1、CHAPTER 7Foreign Exchange Market: Operation and Mechanics PART I. INTRODUCTIONI.INTRODUCTIONA.The Currency Market:where money denominated in one currency is bought and sold with money denominated in another currency. INTRODUCTIONB. International Trade and Capital Transactions:facilitated with the ab

2、ilityto transfer purchasing powerbetween countriesINTRODUCTIONC.Location1.OTC-type: no specific location2.Most trades by phone, telex, or SWIFTSWIFT: Society for Worldwide Interbank Financial Telecommunications PART II.ORGANIZATION OF THE FOREIGN EXCHANGE MARKETI.PARTICIPANTS IN THE FOREIGN EXCHANGE

3、 MARKET A.Participants at 2 Levels1.Wholesale Level (95%)- major banks2.Retail Level- business customers ORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.Two Types of Currency Markets1.Spot Market:- immediate transaction- recorded by 2nd business day ORGANIZATION OF THE FOREIGN EXCHANGE MARKET2.Forward

4、Market:- transactions take place at a specified future dateORGANIZATION OF THE FOREIGN EXCHANGE MARKETC.Participants by Market1. Spot Mmercial banksb.brokersc.customers of commercial and central banksORGANIZATION OF THE FOREIGN EXCHANGE MARKET2.Forward Marketa.arbitrageursb.tradersc.hedgersd.specula

5、torsORGANIZATION OF THE FOREIGN EXCHANGE MARKETII.CLEARING SYSTEMSA. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.ORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.FedWire- operated by the Fed- used for domestic transfersORGANIZATION OF THE FOREIGN EXCHANG

6、E MARKETIII.ELECTRONIC TRADINGA.Automated Trading- genuine screen-based marketORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.Results:1.Reduces cost of trading2.Threatens traders oligopoly of information 3.Provides liquidityORGANIZATION OF THE FOREIGN EXCHANGE MARKETIV.SIZE OF THE MARKETA.Largest in th

7、e world2004: US$1.9 trillion dailyorUS$475 trillion a yearIn 1999 the US GDP was US$9.1 trillionORGANIZATION OF THE FOREIGN EXCHANGE MARKETB.Market Centers (2004): #1: London =$753 billion daily #2: New York= $461 billion daily#3: Tokyo = $199 billion dailyPART III.THE SPOT MARKETI.SPOT QUOTATIONSA.

8、Sources 1.All major newspapers2.Major currencies have four different quotes:a.spot priceb.30-dayc.90-dayd.180-dayTHE SPOT MARKETB.Method of Quotation1.For interbank dollar trades:a.American termsb.European termsexample: Peso1.713/$THE SPOT MARKET2.For nonbank customers:Direct quote gives the home cu

9、rrency price (always in the numerator) of one unit of foreign currency.Since this is a direct quote, we know that in the U.S., one pound transacted at $1.81.THE SPOT MARKETC.Transactions Costs1. Bid-Ask Spreadused to calculate the feecharged by the bankBid = the price at which the bank is willing to

10、 buy Ask = the price it will sellthe currencyTHE SPOT MARKET4.Percent Spread Formula (PS):THE SPOT MARKETD.Cross Rates1.The exchange rate between 2 non - US$ currencies.THE SPOT MARKET2.Calculating Cross RatesSuppose you want to calculate the / cross rate.You know .5556/US$ and .8334/US$then / = .55

11、56/US$ .8334/US$= .6667/ THE SPOT MARKETE.Currency Arbitrage1.If cross rates differ from one financial center to another, and profit opportunities exist.2.Buy cheap in one intl market,sell at a higher price in another3.The Critical Role of Available InformationTHE SPOT MARKETF.Settlement Date Value

12、Date:1.Date monies are due2.2nd Working day after date of original transaction.THE SPOT MARKETG.Exchange Risk1.Bankers = middlemena.Incurring risk of adverseexchange rate moves.b.Increased uncertainty about future exchange rate requires1.) Demand for higher riskpremium2.)Bankers widen bid-ask spread

13、MECHANICS OF SPOT TRANSACTIONSSPOT TRANSACTIONS: ExampleStep 1.Currency transaction: verbal agreement, U.S. importer specifies:a. Account to debit (his acct)b. Account to credit (exporter)MECHANICS OF SPOT TRANSACTIONSStep 2.Bank sends importercontract note including:- amount of foreigncurrency- agr

14、eed exchange rate- confirmation of Step 1.MECHANICS OF SPOT TRANSACTIONSStep 3.SettlementCorrespondent bank in HongKong transfers HK$ fromnostro account to exporters.Value Date. U.S. bank debits importersaccount.PART IV.THE FORWARD MARKETI.INTRODUCTIONA. Definition of a Forward Contract:an agreement

15、 between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.THE FORWARD MARKET2. Purpose of a Forward:Hedgingthe act of reducing exchangerate risk.THE FORWARD MARKETB.Forward Rate Quotations1. Two Methods:a.Outright Rate: quoted to commercial customers.b.Swap Rate: quoted in theinterbank market as a discount or premium.THE FORWAR