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Introduce the quotation methods of foreign exchange rates in detail Discuss the relationship of cross exchange rates and the possibly international arbitrages among them
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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 rate, e.g., spot, forward, and swap transactions discussed later or other kinds of currency derivatives
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Exhibit 6.1 Measuring Foreign Exchange Market Activity: The Trading Volume of Currency Transactions Per Hour
This exhibit illustrates the trading volume of currency transactions ebbs and flows as the major currency trading centers across the globe open and close throughout the day The per-hour trading volume data suggests that Europe is the major center for foreign exchange transactions, the U.S. is the next, and Asia is the third
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Market Participants
The foreign exchange market consists of two tiers:
Interbank or wholesale markets
The size (or notional principal) for each contract is multiples of 1 million US$ or the equivalent value in other currencies
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A large proportion of speculation and arbitrage is conducted on behalf of major banks by traders employed by those banks
Thus banks could act both as dealers and as speculators and arbitragers
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Forward-forward
For example, a dealer sells 1,000,000 forward for US dollars for delivery in two months at $1.842/ (two-month forward exchange rate) and simultaneously buys 1,000,000 forward for delivery in three months at $1.84/ (three-month forward exchange rate)
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Another advantage of using NDFs is for emerging market currenciescurrencies that typically do not have liquid money markets, because it is not necessary to buy or sell the foreign currency physically
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Exhibit 6.2 Global FX Market Turnover (daily averages in April, billions of US$)
Generally speaking, all three categories of traditional currency transactions have rising trends from 1989 to 2007 The only exception is that trading activities diminished in two of the three categories (spot and swaps) between the 1998 and 2001 surveys
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Exhibit 6.3 Geographic Distribution of FX Market Turnover (daily averages in April, billions of US$)
The U.K. continues to be the worlds major foreign exchange market with $1,359 billion in average daily turnover and 34% of daily global transactions in 2007 The U.S. makes 16.6% of global trading in 2007 The growth of the H.K. market can contribute to its role as a key economic and financial linkage to the rapidly rising Chinese economy Australia has grown considerably in recent years reflecting the demand for the carry trade, in which capital flows into the country in pursuit of high interest rate returns 6-23
Currency Distribution of Global FX Market Turnover (percentage shares of average daily turnover in April)
Because all exchange transactions involve two currencies, percentage shares total 200% 90 80 70 60 50 40 30 20 10 0 1989 1992 1995 1998 2001 2004
US Dollar Euro Deutsche Mark French Franc EMS Currencies Japanese Yen Pound Sterling Swiss Franc
For each transaction, it involves two currencies, and the percentage shares are calculated as the ratio between the number of appearance of one currency in all transactions and the number of all transactions, e.g., there are 40 currencies for 20 contracts, and if US$ appears 18 times, the percentage share is 18/20 = 90% Net global turnover since 1999 was dominated by trading in U.S. dollars, Euros, and Japanese yen, which are often called the big three About 80-90% of foreign exchange transactions are associated with the U.S. dollar It is obvious that the US$ is still the most important currency in the foreign exchange rate market, even after the emergence of Euros
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The US$/euro and US$/Japanese yen contracts have been slowly trending downward The US$/Australian dollar have increased in their volume since 2001
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A foreign exchange quotation (or quote) is an announced rate of willingness to buy or sell foreign currencies In the retail market (including newspapers or foreign exchange booths at airports), quotes are often given as the domestic currency price of the foreign currency, i.e., one foreign dollar = S domestic dollars
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2. American terms: The dollar price of a unit of foreign currency (from the viewpoint of the U.S.)
The exchange rate between US dollars and the Swiss franc can also be stated as $0.6250/SF
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In this pair of definitions, the home or base country of the currencies being discussed is critical The form of the quote depends on what the speaker regards as the home country
For example, SF1.600/$ is a direct quotation in Switzerland as well as a indirect quotation in the U.S. 6-30
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The bank would buy dollars with Japanese yen (equivalent to selling Japanese yen) at the bid price of 118.27/$, so the bid price of 118.27/$ to purchase US$ is also the ask price to sell Japanese yens for US$ Similarly, the bank will sell dollars for Japanese yen (equivalent to buying Japanese yen) at the ask price of 118.37/$, so the ask price of 118.37/$ to sell US$ is also the bid price to buy Japanese yens with US$
In practice, traders tend to abbreviate the above outright quotations as 118.27-37 when talking on the phone or putting quotations on a video screen 6-32
In addition, a forward quotation is expressed as the difference between the forward and the spot exchange rates See Exhibit 6.5 on the next slide for the spot and forward quotations for the Euro and Japanese yen
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The three month point-quotations for the Japanese yen are 143 points for bid and 140 points for ask, which means the quotations for the 3-month forward exchange rate are 116.84/$ (=118.27 1.43) for bid and 116.97/$ (=118.37 1.40) for ask
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Consider the following spot and forward quotations, where the US dollar is the home currency
Foreign currency/ home Home currency/Foreign currency (indirect quote) currency (direct quote)
Spot 3-mon forward Premiums or Discounts 105.65/$ 105.04/$ 2.32% $0.009465215/ $0.009520183/ 2.32%
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For quotations expressed in indirect quotations for the U.S., the formula to calculate forward premium or discount is:
360 Spot-Forward premiums) f 100% : FC is expected to be weaker (at Forward n days discounts) (105.65-105.04) 360 100% 2.32% per annum 105.04 90
+: FC is expected to be stronger (at
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Note that, in practice, it is often to annualize the above results to obtain the annual percentage changes of spot foreign exchange rates 6-37
Since the Swiss franc is 9.008% stronger on the ending date, holders of Swiss receivables will receive 9.008% more dollars, but those who owe Swiss francs (who with the accounts payable) will have to pay 9.008% more for them (we will discuss this FX risk in detail in Ch 11)
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Cross Rate
Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate) For example, a Mexican importer needs Japanese yen to pay for purchases in Tokyo. Both the Mexican peso (Ps) and the Japanese yen () are commonly quoted against the US$:
Japanese yen Mexican peso 110.73/$ Ps11.4456/$
This table shows the cross rates for any combinations of these 7 currencies Each column shows that the amount of each currency (listed on the left of the table) needed to buy a unit of the currency at the top For example, it costs 110.73 Japanese yen or 1.2506 Swiss franc to buy one U.S. dollar
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Intermarket Arbitrage
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)
Citibank quote - $/ Barclays quote - $/ Dresdner quote - / Cross rate calculation: $1.2223/ $1.8410/ 1.5100/
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Intermarket Arbitrage
Three things should be noted for the triangular arbitrage
Such arbitrage is practical only if the participants have instant access to quotes and executions. Hence, such arbitrage is conducted only by institutional investors, and is almost infeasible for individual investors The institutional investors usually use a computer program to monitor the cross rates among major currencies continuously. Once there is an arbitrage opportunity, these transactions are executed by computers automatically Bank traders can conduct such arbitrage without initial money, because the traders are entered into and subsequently washed (i.e., offset) by electronic means before the normal settlement two days later
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