The Foreign Exchange Market ference in location, time, from one place to another or purchase nor sale according to this Saint Thomas Aquinas, ¢. 1264 é there were a single world currency, there would be no need for a foreign exchange eae che raison dere ofthe foreign exchange markers ro enable chasing power from one currency into another, thereby facilitating soods, services, and financial securities. Trade carried senens is probably as old as humankind and has long been a soures for the nations that ‘embraced it. Indeed, international trade {the vanguard of human progress and civilization. The Phoeni- es ins were all great traders whose activities were facilitated by vepiases and mrones changers, both of which se fixed places and fixed times for “eamemorial traders have been faced with several prob- na fmance the physical transportation of merchandise from ne £0 Begs which could be several hundreds or thousands of miles away and Pee athe aveays how ro insure the cargo (from the risk of being lost at sea eee ta or bandits); and last, how to protect against price flucruations in the value fo point B) and over time (berween shipping cory of foreign exchange and its derivative ‘ovative remedies that traders devised to cope across space (from point and delivery time). In many ways, the “gets parallels the increasingly inn swith their predicaments. ns Eecfned to enabling international rade, foreign direct imvestenty and Toreign exchange has recendly emerged as an asset class in its own the recent surge of money flowing through the foreign chet. Catalyzed by improved technology, the unrelenting ~ consrols, the accelerating pace of economic global- vorighmic trading models, the daily turnover in ‘on, thus dwarfing equities and fixed income ‘only 10 percent of trading is morivared by their fnancin nt. This largely explains 35182, THE FOREIGN EXCHANGE MARKET AND CURRENCY DERIVATIVES 4 ‘k within which forex 's chapter first describes the institutional frameworl 1 1 ee cartied out, emphasizing how Internet-based electronic automation has ovethauled the market microstructure. Second, it catalogs ce iaat at exchange products currently traded on the foreign exchange a a a the mechanics of exchange rate quotations and explains how the foreign Pechange market, even though it is geographically dispersed, is very much one global market: Spatial arbitrage, also known as the Law of One Price, makes sure of it. After reading this chapter you will understands © {LOW the interbank foreign exchange market is organized ™ How the Internet is steadily displacing the “visite Fecvan hand” in currency trading & What the different forex products are ; ; * What the mechanics of exchange rates quotations are and the meaning of bid-ask arbitrage transforms a geographically dispersed foreign exchange market into one globally integrated masketplnce HOW FOREX 1 TRADED: THE INSTITUTIONAL, FRAMEWORK ‘The FX market is by far the oldest and largest market in the world, through which end users of foreign excheces 7 gxPortes, importers, multinational perp oFations, institutional investors, hedge funds ors central banks are abe buy or sell currencies as needed. Unlike che New York Stock Exchange, the Paris Bourse, or the Chicago Board of Trade, whisk vie hysically organized and cen. tralized exchanges for trading stocks, bonds, commodities, and their derivarh cy fe foreign exchange market consists of a nenork {rading tooms found mostiy ia ommercial banks, foreign exchange dealers and bet” 8¢ firms, hence its name of an interbank market, I is largely dominated by approximately 26 my ajor banke ther trade via their network of branches, which are Physically dispersed throughout the major financial centers of the world: London, Now York, Tokyo, § ‘ Frankfure, Hong Kong, Paris, and Shanghai, ¥°> Singapore, Zurich, Thus the interbank marker consists of large mu whose dealers trade citer directly among therelna In this sense the interb, Itis the medium tional commercial banks with Currency. Brokers were formerly humans known , Predominantly electronic brokers (automated order-matching systems). eg generally Sranated that approximately one-third of all interbank FX teding Still in the form: of direct dealing among banks’ FX dealers, while two-thisde a Bulded by either voice or electronic brokers, Scanned with CamScanneryo Foro igo Market 133 longed! he FX Trading Room the key building blocks of the FX pant! the world In appearance eee ca found at most banks . ance they look quite similar, with their rows of computer gereens, fancy telephones, dedicated lines re elecrronie brok to customers and voice brokers, and direct i] Jinks to electronic broking systems and ‘ Hake off foreign exchat 1s an newsfeeds, In the 1960s, when FX started i 1 exes) which allo nge rang rooms were linked simply by telephones (and 4 th com wed for fast communication (but nor quasi stantaneous aS 1 ’ doe mputer terminals and the Internet. Each cusench trader would i he “he fore him a special telephone tha links the trading room by direct wire | ie orcign exchange brokers, and the most important ‘commercial customers: | Te connections are so arrange that several of the bank's traders can “isten in’ On the same cal.”™ Today telephone, telex, and facsimile machines play a secondary vale as compater terminals have established themselves as the undisputed medium “transaction, allowing for instantaneous communicay on in this over-the-counte © arket, FX traders with display monitors on thes desks are able ro execure trades at prices they see on ther screens by punching in their orders on a keyboard. FX trading, however, is not a stand-alone act Because exchange rates are continuously fluctuating in response. vers whether thar be developments in Ii sores, commodity prices, inflation, oF other vw peroeconomic variables~ PX trading | pe a sam integral part of banks’ trading activities in shor financial products, including Pi 6 financial derivatives. tow iste FX Trading Room Orgalet? Moss trading rooms ~ also known as the * front vafice” would implement some degrS vision of labor within the stall with Ware yous traders specializing in emigidual carencies of different products ‘such as spot Mrersus forwards or FX swaps (66° Me next section fr definitions of these different (a en behalf of customers ~ so-called d6e"Cy vt pele own accounts using their own CAP tal - proprietary trading? - ‘handled by a separate gr0uP ‘of traders. To manage the Tage flow of FX deals wading se are supported by “back offices” whose staff ig responsible for clearing wd cetting rransactions, €xecutinG their payments, and managing risk. ow to Contel FX Trading Fore exchange trading is avery lucrative busines, and a neil banks i 0) Spee for as much as 10 t0 20 per- for many lat 7 caval ef sro8t. Mf is also a fast-paced Yad hectic activity with billions of dollars ___— Ta Holmes and FH. seots The New York Foreign Bechange Marker,” Federal Reserve Bank of New York, 1965. Tether ‘means that FX brokersfdealers negoite directly with one another. There ‘or clearinghouse is no central physi et x caring iancion of tanks oat as Gracia ners, agency trading is conse eee aig a eave) lowers ae peo prietary trading, on the oher handy i akin co, iti a apelin adn ar ef (sally) but volatile : Wank Neirer should be KePE S@P2"46. swith their own reporting an Recent banking reforms in He Sepat Stes severely cur FX proprietary tradingsNiGE MARKET AND CURRENCY DERRVATIVES 134 THE FOREIGN EXCH. MCE ———eS traders are required to observe trading that no tvsing drought ooms, Cu Feample, he bank may manda tits appli oa snl mansion; for example, the bark may mands ch A i i at the aggregate limit of a trader's single FX trade bein exces of $100 lion and cat the are iched aie net position be no more than $25 milion during che day, to be reduced to very i avoid unwelcome price surprises close to zero by the end of the business day to avoi Sie bene Overnight. Without these rues, the bank CEO would lose sleep at em a few unauthorized trades gambling away the bank's capital. Indeed a ae ‘most part, eam a living by buying and selling foreign currencies at slightly differ. tnt rates ~ also known as th bidhask spread ~ for their corporate customers. The idea is that the bank buys currencies ata slightly lower FX rate than the rate ar ‘which is selling, thereby generating lim but postive profi margins. This is indeed & relatively safe way to make a living, because it does not entail outright speculs- te Positions on currencies. Infact, most banks have established control systems aimed at keeping traders honest by implementing the square position requirement; {his is nothing more than requiring that each trader keep his or her trades in balance find that for each cureeney th amount sold forward in a given currency /or a la bilty postion in that currency equals the amount purchased forward in thor came Curreney (asset position), Indeed, che computerized systems offer currency traders the opportunity to enter orders that are then automatically matched with other outstanding orders ‘already in slobally reaching and linking trading system substantially reduces the time and cost of matching and settling trades. and, more important, Provides the ange market with the tickertape to record the actual prices at which n exchange transactions are executed. However, it should be emphasized that the specifies ofthe actual eansacton (price and volume) have xo fae ‘never been made public, because foreign exchange markets’ biggest traders hare profitably kept this secret to themselves, “The Market That Never Sleeps” This ethereal, ubiquitous, electronic foreign exchange market is literally trading around the clock. At any time during a 24-hour cycle, FX traders ane buying and selling one cureency for another somewhere in the world. By thetme the Na York ers start cain at §:00 aa. EST, major European financial centers here teen in fall swing forfour or ie hours. San Francisco and Los Angeles crane US. FX trading activities by thee hours, and by dinnertime on the West Coast, Far Eastern markets, principally Tokyo, Hong Kong, and Singapore, will begin trading, As their trading activities draw to a close, Mumbai (Bombay) and Bahrain will have been open for a couple of hours, and Western European markers wil ie about to start trading, beginning the cycle all over again (see exhibit 5.1). One major implication of a 24-hour currency marker is that ‘exchange rates dlo provide a continuous realxime marker assessment of new developmests and therefore will change quasi-instantaneously in response to any new information, jTepgan comacet ins! and father diced in th nets. No tha quae reitons requirement stil slows forthe mismatching of forward contacts martes i 4 ven curteneyreign Exchange Market ‘ue Forel! 1 ‘thus, FX traders must be light sleepers ready to work the night shift if necessary, gince they May need to act on news resulting in a very § g ina very sharp exchange ra ome! that occurs on anot! ib 'y sharp exchange rate movement a the ean inthe mid ofthe night However over the course USS vs, YTD % WO. Correney Coenen Caren Cate In USS Per USS CHG Amicas Axgeteina pee” 0.0335 29.8555 605 Sreies RL 02518 3.9702 19.9 a cap 13045, 3.8 1.3046 43 13031 43 oes 133007 42 Silogee ae oworsse 668.5 86 18.9952 “34 31.46 92 o.e0000403 248409 2401878 07338 1.3628 64 01458 6.8584 SS O1274 7.8494 0s 0143 69.7585 92 0.000686 14573 81 c.00908 110. 3 oases 110.01 -19 0.00813 109.52 21 0.00277 361.08 0123736 8.082 02837 4.1035 0.6683 1.5053 o.c0s17 12.46 oo1ss 53.333 0.7303 1.3693 e.c00sss 118.17 0.00623 160.51 0.08255 3072 0.03036 32.98 o.0000s297 23273 oss7i3 1.703 48 oses 6.4607 43 cose 22.42 a uss 6.4956 47 Liss 0.8708 4s a 0.003548 282.1 89 : 0.008243 108.18 45 ontss 8.4456 29 Scanned with CamScanner_ ‘he goreign Exchange Market 145 ps0 (Continued) 180 Curency USS 95. Countey/ Currency Code nS yTD Per USS CHG poland 2oty TIN Romania leu RON a 3.7525 79 eosin ruble RUB ae a gweden krona SEK 0 7 ‘ switzerland franc CHE mE aa Tana forward rte i 3-mos forward. 1.0185 5 amos forward . 7 “Turkey lira” TRL a6 Ukraine hryvnia UAH a UK pownd arte) 12095 1.2797 ‘einos forward Somos forward G-mos forward Middle East/Africa ‘alirain dinat BHD 26515 0372 001 Fgype pound” EG? 00558 173913 0s Israel shee us 02737 3.6582 5 Kuwait dinat KWD. 3297 03033 06 ‘Oman sil al OM 2539703 039 093 Qatar ral Qar 02753 3.633 os agate SAR 02666 3.7508 001 00688 143261 175 0719830 0.03 ewers Source: Wall tee" Journal cemerber tat ihe ane indirect quores are exactly the rer cereal of the rr For example, the eacionship tris important © (Gs exchange came thing, since OE wae an he diet an ‘niece rare quotations i simply: 1 1 ois? sae 07 5 yes ene dhe pound sting o the Japanese Y=) ihe wen on ora dia ete a5 a ‘aad For most he ; over in this chaptet. For ont, thee Te once to which We ret » —— 7 — amScannerHWE FOREIGN EXCHANGE MARKET AND GUITENGY DERIVATIVES NOANAMES IUTMIEERNINAKED ‘1 thie than Sony tats ton tro cue pl hy kane eather da ‘hete format namie, Tho U8, dotlae ant pound sterling pal ea wal New York Gado (frome the days when exchange nates between Lond 7 ae Werecommnnnicated by transatlantic eable), the Canadian dollar as the Laoniey fe Swiss thane as the Sos thy Austatian dolar as the Ansley mi le Now Foatanal dollar asthe Sint Mane rocently, the pound sterling paired vt be cu is voter 49 ae the Chuamnel and as the Gepppie when the pound fs Inxivot yuith tho Japanese yor, Currency Symbols Rather than writing the full name of each enrreney, parties entering into foreign exchange contracts use abbyeviations that should be easily understand, ‘The Intec Rational Organization for Stannlanization (its acronynr ISO is the classieal Greek Nowt for api) established enttency abbreviations now widely used in both trading Sows anal commensal transactions, ISO currency symbols are the tworletter cout: FA ga ate a thisd Letter trom the name of the curteney, For example, the Canadian (CN atl OD) is denoted as CAD, Similar the Thai CTH) baht (3) is abbeestaced STUB, Exhibit S16 provides comprehensive lst of stich symbols, For the widely SEMA currencies, the tinehonove symbols for the U.S, dollar (8), pound sterling (2), Japanese yew (¥), and euto (€) are used in this howl, denoted by their 180 symbols, I other curren 8 are Cross-Rates indicated earlier, most EX trading involves the U, ction. and as a result currencies tend to he quoted interns of the dollar price of one unit of foreign em eney posea bank customer wants to sell yen (V) for Austealias dl the bank quote a etoscrate § xun() (which is not read Available) when available ares are yen against US. dollars 8s(0) = 76 and US, doll 8 against Australian 1.122 Believe it oF not, the bank will first buy U.S, dollars with yew and then purchase Anstraian dollars with the U.S, dollae broceeds. It will there- Ure ae # srosrate nse on the respective rates af bath ore Against the US. dollar: dollar on one side of the cither directly or indirectly A0= VS. s(0) But sup- lars (AUD). How should dollars § yuntt) = Vo~ $1 =» AUD 1/112. AUD 0.89 ‘or it will cos 85S = AUDI 06 f0 use oUF notation: J naunltl = Syglt) X Ss run(t). "Since it costs ¥ to buy AUD 0.89, i will cost ¥(7620,8 = 85 to buy AUD 1,ori Exchange Market ——— n8T88 Currency Symbols, ere eee 180. Country Argentina ‘gstlia ‘pabrain Brazil Canada Chile China Colombia Carch Republic ‘Denmark ‘Ecuador oronone Hong Kong Hungary India Indonesia Isr Japan Jordan Korea, South vai Lebanon Fue cavomne Tneees Aoi, Deum, Crom, Eston Pets Thea Lavi Liban Lnembou Mala Netbeans Slovenia, and Spain. “The reader should nore how essy and Tos serge cures by simply ang te S. dollar as the middle seripuleurrency. The reader may sll WON SF sda rather than eed tading Yen ia ow anks oraz thi forex rading ei to do wader or wading desk deine (oa given reflecting @ ieee Caren urrent ey Code Coumry Cuneney Code se ARS Malaysia Ringgit MYR a AUD Mexico Nuevo peso MXN aa BHD New Zealand Dollar NZD _ BRL Nonvay Krone NOK a CAD Pakistan Rupee PKR eso LP Peru Newsol PEN Renminbi CNY Philippines Peso. PHP Peso COP Poland Newaloy PLN Korum CZK Rasa Ruble Krone DKK —_ Saudi Arabia Riyal SAR US.dollar USD Singapore Dollar 86D Euro (@) EUR South Africa Rand ZAR Dollar © HKD Sweden Krona SEK Forim © HUF Switzerland Frane CHF ‘Rupee INR ‘Taiwan Dollar TWD Rupiah, IDR ‘Thailand Baht THB ‘Shekel Is ‘Turkey Lira TRL see) TRY United Ab ites Diba 0 Ye TD United Kingiom = Foundit) GOP Won ‘KRW ‘United States: Dollars) USD. Dine = XWD_Urguey U Pound ‘LBP Venezuela ‘B Finland, Germany, Portugal, Sloval it is to express the cross-rate in the first sub- der why the bank is taking this detour via for Australian dollars. The reason has ‘They would typically nrrency against the U.S dollar, or ad pet in ha carency ri, Las sy 10 currencies are Teaey raed agaist the US. dll That means the bank must have a minimum staff of 10 sal of oases of sai currency vd torre ro make & martin SO MANY Tos aoeenutte fr the mos att fe ein ers and probaly mor. Ten cutences ao correspond the US. dallar). It would indeed “crossrates, and that's why banks jon rading cutrencies against the US. dollar. ‘Bid Ask Spreads “To complicate maves somewhat, a ypcal foreign exchan tere ater than one- The ‘ypical fregn exchange quotation gives two iswilling to boy Tid pe uth rice at which n X trader in one Th i andthe Thaker pe 2 Scanned with CamScanner148, i Jvich atta ih Po exainlscuppove Ga eite aveiad the price av which a hale HET a OF Saline ae 504 34 Ute scans th suit Stable rea ‘ Py daldduan ay 84-2554 (he ask price). Usually the knows the “big” 34, aosuininy that the eoUnter party Tre sina ac 2 Nc on caper sb pre nes sam De a prices the difference is havens the lah apraad. Thus, she costo cting enbage READS as the foreign exchange mathet cate be expressed percentage 4? Ask pve 100 Siweult = "pre hand = 0.40% 1504 The difference between the bid price and the ask price is the benk’s compensa~ ‘Hon for making the trade, which fy ihe reason why banks do not cherge commission fees. The FX trader ix in eltect a market maker in the currency he or she trades, who will keep an inventory of said curnency, In this sense the spread is the cost of being in business, tying ap capital ino an inventory and being compen- sated for beating the risk of holding in inventory an asset whose value is volatile, For widely traded wurrencies such as the euro, the Japanese yen, or the pound ster- ling and trades of atleast $1 million, the size of the bid-ask spread is approximately 0.2.10 0.5 percent. Is size vaties from one currency to another. For a given currency, the spread depends on the level of competition among FX traders for that currency, the currency’s volatility, and the average volume of daily trading. Less heavily traded currencies from emerging market countries such as the Russian ruble, the Turkish lira, the South African rand, and many others will exhibit wider spreads that reflect in part their volatility and the thinness of their currency marker. Direct versus Indirect Quotation of the Bid-Ask Spread Bid-ask exchange rates can also be expressed as the euro price of one US. dollar: The reciprocal of the bid price becomes 1/1.2504 = €0.7997/$ and, similarly, 1/1.2554 = €0.7966/S for the ack price. The reader may wonder why the reciprocal of the bid price is now more expen- sive than the reciprocal of the ask price when quoted in euro terms per one U.S, duller Ineffect, when the bank is offering to buy euros fr $1.2504 (the bid price for eoros) it also offering to sll US. dollars for €0.7997 (the ask price for US, dollar), Inother words, the reciprocal of the bid price for euros has become the ask price fog US. dollars. ler to mi Q Explain why the reciprocal ofthe ask price is cheaper than the reciprocal of the bid price when quoted in curo terms per one U.S, dollar, Az When the bank is offering to sell eutos for $1.2854 {the ask price for euros), itis also offering to buy US. dollars for ls €0.7966 (the bid price for Us dollars): The reciprocal of theask price for eutos has become the bid price for US. dollars Cross ates with BHABK Spreads Assume that the ‘Thai baht (THR) i quoted as PHB 30.2511-3987 per $1 and thatthe Japanese yen (8) as 76.2518-7985 per $1, What is the toss ¥ price for buying one Thai baht thar the bank weld quotes ae aa) eee Scanned witl 4 e. csno Forwian Exchange Markot The Crosser ¢ Syu(t) combines two transact ven) at the asking, price of § Fansactionss purchase of U6. dollars (welling, , Hs Prive of Sys(t) = 726.7985 and buying ‘Thai halt tally uz dollars) at the asking price of §y y(t) = tot price for US, dela ull) © 130.25 11 (which isthe reciprocal of the bid Y76.7985 -» $1» THB 30.2511 or ¥202285 Sar @ Y254/TH Or in terms of our notation, the yen bid price for baht is: 1 30,2511 Syeruun(D = Sys) * Ssryn(l) = 76.7985 % ‘Spatial Apbitvage and the Law of One Price jon in cde no mention of the geographi hapter 2 of the equilibrium exchange rate set in a tworcurrency 1 origin of the quotation, Hecause 5% mre part af a workdwide network of trading, desks at banks, brokerage Bers hedge funds, or multinational conporations rather than being bowed together in a eee zed market, itis most unlikely that they will quote identical exchange rave ta given point in time, These price discrepancies are inevitable in a geographically dispersed market such a the foreign exchange market and as generally referred t0 fs price dispersion, For example, is 1.31 the dollar price of one pound prevailing, 2 Or York City, London, or in some distant foreign exchange market such as Singapore? As it curns out, the matter i irrelevant because of the integrative role played by arbitrageuts. Suppose, for instan ‘ader: , the price of one pound is 1.32 in London but only 130 in New York City.” Exchange arbitrageurs (that is, currency traders manning, the foreign exchange desks of large banks tad assisted by computer models) will correct crepancy in pices quoted for the same currny (pounds) in evo distinct ge0- jraphical locations (London and New York City) by buying pounds in New York City at $1.30 and selling them in London at $1.32." Increased demand for pounds will push up the price of pounds in New "York City while, at the same time, increased Supply of pounds in London wil push down the rate until one single price prevails in ark locations. As a result, foreign ‘exchange arbitrageurs provide the mechanism patereby geographical distinet exchang® Te 1s are integrated in an economic ener The equilibrium condition can be expressed as: ne £ in New York = § price of one in London = $ price of one $ price of o Lin Singapore Saas tha ; , ToT his assumes that both markets are cading sina ecause of different time zoe, overlapping trading hours are relatively limited. ae rch pound bought ia New York CO tours 7 gems foreach pound boop io NG Tsp ebr of 2 WArbitragcurs wou! m i pe Peta aston costs incurred in such PATS Ks cei per pound. However, such eramsacton co oer generally wey small reati00 Simount that may be transacted 33 Scanned with CamScannerIGN EXGHANGL MARKET AND GUARENGY OF NIVATIESS 180 Tue FON ‘or formally, Ss, siogapore [S54 vk = ESCM lon eof one pX for immediate delivery where Sg.¢(¢) denotes the spot dollar price of one pound prevailing at ime t, Tnisteral arbitrage ‘The prevedting condition of bilateral equiibriuny om et a Lai eralized by relaxing the restrictive assumption of a two-curreney world Fl ae wees iL sider first, asa intermestiate step.a three-curtency world (U.S. flan Metish wah ander, Abinaea erations illeie tat pbs pos ciety with dollars at the unit price of Sg ¢(¢) or through the intermediary of a third currency «for example, the enro (€)~ should be equivalent alternatives, That is, S$ price of one & © $ price af one €X € price of one £ Soul > Spe(OX Sel) where $5 ¢(¢) denotes the dollar price (§) of one euro (€) for spot delivery prevailing ar time t, and Si ¢(#) denotes the € price of one pound (£) for spot delivery also, Prevailing at time t, The trilateral equiibyium condition simply expresses: that whether dollars are used to purchase one pound or to purchase the number of euros necessary t0 acquire one pond, the casts incurred should be identical, Suppose, for instance, arbiteageurs were confronted with the following, configuration af exchange rates: S6(0 LPS e(O = LAL Se (0) & 1.20 Here indiret purchase of pounds ~ that is, purchasing euros first and using the resulting proceeds to purchase pounds ~ would cost them only 1,69 U.S. dollars 38 opposed t0 a direct purchase of pounds at cost of 1.72 US, dollars. Atbe teagenrs would thus neta profit of 3 eens per pourul transacted by buying pound indieetly at $1.69 and selling inuediatly at $1.72/6, Fach € costs SAT, anal gach £ costs €1.20, rect purchase of € vin € dhs costs ($1.4 UE) x (€1-2014) = $1.69/E: Indirect £ purchase costs: £1 -+ CL20/L = €1.20/£x $1.41 /6 $1696 This is cheaper than direct £ purchase atthe cost of $1.72, of using our notations: Sell) = Spel Sell) = LAL 1.205 169 In doing so, however, both the dollar price of euros and the should be driven up as a result of stepped-up purchas of pounds should he driven down because ofthe nliional sales of pounds nee anbitrageurs are buying ponds indirectly at $1.6946 al ein a the higher diteet rate of $1.72/6 until he tilateral equilibsum condition is obtained. Thus, regards tes of where dlls are cred for pon, spatial abiteae ensites that the eign exchange rate will be the same, This is what is generally known as the Lavy of One Price, : couro price of pounds 5 whereas the dollar price canned wit!> ee ia ee 151 egn xchange Market ward Exchange Contracts tas a commitment to buy The fre (the maturity OF ed earlier @ forward exchange contract ed upon when the contact ansty of foreign exchange on a certain date in at a price (the forward exchange rate) aBr We defi certain qu the contract ve signe (the present) erence, fr example, the case ofa 90-day fo ounds sterling (£) for US. dollars (8) at the forwar ward sale contract’ of 100 million drate of $1-5135 per £1, den red ¢, fulfillment of the sale 008 Pp 3 FOO) a sis” ‘Ac detivery time, 90 days later, calls for the livery of 100 millior id ing it hi for taki deli at US 100 ion pounds serting in exchange fo" ing rate itself is defined as the domestic oF" i ly, che forward exchange ane unit of foreign currency i fF delivery ei she time ier Beet equal transaction takes Pace In thi at sti che day © is examples More general ency price (S) of date; the symbol used is Fid), wl react is signed and the day the ‘would simply write: F(90) = 5135 sovwand Discount nd Premio A forisy curcency is aid v0 be a 2 forward disor: Nomen the domestic currency A fe pr of ne cit OF (OTE caerency 11s 1 than its spot Price: Fed) < SO) se said vo be aca fortard Pemir® whenever the currency #15 more that is Conversely ‘of one unit of foreign domestic currency spot price: Fd) > S(O) anilluserarion asst As one pound serling 3 expres ay): (30 days): (90 days): change rate (C04: exchange Fate exchange Fate 1g Fid) ~ S(O) is seen widening over -The forward discount for the pound steslin the next three cae Ty snot — 1.5255 = -0.0054 £30) - 510) (90) - S10) "5135 — 1.5255 = 0.0120 s Sine denon of a forward purchase contract Phe os a leave the cepjven ime period: “pncacterisically, option fora sin Pc mde wn the es an son a specific date 1d contracts provide ‘or last 10 days of the month (opCion 55 et Scanned with CamScanner182 THE FOREIGN EXCHANGE MARKET AND CURRENCY DERIVATIVES Implicit Interest Rate Premiums and discounts over a d-day period are Benerally expressed as percentage carnings per yeat. This annualized earnings rate is called the implicit interest rate and lends itself directly to comparison with interest rate differentials. It is defined as: F(d) ~ S(O) |. 360 SO) *d In the previous example, the annualized implicit interest rate corresponding to the different maturities would be computed as: F(30)— S(O) . 360 _ -0.0054 360 Implicit interest rate = 360 _ =0.0054 , 360 _ 9 9495 SO) * 30 ~ 1.5255 * 30 ora 4.25 percent per annum discount and FO90) = S10) , 360 _ -0.0120 , 360 __g.9315 SO 90 * T5255 * 90 or a 3.15 percent per annum discount. The practical usefulness of the implicit interest rate will become clear in the context of the interest rate parity theory discussed in the next chapter, when it is compared to interest rate differentials. More specifically, according to the interest rate parity theory, when interest rates and exchange rates are free to adjust (no cen. tral bank intervention), the forward premium or discount on a foreign currency is equal tothe difference in interest rates between the domestic currency and the foreign currency. A foreign currency commanding a higher interest rate than the dome currency isata forward discount; conversely, a foreign currency commanding lower interest rate is at a forward premium. Q: Ie is May 1, 2015, and Crédit Suisse’s head currency strategist has just learned from her chief economist that there is an 80 percent chance that Greece will leave the eurozone by year-end. By then because of footloose capital aban. doning the euro to seek shelter into the Swiss franc seen as a refuge currency the Swiss National Bank would abandon its unofficial peg to the euro at CHF 1.20 = €1 with an immediate appreciation of the Swiss franc of 12 t0 15 per- cent against the euro. Current three- and six-month forwards are quoted at CHF 1.1900 and CHF 1.1750 = €1. How should she speculate? A: The currency trader would sell six-month euro forward at CHF 1.1750 hop- ing thet the euro would indeed devalue by 12 to 15 percent to CHF 1.0714 or 1.0435. At maturity of the contract, our trader would purchase euros at theit depreciated value of CHF 1.0435 and immediately deliver each euro, receiving the forward rate of CHF 1.1750 for a profit of CHF 1.1750 - CHF 1.0435 = CHF 0.1315 per euro sold forward. afarkol jg xchange Mar ; - ‘Ne TERNATIONAL CORPORATE FINANCE IN PRAGTI citivank’s Forex Losses?! on Junc 19, 1965, in the heyday of the Bretton. Woods ystems of fixed exchange eats, the First National City Bank ~the second last Americans eennnerci bank, with 177 offices in 58 countries = announced a loss of $4 million”? The loss was attributed to unauthorized forward speciation on the pound sterling by a Belgian trader in the bank’s Brussels branch, who was betting, that the pound sterling pegged then at $2.80 would not devalue {he amount of the underlying transactions was rumored to be close to $800 million, How coulda single employce fool one of the largest aid mont sophisticated commercial banks? How could such a Jarge speculative bet go undetected by the firm’s back office and lose so much money for the bank when, for all prac: tical purposes, currency prices were quasi-fixed? Indeed! banks, for the tnt part, earn a living by buying and selling foreign currencies at slightly different fates — also known as the bidlask spread ~ mostly on a spot basis and to a lesser extent on a forward basis for corporate customers (and more re ly on options, swaps, and other derivative products; his i indeed a relatively wtf way to make a living because it does not entail outright speculative positions Ot currencies, This is known as agency fradivg, whereby the bank wets ws a forex broker on behalf of its client and unlikespeculative proprietary trading. av prive ticed by hedge funds. In fact, most banks have set in place control systen sinied at keeping traders honest by implementing the squu position requirement; this is nothing more than requiring that each trader keep his trades in balance a i | Ghacfor each currency the amount sold forward would equal the amount pur: Chased forward. For example, our Belgian trader could sell one month short $10 million at $2.77 = £1 and buy 6 mom long, £10 million at § i, Should sterling devaluc to $2.40 after 15 days the trader would generate a ya anche forward sale contract maturing. on day 30 in the amount of £10,000,000 2.97 - 2.40) = $370,000 but incur loss on the s-amonth forward purchave | CGntract to the tune of £10,000,000 (2:40 - 2.75) = $350,000, ‘Gur Belgian trader made a simple bet that the pound sterling, would survive « pressure and would not devalue in the following, 2~18 months, TTaentng this bet into a profitable trade involved buying, pound sterling, forward (going long pound sterling) at rates. a5 low a $2.69 = Ll for maturii 's rangitiy, oreo 18 months. The reader may wonder how the forward rate could (Continued) the speculati HAdapred from L. Jacque, “Global Derivative Debacles: From The oe Sbeapore and London: WorldScienif, 2015), pp. 29-40, Theory to Malpnactlea” 2nd 22Approximately $120 million in 2018 dollars, : Scanned with CamScannerfall below the floor spor rate and trade at a discount when the spot exchange rate was limited to fluctuating within a tunnel closely monitored by the Bank of England. It has to do with the interest rate differential between dollar and sterling and the theory of interest rate parity (discussed itt Chapter 6! as che Bank of England defended the $2.80 = £1 parity, itinereased interest tates front 4.50% to 7.50% to encourage short-term capital inflow, which ie tues pushes up the spot dollar price of sterling while drivi Here is the loophole exploited by our Belgian trader, which allowed hin to conceal his speculative bet that the pound sterling would nor devalie. Recall that our trader had purchased 360 days forward pound sterbngs ar $2.69, thereby creating, a pound sterling lonpfasset position, which had te be neutralized by a short/iability position of matching amount (bur ef iis matching, maturity). Otherwise his large pound sterling asset position would have undoubtedly attracted the Citibank comptrotler’s attention. ty balanee his long and long-dated pound sterling position, iy order ty satisty the squate position requirement our trader had ta sell pound sterling (short) ty create an offsetting liability position, OF course, the amoritts lat to be mnateliinns but forward contract maturities would be mismatched as our (rater sold sterling 30 and 60 days forward (while buying 270 and Jo days torwand) thereby reporting a square position at all times, Howeven as long as the pound did not devalue, he would stand to benetit handsomely trot his logy, asset position as long as the losses incurred on the short positions were kopt sinatl More formally, our Belgian trader was hoping, “Losses on sterling short sales < Gains on sterling long, purchases.” nota chance to bring ty clostine his vteative spectilanee scheme. Indeed, the pound sterling did not devalite ait at least his sorts aii, position would have paid off in due tine bur he was wever allowed tas Gael aad Sometime in the spring of 1965, Walter Wristony they heart of Ciilsanbes (ae cign operations, was alerted by a friend of his, Baul Joanity, whos ayentioued that his firm, Montague, had a $100 million comieace wom die the tat lowing, week with Ci k's Belgian branch. SP alinust dhagyedt nny wath Wriston said, “because that was ten tintes the contact t biaiel Ghat ste cate possibly have.”*? Shortly thereafter, the contpivatler’s depariniet expoed the Belgian trader and anwotrtdl the ontstarieliiiyy pusiianes tl Uh Cable Cit spot and forward rates, a8 is often the case with forced Liquitlationt ot lane scale speculative position, restilting id loss OE MN WilMini Wihoed, Avetig chose to 10% of Citibank’s entire amid! Warkhvhke cotisutintiteal vatits ba aie at a rogue trader’s ineptitude ii the Boliglat Liiicl Was a Whigs esporneice, especially at atime whe the havik was reituly tiny (sell Ves Gastye S350) qundliaaty ast subordinated convertible debt. down its forward tate, Our trader never Scanned with CamScanner’ potoon extange Mate ysontrfnak quotalins As pe m vo nees | ou spe and fora interban n pes eran ene: il price at whl dealer Hehe or she i wii sa ecto crrency anda eletasked pe f (vl), with ye oetweets both rates eansticuting thee pret guppose the pound sterling i quoted at $1.5250-1,5260. This means arta to buydbid pons at $1,5250 aud t9 Pak an $ 1.5260. 1 PP will not quote the fall rate chy other but inste dl quote the x rwo digit dof each currency in this ease, 50-60, Assuming th the leis i ariel accent, wih ithe primary medi ( Fiat and offer spat rate for pounel serine wont 2 ee es onward eae isqored 38 S36 ay 182-187 discount. 5 4h quotes sh jon, in this case: 1 hank atic’ price played rates, the Similarly, suppose month forward 6 from the spot bid/otfer outriy ‘Spot exchange One-month month fore Snarighe quotations , Point quotations: so-a i 56 ] he spec wenn bid offer the market (07 uh and clepel of In the ease of Ja hig a widely traded er spread will the forward eurte! fas well as 08 will range x cure ncy's volatility 2 vo 0.5 perc cent, and trade J market. Ie trades en both Western largest finan ac its highest whe train ym sessine response (0 ymorphosing th ange clock. 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