Lecture 1 Module 1

Foreign Exchange Markets

Text Reference: Eiteman et al, Chapter 6, pp. 138-150, 152-155. www.pearsonhighered.com/eiteman/#MBF

Learning Objectives
To examine the functions performed by the foreign exchange market To describe the roles of the main participants in the foreign exchange market To analyse how spot rates are quoted and interpreted To derive cross rates and the opportunity for triangular arbitrage

Size of the Foreign Exchange Market

The

Bank for International Settlements (BIS) estimated daily global net turnover in traditional foreign exchange market activity to be US$ 3.21 trillion in April 2007 (see
slide 5)

For

Australia, average daily turnover at survey time was about US$ 170 billion approx. 5.3% of total (see slide 6).
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Global foreign exchange market turnover (daily average US$ billions)

3500 3000 2500 2000 1500 1000 500 0 1989 1992 1995 1998 Year
5

US$ billion

2001

2004

2007

Source: BIS, October 2007

Australian foreign exchange market turnover (daily average US$ billions)

Source: RBA Bulletin, Jan 2008

6

Reported Foreign Exchange Market Turnover by Currency Pair

Daily Averages in April 2007, in billion of US dollars and per cent

2007 Currency Pair USD/Euro USD/Yen

Amount % Share

840 397

27 13

USD/Sterling USD/Australian dollar USD/Swiss franc USD/Canadian dollar

Source: BIS, 2008

361 175 143 115

12 6 5 4
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Circadian Rhythms of the FX Market

Electronic Conversations per Hour
average peak

45000 40000 35000 30000 25000 20000 15000 10000 5000 0 1:00 3:00 5:00 7:00 10 am in Lunch Europe Tokyo hour in coming in Tokyo 9:00 11:00 1:00 15:00 5:00 19:00 9:00 11:00 Asia Lunch Americas London New 6 pm in going out hour in coming in going out Zealand NY London coming in

FX market is a 24-hour market & doesnt go to sleep (different time zones).

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Market Participants

The foreign exchange market consists of two tiers, the inter-bank or wholesale market, and the client or retail market Four broad categories of participants operate within these two tiers
Bank and non-bank foreign exchange dealers Dominated by large international banks Individuals and firms conducting commercial or investment transactions Foreign exchange brokers Central banks

Bank and Non-bank Dealers

Dealers act as market makers, willing to buy or sell currencies without a counterpart to unload the inventory Dealers profit from buying currencies at a bid price and then reselling them at an offer or ask price
May also involve arbitrage and speculative activity

Competition among dealers narrows the spread between the bid and offer rate contributing to the markets efficiency
Connected by a network of sophisticated communications systems

Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the foreign exchange market
Correspondent banking relationships

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Individuals and Firms

Importers, exporters, portfolio investors, MNEs, tourists and others use the foreign exchange market to facilitate execution of commercial or investment transactions Some of these participants use the market to hedge foreign exchange rate risk

Hedging aims to protect against adverse movements in exchange rates

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Foreign Exchange Brokers

Foreign exchange brokers are agents who match buy and sell orders between dealers:
Do not set prices or carry inventories of currencies Charge a small commission Maintain instant access to hundreds of dealers worldwide via open lines, with separate lines for different currencies, spot and forward rates Electronic broking now dominates

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Central Banks

Central banks use the market to acquire or spend their countrys official currency reserves, as well as to influence the price at which their own currency trades They may act to support the value of their currency because of their governments policies or commitments with other central banks Earning a profit is not a motive The Bank for International Settlements (BIS) in Basel, Switzerland, acts as the central bankers central bank and serves as a gathering place where central bankers meet to discuss monetary cooperation.

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Australian forex turnover by participant

(daily average A$ billions)

Source: RBA Bulletin, Jan 2008

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Transactions in the Foreign Exchange Market

Transactions within the inter-bank market can be executed on a spot, forward, or swap basis
A spot transaction requires almost immediate delivery of foreign currency A forward transaction requires delivery of foreign currency at some future date A swap transaction is the simultaneous purchase and sale of a given amount of foreign currency for two value dates/settlement dates

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Transactions in the FEM

Source: RBA Bulletin, Jan 2008.

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Spot Transactions

The spot exchange rate is the quoted price for foreign currency to be delivered at once, or in two business days for inter-bank transactions Example: A quote of HKD6.621/AUD could be used by a customer who wants to buy Hong Kong dollars (sell Aussie dollars) for immediate delivery Example: A student from New Zealand wishes to sell NZD10k (buy Aussie dollars) to cover living expenses in Australia. Example: An Australian tourist wishes to buy NZD10k (sell Aussie dollars) to cover holiday expenses in New Zealand.
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Quoting Foreign Exchange

A foreign exchange quote is a statement of willingness to buy/bid or sell/offer/ask at an announced rate Generally, exchange rates are given to 4 decimal places The difference between the bid and offer prices/rates is called spread or margin The bid-ask spread is the difference between the price at which a bank or market marker will sell ("ask", or "offer") and the price at which a bank or market marker will buy ("bid") from a wholesale or retail customer. The customer will buy from the market-maker at the higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade. For the banks or market markers, the bid-ask spread represents the profit for them. The spread is small or minimal for actively traded pairs of currencies, usually 03 pips. For example, the bid/ask quote of EUR/USD might be 1.2200/1.2203 on a wholesale broker. 1 pip = 1 basis point = 0.01% (100 basis point = 1%)
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Direct and Indirect Quotes

A direct quote is a home currency price of a unit of a foreign currency NOK 4.869/AUD is a direct quote in Norway (Norwegian krone/Australian Dollar) An indirect quote is a foreign currency price in a unit of the home currency NOK 4.869/AUD is an indirect quote in Australia AUD0.2054/NOK is a direct quote in Australia and an indirect quote in Norway

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Spot Quotes

Interpreting market quote: RM/US$3.3360-3.4610 (refer to Slide 21) 1. First currency = quoted or terms currency is RM 2. Second currency = unit or commodity currency is US$ Quote shows the number of Ringgit Malaysia the bank will buy and sell against one US$ i.e. the price of one US$ in terms of RM 3. First number (3.3360)= rate at which the bank buys the unit currency (US$) and sells the terms currency (RM) 4. Second number (3.4610)= rate at which the bank sells the unit currency (US$) and buys the terms currency (RM)
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Foreign Exchange Rates (Forex):

Foreign Exchange Rates (Last updated 24/02/10 10:45 AM)
Currency Selling TT/OD Buying TT Buying OD Currency Notes Selling Buying

1 US Dollar
1 Australian Dollar 1 Euro 1 New Zealand Dollar 1 Sterling Pound 100 Indian Rupee 100 Indonesian Rupiah 100 Japanese Yen 100 Saudi Riyal 100 Singapore Dollar 100 Swiss Franc

3.4410
3.0850 4.6630 2.4070 5.3370 7.6990 0.0383 3.8150 92.6800 244.1700 317.4800

3.3680
2.9990 4.5570 2.3220 5.1900 N/A 0.0356 3.7290 N/A 238.7300 310.6900

3.3640
2.9840 4.5490 2.3150 5.1810 7.0360 0.0346 3.7240 88.6800 238.4000 310.5100

3.4610
3.1110 N/A N/A 5.6110 N/A N/A 3.8700 N/A 245.3000 N/A

3.3360
2.9480 N/A N/A 5.1570 N/A N/A 3.7000 N/A 236.6000 N/A

100 Thai Baht

11.2000

9.4000

8.8650

11.1600

9.4500

Source: Public Bank Berhad

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Interpretation of Quotes
What do the below quotes mean? RM/A$2.9990 - 3.0101 RM2.9990 /A$ RM3.0101/A$ What is the unit (base) currency? What is the terms (foreign) currency? What is the bid price? What is the ask price? What is a spread? How many basis points or pips is the spread? Spread = 111pips or basis points or 1.11%
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Quoting Cross Rates

Cross Rates: Foreign exchange rates between two currencies other than USD that are derived via a third currency. Quotes for currencies not involving the USD are obtained by crossing with the USD Why cross rates are needed? Sometimes we may not be able to get the rate for a less common currency (A) against another currency (B). However, if the price of that currency (A) against USD is available, we can cross the rate and obtain the rate of that currency (A) against currency (B). Note that USD is the base currency for interbank dealing. Example: Nepalese Rupee (Rs) against Malaysian Ringgit (RM)- NRs/RM
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Calculating Cross Rate

Assume there are three currencies represented by X, Y and Z. Bid rate =b and Ask rate = a

(x/y)b =
(x/y)a =

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Example: Cross Rate

RM/US$ = 2.5745-2.5755 CHF/US$= 1.1702-1.1709

What is the bid rate or bid price for RM/CHF? What is the ask rate or ask price for RM/CHF?

(RM/CHF)b = (RM/CHF)a =
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Arbitrage

The simultaneous purchase and sale of currencies for the sake of making profit (risk free profit) due to price differences in different foreign exchange markets. Two-point Arbitrage is profitable if the exchange rate between 2 currencies is not the same in 2 financial centres. Triangular Arbitrage is the process of converting one currency to another, converting it again to a third currency and, finally, converting it back to the original currency within a short time span.
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Triangular Arbitrage
Example: Suppose you have US$1 million and you are provided with the following quotes: /US$ = 0.8631 / = 1.4600 US$/ = 1.6939 Assume no transaction costs and taxes, check whether you can make arbitrage profit. Steps to check: 1. Check if quoted (given) rates equal implied (calculated) rates 2. Determine the profitable sequence Answer: Arbitrage profit =US$1,373.
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