CHAPTER SIX FOREIGN EXCHANGE MARKET ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • THE PARTICIPANTS – Large commercial Bank – Foreign exchange brokers in the interbank market – Commercial customer: MNCs – Central Banks • THE MAJOR PARTICIPANTS IN THE FORWARD MARKET – Arbitrageurs – Traders – Hedgers – Speculators CHAPTER OVERVIEW • Spot market for Foreign Exchange Copyright@McGrawHill Educations – Market characteristics – Arbitrage • Forward market for Foreign Exchange – Why is it used – Market characteristics – Arbitrage Copyright@McGrawHill Educations Copyright@McGrawHill Educations Copyright@McGrawHill Educations Copyright@McGrawHill Educations Transactions in the Interbank Market • In interbank markets, forward exchange rates are usually quoted for value dates of 1, 2, 3, 6, and 12 months • Buying FX forward and selling FX forward describe the same transaction (the only difference is the order in which currencies are referenced) – A FX forward contract to deliver dollars for Euros in six months is buying Euros forward with dollars or selling dollars forward for Euros http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=mdc_curr_pglnk Exhibit 6.1 Measuring Foreign Exchange Market Activity: The Trading Volume of Currency Transactions Per Hour TRANSACTIONS IN THE INTERBANK MARKET • A foreign exchange swap transaction (FX swap) in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates with the same counterparty • Some different types of FX swaps are: – Spot against forward • The dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in the forward market ※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 TRANSACTIONS IN THE INTERBANK MARKET • For example, if a Taiwanese firm needs US$1 million for the following months, it can enter into a spot against forward swap, in which this firm buys US$ million at the spot exchange rate today (e.g., NT$34/US$) from a bank, and this firm agrees to sell US$ million back to the bank after three months at the 3-month forward exchange rate (e.g., NT$32/US$) • Because these two transactions are in a single contract with one counterparty, it can save some transaction costs • A swap can be viewed as a technique for borrowing another currency on a fully collateralized basis (in the above example, the NT$ is the cash collateral for borrowing US$ million) – 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) Transactions in the Interbank Market • In addition to traditional spot, forward, or swap foreign exchange transactions, there are new types of transactions, e.g., nondeliverable forwards • Nondeliverable forwards (NDF) – Created in the early 1990s, NDF is now a relatively common derivative in the interbank market – Similar to traditional FX forward contracts, except that they are cash-settled (in domestic currency) and the foreign currency being sold forward or bought forward is not delivered physically on the maturity date – The profit or loss of the NDF at the time of the maturity date is calculated by taking the difference between the agreed forward exchange rate and the spot exchange rate at that time point, for an agreed notional amount of funds TRANSACTIONS IN THE INTERBANK MARKET – For example, consider a NDF of buying US$1,000,000 with NT$ after one month and the one-month forward exchange rate is NT$34/US$ After one month, if the spot exchange rate becomes NT$35/US$, the holder of the NDF can earn (NT$35/US$ – NT$34/US$) × US$1,000,000 = NT$1,000,000 – Note that it is not necessary to buy foreign currency (US$1,000,000) with the domestic currency (NT$34,000,000) after one month • Comparing to the traditional forward contracts, on the maturity date, the holder should buy US$1,000,000 with NT$34,000,000 physically and resale US$1,000,000 in the market to exchange for NT$35,000,000 – Another advantage of using NDFs is for emerging market currencies–currencies that typically not have liquid money markets, because it is not necessary to buy or sell the foreign currency physically FOREIGN EXCHANGE MARKET CONDITION • Every three years, the Bank for International Settlements (BIS) conducts a survey to estimate the global trading activity of traditional foreign exchange transactions • The BIS data for surveys from 1989 to 2010 is shown in Exhibits 6.2 • For the market size in Exhibit 6.2 – In the surveys of 2007 and 2010, the daily global trading amount in traditional foreign exchange market activities are $3.32 trillion and $3.98 trillion, respectively – Those results imply increase of nearly 19.8% for the foreign exchange trading from 2007 to 2010 Exhibit 6.2 Global FX Market Turnover (daily averages in April, billions of US$) LOCATIONAL ARBITRAGE PROFIT CASE 1: ARBITRAGE POSSIBLE CASE 2: NO ARBITRAGE POSSIBLE • New York Bank quotes: • Chicago Bank quotes: – Ask $1.84/1BP – Ask $0.64/1SF – Bid $1.81/1BP – Bid $0.60/1SF • London Bank quotes: • Berlin Bank quotes: – Ask $1.89/1BP – Ask $0.66/1SF – Bid $1.86/1BP – Bid $0.62/1SF Generally speaking, all three categories of traditional currency transactions have rising trends from 1989 to 2010 http://www.bis.org/publ/rpfxf10t.pdf LOCATIONAL ARBITRAGE 19 THE SPOT MARKET CURRENCY ARBITRAGE • Buy low in one location & sell high in another location – For example, suppose we observed the following for the Mexican peso (Ps) and the Swiss franc (SF): In the FX market – The buying price (ask price) in one bank is lower than the selling price (bid price) of another bank Ps per $1 = 10.00 in Mexico SF per $1 = 2.00 in New York Ps per SF1= 4.00 in Zurich • Market adjustments which will eliminate locational arbitrage – Is there an arbitrage opportunity, suppose you have $100? In the FX market: – The ask price will rise and bid price will fall – Till ask price (of one bank) is greater than or equal to bid price (of another bank) 18 20 FOREIGN EXCHANGE MANAGEMENT - IRP CURRENCY ARBITRAGE Round-trip profit equals $25 New York Example: US corporation receive dividend from France Subsidiary Company They decide to invest this money to another company in Start $100 Finish $125 Buy dollars in NY at SF2/$ Swiss Whether they buy SFr, as follow information: Sell $100 in Mexico at Multiplied Ps10/$ Ps10/$ Divided by SF2/$ Citibank: $1.4341-1.4372/€ Eurobank SF 250 Zurich €0.6777-97/$ €0.6218-58/SFr Ps 1.000 Divided by Ps4/SF $0.9050-0.9071/SFr Mexico UBS SFr1.1024-53/$ SFr1.6010-40/€ Buy these SFr in Zurich at Ps4/SF 21 THE SPOT MARKET CURRENCY ARBITRAGE 23 USING FORWARD CONTRACTS FOR SPECULATION: THEORY • Buy Forward Contracts (take a Long Position in the FM): – Example, suppose the exchange rate for the British pound and Swiss Franc When you expect the future spot rate to be higher then the current forward rate: – You will gain when the future spot rate is higher than the current forward exchange rate – You will lose when the future spot rate is lower than the current forward exchange rate – Pound per $1 in New York = 0.6 – SF per $1 in Frankfurt = 2.00 – SF per pound in London = 3.00 • Sell Forward Contracts (take a Short Position in the FM): When you expect the future spot rate to be lower then the current forward rate: – You will gain when the future spot rate is lower than the current forward exchange rate – You will lose when the future spot rate is higher than the current forward exchange rate – Is there an arbitrage opportunity, assume you have $100? 22 24 INTEREST RATE PARITY THEORY INTEREST RATE PARITY - IRP • Spot and forward rate are closely linked to each other and to interest in different currencies through the medium of arbitrage • The movement funds between two currencies to take advantage of interest rate differential is a major determinant of the spread between forward rate and spot rates • The forward discount and premium is closely related to the interest differential between the two currencies • According to interest parity theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the country with higher rate • In the efficient market with no transaction cost, the interest differential should be equal to forward differential • Covered interest arbitrage forces interest rates on different currencies to be at parity with each other Indicate: f: forward rate compute from interest rate parity equation, F: forward rate in the market If F > f : sell foreign currency in forward rate If F < f : buy foreign currency in forward rate f s (1 rh ) (1 rf ) 25 27 INTEREST RATE PARITY - IRP Fund will flow from home country to foreign country if and only if: (1 rh ) • Illustration, • Suppose an investor with $1.000.000 to invest for 90 days Interest rate and exchange rate in exchange market as follows: – 8%per annum (2%/90 days)in dollar, 6%/year (1.5%/90 days) in SFr – Spot rate: SFr1.5311/$, 90-day forward rate: SFr 1.5146/$ rh F S rf rh F rf S • INTEREST RATE PARITY - IRP F (1 r f ) S Fund will flow from foreign country to home country if and only if: (1 rh ) F (1 r f ) S 26 28 INTEREST RATE PARITY - IRP INTEREST RATE PARITY - IRP Illustration, • Suppose an investor with $1.000.000 to invest for 90 days Interest rate and exchange rate in exchange market as follows: – 8%per annum (2%/90 days)in dollar, 6%/year (1.5%/90 days) in SFr – Spot rate: SFr1.5311/$, 90-day forward rate: SFr 1.5236/$ • When transaction cost exist, how can define arbitrage opportunity • Defined: – Sb & Sa : Bid price and ask price (spot rate) – Fb & Fa : Bid price and ask price (Forward rate) – rha & rhb : borrow rate (ask rate) and lend rate (bid rate) in home currency – rfa & rfb : borrow rate and lend rate (foreign currency) There are two cases: – borrow in home currency – Borrow in foreign currency 29 INTEREST RATE PARITY - IRP 31 INTEREST RATE PARITY - IRP • Borrow in home currency • Example: • Suppose: 7%/year for dollar in New York, 12%/year for £ in London - Spot rate: £ =$1.75, one year forward rate : £ =$1.68 • Is there an arbitrage opportunity? Compute the profit using $? Fb S a 1 iha 1 i fa fb • Fb> fa: company can gain in the foreign exchange, by selling foreign currency at forward rate • Borrow in foreign currency Fa S b 1 ihb 1 i fb fa • Fa fb: company can gain in the foreign exchange, by buying foreign currency at forward rate 30 32 INTEREST RATE PARITY - IRP INTEREST RATE PARITY - IRP • Suppose the annualized interest rate on 180-day GBP deposits is 67/16-5/16%, meaning that GBP can borrowed at 67/16% (ask rate) and lent at 65/16% (bid rate) At the same time, the annualized interest rate on 180-day AUD deposits is 3/8-1/8%, spot rate and 180 day forward quotes on AUD are £0.4706-80/AU$ and £0.4811-75/AU$ respectively Is there an arbitrage opportunity? Compute the profit • • Covered cost and arbitrage opportunity American company will pay €100.000 due in 180 days They can one of two ways as follows: – Negotiating 180 day forward contract – Investing in money market, borrow USD -> convert to Euro -> invest Euro at r can get € 100.000 in 180 days – Compare technical term and make a decision EX.: American company have to pay € 100,000 to German company due in 180 days Company want to expose this payment Suppose, Spot rate: $1.14/ €, and 180 day-Forward rate: $1.24/€ Interest in European money market: 8%/year for $ and 10%/year for € 33 INTEREST RATE PARITY - IRP 35 IMPACT OF ARBITRAGE ON AN MNC’S VALUE • Suppose the annualized interest rate on EUR deposits is 77.5%, meaning that EUR can borrowed at 7.5% (ask rate) and lent at 7% (bid rate) At the same time, the annualized interest rate on USD deposits is 91/4-3/4%, spot rate and one year forward rate quotes on EUR are 1.2320-60$/€ and 1.2430-80$/€ respectively Is there an arbitrage opportunity? Compute the profit 34 Forces of Arbitrage m E CFj , t E ER j , t n Value = j 1 t 1 k t =1 E (CFj,t ) = expected cash flows in currency j to be received by the U.S parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent 36 ... the annualized interest rate on 180-day GBP deposits is 67 / 16- 5/ 16% , meaning that GBP can borrowed at 67 / 16% (ask rate) and lent at 65 / 16% (bid rate) At the same time, the annualized interest... – Ask $1.84/1BP – Ask $0 .64 /1SF – Bid $1.81/1BP – Bid $0 .60 /1SF • London Bank quotes: • Berlin Bank quotes: – Ask $1.89/1BP – Ask $0 .66 /1SF – Bid $1. 86/ 1BP – Bid $0 .62 /1SF Generally speaking,... Citibank: $1.4341-1.4372/€ Eurobank SF 250 Zurich €0 .67 77-97/$ €0 .62 18-58/SFr Ps 1.000 Divided by Ps4/SF $0.9050-0.9071/SFr Mexico UBS SFr1.1024-53/$ SFr1 .60 10-40/€ Buy these SFr in Zurich at Ps4/SF 21