The Foreign Exchange Market

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Slide 8-1

Key Issues
What is the form and function of the foreign exchange market? What is the difference between spot and forward exchange rates? How are currency exchange rates determined? What is the role of the foreign exchange market in insuring against foreign exchange risk? What are the merits of different approaches toward exchange rate forecasting? Why are some currencies not always convertible into other currencies? How is countertrade used to mitigate problems associated with an inability to convert currencies?
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Introduction
1. Introduction a. The Currency Market: where money denominated in one currency is bought and sold with money denominated in another currency

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Introduction
b. International Trade and capital Transactions: facilitated with the ability to transfer purchasing power between countries

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 C. Location: 1. OTC type: No specific location 2. Most trades by phone, telex, or SWIFT (Society for worldwide Interbank Financial Telecommunications)

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Definition of foreign exchange

Deposits, credits and balances payable in foreign currency Drafts, travellers cheques, letter of credit or bill of exchange expressed or drawn in Indian currency but payable in foreign currency Drafts, travellers cheques, L/Cs, etc. drawn by banks, institutions or persons outside India but payable in Indian currency The above definition is as per FEMA (1999)
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Slide 8-1

Foreign Exchange
The foreign exchange market
Is the market where one buys (or sells) the currency of country A with (or for) the currency of country B

A currency exchange rate

Is simply the ratio of a unit of currency of country A to a unit of the currency of country B at the time of the buy or sell transaction

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Exchange Rates and International Transactions

An exchange rate can be quoted in two ways:
Direct
The price of the foreign currency in terms of dollars

Indirect
The price of dollars in terms of the foreign currency

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The Foreign Exchange Market

Exchange rates are determined in the foreign exchange market.
The market in which international currency trades take place

The Actors
The major participants in the foreign exchange market are:
Commercial banks International corporations Nonbank financial institutions Central banks
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Factors affecting exchange rate

Major banks that act as market-makers always give two-way quotes; gives depth and volume to the market Fundamental reasons Technical reasons Speculation

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Fundamental reasons
Balance of payments->surplus>appreciation Growth rate of the economy-> higher growth->depreciation of currency Fiscal policy-> financing of fiscal deficit influences exchange rate Monetary policy->loose monetary policy-> depreciation of exchange rate
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Technical reasons
Freedom or restrictions on capital movements can affect exchange rates to a large extent Among other factors there are:
Huge trade surpluses of oil exporting countries Capital moving from low-yielding currencies to high yielding currencies (interest differential)
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Speculation
Self-fulfilling prophecies
Anticipation of depreciation of a currency can cause dealers to sell that currency

Speculation serves to provide depth and liquidity to the forex market Acts as a cushion as well- contrarian traders exist in the market
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Types of exchange rate (1)

Ready/cash- Settlement of funds on the same day (date of the deal). Tom- Settlement of funds takes place on the next working day of the date of the deal Spot- Settlement of funds takes place on the second working day following the date of the deal
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Types of exchange rate (2)

Forward- Delivery takes place on any day after the date of the deal In the forex market all rates that are quoted are generally spot rates When delivery takes place beyond the spot date then it is a forward transaction and the forward rate is applicable Forward rate = Spot rate + Premium (discount)
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Slide 8-2

The Foreign Exchange Market

Currency conversion in the foreign exchange market
Is necessary to complete private and commercial transactions across borders A tourist needs to pay expenses on the road in local currency A firm
Buys/sells goods and services in the other countrys local currency Uses the foreign exchange market to invest excess funds

Is used to speculate on currency movements

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Slide 8-3

The Foreign Exchange Market

Minimizes foreign exchange risk (unpredictable rate swings) There are different ways to trade currencies
Spot exchange rates: the days rate offered by a dealer/bank Forward exchange rates:
Agreed in advance rates to buy/sell a currency on a future date Usually quoted 30, 90, 120 days in advance

The market is open 24 hours Arbitrage: buying low and selling high given slightly different exchange rate quotes in one location vs another (e.g., London vs Tokyo)
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PART II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

I .

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PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET A. Participants at 2 Levels 1. Wholesale Level (95%)- major banks 2. Retail Level - business customers.
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2.Forward Market: - transactions take place at a specified future date

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. FedWire - operated by the Fed - used for domestic transfers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Results: 1. Reduces cost of trading 2. Threatens traders oligopoly of information 3.
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Provides liquidity
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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE MARKET A. Largest in the world 1995: $1.2 trillion daily

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily
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PART III. THE SPOT MARKET

I. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes:
a. b. c. d. spot price 30-day 90-day 180-day

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THE SPOT MARKET

B. Method of Quotation 1. For interbank dollar trades: a. American terms
example: $.5838/dm

Dm- duetsche mark b. European terms

example: dm1.713/$
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THE SPOT MARKET

2. For nonbank customers: Direct quote
gives the home currency price of one unit of foreign currency.

EXAMPLE:
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dm0.25/FF
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Ff- French franc

THE SPOT MARKET

C. Transactions Costs 1. Bid-Ask Spread used to calculate the fee charged by the bank
Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency
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THE SPOT MARKET

4.Percent Spread Formula (PS):

Ask Bid PS = x100 Ask

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THE SPOT MARKET

D. Cross Rates 1. The exchange rate between 2 non - US$ currencies.

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THE SPOT MARKET

2.Calculating Cross Rates When you want to know what the dm/ cross rate is, and you know dm2/US$ and .55/US$ then dm/ = dm2/US$ .55/US$ = dm3.636/
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THE SPOT MARKET

E. Currency Arbitrage 1. If cross rates differ from one financial center to another, and profit opportunities exist.

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THE SPOT MARKET

2.Buy cheap in one intl market, sell at a higher price in another 3.Role of Available Information

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THE SPOT MARKET

F. Settlement Date Value Date:

1. Date monies are due 2. 2nd Working day after date of original transaction.
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THE SPOT MARKET

G. Exchange Risk 1. Bankers = middlemen a. Incurring risk of adverse exchange rate moves. b. Increased uncertainty about future exchange rate requires
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THE SPOT MARKET

1.) Demand for higher risk premium 2.) Bankers widen bid-ask spread

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PART II. MECHANICS OF SPOT TRANSACTIONS

SPOT TRANSACTIONS: An Example Step 1. Currency transaction: verbal agreement, U.S. importer specifies: a. Account to debit (his acct) b. Account to credit (exporter)
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MECHANICS OF SPOT TRANSACTIONS

Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1.
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MECHANICS OF SPOT TRANSACTIONS

Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporters. Value Date. U.S. bank debits importers account.
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PART III. THE FORWARD MARKET

I. INTRODUCTION A. Definition of a Forward Contract
an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.
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THE FORWARD MARKET

2. Purpose of a Forward: Hedging the act of reducing exchange rate risk.

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THE FORWARD MARKET

B. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to
commercial customers.

b.

Swap Rate: quoted in the

interbank market as a discount or premium.

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THE FORWARD MARKET

CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 100 S n
where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract
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THE FORWARD MARKET

C. Forward Contract Maturities 1. Contract Terms
a. 30-day b. 90-day c. 180-day d. 360-day Longer-term Contracts
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2.
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3. Four theories
.
Difference in interest rates 1 + r 1 + r$
Interest Rate parity Fisher Theory

Exp. difference in inflation rates 1 + iSFr 1 + i$

Relative PPP

Difference between forward & spot rates F/$ Exp. Theory s/$ of forward
rates
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Expected change in spot rate E(s/$) S/$

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Theory #1: Purchasing power parity

Law of One Price Versions of Versions of PURCHASING PURCHASING POWER POWER PARITY PARITY

Absolute PPP

Relative PPP

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The Law of One Price

A commodity will have the same price in terms of common currency in every country
In the absence of frictions (e.g. shipping costs, tariffs,..) Example

Price of wheat in France (per bushel): P Price of wheat in U.S. (per bushel): P$
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P = s/$ P$

The Law of One Price, continued

Example: Price of wheat in France per bushel (p) = 3.45 Price of wheat in U.S. per bushel (p$) = $4.15 S/$ = 0.83215 (s$/ = 1.2017)
Dollar equivalent price of wheat in France = s$/ x p
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= 1.2017 $/ x 3.45 = $4.15

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Absolute PPP
Extension of law of one price to a basket of goods Absolute PPP examines price levels
Apply the law of one price to a basket of goods with price P and PUS (use upper-case P for the price of the basket):
S/$ = P / PUS

where
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P = i (wFR,i p,i ) PUS = i (wUS,i pUS,i )

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Absolute PPP
If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:
May 21 : s/$ = P / PUS

= 1235.75 / $1482.07 = 0.8338 /$

May 24: s/$ =

1235.75 / $1485.01 = 0.83215 /

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Relative PPP
Absolute PPP:
P = s/$ P$

For PPP to hold in one year: P (1 + i) = E(s/$) P$ (1 + i$), or: P (1 + i) = s/$ [E(s/$)/s/$ )] P$ (1 + i$) Using absolute PPP to cancel terms and rearranging:

Relative PPP:
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1 + i = E(s/$) 1 + i$ s/$
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Relative PPP
Main idea The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:
1 + i = E(s/$) 1 + i$ s/$

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Deviations from PPP

Simplistic model Why does Why does PPP PPP not not hold? hold?

Imperfect Markets

Statistical difficulties

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Deviations from PPP

Simplistic model
Transportation costs Tariffs and taxes Consumption patterns differ Non-traded goods & services Sticky prices Markets dont work well Construction of price indexes - Different goods - Goods of different qualities

Imperfect Markets

Statistical difficulties

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Summary of theory #1:

.
Exp. difference in inflation rates 1 + i 1 + i$
Relative PPP

Expected change in spot rate E(s/$) S/$

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Theory #2: Interest rate parity

Main idea: There is no fundamental advantage to borrowing or lending in one currency over another This establishes a relation between interest rates, spot exchange rates, and forward exchange rates
Forward market: Transaction occurs at some point in future BUY: Agree to purchase the underlying currency at a predetermined exchange rate at a specific time in the future SELL: Agree to deliver the underlying currency at a predetermined exchange rate at a specific time in the future

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Example of a forward market transaction

Suppose you will need 100,000 in one year Through a forward contract, you can commit to lock in the exchange rate f$/ : forward rate of exchange Currently, f$/ = 1.19854 1 buys $1.19854 1 $ buys 0.83435
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Interest Rate Parity

START (today)
r$=2.24% $117,228 (Invest in $)
$117,228 1.0224 = $119,854

END (in one year)

s/$=0.83215

One year

f/$=0.83435

$117,228 0.83215 = 97,551

(Invest in ) r=2.51%

97,551 1.0251 = 100,000

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Interest rate parity

Main idea: Either strategy gets you the 100,000 when you need it. This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates Interest Rate Parity:
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1 + r = f/$ 1 + r$ s/$

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Interest rate parity example

Suppose the following were true:
U.S Dollar 12 month interest rate Spot rate Forward rate 2.24% Euro 2.70% 1.2017 / $ 1.19854 / $

Does interest rate parity hold? Which way will funds flow? How will this affect exchange rates?
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Evidence on interest rate parity

Generally, it holds Why would interest rate parity hold better than PPP?
Lower transactions costs in moving currencies than real goods Financial markets are more efficient that real goods markets
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Summary of theories #1 and #2:

.
Difference in interest rates 1 + r 1 + r$ Exp. difference in inflation rates 1 + i 1 + i$
Relative PPP

Interest Rate parity

Difference between forward & spot rates fr/$ s/$

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Expected change in spot rate E(s/$) s/$

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Theory #3: The Fisher condition

Main idea: Market forces tend to allocate resources to their most productive uses So all countries should have equal real rates of interest Relation between real and nominal interest rates: (1 + rNominal) = (1 + rReal)(1 + i ) (1 + rReal) = (1 + rNominal) / (1 + i )
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Example of capital market equilibrium

Fisher condition in U.S. and France: (1 + r$(Real)) = (1 + r$) / (1 + i$) (1 + r(Real)) = (1 + r) / (1 + i) If real rates are equal, then the Fisher condition implies: 1 + r = 1 + i
1 + r$

1 + i$

The difference in interest rates is equal to the expected difference in inflation rates
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Summary of theories 1-3:

.
Difference in interest rates 1 + r 1 + r$
Fisher Theory

Exp. difference in inflation rates 1 + i 1 + i$

Relative PPP

Interest Rate parity

Difference between forward & spot rates f/$ s/$

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Expected change in spot rate E(s/$) s/$

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Theory #4: Expectations theory of forward rates

Main idea:
The forward rate equals expected spot exchange rate
f/$ = E(s/$)

Expectations theory of forward rates:

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f/$ = E(s/$ ) s/$ s/$

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Expectations theory of forward rates

With risk, the forward rate may not equal the spot rate
Group 1: Receive Group 1: Receive in six months, want $ in six months, want $ Wait six months and Wait six months and convert to $ convert to $ or or Sell forward Sell forward Group 2: Contracted to Group 2: Contracted to pay out in six months pay out in six months Wait six months and Wait six months and convert $ to convert $ to or or Buy forward Buy forward

If Group 1 predominates, then E(s/$) < f/$

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Takeaway: Summary of all four theories

.
Difference in interest rates 1 + r 1 + r$
Interest Rate parity Fisher Theory

Exp. difference in inflation rates 1 + i 1 + i$

Relative PPP

Difference between forward & spot rates f/$ Exp. Theory s/$ of forward
rates
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Expected change in spot rate E(s/$) s/$

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INTEREST RATE PARITY THEORY

2. The forward premium or discount equals the interest rate differential. (F - S)/S = (rh - rf)
where rh = the home rate rf = the foreign rate

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INTEREST RATE PARITY THEORY

3.In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S
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INTEREST RATE PARITY THEORY

B. Covered Interest Arbitrage 1. Conditions required : interest rate differential does not equal the forward premium or discount. 2. Funds will move to a country with a more attractive rate.
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INTEREST RATE PARITY THEORY

3. Market pressures develop: a. As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates. c.
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Parity eventually reached.

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INTEREST RATE PARITY THEORY

C. Summary: Interest Rate Parity states: 1. Higher interest rates on a currency offset by forward discounts. 2. Lower interest rates are offset by forward premiums.
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Slide 8-4

Prices and Exchange Rates

The law of one price:
In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in the same currency

Purchasing Power Parity (PPP):

If the law of one price holds for all goods and services, the PPP exchange rate can be found by comparing the prices of identical products in different countries Changes in relative prices will change exchange rates...

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Slide 8-5

Money Supply and Currency Value

Changes in relative prices in two countries will change the exchange rate of their currencies; the country with the highest price inflation should see its currency decline in value. Relative inflation rate levels and trends can predict relative exchange rate movements Inflation happens when the quantity of money in circulation rises faster than the stock of goods and services; money supply growth is related to currency value
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Slide 8-6

Interest Rates and Exchange Rates

Interest rates reflect expectations about likely future inflation rates;
high interest rates reflect high inflation expectation Fisher Effect: i = r + I
i: nominal interest rate in a country r: real interest rate I: inflation over the period the funds are to be lent

International Fisher Effect: (S1-S2)/S2 X 100 = i$ - i

For any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries S1: spot rate at time 1, S2 : spot rate at time 1; i$, i: nominal interest
rates in the US and Japan

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Slide 8-7

Exchange Rate Forecasting

The efficient market school
Prices reflect all available public information

The inefficient market school

Prices do not reflect all available public information

Approaches to forecasting future movements

Fundamental analysis: predictions with econometric models based on economic theory Technical analysis: extrapolation/interpretation of past trends assuming they predict future
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Slide 8-8

Convertibility
Convertibility and government policy
Currency freely convertible: residents/non-residents allowed
to purchase unlimited amounts of a foreign currency with the local currency

Currency not freely convertible: residents/non-residents not

allowed to purchase unlimited amounts of a foreign currency with the local currency

Countertrade
Barter-like agreements by which goods and services can be traded for other goods and services Used to get around the non-convertibility of currencies

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