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The Foreign Exchange Market

Ch. 6 ESM
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The Foreign Exchange Market
The 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 rate of exchange between
currencies, and
is where foreign exchange transactions are
physically completed.
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The Foreign Exchange Market
Foreign 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.
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Geography
The foreign exchange market spans the globe,
with prices moving and currencies trading
somewhere every hour of every business day.
As the next exhibit will illustrate, the volume of
currency transactions ebbs and flows across the
globe as the major currency trading centers open
and close throughout the day.
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Exhibit 6.1 Measuring Foreign Exchange Market Activity: Average Electronic
Conversions Per Hour
Exhibit 6.2 Global Currency Trading:
The Trading Day
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Functions of the Foreign Exchange
Market
The foreign exchange Market is the
mechanism by which participants:
transfer purchasing power between countries;
obtain or provide credit for international trade
transactions, and
minimize exposure to the risks of exchange rate
changes.

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Market Participants
The 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).
Four broad categories of participants operate within these
two tiers; bank and nonbank foreign exchange dealers,
individuals and firms conducting commercial or investment
transactions, speculators and arbitragers, and central banks
and treasuries.
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Market Participants: Bank and Nonbank Foreign Exchange
Dealers
Banks and a few nonbank foreign exchange dealers operate in both the
interbank and client markets.
The profit from buying foreign exchange at a bid price and reselling it at
a slightly higher offer or ask price.
Dealers 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.
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Market Participants: Individuals and Firms
Individuals (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 necessary but
nevertheless incidental to their underlying commercial or
investment purpose.
Some of the participants use the market to hedge foreign
exchange risk.
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Market Participants: Speculators and Arbitragers
Speculators 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.

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Market Participants: Central Banks and Treasuries
Central 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.
The 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.
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Transactions in the Interbank Market
A 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.
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Transactions in the Interbank Market
An outright forward transaction (usually called just forward) 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 exchange rates are usually quoted for value dates of one, two,
three, six and twelve months.
Buying forward and selling forward describe the same transaction (the
only difference is the order in which currencies are referenced.)
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Transactions in the Interbank Market
A 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.
Some different types of swaps are:
spot against forward,
forward-forward,
nondeliverable forwards (NDF).
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Market Size
In April 2010, a survey conducted by the Bank
for International Settlements (BIS) estimated
the daily global net turnover in traditional
foreign exchange market activity to be $3.2
trillion, up from $1.9tn in 2004.
This most recent period showed dramatic
growth in foreign exchange trading over that
seen in April 2001.
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Exhibit 6.3 Top 10 Geographic Trading Centers in the Foreign Exchange
Market, 19922007
(daily averages in April, billions of U.S. dollars)
Exhibit 6.4 Global Foreign Exchange Market Turnover, 1989-
2010 (average daily turnover in April, billions of U.S. dollars)
Exhibit 6.5 Top 10 Geographic Trading Centers in the Foreign
Exchange Market, 1991-2010 (average daily turnover in April)
Exhibit 6.6 Foreign Exchange Market Turnover by Currency Pair
(daily average in April)
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Foreign Exchange Rates and
Quotations
A foreign exchange rate is the price of one
currency expressed in terms of another
currency.
A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
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Foreign Exchange Rates and
Quotations
Most foreign exchange transactions involve the
US dollar.
Professional dealers and brokers may state
foreign exchange quotations in one of two ways:
the foreign currency price of one dollar, or
the dollar price of a unit of foreign currency.
Most foreign currencies in the world are stated in
terms of the number of units of foreign currency
needed to buy one dollar.
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Foreign Exchange Rates and
Quotations
For example, the exchange rate between US
dollars and the Swiss franc is normally stated:
SF 1.6000/$ (European terms)
However, this rate can also be stated as:
$0.6250/SF (American terms)
Excluding two important exceptions, most
interbank quotations around the world are
stated in European terms.
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Foreign Exchange Rates and
Quotations
As mentioned, several exceptions exist to the use
of European terms quotes.
The two most important are quotes for the euro
and U.K. pound sterling which are both normally
quoted in American terms.
American terms are also utilized in quoting rates
for most foreign currency options and futures, as
well as in retail markets that deal with tourists.
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Foreign Exchange Rates and
Quotations
Foreign 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.
An 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.
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Foreign Exchange Rates and
Quotations
Interbank 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.
Dealers 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.
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Foreign Exchange Rates and Quotes
Forward 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.

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Foreign Exchange Rates and Quotes
Forward quotations may also be expressed as
the percent-per-annum deviation from the
spot rate.
This method of quotation facilitates
comparing premiums or discounts in the
forward market with interest rate differentials.
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Foreign Exchange Rates and Quotes
Many currency pairs are only inactively
traded, so their exchange rate is determined
through their relationship to a widely traded
third currency (cross rate).
Cross rates can be used to check on
opportunities for intermarket arbitrage.
This situation arose because one banks
(Dresdner) quotation on / is not the same a
calculated cross rate between $/ (Barclays)
and $/ (Citibank).
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Foreign Exchange Rates and Quotes
Citibank quote - $/ $1.2223/
Barclays quote - $/ $1.8410/
Dresdner quote - / 1.5100/
Cross rate calculation:
$1.8410/

$1.2223/

= 1.5062/

=
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Exhibit 6.8A Triangular Arbitrage
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Foreign Exchange Rates
and Quotes
Measuring a change in the spot rate for quotations expressed
in home currency terms (direct quotations):
% = Ending rate Beginning Rate

Quotations expressed in foreign currency terms (indirect
quotations):
% = Beginning Rate Ending Rate

Beginning Rate
x 100
Ending Rate
x 100
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Mini-Case Questions: The Venezuelan Bolivar Black
Market
Why does a country like Venezuela impose
capital controls?
In the case of Venezuela, what is the
difference between the gray market and the
black market?
Create a financial analysis of Santiagos
choices and use it to recommend a solution to
his problem.