Main contents

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Definition of Foreign Exchange Market

Characteristics of FX Market

Chapter 5 Foreign Market Participants

Exchange
FOREIGN EXCHANGE Market
Types of FX Market
MARKET
Types of Transaction

Forex Derivatives
School of Banking and Finance
Nguyen Thi Dieu Chi (Assoc. Prof.) 2

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Definition of Foreign Exchange Definition of Foreign Exchange Market

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Foreign exchange: Foreign exchange is the exchange of one

currency for another or the conversion of one currency into another
currency.
According to Vietnamese Law, there are 5 kinds of foreign
exchange:
The foreign exchange market is a global online network where
 Foreign Currency;
traders buy and sell currencies.
 Valuable papers in foreign currency;
 Standard metals, diamond, gold, silver, copper...; It has no physical location and operates 24 hours a day, seven
 Vietnamdong origins from foreigners; days a week. It sets the exchange rates for currencies with floating
rates.

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Characteristics of FX Market Functions of FX Market

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

The largest financial market with

average daily turnover of over US $ 2
trillion which keeps increasing;
Non-sleep market; Credit
70% of foreign exchange transactions Function
involve in cross border counterparties;
Only under 10% of daily spot
transaction involve in non-financial FX Market
customers. Therefore, it is called Functions
INTERBANK MARKET,
London is the largest FX market;
US dollar involves in about 44% of all
transactions;
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 Functions of FX Market Functions of FX Market
Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Transfer Function: The basic and the most visible function of foreign
exchange market is the transfer of funds (foreign currency) from one
country to another for the settlement of payments. It basically includes
the conversion of one currency to another, wherein the role of FOREX is
to transfer the purchasing power from one country to another.
Credit Function: FOREX provides a short-term credit to the
importers so as to facilitate the smooth flow of goods and services from
country to country. An importer can use credit to finance the foreign
purchases. Such as an Indian company wants to purchase the machinery
from the USA, can pay for the purchase by issuing a bill of exchange in the
foreign exchange market, essentially with a three-month maturity.
Hedging Function: The third function of a foreign exchange market is
to hedge foreign exchange risks. The parties to the foreign exchange are
often afraid of the fluctuations in the exchange rates, i.e., the price of one
currency in terms of another.
The change in the exchange rate may result in a gain or loss to the
party concerned. Thus, due to this reason the FOREX provides the services
for hedging the anticipated or actual claims/liabilities in exchange for
the forward contracts.
A forward contract is usually a three month contract to buy or sell
the foreign exchange for another currency at a fixed date in the future at a
price agreed upon today. Thus, no money is exchanged at the time of the
contract.

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Main roles of the FX market Market Participants

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Medium of exchange – facilitate trade in

Dealer
good and services
Broker
Medium of exchange – facilitate
Individuals and Firms
purchase/sale of securities
Medium to re-denominate and manage Speculator and Arbitragers

currency risk in stock asset or liability Central banks and Treasuries

positions

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Types of FX Market Types of Transaction

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Spot Market: A spot market is the

immediate delivery market, representing Forward
that segment of the foreign exchange Transaction
market wherein the transactions (sale and
purchase) of currency are settled within
Spot Market
two days of the deal.
Spot Future
Types of FX That is, when the seller and buyer close Transaction
Transaction
Market their deal for currency within two days of
the deal, is called as Spot Transaction. Transactions

Forward Forward Market: The forward exchange

market refers to the transactions – sale and
Market purchase of foreign exchange at some specified
date in the future, usually after 90 days of the
Option Swap
deal. That is, when the buyer and seller enter into
Transaction Transaction
a contract for the sale and purchase of foreign
currency after 90 days of the deal at a fixed
exchange rate agreed upon now, is called
a Forward Transaction.

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 Types of Transaction Types of Transaction
Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Spot Transaction: The spot transaction is when the buyer and
seller of different currencies settle their payments within the two days
of the deal.
It is the fastest way to exchange the currencies. Here, the
currencies are exchanged over a two-day period, which means no
contract is signed between the countries.
The exchange rate at which the currencies are exchanged is
called the Spot Exchange Rate. This rate is often the prevailing
exchange rate. The market in which the spot sale and purchase of
currencies is facilitated is called as a Spot Market.
Forward Transaction: A forward transaction is a future
transaction where the buyer and seller enter into an agreement of sale
and purchase of currency after 90 days of the deal at a fixed
exchange rate on a definite date in the future.
The rate at which the currency is exchanged is called
a Forward Exchange Rate. The market in which the deals for the
sale and purchase of currency at some future date is made is called
a Forward Market.

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Types of Transaction Types of Transaction

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Future Transaction: The future transactions are also the forward

Swap Transactions: The Swap Transactions involve
transactions and deals with the contracts in the same manner as that of
normal forward transactions. But however, the transactions made in a future a simultaneous borrowing and lending of two different currencies
contract differs from the transaction made in the forward contract on the
following grounds: between two investors. Here one investor borrows the currency and
The forward contracts can be customized on the client’s request, while lends another currency to the second investor. The obligation to repay
the future contracts are standardized such as the features, date, and the size
of the contracts is standardized. the currencies is used as collateral, and the amount is repaid at
The future contracts can only be traded on the organized
exchanges, while the forward contracts can be traded anywhere depending a forward rate.
on the client’s convenience. The swap contracts allow the investors to utilize the funds in the
No margin is required in case of the forward contracts, while
the margins are required of all the participants and an initial margin is currency held by him/her to pay off the obligations denominated in a
kept as collateral so as to establish the future position.
different currency without suffering a foreign exchange risk.

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Types of Transaction Forex Derivatives

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Option Transactions: The foreign exchange option gives an

Currency
investor the right, but not the obligation to exchange the currency in
Futures
one denomination to another at an agreed exchange rate on a pre-
defined date. An option to buy the currency is called as a Call
Currency
Option, while the option to sell the currency is called as a Put Currency Swaps
Forwards Derivatives
Option.
Thus, the Foreign exchange transaction involves the conversion
of a currency of one country into the currency of another country for
the settlement of payments. Currency
Options

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 Forex Derivatives Forex Derivatives
Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

A derivative is a financial agreement that has its value
determined from the price of a certain asset, commodity, rate, index or
the happening or significance of an event.
The meaning of the word derivative itself comes from the way in
which the value of these agreements are derived from the price of the
item of significance.
There are many known examples of derivatives such as futures,
swaps, forwards, and options, all of which can be joined with
traditional securities and loans thus creating structured securities, also
commonly referred to as hybrid instruments.
Forward deals are provide insurance against the possibility that
exchange rates will fluctuate and ultimately differ from what they are
between the present and the delivery date of the contract.
A forward is also a simple common derivative because simply
stated, it is a financial agreement with its price rooted in another asset.
The delivery price is the price in a forward contract. This gives
the investor the permission to fix the current exchange rate thus
avoiding changes in the forex exchange rates.

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Forex Derivatives Forex Derivatives

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Futures contracts are similar in many ways to forwards, with the
exception that they are very standardized.
The future contracts which are commonly traded on the majority
of organized exchanges are so highly standardized that they are given
the label of fungible - which means that they can be easily
substitutable for one for another.
Fungibility is advantageous in that it promotes trading and yields
a larger trading volume in addition to greater market liquidity.
Options are nice in that they allow investors increased flexibility.
While options certainly cost more than futures contracts, an options'
value lies in the fact that they allow investors whether to exercise a
future contract or not.
Call options permit the investor the right, without any obligation,
to buy whatever asset at the exact price (strike price) on a specific
date. Again the option holder inherets no obligation to buy or sell the
asset at stake.

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Currency Arbitrage Three Currency Arbitrage (Triangular Arbitrage)

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

A currency arbitrage is a forex strategy in which a currency trader Bank Quotations Bid Ask
takes advantage of different spreads offered by brokers for a particular
currency pair by making trades. Different spreads for a currency pair imply Deutsche Bank $:£ $1.5400 $1.5405
disparities between the bid and ask prices. Currency arbitrage involves
buying and selling currency pairs from different brokers to take advantage
Credit Lyonnais $:€ $1.3087 $1.3092
of the miss priced rates. Credit Agricole €/£ €1.1764 €1.1770
Currency arbitrage involves the exploitation of the differences in
quotes rather than movements in the exchange rates of the currencies in the “No Arbitrage” €/£ €1.1763 €1.1771
currency pair. Forex traders typically practice two-currency arbitrage, in Suppose we observe these banks posting these exchange rates.
which the differences between the spreads of two currencies are exploited. As we have calculated the “no arbitrage” €/£ cross bid and ask rates,
Traders can also practice three-currency arbitrage, also known as
we can see that there is an arbitrage opportunity: Credit Agricole’s
triangular arbitrage, which is a more complex strategy. Due to the use of
computers and high-speed trading systems, large traders often catch
bid is too high and their ask is too low.
differences in currency pair quotes and close the gap quickly. $1.5400 €1.00
£1 × £1.00 × $1.3092 = €1.1763

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 Triangular Arbitrage Triangular Arbitrage
Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Bank Quotations Bid Ask Bank Quotations Bid Ask

Deutsche Bank $:£ $1.5400 $1.5405 Deutsche Bank £:$ $1.5400 $1.5405
Credit Lyonnais $:€ $1.3087 $1.3092 Credit Lyonnais €:$ $1.3087 $1.3092
Credit Agricole €/£ €1.1758 €1.1760 Credit Agricole £:€ €1.1758 €1.1760
“No Arbitrage” €/£ €1.1763 €1.1771 Start with £1m. Sell £ to Deutsche Bank for $1,540,000:
$1.5400
By going through Deutsche Bank and Credit Lyonnais, we can sell £1,000,000 ×
£1.00
= $1,540,000.
pounds for €1.1763.
$1.5400 €1.00 Buy € from Credit Lyonnais, receive €1,337,132:
£1 × £1.00 × $1.3092 = €1.1763 €1.00
$1,540,000 × = €1,176,291.
$1.3092
The arbitrage is to buy the pounds from Credit Agricole for €1.1760. Buy £ from Credit Agricole, receive £1,000,247.

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The Forward Market The Forward Market

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

A forward contract is an agreement to buy or sell an asset in the
future at prices agreed upon today.
The forward market for FX involves agreements to buy and sell
foreign currencies in the future at prices agreed upon today.
Bank quotes for 1, 3, 6,9 and 12 month maturities are readily
available for forward contracts.
Ex. Spot rate of British pounds: €1.3540 = £1.00
While the 90-day forward rate is: €1.2340 = £1.00
What’s up with that? It tells you that there is an expectation that
the value of £ (in term of €) in the future will be LOWER than its
value (in term of €) right now.
Forward Premium/Discount: The amount over/under the spot
exchange rate for a forward rate that is expressed as an annualized
percent deviation from the spot rate.

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The Forward Market Long Positions

Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Ex. Suppose the € í expected to appreciate from S($/€) = 1.25 to F180 Long – Buy foreign currency/assets
in foreign currency
($/€) = 1.3. The 180 – day forward premium for € is given by: If you make a long position on an
f180,€ = [(F180 ($/€) - S($/€) )/ S($/€) ] * 360/180 IBM stock at $105/IBM, it means
that you say $105/share. If later on
= [(1.3 – 1.25)/1.25] * 2 = 0.08 the price turns out to be $120 then
The above is the case of forward premium because the F is greater you make a positive payoff $15.
Or, If later on the price turns out to
than the S. So the outcome is positive. be $100 then you make a negative
IF the F is less than the S, then the outcome will be negative and it is payoff $15

what we call “forward discount”.

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 Short Positions Long - Short Forward Positions
Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Short – Sell foreign currency/assets

in foreign currency
If you make a short position on an
IBM stock at $105/IBM, it means
that you say $105/share. If later on
the price turns out to be $100 then
you make a positive payoff $5. Or,
If later on the price turns out to be
$110 then you make a negative
payoff $15

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Nguyen Thi Dieu Chi. Assoc. Prof. – Course of International Finance

Q&A

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