FOREIGN EXCHANGE MARKET. Luigi Vena 05/08/2015 Liuc Carlo Cattaneo
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1 FOREIGN EXCHANGE MARKET Luigi Vena 05/08/2015 Liuc Carlo Cattaneo
2 TABLE OF CONTENTS The FX market Exchange rates Exchange rates regimes Financial balances International Financial Markets 05/08/2015 Coopeland ch. 1, 2 and 8
3 The FX market As every markets, the market for foreign currency can be viewed as the place where supply and demand of foreign currency meet.
4 The FX market The foreign exchange market, or simply Forex or FX, is a global decentralize. The FX market is the place where people exchange currencies. The FX market operates on several levels: The Interbank FX market; The Corporate and retail FX market.
5 FX market structure Traders as well as market makers are geographically dispersed. They are linked by: Voice brokers; Direct dealing through telephone conversations. Quotations are distributed over proprietary systems and typically for indications.
6 FX market structure General Motors Microsoft Motorola Chase Bank Dealer Deutsche Bank Dealer Broker Barclay s Bank Credit Suisse Bank of Tokyo Bank of America
7 FX market structure It is geographically dispersed It is a dealer market Open 24 hours a day There is price dispersion Highly customized products
8 Daily average in billion US$ FX market size
9 Daily volumes by location Germany 02% Others 13% Denmark 02% France 03% Australia 04% UK 37% Hong Kong 05% Switzerland 05% Singapore 05% Japan 06% US 18%
10 Daily volumes by location
11 Percentage shares of average daily turnover Daily volumes by currency
12 Turnover by currency pair % 27.7% $ pairs 84.9% pairs 39.1% % % 6.3% 4.2% 4.6% 2.8% 2.7% 1.8% 4.1% 3.7%
13 Main roles of the FX market Medium of exchange The foreign exchange market facilitates trades in goods and services; Medium of exchange It facilitates purchase and sale of securities. Medium of risk management It helps to redenominate and manage currency risk in asset stock or liability positions.
14 Main roles of the FX market Who are the suppliers or demanders of the foreign currency? 1. Exporters: they are paid with the foreign currency and therefore the need to convert it. 2. Foreign investors: British investors exchange pounds for dollars so as to buy shares in Apple. 3. Speculators: they operate in the FX markets aiming to obtain profit from the trading activity.
15 What is an exchange rate? The first thing to understand about an exchange rate is that it is simply a price. While it is normal to talk of the price of books rather than the price of money, there is no normal way to express an exchange rate. Indeed, the same exchange rate can be expressed in the following way: EUR/USD=1.0758, that is 1EUR=1.0758USD USD/EUR=0.9295, that is 1USD=0.9295EUR
16 What is an exchange rate? The bilateral exchange rate is defined as the price of the foreign currency in units of the domestic currency. In other words, the exchange rates defines the number of foreign currency units purchasable with one domestic currency unit. The bilateral exchange rate between, say, the UK and the USA, is the price of dollars in terms of pounds.
17 What is an exchange rate? Suppose that the EUR/USD= How many dollars can you buy with 100 euros? How many euros can you buy with 100 dollars? What if the exchange rate rises to 1.11? What if the exchange rate decline to 1?
18 What is an exchange rate? The cross exchange rate is an exchange rate between the two currencies A and B, computed through the currency C. It can be computed as the ratio of the exchange rate of A to C, divided by the exchange rate of B to C. A B = A/C B/C
19 What is an exchange rate? Suppose that: /$=1.0796, that is 1 =1.0796$ /$=1.5044, that is 1 =1.5044$ The exchange rate / equals
20 Types of exchange rates Floating rates: A completely flexible (or floating rates) is the one whose level is solely determined by the market demand and supply. Therefore, there is not any outside intervention. Example. As the import grows, the demand (supply) of foreign (domestic) currency increases too. All else equal the greater the demand the greater will be the clearing market exchange rate.
21 Types of exchange rates Floating rates The EUR/USD example
22 Types of exchange rates Fixed rates The excessive volatility of the exchange rate may be hurtful. For this reason sometimes governments want the exchange rates not to vary. They can do this imposing restrictions on dealing, or intervening directly on the market Fixing the interest rate implies surrendering control of the domestic money stock.
23 Types of exchange rates Fixed rates The USD/CNY example
24 Types of exchange rates Managed exchange rates Between the two boundaries represented by the freely and the fixed rate, there is the compromise of the managed floating exchange rates. This time the authorities sometimes intervene on the market, fixing the exchange rate, sometimes decide to remain on the sideline.
25 Types of exchange rates Managed rates example
26 Types of exchange rates In general the regimes can be classified on the basis of the foreign currency reserves. Under a pure float regimes, reserves are constant. Under a managed regimes, reserves vary on a constant basis but remain constantly around a broad level. Under a fixed regimes, reserves must carry the burden of the exchange rate fluctuations. Therefore, the reserves probably exhibit swings up or down.
27 Types of exchange rates Fixed exchange rate and foreign currency reserves.
28 FX vocabulary Appreciation vs Depreciation Because every exchange rate involves two currencies Appreciation of currency A against B Depreciation of currency B against A
29 FX vocaabulary Appreciation vs Depreciation Example Change from /$=1.30 to /$=1.00 (alternatively expressed as change from =1$ to 1 =1$) Appreciation of dollar against euro or, alternatively, depreciation of euro against dollar.
30 FX vocabulary Appreciation vs Depreciation Exact percentage measures depend on the base rate. x% depreciation of the Mexican peso means x% more pesos to buy 1$ y% appreciation of the US$ means y% fewer dollars to buy 1 peso.
31 FX vocabulary Sometimes exchange rates are indicated as follow: 4MP/$, that is 1dollar for 4 Mexican pesos. Therefore change from 4MP/$ to 8 MP/$ means an appreciation (depreciation) of dollar (Mexican peso) against Mexican peso (dollar). From 4MP/$ to 8 MP/$ means a 100% depreciation of the Mexican peso, that is a 50% appreciation the US dollar.
32 FX contracts Spot exchange rates It is an exchange of two currencies for immediate delivery. They involve the delivery of currency immediately after the bargain is struck. In other words, it is the rate figuring in agreements to exchange one currency for another more or less immediately.
33 FX contracts Forward exchange rates It is the exchange rate agreed today for obligatory delivery at a specified time in the future. No exchange of funds on agreement day, or at any time until the settlement date. Quoting conventions: Outright % premium or discount relative to spot
34 FX contracts Forward exchange rate example On 05/08/15 buy 1,000,000 1-month forward at $1.60/. On 06/08/15 (settlement date) when spot pound is $1.55: Take delivery of 1,000,000, pay out $1,600,000; Cash settle, pay $50,000 to cancel the obligation
35 Covered interest rate parity Spot and forward exchange rates are linked by a noarbitrage relation. The forward exchange rate depends on three known variables: The spot exchange rate (S); The domestic interest rate (r); The foreign interest rate (r*);
36 Covered interest rate parity In order to avoid risk-free arbitrage opportunity the following relation must hold: 1 + r = F S (1 + r ) The following allows for no-arbitrage opportunities since the return in domestic deposits equals the return in foreign deposits.
37 Covered interest rate parity 1 + r = F S (1 + r ). Reorganizing 1 + r = 1 + f (1 + r ) Where 1 + f = F is known as the forward premium S (discount) that is the proportion by which a country s forward exchange rate exceeds its spot rate.
38 FX vocabulary Direct quotations: the exchange rate expresses the number of domestic currency units purchasable with a foreign currency unit. (In US the direct quote for Euro is $1.0796= 1) Indirect quotations: the exchange rate expresses the number of foreign currency units purchasable with a domestic currency unit. (In US the indirect quote for Euro is $1= )
39 Exercise Fill in the blank based on the following quotes: Currency US $ Equivalent Currency per $ Yen Euro ( ) Canadian $ Equivalent of $4,000 $Equivalent of 6,000 units of foreign currency GB pounds ( ) $9,633,91 Swiss Franc Chinese Yuan Indian Rupee 181,405.90
40 Exercise Based on the quotes around a one year interval, determine the extent to which USD and the foreign currency appreciated or depreciated during the period Currency 5/8/201X 5/8/20X+1 USD/JPY % appreciation/ depreciation of USD % appreciation/ depreciation of foreign currency EUR/USD USD/CNY AUD/USD
41 FX dealers behavior Quoting behavior There is little evidence of quote shading as a tool for inventory control in interbank trades; Quote shading: raising quotes when dealer is below the desired inventory level and lowering quotes when above; Dealer does not want to give away information about his position to other interbank dealers. Inventory controls Dealers regains desired inventory level quickly (5/6 minutes) by actively initiating trades at other dealers quotes.
42 Exchange rate - focus Since the FX market is a dealer market we have: Bid rate (Price). It is the price of currency A in terms of currency B at which dealers buy currency A (or sell the currency B). Ask rate (Price). It is the price of currency A in terms of currency B at which dealers sell currency A (or buy currency B). The difference between the bid and ask rate is the so called bid-ask spread.
43 Exchange rate - focus The bid-ask spread measures the cost of liquidity services The bid-ask spread can varies on a constant basis The bid-ask spread increases when the volatility in the spot rate increases too, and decreases when more dealers are in the market. The bid ask spread increases at the start of the trading day (due to the investors feelings ) The bid-ask spread increases at the end of the trading day (due to the inventory adjustment)
44 Exchange rate - focus Since one can buy one currency by simultaneously selling one another, the ask price of currency A in terms of currency B is the reciprocal of the bid price of currency B in terms of currency A and vice versa. In formula: where: S a A B = 1 S b (B A) S(A/B) the price of B in terms of A S a and S b, respectively, the ask and bid rates
45 Exercise Given the following bid and ask (direct) quotations, please compute the respective indirect quotes. Bid Ask Bid Ask EUR (Euro) JPY (Yen)
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