth- erwise we need to deduct the costs. The triangular arbitrage condition is a no-profit condition that relates spot rates and implied cross rates. For instance, the triangu- lar arbitrage condition between dollar rates and pound and euro will be given by; ($/pound)*(pound/Euro)=$/Euro. This condition is viewed as an equilibrium condition in the spot market.
4 Forward Rates
Not all the transactions in the foreign exchange (FX) market are on the spot. Important portion of the transactions involve buying and selling future contracts. The forward exchange market is the market where currencies are bought and sold for delivery in a future period. The forward price of a currency is called forward exchange rate. We will denote forward rates by Ft and t stands for the time period. For instance, Ft, 1 is the forward rate for a contract that expires (delivery of the FX is due) on say 1 month from date t. A little bit of terminology: short position When you sell a position, (you agree to sell an asset, say FX for a delivery price), you hope that the underlying asset will go down in price. In this case we say that you have a short position. long position When you buy into a position, (you agree to buy an asset, say FX at a price), you hope that the underlying asset will go up in price. We say that you have a long position. A pure bet in the forward market involves guessing whether the future spot price, St+ will be greater or less than Ft, 1. If you are short a forward contract and St+1 < Ft, 1 , (say future spot rate-one month ahead spot rate- is less than 1 month forward rate) you win money. You buy FX at
and makes a swap arrangement with Llyods. Hence, Bank of America will trade dollars to Llyods and in return will receive pounds. In three months the reverse trade will be realized. That is Bank of America will receive dollars and pay out pounds to Llyods. Suppose the spot rate is $/L=2.00, and three month forward rate, Ft, 3 = $2.10. There is a $0.10 premium on pounds. The three month return on this swap is Ft, (^3) S−t St= 2. 102 −. 002. 00 = 0.05. To find the annual return, we need to multiply this by 4 (as
there ar 4 three months in a year). Hence the annual return is 4*0.05=0.20, that us annual return is 20 percent.
Swaps are an efficient way of meeting a bank’s FX needs.To avoid any FX risk, banks try to match the liability created by borrowing foreign currencies with the asset created by lending domestic currency, both to be repaid at the known future exchange rate. This is knowing as hedging the FX risk.
6 The Futures Market
The futures market is a market where foreign currencies are bought and sold for delivery at a future date. The difference from forward market is that only a few currencies are traded, trading occurs in standardized contracts, and trading occurs in a specific location, such as Chicago Mercantile Exchange. Link:www.cme.com Contracts mature on the 3rd Wednesday of March, June, September, or December. Contracts come in fixed sizes, such as 100,000 Australian dollars, 62,500 British pounds, etc. Exchange is just a clearing house in the sense that long positions are matched exactly to short positions. To take a position (long or short), you post an initial margin. A margin is the amount required with a broker for trading in the futures market. Positions are marked to market each day. Gains and losses are posted in margin accounts. Suppose Euro
September contract requires $10,000 in margin. If the price fell by $0.1 in one day, then this fall represents a loss of $0.1*100,000=$1000 on the $100,000 futures contract. The daily settlement involves deducting this daily loss from the margin deposited with the broker. example Consider the hypothetical movements in a $100,000 euro futures contract, where you take a long position (you buy the contract) and I take a short position (I sell the contract). We each put up $10,000 in margin.
Day Futures price
Contract value
Long- margin
Short- margin
spot rate
1 $0.96 $96,000 $10,000 $10,000 $0. 2 $0.93 $93,000 $7,000 $13,000 $0. 3 $0.95 $95,000 $9,000 $11,000 $0. Say we both unwind our positions on day 3. You have lost $1000 to me. But in the mean time, the spot exchange rate has come down. The futures contract allowed you to avoid currency risk by locking into the euro price of $0.98. This is because at the end of day 3 (assuming for simplicity day 3 is the maturity date or the future contract is reversed at the end of day 3) you can buy euros at 0.96 dollars and sell them in the spot market at 0.97 dollars and make a profit of 1000 dollars.
7 Foreign Exchange Options
A foreign exchange option is a contract that provides the right to buy or sell a given amount of currency at a fixed exchange rate on or before the maturity date. This type of option is known as American option. There is also what is called European options where the contracts are exercised at only maturity date. There two kinds of options. A call option gives the holder the right to buy some underlying asset at a prespecified (strike) price during the life of the call. You can buy or sell a call option.
