Foreign exchange markets : learning objectives

Review of the functions performed by the foreign exchange market (FOREX), its participants, its size,
geographic composition and in terms of currency.
Distinction between cash instruments, futures, swaps, and other types of financial instruments in foreign
currency.
Identifying forms of currency quotations used by currency traders, financial institutions and agents.
Analysis of the interaction between currency values and their fluctuations,crossed exchange rates and
the opportunities arising from cross-market arbitrage.

Foreign exchange markets

The FOREX market offers a physical and institutional structure within which currencies are exchanged
between countries against those of another country.
The exchange rate between currencies is determined.
Currency transactions are done physically.
An exchange transaction is an agreement between a buyer and a seller whereby a specified amount of a
currency is issued in exchange for another currency at a specified rate .
There are six main characteristics of the FOREX markets that will be discussed
The geographic scope
The three main functions
the market participants
Its daily trading volume
The types of transactions, particularly cash, futures and swaps
The methods of expression in exchange rates, stock prices, and fluctuations in exchange rates

The geographic scope of the market

Geographically, the FOREX market covers the entire globe, the rates change and currencies are traded
every hour of every working day.
The global large-scale operations start every morning in Sydney and Tokyo
Then they travel to Hong Kong and Singapore
They continue in Europe and end on the West Coast of the United States

The functions of the FOREX market

The FOREX market is the mechanism by which the participants transfer the purchasing power between
countries
These transactions are necessary insofar as international trade and capital transactions involve parties
who live in countries whose currencies are different
Allow to obtain or make credit available to stakeholders for the realization of international trade
transactions
Inventory in transit should be funded
Limit exposure to currency risk
Forex markets offer instruments used in the context of "hedging" or transfer of risks to parties who are
more willing to assume them

The market participants

The FOREX market consists of two levels, the interbank market or wholesale market and the customer or
the retail market
Five broad categories of participants operate at both levels
Banking and non-banking foreign exchange market
Individuals and companies conducting business operations or investment
Speculators and arbitrageurs
Central banks and treasuries
Foreign exchange brokers

Banking and non banking

They conduct transactions with other banks and operators to keep their inventories at manageable levels
Foreign Exchange transactions are profitable and often represent 10 to 20% of average net income of
banks. Small and medium-sized banks are rarely key market players but are still involved in the
interbank market
Individuals and companies conducting business transactions or investment
Importers, exporters, portfolio investors, MNEs, tourists and other operators are using the FOREX market
to facilitate the conduct of business transactions or investments
Some of the participants use the market to hedge exchange

Speculators and arbitrageurs

Speculators and arbitrageurs seek to profit from trading in the market itself
They work for their own benefit, without the need or obligation to serve customers and to ensure
continuity of the market
Speculators ensure to benefit from fluctuations in exchange rates
Arbitrageurs seek to benefit from simultaneous differences in exchange rates in different markets
A significant proportion of speculation and arbitration is conducted on behalf of major banks by traders
employed by these banks

Central banks and treasuries

Central banks and treasuries use the market to acquire or spend foreign exchange reserves of their
country and to influence the rate of their own currency
They can take steps to support the value of their currency, considering the policies of their government or
obligations, or because of commitments made in agreements such as the floating concerted European
Monetary System (EMS).
Their motivation is not profit but rather the influence of the exchange value of their currencies so as to
serve their interests

Foreign exchange dealers

Foreign exchange dealers are agents that promote negotiations between the operators themselves
without being party to the transaction
They charge a commission for this limited service
They maintain instant access to hundreds of operators worldwide through open lines, and can sometimes
draw lines with several banks, separate lines for different currencies, spot rates and forwards.

Transactions on the interbank market

spot transactions,fowrard transactions or swaps

A spot transaction requires almost immediate surrender of foreign exchange

A forward transaction requires delivery of foreign currency, but in this market, transactions can be
conducted at a later date

A swap is the simultaneous exchange of one foreign currency for another

Cash Transactions

A spot /cash transaction on the interbank market is the purchase of foreign exchange, remittance and
payment between banks usually before the second following

business day takes place

The settlement date is often called value date

This is the date most dollar transactions are settled electronically through the Clearing House Interbank
Payment Systems (CHIPS) in New York

The outright forwards

This transration requires the filing date of a future value of a stipulated amount of one currency for
another

The exchange rate is agreed at the time of the transaction, but payment and delivery are delayed

The forward rates contracts are traded on the value dates of one, two, three, six, nine and twelve
months

It is generally about buying or selling futures

A contract for delivery of dollars for euros to six months tallies with a forward purchase of euros for dollars
and a forward sale of dollars for euros

Swaps

A swap transaction on the interbank market is the simultaneous purchase and sale of a particular amount
of foreign currency for two different value dates

Buying and selling are both made with the same party
A common type of swap is a spot tranaction for a forward transaction

A trader buys a currency cash and simultaneously sells the same amount to the same bank on the
futures market

As this transaction occurs at the same time and with the same party,traders will not face any exchange
risk

Future for future swaps,- A trader sells 20 000 for dollar for a future delivery in two months at $ 1.8420
/ and simultaneously buys 20 000 for a future delivery in three months at $ 1.8400 /

The difference between the purchase price and sale price is equivalent to the differential in interest rates

A swap can be regarded as a technique of borrowing a different currency on a fully guaranteed basis

NDF (Non-Deliverable Forward) have the same characteristics as traditional futures contracts, except that
they are settled in U.S. dollars and the forward sold or purchased foreign currency is not delivered

The dollar payment is related to the fact that the NDF are transactions carried out abroad and that are out
of reach and regulatory frameworks of governments of countries of origin

NDF prices reflect the incremental interest rates base

The FOREX Market Size

The Bank for International Settlements (BIS) estimates that the figure of the world's net daily activity on
the traditional FOREX market was to 1210 billion USD in April 2001

It was the first decline recorded by the BIS since the launch of its survey of banks in respect of
transactions on the FOREX market in the 1980s

Two of the three categories were down between 1998 and 2001 and the number of daily activity on the
spot market is the one who has experienced the steepest decline, from 568 billion USD in 1998 to 387
billion USD 2001

Futures trading has increased slightly to 128 billion USD in 1998 to 131 billion USD in 2001

waps fell to 656 billion USD in 2001 compared to 734 billion USD in 1998

The BIS attributes this reduction to the introduction of the Euro, the growing share of electronic broking in
the spot market and the consolidation of the banking sector

Exchange rates and currency rates

The rate of a currency is an expression of an agreement for selling or buying at an announced price.

On the retail market (newspapers and exchange booths), prices are often given as the price of foreign
currency in the currency of the country of origin

Interbank quotes -traders or professional brokers may express the rates in one of the two ways

The price of foreign-currency of one dollar

1.6000 Sfr. / $ Means 1.600 Swiss franc per dollar

The dollar price of a unit of a foreign currency

$ 0.6250 / Sfr. mean 0.625 dollar per Swiss franc

The previous rate is considered "European terms" and the last "in American terms"

Almost all European currencies, with the exception of two of them are listed as European

The Pound Sterling and Euro are two exceptions

Furthermore, the Australian dollar and New Zealand are also expressed in American terms

Direct and indirect rates

A direct rate is the price of a unit of foreign currency in local currency

1.6000 Sfr. / $ Is a direct rate in Switzerland

An indirect rate ia the cost of a foreign currency in a unit of local currency

1.600 Sfr. / $ Is an indirect rate in the U.S.

$ 0.625 / Sfr. is a direct rate in the United States and an indirect rate in Switzerland

The interbank rates are presented as the bid price - ask price

The bid price is the price at which a trader buys an other currency

The bid price or offer is the price at which a trader sells an other currency

Example: 118.27 - 118.37 / $ is the bid price - ask price for the Japanese yen

The bank will buy yen at the rate of 118.27 yen per dollar and sell yen at the rate of 118.37 yen per dollar
and makes profit on the difference

Expression of the futures price on the basis of points

the previously listed yen rates are considered closed rates

Futures prices are different and usually expressed as points

A point is the last digit of a rate, and a convention dictates the number of digits to the right of the decimal

One point is equal to 0.0001 for most currencies

Expression of the futures price on the basis of points

The rate of the yen is expressed with only two decimal points

Futures price is not an exchange rate.Rather, the difference between spot transactions and futures

Example:

uncompensated Cash: 118.27 yen 118.37 yen

Plus points (3 months: -1.43 -1.40

Uncompensated futures = 116.84 yen 116.97 yen

Futures prices in percentage terms

Futures prices can also be expressed as the deviation in percentage term per year compared to the spot
rate

It is about an expression similar to a discount or a previously calculated premium term

It is important not to forget what currency is the local currency or the base currency

For indirect rates (that is to say prices expressed in terms of foreign currency), the formula is as follow

F (k) = (Cash-forward) divided by (forward) x (360 divided by the number of days) x 100

For direct rates (that is to say prices expressed in local currency terms), the formula is

F (k) = (Cash-forward) divided by (forward) x (360 divided by the number of days) x 100

Cross rates

Many currency pairs are traded in an inactive way, so that their exchange rate is determined by their
relationship to a widely traded third currency

Example: A Mexican importer needs Japanese yen to shop in Tokyo. The Mexican Peso (MXP) and
Japanese yen () are quoted in U.S. dollars

Let's assume the following rates:

Japanese yen 110.73 / $

11.4456 pesos / $

The Mexican importer can buy one U.S. dollar for 11.4456 pesos and buying with the dollar 110.73 yen.
The cross rate would be

(Japanese Yen / USD) divided by (Mexican pesos / USD) = (110.73 yen / $) divided by (MXP 11.4456 / $)
= 9.6745 yen / MXP

Cross-market arbitrage
Cross rates can allow to evaluate the opportunities of international markets arbitrage

Example: let's assume that exchange rates are

Citibank $ 1.2223 / euro

Barclays Bank 1.8410 USD / GBP

1.5100 Dresdner Bank EUR / GBP

The cross rate between Citibank and Barclays is

1.8410 USD / GBP) divided by (1.2223 USD / EUR) = 1.5062 Euro / GBP

This cross rate is not the same as the rate of Dresdner at 1.5100 /

There is therefore an opportunity to profit without a risk or arbitration

Summary of learning objectives

The three functions of the foreign exchange market (FOREX) is to transfer power to buy, make credit
available and to minimize foreign exchange risks

The FOREX has two levels: the interbank market and the customers market . Participants in these levels
are among others the foreign exchange banking and non-banking operators , individuals and companies
acting in trade and investment, speculators and arbitrageurs, central banks and treasuries and foreign
exchange dealers

Geographically, the FOREX market covers the entire globe,rates change and currencies are traded every
hour of every working day

An exchange rate is the price of one currency expressed in another currency

The price of a currency is an expression of willingness to buy or sell at a announced price

Transactions on the FOREX market are performed in cash, which requires a delivery two days after the
transaction, or future, which requires a payment to a later designated date

Rates in European terms are the price of foreign currency per U.S. dollar. The terms correspond to the
U.S. dollar price of foreign currency

Rates can also be direct or indirect. A direct rate is the price in local currency of one unit of foreign
currency, and an indirect rate is the price of a unit of local currency in foreign-currency

Direct and indirect are not synonymous American and European terms , because the local currency
exchange rate changes at the end of calculations

A cross rate is an exchange rate between two currencies, calculated from the common relationship of
these currencies with a third currency
When the cross rates are different from direct rates between two currencies, arbitrage between markets is
possible

Mini case: the black market for Venezuelan bolivar

On 21st of January 2003, the bolivar ended the session at a record low price

The next day, President Hugo Chavez suspends sales of U.S. dollars

An unofficial currency black market (ie Venezuelan bolivars for U.S. dollars) develops immediately

Capital flight is accelerating while control measures are put in place

Explain why we use measures of capital controls in this situation. Analyze choices of Santiago and
recommend solutions

What is the difference between a gray market and a black market (referring to this particular case)?