the market for foreign exchange

The Market for Foreign Exchange
Chapter Four

Copyright © 2012 by the McGraw-Hill
Companies, Inc. All rights reserved.


Chapter Outline
 Function and Structure of the FX Market
– FX Market Participants
– Correspondent Banking Relationships

 The Spot Market
–
–
–
–
–
–

Spot Rate Quotations
The Bid-Ask Spread
Spot FX Trading
Cross Exchange Rate Quotations
Triangular Arbitrage
Spot Foreign Exchange Market Microstructure
4-2


Chapter Outline Continued
 The Forward Market

–
–
–
–
–

Forward Rate Quotations
Long and Short Forward Positions
Forward Cross-Exchange Rates
Swap Transactions
Forward Premium

 Exchange-Traded Currency Funds

4-3


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.
4-4


Circadian Rhythms of the FX Market

Source: Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve Bank of New York,
www.newyorkfed.org.

4-5


Correspondent Banking Relationships
 Large commercial banks maintain demand deposit
accounts with one another, which facilitates the
efficient functioning of the FX market.

4-6


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

London

$200
£100

Bank B
NYC
4-7


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

$200
£100

London
Assets

Liabilities

£ deposit at B £300m B’s Deposit$1,000m
£400m
$1,200m
$ deposit at B $800m B’s Deposit £200m
$600m
Other Assets £600m Other L&E

£100m

£600m

Total Assets £1,300m Total L&E £1,300m

Bank B
NYC

Assets

Liabilities

$ deposit at A$1000m
$1200m
£ deposit at A £200m
£100m

A’s Deposit £300m
£400m
A’s Deposit $800m
$600m

$800m

Other L&E $800m

Total Assets $2,200m

Total L&E $2,200m

Other Assets

You can check your work: make sure that
£1,300m = $1,200x(£1/$2) +£100 + £600

4-8


Practice Problem
 Bank X is in Milan. Bank Y is in London.
 The current exchange rate is €1.10 = £1.00.
 Show the correct balances in each account if a
currency trader employed at Bank X buys
£100,000,000 from a currency trader at Bank Y for
€110,000,000. (The balance sheets are shown on the
next slide.)

4-9


Practice Problem

Bank X buys
£100m from Y
Bank
for €110m X

€1.10 = £1.
Bank Y

Milano

London

Bank X
Assets
Liabilities
£ deposit at Y £300m Y’s deposit €1,210m
£400
€1,320
m
€ deposit at Ym
€880m Y’s deposit £200m
€770
m
Other Assets £600m Other L&E

£100
m
£400m

Total Assets £1,700m Total L&E £1,700m

Bank Y
Assets
Assets
Liabilities
Liabilities
€ deposit at X€1,210m X’s deposit £300m
€1,320
£400

m
m
£ deposit at X £200m X’s deposit €880m
€770
£100
m
m
Other Assets €590m Other L&E €810m
Total Assets €2,020m

£1.00
Check: £1,700m = €1,320m x
€1.10

Total L&E €2,020m

+£100
4-10


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.
4-11


Spot Rate Quotations
 A direct quotation is:

– The U.S. dollar equivalent.
– E.g., “a Japanese Yen is worth about a penny.”

 An indirect quotation is:

– The price of a U.S. dollar in the foreign
currency.
– E.g., “you get 100 yen to the dollar.”

 See Exhibit 4.4 in the textbook.

4-12


Spot Rate Quotations

1

.5072 1 9717
= .

Currencies
Currencies

U.S.-dollar foreign-exchange rates inin late New York trading.
U.S.-dollar foreign-exchange rates late New York trading.
--------Friday-------

--------Friday--------------Friday-------

Country/currency

The direct quote US$ the US$
for per
in
pound is:
$1.97171.0016
Canadian dollar £1 = .9984

Country/currency
Country/currency

in US$ per US$
in US$ per US$

Euro area euro
Euro area euro

1.4744
1.4744

.6783
.6783

1-mos forward

1-mos forward
1-mos forward

1.4747
1.4747

.6781
.6781

3-most forward
3-most forward

1.4744
1.4744

.6782
.6782

6-mos forward
6-mos forward

1.4726
1.4726

.6791
.6791

British pound

British pound

1.9717
1.9717

.5072
.5072

1-mos forward
1-mos forward

1.9700
1.9700

.5076
.5076

3-most forward
3-most forward

1.9663
1.9663

.5086
.5086

6-mos forward
6-mos forward

1.9593

1.9593

.5104
.5104

.9986
1.0014
The indirect quote for the
3-most forward
.9988
pound is: £.5072 = $1 1.0012
6-mos forward

Note that
Japanese yen

.9979

1.0021

the direct quote is
.009220
108.46
the reciprocal of the indirect
1-mos forward
.009250
108.11
1
quote:
3-most forward

=.009306 107.46
1.9717

6-mos forward

.009378
.5072

106.63

4-13


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.

4-14


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.
Percent Spread =

Ask Price – Bid Price
Ask Price

$1.4744 –
0.0339% $1.4739
=
x 100 $1.4744

× 100

4-15


The Bid-Ask Spread
USD Bank
Quotations

American Terms
Bid

Ask

European Terms
Bid

Ask

Pounds
1.9712 1.9717
.5072
.5073
A dealer pricing pounds in terms of dollars would likely
quote these prices as 12–17.
Anyone trading $10m knows the “big figure.”

4-16


The Bid-Ask Spread
USD Bank
Quotations

American Terms

European Terms

Bid

Ask

Bid

Ask

Pounds

1.9712

1.9717

.5072

.5073

Notice that the reciprocal
of the S($/£) bid is the
S(£/$) ask.
£.5073
$1.00

=

£1.00
$1.9712
4-17


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

S($/£)
S(£/$)

Ask

1.9715 – 20
.5071 –

Dealer will pay $1.9715
for 1 GBP; he is asking
$1.9720.

He will pay £.5071 for
72 $1 and will charge
£1
£.5072
$10,000 for $1 = £5,071

×$1.972

4-18


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
$1,353,502.58
x
8


Another Sample Problem
 An Italian has just completed transactions in America
and England.
– He is now holding $100,000 and £500,000, and
wants to convert both amounts to the euro.
 His currency dealer provides this quotation:
$1.00 GBP/USD 0.5025 – 76
$985,027.5 £500,00
8=
0 x £.5076
USD/EUR 1.4739 – 44
€1.00
($985,027.58 +
=

$100,000) x $1.474 €735,911.2
 What are his proceeds from conversion?
4
7
4-20


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.

4-21


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
Pay attention to your “currency
algebra”!

4-22


Cross Rates with Bid-Ask Spreads

£10,000sell £ at bid
$19,712buy € at ask€13,371
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 ×
× $1.00 = €13,370.65
£1.00
He has effectively sold £ at a €/£ bid price of €1.3371/£.
4-23


Cross Rates with Bid-Ask Spreads
€10,000sell € at bid
$14,738 buy £ at ask£7,475
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 £:

$1.00
£1.00
€10,000 ×
× $1.9717 = £7,474.97
€.6785
He has effectively bought £ at a €/£ ask price of €1.3378/£.
4-24

Cross Rates with Bid-Ask Spreads
Bank
Quotations

direct
American Terms

indirec
European Terms
t
Bid
Ask

Bid

Ask

£:$

$1.9712

$1.9717

£.5072

£.5073

€:$

$1.4738

$1.4742

€.6783

€.6785

£:€
€1.3371 €1.3378
£0.7475
£0.7479
€1.3371
€1.00
Recall that the reciprocal of
=
the S(£/€) bid is the S(€/£)
£1.00
£.7479
ask.
4-25