1、Chapter 3Foreign Exchange Market and Foreign Exchange Rate.Foreign Exchange MarketForeign exchange is another countrys money. The dynamic meaning of the foreign exchange refers to the act of trading different countrys currencies.Convertibility means a currency can be freely exchanged for another cur

2、rency. This is the most important characteristic of the foreign exchange.Foreign exchange rate is the price of one currency in terms of another.Foreign exchange market is the place where currencies are bought and sold.The foreign exchange market is by far the largest financial market in the world.Fo

3、reign exchange market has two functions: the first is to convert one currency into another (the spot exchange market); the second is to provide insurance against foreign exchange risk (the forward exchange market).The foreign exchange market is an informal, over-the-counter and around-the-clock mark

4、et.It has no centralized meeting-place and no formal requirements for participation.The market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. During these three hours, trading continues in a number of minor centers, particularly San Francisco and Sydney. .Me

5、asuring foreign exchange market activity: Average electronic conversions per hour.As of 2021, more than $3 trillion are traded in this market on a daily basis. This was a massive increase of nearly 70% over the 2004 surveys estimate of $1.9 trillion.The U.S. dollar was involved in more than 90% of a

6、ll foreign exchange transactions, followed by the euro (38%), yen (23%), and British pound sterling (13%).London is the largest world foreign exchange market, followed by New York and Tokyo. London accounts for 34.1% of daily world exchange. New York is about 16%. .Global foreign exchange market tur

7、nover, 1998 -2021 (daily averages in April, billions of U.S. dollar).Top 10 geographic trading center in the foreign exchange market, 1992-2007 (daily averages in April, billions of $).Foreign exchange market structureCustomers buy $ with ￥ Customers buy ￥with $ Local banksLocal banksMajor banksInte

8、rbank marketsForeign exchangebrokersMNCs& Others.Participants in the foreign exchange marketRetail customers are made up of individuals, international investors, small businesses, speculators or the like who need foreign exchange.Commercial banks (market dealers) carry out buy/sell orders from their

9、 retail clients and buy/sell currencies on their own account. .Dealers often function as market makers who stands ready to buy and sell at quoted exchange rates, earning their profit by the difference of the bid and ask price.Small- to medium-size banks are not market makers in the interbank market.

10、 They buy from and sell to larger banks to offset retail transactions with their own customers.Foreign exchange brokers do not put their own money at risk. They serve three purposes in the market. First, they are the sources of information. Second, they bring buyers and sellers together and contribu

11、tes to market efficiency. Third, they make it possible for traders to remain anonymous.Businesses such as MNCs are the major non-bank participants in the market.Central banks buy and sell currencies in a bid to influence the exchange rate. .Spot Exchange Market and Exchange Rate QuotationsThe spot e

12、xchange market is a market that deals in foreign exchange for immediate delivery. Immediate delivery in foreign currencies usually means within two business days. A spot exchange rate is the current market price, the rate at which a foreign exchange dealer converts one currency into another currency

13、 on a particular day.Foreign exchange rate quotations on the U.S. Dollar/British Pound in the Financial Press.An exchange of currencies involves two currencies. Either of which may be placed in the denominator. The quotation of the exchange rates follows conventions.Direct quote is the amount of dom

14、estic currency per unit of foreign currency. In Japan ￥115 = 1 In Canada C$1.50 = 1Indirect quote is the amount of foreign currency per unit of domestic currency. In England $1.60 = 1.American quote is the dollar per currency quote, i.e. the price of other currencies in terms of the dollar. Example:

15、 US$ 1.57 = 1 US$ 1.35 = 1European quote is the currencies per dollar quote, i.e. the price of the dollar in terms of the other currencies. Example: A$ 1.02 = US$ 1 0.74 = US$ 1.Bid and ask quotes are the prices at which a bank likes to buy and sell standard amounts of foreign currency. Example: $1.

16、0206/SFr Bid $1.0217/SFr AskWhen bid is lower than ask, the bank is buying or selling the currency in the denominator of the quote.When bid is higher than ask, the bank is buying or selling the currency in the numerator of the quote. .Example: SFr0.9798/$ Bid SFr0.9787/$ Ask The bank spends one doll

17、ar to buy SFr0.9798; It sells SFr0.9787 for one dollar.Bid-ask spread is the difference between the bid and ask price. It is usually expressed by “point.Example: SFr1.0206/$ Bid SFr1.0217/$ Ask Here bid-ask spread is SFr 0.0011/$ or 11 basis points.one basis point = 1% of 1% = 0.0001When the spread

18、is expressed as a percent of the ask price, it is called bid ask margin.Bid ask margin = (ask bid)/ask x 100Example: SFr1.0206/$ Bid SFr1.0217/$ Ask Bid ask margin = (1.0217 1.0216) / 1.0217 x 100 = 0.1077%.A cross rate is the rate which is calculated from two other bilateral exchange rate. S(x/y) =

19、 S(x/z) / S(y/z)Example: Suppose ￥/$ 6.6766 and SFr/$ 0.9644, applying the above formula, ￥/SFr = 6.6766/0.9644 = 6.9230The following formula is available when both the bid and ask prices are calculated: Sa(x/y) = Sa(x/z) / Sb(y/z) Sb(x/y) = Sb(x/z) / Sa(y/z).Examples: If J￥/$ = 85.01 08 and SFr/$ =

20、 0.9855 65 J￥/SFr (bid) = 85.01/0.9865 = 86.17 J￥/SFr (ask) = 85.08/0.9855 = 86.33If $/ = 1.6000 10 and J￥/$ = 85.01 08 J￥/ (bid) = 1.6000 x 85.01 = .01 J￥/ (ask) = 1.6010 x 85.08 = .21.Foreign exchange cross rates at close of business, 4 January 2005.The Value of a CurrencyWhen a currency gains val

21、ue relative to another, the currency appreciates. Otherwise, it depreciates. In foreign exchange market, if the demand for dollar is more than the supply of the dollar, the dollar appreciates.Percentage change in foreign currency value: (Ending rate Beginning rate) (Beginning rate).Example: 6 months

22、 ago: CHF/USD 1.0235 right now: CHF/USD 0.9644 Percentage change in the value of the dollar: (0.9644 1.0235) / 1.0235 x 100 = -5.77% The dollar depreciated against the franc by 5.77%. Annual depreciation rate: 11.54%.Percentage changes in currency values are asymmetric. When the dollar is depreciate

23、d against franc by 11.54% p.a., it does not mean the franc is appreciated against the dollar by 11.54% p.a.To calculate the percentage change in Swiss franc, we can use the following formula: (Beginning rate Ending rate ) (Ending rate)Applying the formula, the change in Swiss franc is: (1.0235 0.964

24、4) / 0.9644 = 6.13% The Swiss franc appreciates against the dollar by 12.26% annually.Foreign Exchange ArbitrageArbitrage means a profitable position obtained with no net investment and no risk.Foreign exchange arbitrage refers to buying one currency in one place and selling it in another place at t

25、he same time.Spatial arbitrage refers to arbitrage activities conducted across two different geographical markets.Suppose $/Dkr = 0.1584 0.1594 in New York, and the exchange rate (Dkr/$) is 6.3520 6.3540 in London, what should the foreign exchange trader do to make profit?Assume the trader has $1 mi

26、llion line of credit and both markets are open without any restrictions against buying and selling currencies. The trader should buy Danish krone in London and sell the krone for dollar in New York.Buying Kroner in London: $1m x 6.3520 = Dkr6.3520m (in London)Selling Kroner in New York: Dkr6.3520m x

27、 0.1584 = $1.006157m (in New York)Profit: $1.006157m - $1m = $6,157Such arbitrage is practical only if the participants have instant access to quotes and executions. Bank traders can conduct such arbitrage without an initial sum of money, other than their banks credit standing.When the process is ta

28、king place in three places, it is called Triangular Arbitrage.The no-arbitrage condition for triangular arbitrage in the currency markets is: (three currencies d, e, f, are involved) Sd/e Se/fSf/d = 1If the product of the three exchange rates is not equal to one. An arbitrage opportunity exists. A r

29、ule for determining which currencies to buy and sell in triangular arbitrage.If Sd/e Se/fSf/d 1, sell the currencies in the denominators for the currencies in the numerators.Example. If in New York $/￥ = 0.00960984, in Tokyo ￥/SFr = 60.75, in Zurich SFr/$ = 1.7125, is there an arbitrage opportunity?

30、.The product of these exchange rates is Sd/eSe/fSf/d = S$/￥S￥/SFrSSFr/$ Since 0.00960984 x 60.75 x 1.7125 = 0.999754 1 then, Buy ￥ with $, (1m)/0.00960984 = ￥104.06 m Buy SFr with ￥, 104.06/60.75 = SFr 1.712922 m Buy $ with SFr, 1.712922/1.7125 = $ 1.000246 mProfit: 1.000246m 1m = $246.00 .The Forwa

31、rd Foreign Exchange MarketForward foreign exchange market is for forward foreign exchange transactions. It means the rates and the amounts of the deal are agreed on today but settlement occurs sometime in the future.Forward exchange rate is defined as the rate to be paid for delivery of specific cur

32、rency at some future date.Forward Premium and Discount Bid AskSpot: ￥120.25/ ￥120.45/Forward: (90 days) ￥118.84/ ￥118.97/ Bid AskSpot: ￥120.25/ ￥120.45/ Forward: (90 days) -141 -148 basis points.Forward premium: a currency is trading at a forward premium when the value of that currency in the forwar

33、d market is higher than in the spot market.Forward discount: a currency is trading at a forward discount when the value of that currency in the forward market is lower than in the spot market.Formula for forward premium/discount (n) (Ftd/f S0d/f) / (S0d/f) n: number of compounding periods per year.E

34、xampleIf S0$/SFr = 1.04 and F6$/SFr = 1.0000 Swiss franc is selling at a 6-month forward discount $0.0400/SFr, or 400 basis points. Annualized percentage deviation from the spot rate is: (n) (Ftd/f S0d/f) / (S0d/f) = (2) (1.0000 1.0400) / 1.0400 = -0.06923 = 6.923% discount rate annually .Foreign Ex

35、change RiskForeign exchange risk refers to fluctuations in the domestic value of assets, liabilities, income or expenditure due to unanticipated changes in exchange rates.Risk exists when the future is unknown; that is, whenever actual outcomes can deviate from expected outcomes.Foreign exchange exp

36、osure is what is at risk.Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation expo

37、sure is basically concerned with the present measurement of past events.Economic exposure is the extent to which a firms future international earning power is affected by changes in exchange rates. Economic exposure is concerned with long-run effect of changes in exchange rates on future prices, sal

38、es, and costs.Hedging is the act of offsetting exposure to risk.Long position in foreign currency means foreign currency or a claim in foreign currency is owned.Short position in foreign currency means a foreign currency liability is owed.A Chinese exporting company expects to receive the U.S. dolla

39、r in the near future. The company takes long position on the dollar. If a company will pay dollar, the company takes short position on the dollar.Hedging a long position refers to selling foreign exchange forward.Hedging a short position involves buying foreign exchange forward. companys income in R

40、MB Unhedged position 6.90m 6.85m Hedging with a 6.80m forward contract 6.80 6.85 6.90 ￥/$ spot rate. companys expenditure in RMB Unhedged position 6.90m 6.85m Hedging with a 6.80m forward contract 6.80 6.85 6.90 ￥/$ spot rate.Real exchange rate and effective exchange rateNominal exchange rate is the exchange rate that prevails at a given date.Real exchange rate is the nominal exchange rate adjusted for relative changes in domestic and foreign price levels. That is, adjusted for inflation differential. So the real exchange rate captures changes i