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INTERNATIONAL

FINANCIAL

MANAGEMENT

EUN / RESNICK

Second Edition

4

Chapter Four

The Market for

Foreign Exchange

Chapter Objectives:

•This chapter serves to introduce the student to the institutional framework within which exchange rates are determined.

•This chapter lays the foundation for much of the

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Chapter Outline

Function and Structure of the FOREX Market The Spot Market

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Chapter Outline

Function and Structure of the FOREX Market

FX Market Participants

Correspondent Banking Relationships

The Spot Market

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Chapter Outline

Function and Structure of the FOREX Market The Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX Trading

Cross Exchange Rate Quotations Triangular Arbitrage

Spot Foreign Exchange Market Microstructure

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Chapter Outline

Function and Structure of the FOREX Market The Spot Market

The Forward Market

Forward Rate Quotations

Long and Short Forward Positions Forward Cross-Exchange Rates Swap Transactions

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The Function and Structure of the

FOREX Market

FOREX Market Participants

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FOREX Market Participants

The FOREX market is a two-tiered market:

Interbank Market (Wholesale)

About 700 banks worldwide stand ready to make a market in Foreign exchange.

Nonbank dealers account for about 20% of the market.

There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.

Client Market (Retail)

Market participants include international banks, their customers, nonbank dealers, FOREX

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Correspondent Banking Relationships

Large commercial banks maintain demand deposit

accounts with one another which facilitates the efficient functioning of the forex market.

International commercial banks communicate with one another with:

SWIFT: The Society for Worldwide Interbank Financial Telecommunications.

CHIPS: Clearing House Interbank Payments System

ECHO Exchange Clearing House Limited, the first global

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The Spot Market

Spot Rate Quotations The Bid-Ask Spread Spot FX trading

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Spot Rate Quotations

Direct quotation

the U.S. dollar equivalent

e.g. “a Japanese Yen is worth about a penny”

Indirect Quotation

the price of a U.S. dollar in the foreign currency

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! $

Spot Rate Quotations

The direct

quote for British pound is:

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Spot Rate Quotations

The indirect

quote for British pound is:

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Spot Rate Quotations

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The Bid-Ask Spread

The bid price is the price a dealer is willing to pay you for something.

The ask price is the amount the dealer wants you to pay for the thing.

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Spot FX trading

In the interbank market, the standard size trade is about U.S. $10 million.

A bank trading room is a noisy, active place. The stakes are high.

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Cross Rates

Suppose that S($/DM) = .50 i.e. $1 = 2 DM

and that S(¥/DM) = 50 i.e. DM1 = ¥50

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Triangular Arbitrage

$

£ ¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross

rates to see if an

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Triangular Arbitrage

$

£ ¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

The implied S(¥/£) cross

rate is S(¥/£) = 80

Credit Agricole has posted a quote of

S(¥/£)=85 so there is an

arbitrage opportunity.

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Triangular Arbitrage

$

£ ¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

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Triangular Arbitrage

Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000

Sell our £ 150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥ 12,750,000 for $ at S(¥/$) = 120

receive $106,250

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Spot Foreign Exchange Microstructure

Market Microstructure refers to the mechanics of how a marketplace operates.

Bid-Ask spreads in the spot FX market:

increase with FX exchange rate volatility and decrease with dealer competition.

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The Forward Market

Forward Rate Quotations

Long and Short Forward Positions Forward Cross Exchange Rates

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The Forward Market

A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock

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Forward Rate Quotations

The forward market for FOREX involves

agreements to buy and sell foreign currencies in the future at prices agreed upon today.

Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.

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Forward Rate Quotations

Consider the example from above: for Japanese yen, the spot rate is

¥115.75 = $1.00

While the 180-day forward rate is £112.80 = $1.00

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Spot Rate Quotations

Clearly the market

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Long and Short Forward Positions

If you have agreed to sell anything (spot or forward), you are “short”.

If you have agreed to buy anything (forward or spot), you are “long”.

If you have agreed to sell forex forward, you are short.

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Payoff Profiles

0 S180($/¥)

F180($/¥) = .009524

Short position loss

profit

If you agree to sell anything in the future at a set price and the spot price later falls then you gain.

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Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

profit

Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote:

F180(¥/$) = 105 or

F180($/¥) = .009524.

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Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

-F180(¥/$)

When the short entered into this forward contract,

he agreed to sell ¥ in 180 days at F180(¥/$) = 105

profit

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! $ %

Payoff Profiles

loss

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! $ %

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

Long position

-F180(¥/$)

F180(¥/$) short position

profit

Since this is a zero-sum game, the long position payoff is the

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! $ %

Payoff Profiles

loss

0 S180(¥/$)

F180(¥/$) = 105

Long position

-F180(¥/$)

profit

The long in this forward contract agreed to BUY ¥

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! $ %%

Forward Cross Exchange Rates

It’s just an “delayed” example of the spot cross rate discussed above.

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! $ %$

SWAPS

A swap is an agreement to provide a counterparty with something he wants in exchange for

something that you want.

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Comparative Advantage

as the Basis for Swaps

Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based

multinational.

Both firms wish to finance a project in each other’s country of the same size. Their borrowing

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A is the more credit-worthy of the two firms.

A pays 2% less to borrow in dollars than B and A pays .4% less to borrow in pounds than B:

Comparative Advantage

as the Basis for Swaps

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One Feasible Swap:

Company A

Company

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! borrow at £11%

One Feasible Swap:

Company A

Swap

Bank

Company

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! borrow at $9.4%

One Feasible Swap:

Company A

Swap

Bank

Company

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!

One Feasible Swap:

Company A

Swap

Bank

Company

B

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!

One Feasible Swap:

Company A

Swap

Bank

Company

B

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!

One Feasible Swap:

Company A

Swap

Bank

Company

B

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! $ $%

SWAPS

A swap can be viewed as a portfolio of spot and forward positions.

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! $ $$

Forward Premium

It’s just the interest rate differential implied by forward premium or discount.

For example, exhibit 4.4 shows the DM appreciating from S($/DM) = .5235 to

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! $ $&

Referensi

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