FIN+385+Topic+4+Foreign+Exchange+Market.ppt

THE FOREIGN EXCHANGE MARKET Topic 4FIN 385Chapter 6Agenda1.What is the foreign exchange market?2.Types of foreign exchange transactions.3.Methods used in foreign exchange rates and quotations.4.Sources of information about the foreign exchange market.1.What is the foreign exchange market?1.1 Key terms to learn foreign exchange,foreign exchange transaction,foreign exchange market.1.2 Geographical extent of the foreign exchange market.1.3 Functions of the foreign exchange market.1.4 Participants in the foreign exchange market.1.What is the foreign exchange market?6-41.1Key termsThe Foreign Exchange Market provides:the physical and institutional structure through which the money of one country is exchanged for that of another country;the determination of the rate of exchange between currencies,anda location where foreign exchange transactions are physically completed.1.What is the foreign exchange market?6-51.1Key termsForeign exchange means the money of a foreign country;that is,foreign currency bank balances,banknotes,checks and drafts.A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified date.1.What is the foreign exchange market?6-61.2GeographyThe foreign exchange market spans the globe,with prices moving and currencies trading somewhere every hour of every business day.As the next ppt will show,the volume of currency transactions varies across the globe as the major currency trading centers open and close throughout the day.Exhibit 6.1 Measuring Foreign Exchange Market Activity:Average Electronic Conversions Per Hour6-71.What is the foreign exchange market?6-81.3Functions of the FX MarketThe foreign exchange market is the mechanism by which participants:transfer purchasing power between countries;obtain or provide credit for international trade transactions,andminimize exposure to the risks of exchange rate changes.1.What is the foreign exchange market?6-91.4 Participants in the FX MarketThe foreign exchange market consists of two tiers:the interbank or wholesale market*(multiples of$1MM US or equivalent in transaction size),and the client or retail market(specific,smaller amounts).1.What is the foreign exchange market?1.4 Participants in the FX MarketFour categories of participants operate within these two tiers:(1)bank and nonbank foreign exchange dealers,(2)individuals and firms conducting commercial or investment transactions,(3)speculators and arbitragers*,and(4)central banks and treasuries.1.4 Market Participants:Bank and Nonbank Foreign Exchange Dealers6-11Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets.They profit from buying foreign exchange at a“bid”price and reselling it at a slightly higher“offer”or“ask”price.Known as the spread.1.4 Market Participants:Bank and Nonbank Foreign Exchange DealersDealers in the foreign exchange department of large international banks often function as“market makers.”These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an“inventory”position in those currencies.1.4 Market Participants:Individuals and Firms6-13Individuals(such as tourists)and firms(such as importers,exporters and MNEs)conduct commercial and investment transactions in the foreign exchange market.Their use of the foreign exchange market is incidental to their underlying commercial or investment purpose.Some of the participants use the market to“hedge”foreign exchange risk.1.4 Market Participants:Speculators and Arbitragers6-14Speculators and arbitragers seek to profit from trading in the market itself.They operate in their own interest,without a need or obligation to serve clients or ensure a continuous market.While dealers seek the bid/ask spread,speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets.1.4 Market Participants:Central Banks and Treasuries6-15Central banks and treasuries use the market to acquire or spend their countrys foreign exchange reserves as well as to influence the price at which their own currency is traded.They may act to support the value of their own currency because of policies adopted at the national level or because of commitments entered into through membership in joint agreements such as the European Monetary System.1.4 Market Participants:Central Banks and TreasuriesThe motive is not to earn a profit as such,but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.As willing loss takers,central banks and treasuries differ in motive from all other market participants.2.Types of FX Transactions2.1Spot transactions2.2Forward transactions2.3Swap transactions2.4Market size of FX transactions2.1 Spot transactions6-18A spot transaction in the interbank market is the purchase of foreign exchange,with delivery and payment between banks to take place,normally,on the second following business day.The date of settlement is referred to as the value date.For example US bank transfers X pounds to a London bank,and the London bank transfer$Y to the US bank.2.2 Forward transactions6-19A forward transaction requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency.The exchange rate is established at the time of the agreement,but payment and delivery are not required until maturity.Forward contracts to buy or sell currency may be taken to protect against movements in exchange rates.2.3 Swap transactions6-20A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.Both purchase and sale are conducted with the same counterparty.2.4 Market Size of FX Transactions6-21In April 2004,a survey conducted by the Bank for International Settlements(BIS)estimated the daily global net turnover in traditional foreign exchange market activity to be$1.9 trillion.Estimate today is$2.5 trillion.3.Methods Used for FX Rates and Quotations3.1Currencies used for FX rates and quotes3.2Direct and indirect quotations3.3Bid and Ask quotations3.1 FX Rates and Quotations6-23A foreign exchange rate is the price of one currency expressed in terms of another currency.A foreign exchange quotation(or quote)is a statement of willingness to buy or sell at an announced rate.3.1 FX Rates and Quotations6-24Most foreign exchange transactions involve the US dollar.Professional dealers and brokers may state foreign exchange quotations in one of two ways:the foreign currency price of one dollar,orthe dollar price of a unit of foreign currency.Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar.3.1 FX Rates and Quotations6-25For example,the exchange rate between US dollars and the Swiss franc is normally stated:SF 1.6000/$(European terms)However,this rate can also be stated as:$0.6250/SF(American terms)Most interbank quotations around the world are stated in European or USD terms.3.1 Direct and Indirect Quotations6-26Foreign exchange quotes are at times described as either direct or indirect.In this pair of definitions,the home or base country of the currencies being discussed is critical.A direct quote is a home currency price of a unit of foreign currency.3.1 Direct and Indirect QuotationsAn indirect quote is a foreign currency price of a unit of home currency.The form of the quote depends on what the speaker regard as“home.”3.2 Bid and Ask Quotations6-28Interbank quotations are given as a bid and ask(also referred to as offer).A bid is the price(i.e.exchange rate)in one currency at which a dealer will buy another currency.An ask is the price(i.e.exchange rate)at which a dealer will sell the other currency.3.2 Bid and Ask QuotationsDealers bid(buy)at one price and ask(sell)at a slightly higher price,making their profit from the spread between the buying and selling prices.A bid for one currency is also the offer for the opposite currency.3.2 Bid and Ask Quotations6-30Forward rates are typically quoted in terms of points.A forward quotation is expressed in points is not a foreign exchange rate as such.Rather,it is the difference between the forward rate and the spot rate.Cross Rates6-31Many currency pairs are only inactively traded,so their exchange rate is determined through their relationship to a widely traded third currency(cross rate).See the example provided on page 152-153 of the textbook.4.Sources of Market Information4.1Commercial Services4.2Newspapers4.1 Commercial Sources of Market InformationAll market participants need access to real time prices and news events.Commercial sources:-Moneyline Telerate-Reuters-Bloomberg4.2 Newspaper Sources of Market InformationWorld newspapers:-Wall Street Journal-Financial TimesPrivate Study:look at the internet sites for these newspapers and see how they present FX market information.