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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,CHAPTER 7,Foreign Exchange Market:Operation and Mechanics,PART I.INTRODUCTION,I.,INTRODUCTION,A.The Currency Market:,where money denominated in one currency is bought and sold with money denominated in another currency.,INTRODUCTION,B.International Trade and Capital Transactions:,facilitated with the ability,to transfer purchasing power,between countries,INTRODUCTION,C.Location,1.OTC-type:no specific location,2.Most trades by phone,telex,or SWIFT,SWIFT:,Society for Worldwide,Interbank,Financial Telecommunications,PART II.ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,I.PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET,A.Participants at 2 Levels,1.Wholesale Level(95%),-major banks,2.Retail Level,-business customers,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,B.Two Types of Currency Markets,1.Spot Market:,-immediate transaction,-recorded by 2nd business day,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,2.Forward Market:,-transactions take place at a specified future date,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,C.Participants by Market,1.Spot Market,mercial banks,b.brokers,c.customers of commercial and central banks,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,2.Forward Market,a.arbitrageurs,b.traders,c.hedgers,d.speculators,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,II.CLEARING SYSTEMS,A.Clearing House,Interbank,Payments System(CHIPS),-used in U.S.for electronic,fund transfers.,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,B.,FedWire,-operated by the Fed,-used for domestic transfers,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,III.ELECTRONIC TRADING,A.Automated Trading,-genuine screen-based market,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,B.Results:,1.Reduces cost of trading,2.Threatens traders oligopoly of information,3.Provides liquidity,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,IV.SIZE OF THE MARKET,A.Largest in the world,2004:US$1.9 trillion daily,or,US$475 trillion a year,In 1999 the US GDP was US$9.1 trillion,ORGANIZATION OF THE FOREIGN EXCHANGE MARKET,B.Market Centers(2004):,#1:London=$753 billion daily,#2:New York=$461 billion daily,#3:Tokyo=$199 billion daily,PART III.THE SPOT MARKET,I.SPOT QUOTATIONS,A.Sources,1.All major newspapers,2.Major currencies have four different quotes:,a.spot price,b.30-day,c.90-day,d.180-day,THE SPOT MARKET,B.Method of Quotation,1.For,interbank,dollar trades:,a.American terms,example:$1.21/,b.European terms,example:Peso1.713/$,THE SPOT MARKET,2.For,nonbank,customers:,Direct quote,gives the home currency price(always in the numerator)of one unit of foreign currency.,EXAMPLE:$1.81/,Since this is a direct quote,we know that in the U.S.,one pound transacted at$1.81.,THE SPOT MARKET,C.Transactions Costs,1.Bid-Ask Spread,used to calculate the fee,charged by the bank,Bid=the price at which the bank is willing to buy,Ask=the price it will sellthe currency,THE SPOT MARKET,4.Percent Spread Formula(PS):,THE SPOT MARKET,D.Cross Rates,1.The exchange rate between 2 non-US$currencies.,THE SPOT MARKET,2.Calculating Cross Rates,Suppose you want to calculate the,/,cross rate.,You know,.5556,/US$and,.8334/US$,then,/,=,.5556,/US$,.8334/US$,=,.6667/,THE SPOT MARKET,E.Currency Arbitrage,1.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 another,3.The Critical Role of Available Information,THE SPOT MARKET,F.Settlement Date Value Date:,1.Date monies are due,2.2nd Working day after date of original transaction.,THE SPOT MARKET,G.Exchange Risk,1.Bankers=middlemen,a.Incurring risk of adverse,exchange rate moves.,b.Increased uncertainty about future exchange rate requires,1.)Demand for higher risk,premium,2.)Bankers widen bid-ask spread,MECHANICS OF SPOT TRANSACTIONS,SPOT TRANSACTIONS:Example,Step 1.Currency transaction:verbal agreement,U.S.importer specifies:,a.Account to debit(his acct),b.Account to credit(exporter),MECHANICS OF SPOT TRANSACTIONS,Step 2.Bank sends importer,contract note including:,-amount of foreign,currency,-agreed exchange rate,-confirmation of Step 1.,MECHANICS OF SPOT TRANSACTIONS,Step 3.Settlement,Correspondent bank in Hong,Kong transfers HK$from,nostro,account to exporters.,Value Date.,U.S.bank debits importers,account.,PART IV.THE FORWARD MARKET,I.INTRODUCTION,A.Definition of a Forward Contract:,an agreement 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 MARKET,2.Purpose of a Forward:,Hedging,the act of reducing exchange,rate risk.,THE FORWARD MARKET,B.Forward Rate Quotations,1.Two Methods:,a.Outright Rate:quoted to commercial customers.,b.Swap Rate:quoted in the,interbank,market as a discount or premium.,THE FORWARD MARKET,CALCULATING THE FORWARDPREMIUM OR DISCOUNT,=,F-S,x,12,x 100,S n,where F=the forward rate of exchange,S=the spot rate of exchange,n
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