Professional Documents
Culture Documents
Kc-Fin 315 - Chapter 4
Kc-Fin 315 - Chapter 4
5-1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
Function and Structure of the FX Market
FX
The Market
Spot Participants
Market
Correspondent
Spot
The Forward Banking Relationships
Rate Quotations
Market
The Spot
The Market
Bid-Ask Spread
Forward Rate Quotations
Spot
The
Long FX
andTrading
Forward Market
Short Forward Positions
Cross Exchange
Forward Rate Quotations
Cross-Exchange Rates
Triangular Arbitrage
Swap Transactions
Spot Foreign
Forward Exchange Market Microstructure
Premium
The Forward Market
5-2 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1
The Function and Structure of the FX
Market
FX Market Participants
Correspondent Banking Relationships
5-3 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
FX Market Participants
5-4 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-5 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
2
Correspondent Banking Relationships
Large commercial banks maintain demand deposit
accounts with one another which facilitates the
efficient functioning of the FX market.
5-6 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-8 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
3
Correspondent Banking Relationships
International commercial banks communicate with
one another with:
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.
5-9 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-10 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-11 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
4
Spot Rate Quotations
5-12 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-13 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
The indirect
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 quote for
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 British
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
pound is:
1 Month Forward 1.9044 1.9101 0.5251 0.5235
3 Months Forward 1.8983 1.9038 0.5268 0.5253
£.5242 = $1
6 Months Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
5-14 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5
Spot Rate Quotations
Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
Note that
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 the direct
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 quote is the
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
reciprocal of
1 Month Forward 1.9044 1.9101 0.5251 0.5235 the indirect
3 Months Forward 1.8983 1.9038 0.5268 0.5253 quote:
6 Months Forward 1.8904 1.8959 0.5290 0.5275
1
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395 1.9077 =
1 Month Forward 0.8037 0.8069 1.2442 1.2393 .5242
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
5-15 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-16 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-17 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
6
The Bid-Ask Spread
Spot FX trading
In the interbank market, the standard size trade is
about U.S. $10 million.
A bank trading room is a noisy, active place.
The stakes are high.
The “long term” is about 10 minutes.
5-19 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Cross Rates
Suppose that S($/€) = 1.50
i.e. $1.50 = €1.00
and that S(¥/€) = 50
i.e. €1.00 = ¥50
What must the $/¥ cross rate be?
$1.50 €1.00 $1.50
× =
€1.00 ¥50 ¥50
$1.00 = ¥33.33
$0.0300 = ¥1
5-20 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
7
Triangular Arbitrage
Suppose we
$
observe these
Barclays
banks posting Credit Lyonnais
these exchange S(¥/$)=120
S(£/$)=1.50
rates.
¥ Credit Agricole
First calculate any £
implied cross rate S(¥/£)=85
to see if an
arbitrage exists. £1.50 $1.00 £1.00
× =
$1.00 ¥120 ¥80
5-21 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Triangular Arbitrage
So, how can we make money? Buy the £ @ ¥80; sell @ ¥85.
Then trade yen for your preferred currency.
5-22 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Triangular Arbitrage
As easy as 1 – 2 – 3:
$
1. Sell our $ for £, Barclays
Credit Lyonnais
2. Sell our £ for ¥, S(¥/$)=120
3 1 S(£/$)=1.50
3. Sell those ¥ for $. 2
¥ Credit Agricole
£
S(¥/£)=85
5-23 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
8
Triangular Arbitrage
Sell $100,000 for £ at S(£/$) = 1.50
receive £150,000
Sell our £150,000 for ¥ at S(¥/£) = 85
receive ¥12,750,000
Sell ¥12,750,000 for $ at S(¥/$) = 120
receive $106,250
profit per round trip = $106,250 – $100,000 = $6,250
5-24 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Triangular Arbitrage
Here we have to go
“clockwise” to make $
money—but it doesn’t Barclays
Credit Lyonnais
matter where we start. S(¥/$)=120
2 3 S(£/$)=1.50
1
¥ Credit Agricole
£
S(¥/£)=85
If we went “counter clockwise” we would be the source
of arbitrage profits, not the recipient!
5-25 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-26 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9
The Forward Market
Forward Rate Quotations
Long and Short Forward Positions
Forward Cross Exchange Rates
Swap Transactions
Forward Premium
5-27 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-28 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-29 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
10
Forward Rate Quotations
Consider the example from above:
for British pounds, the spot rate is
$1.9077 = £1.00
While the 180-day forward rate is
$1.8904 = £1.00
What’s up with that?
5-30 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Country
USD equiv
Friday
USD equiv
Thursday
Currency per
USD Friday
Currency per
USD Thursday
Clearly the
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 market
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 participants
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
expect that
1 Month Forward 1.9044 1.9101 0.5251 0.5235 the pound
3 Months Forward 1.8983 1.9038 0.5268 0.5253 will be
6 Months Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
worth less in
1 Month Forward 0.8037 0.8069 1.2442 1.2393 dollars in
3 Months Forward 0.8043 0.8074 1.2433 1.2385 six months.
6 Months Forward 0.8057 0.8088 1.2412 1.2364
5-31 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
$HPR = –0.0091
Annualized dollar HPR = –1.81% = –0.91% × 2
5-32 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
11
Forward Premium
The interest rate differential implied by forward
premium or discount.
For example, suppose the € is appreciating from
S($/€) = 1.25 to F180($/€) = 1.30
The 180-day forward premium is given by:
F180($/€) – S($/€) 360 1.30 – 1.25
f180,€v$ = × = × 2 = 0.08
S($/€) 180 1.25
5-33 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-34 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Payoff Profiles
profit
If you agree to sell anything in the
future at a set price and the spot
price later falls then you gain.
0 S180($/¥)
F180($/¥) = .009524
If you agree to sell anything in the
future at a set price and the spot
loss price later rises then you lose. Short position
5-35 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
12
Payoff Profiles
profit
short position
Whether the
payoff profile
slopes up or
down depends
0 S180(¥/$) upon whether
F180(¥/$) = 105 you use the direct
or indirect quote:
F180(¥/$) = 105 or
-F180(¥/$)
loss F180($/¥) = .009524.
5-36 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Payoff Profiles
profit
short position
0 S180(¥/$)
F180(¥/$) = 105
When the short entered into this forward contract,
he agreed to sell ¥ in 180 days at F180(¥/$) = 105
-F180(¥/$)
loss
5-37 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Payoff Profiles
profit
short position
15¥
0 S180(¥/$)
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will make
a profit by buying ¥ at S180(¥/$) = 120 and
-F180(¥/$)
loss delivering ¥ at F180(¥/$) = 105.
5-38 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
13
Payoff Profiles
profit
F180(¥/$) Since this is a zero-sum game, the short position
long position payoff is the
opposite of the short.
0 S180(¥/$)
F180(¥/$) = 105
Payoff Profiles
profit
The long in this forward contract agreed to BUY ¥
-F180(¥/$)
in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at S180(¥/$) = 120 and
delivering ¥ at F180(¥/$) = 105.
0 S180(¥/$)
120
F180(¥/$) = 105
–15¥
Long position
loss
5-40 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-41 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
14
Forward Cross Exchange Rates
5-42 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Currency Symbols
In addition to the familiar currency symbols (e.g.
£, ¥, €, $) there are three-letter codes for all
currencies.
It is a long list, but selected codes include:
CHF Swiss francs
GBP British pound
ZAR South African rand
CAD Canadian dollar
JPY Japanese yen
5-43 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
SWAPS
A swap is an agreement to provide a counterparty
with something he wants in exchange for
something that you want.
Often on a recurring basis—e.g. every six months for
five years.
Swap transactions account for approximately 56
percent of interbank FX trading, whereas outright
trades are 11 percent.
Swaps are covered fully in chapter 14.
5-44 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
15
Summary
Spot rate quotations
Direct and indirect quotes
Bid and ask prices
Cross Rates
Triangular arbitrage
Forward Rate Quotations
Forward premium (discount)
Forward points
5-45 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Practice Problem
The current spot exchange rate is $1.55/£ and the three-
month forward rate is $1.50/£. Based on your analysis of
the exchange rate, you are confident that the spot exchange
rate will be $1.52/£ in three months. Assume that you
would like to buy or sell £1,000,000.
a. What actions do you need to take to speculate in the
forward market? What is the expected dollar profit from
speculation?
b. What would be your speculative profit in dollar terms
if the spot exchange rate actually turns out to be $1.46/£?
c. Graph your results.
5-46 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Solution
5-47 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
16
Solution
profit
$20k
0 S180(£/$)
1.46 1.52
F180(£/$) = 1.50
–$40k
loss
5-48 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-49 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
5-50 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
17
Questions and Answers
2. A cross rate is an exchange rate between ___ and
___.
A. The US dollar and the Japanese yen
B. any two non-home currencies
C. the Mexican peso and the euro
D. the domestic currency and a foreign currency
5-51 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Youtube link
Foreign exchange market
https://www.youtube.com/watch?v=NhFlqFVBmx
c
5-52 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
18